form10-q.htm



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
 (Mark One)

x
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2011
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
 
(I.R.S. Employer
incorporation or organization)
 
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)

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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act

Large accelerated filer x
Accelerated filer o
Non-accelerated filer  o
Smaller reporting company o
   
(Do not check if a smaller reporting company)
 

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

As of October 27, 2011 there were 42,794,820 shares of the registrant’s common stock, par value $.01 per share, outstanding.

 
 

 
 
WELLCARE HEALTH PLANS, INC.

TABLE OF CONTENTS

 
Page
Part I — FINANCIAL INFORMATION
 
   
   
Item 1.
Financial Statements
 
     
 
Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2011 and 2010 (unaudited)
 
Condensed Consolidated Balance Sheets at September 30, 2011 and December 31, 2010 (unaudited)
 
Condensed Consolidated Statements of Cash Flows for the three and nine months ended September 30, 2011 and 2010  (unaudited)
 
Notes to Condensed Consolidated Financial Statements (unaudited)
     
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
     
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
     
Item 4.
Controls and Procedures
     
Part II — OTHER INFORMATION
 
     
Item 1.
Legal Proceedings
     
Item 1A.
Risk Factors
     
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
     
Item 6.
Exhibits
     
 
Signatures
 
 
 
1


Part I — FINANCIAL INFORMATION
Item 1. Financial Statements.
 
WELLCARE HEALTH PLANS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands, except per share data)
 
 
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
    2011     2010     2011     2010  
Revenues:
                       
Premium (see Note 1)
  $ 1,541,926     $ 1,385,874     $ 4,499,686     $ 4,077,269  
Investment and other income
    2,433       2,299       7,050       7,506  
Total revenues
    1,544,359       1,388,173       4,506,736       4,084,775  
Expenses:
                               
Medical benefits
    1,197,008       1,147,107       3,626,342       3,435,870  
Selling, general and administrative
    178,405       142,712       512,415       701,691  
Medicaid premium taxes (see Note 1)
    18,869       18,950       55,838       38,078  
Depreciation and amortization
    6,453       6,123       19,824       17,770  
Interest
    3,648       117       3,823       160  
Total expenses
    1,404,383       1,315,009       4,218,242       4,193,569  
Income (loss) before income taxes
    139,976       73,164       288,494       (108,794 )
Income tax expense (benefit)
    51,721       30,248       109,309       (29,257 )
Net income (loss)
  $ 88,255     $ 42,916     $ 179,185     $ (79,537 )
                                 
Net income (loss) per common share (see Note 1):
                               
Basic
  $ 2.06     $ 1.01     $ 4.19     $ (1.88 )
Diluted
  $ 2.03     $ 1.00     $ 4.14     $ (1.88 )


See notes to unaudited condensed consolidated financial statements.
 
 
2


WELLCARE HEALTH PLANS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands, except share data)


   
September 30,
   
December 31,
   
2011
   
2010
Assets
           
Current Assets:
           
Cash and cash equivalents
  $ 1,787,733     $ 1,359,548  
Investments
    217,033       108,788  
Premium receivables, net
    223,826       127,796  
Funds receivable for the benefit of members
          33,182  
Income taxes receivable
          9,973  
Prepaid expenses and other current assets, net
    139,724       114,492  
Deferred income tax asset
    41,770       61,392  
  Total current assets
    2,410,086       1,815,171  
Property, equipment and capitalized software, net
    87,005       76,825  
Goodwill
    111,131       111,131  
Other intangible assets, net
    10,279       11,428  
Long-term investments
    79,850       62,931  
Restricted investments
    64,772       107,569  
Non-current deferred income tax asset
    50,931       58,340  
Other assets
    5,271       3,898  
Total Assets
  $ 2,819,325     $ 2,247,293  
Liabilities and Stockholders' Equity
               
Current Liabilities:
               
Medical benefits payable
  $ 757,102     $ 742,990  
Unearned premiums
    275,757       67,383  
Accounts payable
    6,839       8,284  
Other accrued expenses and liabilities
    193,586       199,033  
Current portion of amounts accrued related to investigation resolution
    43,932       121,406  
Current portion of long-term debt (see Note 4)
    9,375        
Other payables to government partners
    76,672       46,605  
Income taxes payable
    28,222        
Funds held for the benefit of members
    40,875        
Total current liabilities
    1,432,360       1,185,701  
Amounts accrued related to investigation resolution
    100,915       216,136  
Long-term debt (see Note 4)
    138,750        
Subordinated notes (see Note 4)
    111,946        
Other liabilities
    10,597       13,410  
Total liabilities
    1,794,568       1,415,247  
Commitments and contingencies (see Note 7)
           
Stockholders' Equity:
               
         Preferred stock, $0.01 par value (20,000,000 authorized, no shares issued or outstanding)
           
         Common stock, $0.01 par value (100,000,000 authorized, 42,793,466 and 42,541,725 shares 
             issued and outstanding at September 30, 2011 and December 31, 2010, respectively)
    428       425  
Paid-in capital
    441,860       428,818  
Retained earnings
    584,296       405,112  
Accumulated other comprehensive loss
    (1,827 )     (2,309 )
Total stockholders' equity
    1,024,757       832,046  
Total Liabilities and Stockholders' Equity
  $ 2,819,325     $ 2,247,293  


See notes to unaudited condensed consolidated financial statements.

 
3


WELLCARE HEALTH PLANS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)


   
Nine Months Ended
   
September 30,
   
2011
   
2010
Cash from (used in) operating activities:
           
Net income (loss)
  $ 179,185     $ (79,537 )
Adjustments to reconcile net income (loss) to net cash provided by (used in)
               
operating activities:
               
Depreciation and amortization
    19,824       17,770  
Equity-based compensation expense
    13,160       8,655  
Incremental tax benefit from equity-based compensation
    (2,518 )      
Deferred taxes, net
    27,032       (67,386 )
Changes in operating accounts:
               
Premium receivables, net
    (96,030 )     (24,190 )
Prepaid expenses and other current assets, net
    (25,232 )     (17,027 )
Medical benefits payable
    14,112       (98,851 )
Unearned premiums
    208,374       (24,504 )
Accounts payable and other accrued expenses
    (2,967 )     (43,635 )
Other payables to government partners
    30,067       4,300  
Amounts accrued related to investigation resolution
    (80,749 )     249,915  
Income taxes, net
    36,995       7,594  
Other, net
    (2,240 )     (5,088 )
Net cash provided by (used in) operating activities
    319,013       (71,984 )
Cash from (used in) investing activities:
               
Purchases of investments
    (332,934 )     (117,903 )
Proceeds from sale and maturities of investments
    208,758       114,726  
Purchases of restricted investments
    (26,118 )     (18,386 )
Proceeds from maturities of restricted investments
    68,712       24,298  
Additions to property, equipment and capitalized software, net
    (30,773 )     (16,192 )
Net cash used in investing activities
    (112,355 )     (13,457 )
Cash from (used in) financing activities:
               
Proceeds from debt, net of issuance costs
    147,747        
Payments on debt
    (1,875 )      
Proceeds from option exercises and other
    4,624       1,091  
Incremental tax benefit from equity-based compensation
    2,518        
Purchase of treasury stock
    (3,538 )     (4,420 )
Payments on capital leases
    (2,006 )     (935 )
Funds held for the benefit of members
    74,057       22,589  
Net cash provided by financing activities
    221,527       18,325  
Cash and cash equivalents:
               
Increase (decrease) during period
    428,185       (67,116 )
Balance at beginning of year
    1,359,548       1,158,131  
Balance at end of period
  $ 1,787,733     $ 1,091,015  
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
               
Cash paid for taxes
  $ 46,109     $ 35,686  
Cash paid for interest
  $ 697     $ 183  
Equipment acquired through capital leases
  $     $ 8,868  
Issuance of subordinated notes
  $ 112,500     $  


See notes to unaudited condensed consolidated financial statements.

 
4


WELLCARE HEALTH PLANS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited, in thousands, except member, per share and share data)

1. ORGANIZATION, BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES
 
        WellCare Health Plans, Inc., a Delaware corporation (the “Company,” “we,” “us,” or “our”), provides managed care services exclusively to government-sponsored health care programs, serving approximately 2,410,000 members as of September 30, 2011. Through our licensed subsidiaries, as of September 30, 2011, we operate our Medicaid health plans in Florida, Georgia, Hawaii, Illinois, Missouri, New York and Ohio, and our Medicare Advantage (“MA”) coordinated care plans (“CCPs”) in Connecticut, Florida, Georgia, Hawaii, Illinois, Indiana, Louisiana, Missouri, New Jersey, New York, Ohio and Texas. We also operate a stand-alone Medicare prescription drug plan (“PDP”) in 49 states and the District of Columbia. We exited the Medicare private fee-for-service ("PFFS") program on December 31, 2009.

The Kentucky Cabinet for Health and Family Services has awarded us a contract to serve the commonwealth’s Medicaid program in seven of the commonwealth’s eight regions. We began serving approximately 117,000 beneficiaries across these seven regions on November 1, 2011. Our contract is for three years and may be extended for up to four one-year extension periods upon mutual agreement of the parties. Under this new program, we coordinate medical, behavioral and dental health care for eligible Kentucky Medicaid beneficiaries in the Temporary Assistance for Needy Families (“TANF”), Children’s Health Insurance Programs (“CHIP”) and aged, blind and disabled (“ABD”) programs.

Basis of Presentation & Use of Estimates
 
        The accompanying unaudited condensed consolidated interim financial statements should be read in conjunction with the consolidated financial statements and notes thereto for the fiscal year ended December 31, 2010 included in our Annual Report on Form 10-K (“2010 Form 10-K”), filed with the United States Securities and Exchange Commission (the “SEC”) in February 2011.  In the opinion of management, the interim financial statements reflect all normal recurring adjustments that we consider necessary for the fair presentation of our financial position, results of operations and cash flows for the interim periods presented. The interim financial statements included herein have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. These estimates are based on knowledge of current events and anticipated future events and accordingly, actual results may differ from those estimates. Results for the interim periods presented are not necessarily indicative of results that may be expected for the entire year or any other interim period. Certain items in our financial statements have been reclassified from their prior year classifications to conform to our current year presentation. We have evaluated all material events subsequent to the date of these financial statements.

 
5

 
Significant Accounting Policies

Net Income (Loss) Per Share

We compute basic net income (loss) per common share on the basis of the weighted-average number of unrestricted common shares outstanding. Diluted net income (loss) per common share is computed on the basis of the weighted-average number of unrestricted common shares outstanding plus the dilutive effect of outstanding stock options, restricted shares and restricted stock units using the treasury stock method.  The following table presents the calculation of net income (loss) per common share — basic and diluted:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
    2011     2010     2011     2010
                         
Numerator:
                       
Net income (loss)
  $ 88,255     $ 42,916     $ 179,185     $ (79,537 )
Denominator:
                               
Weighted-average common shares outstanding — basic
    42,887,381       42,411,455       42,757,476       42,313,973  
Dilutive effect of:
                               
Unvested restricted stock, restricted stock units and
                               
performance stock units
    334,613       244,024       338,947       -  
Stock options
    202,420       84,890       189,546       -  
Weighted-average common shares outstanding — diluted
    43,424,414       42,740,369       43,285,969       42,313,973  
                                 
Net income (loss) per common share:
                               
Basic
  $ 2.06     $ 1.01     $ 4.19     $ (1.88 )
Diluted
  $ 2.03     $ 1.00     $ 4.14     $ (1.88 )
 
For the three and nine months ended September 30, 2011, respectively, 13,586 and 19,334 restricted equity awards and 73,546 and 81,234 options with exercise prices ranging from $41.24 to $90.52 and $36.39 to $90.52 were excluded from diluted weighted-average common shares outstanding. For the three months ended September 30, 2010, 102,000 restricted equity awards and 971,121 options with exercise prices ranging from $19.38 to $91.64 were excluded from diluted weighted-average common shares outstanding. Due to the net loss for the nine months ended September 30, 2010, 2,444,257 equity awards were excluded from the computation of diluted loss per share because the effect of their inclusion would be anti-dilutive.

Premium Revenue Recognition

We receive premiums from state and federal agencies for the members that are assigned to, or have selected, us to provide health care services under Medicaid and Medicare. The premiums we receive for each member vary according to the specific government program and are generally determined at the beginning of the contract period. These premiums are subject to adjustment throughout the term of the contract by the Centers for Medicare & Medicaid Services (“CMS”) and the states, although such adjustments are typically made at the commencement of each new contract renewal period. Annual rate changes are recorded when they become effective.

Our Medicaid contracts with state governments are generally multi-year contracts subject to annual renewal provisions. Our MA and PDP contracts with CMS generally have terms of one year.

In most cases we receive premiums in advance of providing services, and we recognize premium revenues in the period in which we are obligated to provide services to our members. We are paid generally in the month in which we provide services. Premiums collected in advance of the period in which we are obligated to provide services to our members are deferred and reported as Unearned premiums in the accompanying Condensed Consolidated Balance Sheets and amounts that have not been received by the end of the period remain on the Condensed Consolidated Balance Sheets classified as Premium receivables.

We routinely monitor the collectability of specific accounts, the aging of receivables and historical retroactivity trends, as well as prevailing and anticipated economic conditions, and reflect any required adjustments in current operations. We estimate, on an ongoing basis, the amount of member billings that may not be fully collectible or that will be returned based on historical collection experience, retroactive membership adjustments, compliance with requirements for certain contracts to expend a minimum percentage of premiums on eligible medical expenses, and other factors. An allowance is established for the estimated amount that may not be collectible and a liability is established for premium expected to be returned. The allowance has not been significant to premium revenue.
 
 
6

 
Premium payments that we receive are based upon eligibility lists produced by the government. We verify these lists to determine whether we have been paid for the correct premium category and program. From time to time, the states or CMS require us to reimburse them for premiums that we received based on an eligibility list that a state, CMS or we later discover, through our audits or otherwise, contains individuals who were not eligible for any government-sponsored program, have been enrolled twice in the same program, or belong to a different health plan other than ours. The verification and subsequent membership changes may result in additional amounts due to us or we may owe premiums back to the government. The amounts receivable or payable identified by us through reconciliation and verification of agency eligibility lists relate to current and prior periods. The amounts receivable from government agencies for reconciling items were $37,003 and $270 at September 30, 2011 and December 31, 2010, respectively, and are included in Premium receivables, net, on our Condensed Consolidated Balance Sheets. The amounts due to government agencies for reconciling items were $7,718 and $63,289 at September 30, 2011 and December 31, 2010, respectively, and are included in Other accrued expenses and liabilities on our Condensed Consolidated Balance Sheets. The Georgia Department of Community Health (“DCH”) has made premium adjustments in the current and preceding quarters retroactive to the beginning of the program in 2006 for overpayments related to a reconciliation of duplicate member records. In accordance with the policy stated above, we routinely identify and accrue an estimated liability for overpayments that we believe will be returned to Georgia DCH. Considering the adjustments to historical capitation premium rates that the Georgia DCH is making for the periods affected by duplicative enrollment, the net impact to premium revenue resulting from the adjustments was immaterial to the Condensed Consolidated Statement of Operations for the three and nine months ended September 30, 2011.
 
We record adjustments to revenues based on member retroactivity. These adjustments reflect changes in the number and eligibility status of enrollees subsequent to when revenue was billed. We estimate the amount of outstanding retroactivity adjustments 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. Changes in member retroactivity adjustment estimates had a minimal impact on premiums recorded during the periods presented. Our government contracts establish monthly rates per member that varies based on member demographics such as age, gender or medical history.

In certain states, including Georgia, we are eligible to receive supplemental payments for newborns and/or obstetric deliveries. During the three months ended September 30, 2011, we recognized approximately $14,071 in premium revenue related to certain retrospective maternity claims from 2010 and earlier 2011 periods, following a recent change that the Georgia DCH made in its methodology for accepting qualifying maternity claims.

Risk-Adjusted Premiums
 
       CMS employs a risk-adjustment model to determine the premium amount it pays for each MA member.  This model apportions premiums paid to all MA plans according to the health status of each beneficiary enrolled. As a result, our CMS monthly premium payments per member may change materially, either favorably or unfavorably. The CMS risk-adjustment model pays more for Medicare members with predictably higher costs. Diagnosis data from inpatient and ambulatory treatment settings are used to calculate the risk-adjusted premiums we receive. We collect claims and encounter data and submit the necessary diagnosis data to CMS within prescribed deadlines. After reviewing the respective submissions, CMS establishes the premium payments to MA plans generally at the beginning of the calendar year, and then adjusts premium levels on two separate occasions on a retroactive basis. The first retroactive adjustment for a given fiscal year generally occurs during the third quarter of such fiscal year. This initial settlement (the "Initial CMS Settlement") represents the updating of risk scores for the current year based on the severity of claims incurred in the prior fiscal year. CMS then issues a final retroactive risk-adjusted premium settlement for that fiscal year in the following year (the "Final CMS Settlement"). We reassess the estimates of the Initial CMS Settlement and the Final CMS Settlement each reporting period and any resulting adjustments are made to MA premium revenue. 
 
       We develop our estimates for risk-adjusted premiums utilizing historical experience and predictive models as sufficient member risk score data becomes available over the course of each CMS plan year. Our models are populated with available risk score data on our members. Risk premium adjustments are based on member risk score data from the previous year. Risk score data for members who entered our plans during the current plan year, however, is not available for use in our models; therefore, we make assumptions regarding the risk scores of this subset of our member population. All such estimated amounts are periodically updated as additional diagnosis code information is reported to CMS and adjusted to actual amounts when the ultimate adjustment settlements are either received from CMS or we receive notification from CMS of such settlement amounts. Our risk adjusted premiums receivable was $30,942 as of September 30, 2011 and $56,353 as of December 31, 2010.
 
       As a result of the variability of factors that determine such estimates, including plan risk scores, the actual amount of the CMS retroactive payment could be materially more or less than our estimates. Consequently, our estimate of our plans’ risk scores for any period, and any resulting change in our accrual of MA premium revenues related thereto, could have a material adverse effect on our results of operations, financial position and cash flows. Historically, we have not experienced significant differences between the amounts that we have recorded and the revenues that we ultimately receive. The data provided to CMS to determine the risk score is subject to audit by CMS even after the annual settlements occur. These audits may result in the refund of premiums to CMS previously received by us.  While our experience to date has not resulted in a material refund, this refund could be significant in the future, which would reduce our premium revenue in the year that CMS determines repayment is required. 

 
7


Medical Benefits Payable and Expense 

The cost of medical benefits is recognized in the period in which services are provided and includes an estimate of the cost of incurred but not reported (“IBNR”) medical benefits. Medical benefits payable has two main components: direct medical expenses and medically-related administrative costs. Direct medical expenses include amounts paid or payable to hospitals, physicians and providers of ancillary services, such as laboratories and pharmacies. Medically-related administrative costs include items such as case and disease management, utilization review services, quality assurance and on-call nurses, which are recorded in Selling, general, and administrative expense. Medical benefits payable on our Consolidated Balance Sheets represents amounts for claims fully adjudicated awaiting payment disbursement and estimates for IBNR claims. The following table provides a reconciliation of the total medical benefits payable balances as of September 30, 2011 and December 31, 2010: 

   
September 30,
   
% of
 
December 31,
   
% of
   
2011
   
Total
 
2010
   
Total
                         
Claims adjudicated, but not yet paid
  $ 56,958       8 %   $ 50,879       7 %
IBNR
    700,144       92 %     692,111       93 %
Total medical benefits payable
  $ 757,102             $ 742,990          
 
The medical benefits payable estimate has been, and continues to be, our most significant estimate included in our financial statements. We historically have used and continue to use a consistent methodology for estimating our medical benefits expense and medical benefits payable. Our policy is to record management’s best estimate of medical benefits payable based on the experience and information available to us at the time. This estimate is determined utilizing standard actuarial methodologies based upon historical experience and key assumptions consisting of trend factors and completion factors using an assumption of moderately adverse conditions, which vary by business segment. These standard actuarial methodologies include using, among other factors, contractual requirements, historic utilization trends, the interval between the date services are rendered and the date claims are paid, denied claims activity, disputed claims activity, benefits changes, expected health care cost inflation, seasonality patterns, maturity of lines of business and changes in membership.
 
Changes in medical benefits payable estimates are primarily the result of obtaining more complete claims information and medical expense trend data over time. Volatility in members’ needs for medical services, provider claims submissions and our payment processes result in identifiable patterns emerging several months after the causes of deviations from assumed trends occur. Since our estimates are based upon per-member per-month (“PMPM”) claims experience, changes cannot typically be explained by any single factor, but are the result of a number of interrelated variables, all of which influence the resulting medical cost trend. Differences between actual experience and estimates used to establish the liability, which we refer to as prior period developments, are recorded in the period when such differences become known and have the effect of increasing or decreasing the reported medical benefits expense in such periods.

For the nine months ended September 30, 2011, medical benefits expense was impacted by approximately $154,757 of net favorable development related to prior years, of which $36,731 was recorded in the third quarter of 2011. For the nine months ended September 30, 2010, medical benefits expense was impacted by approximately $39,129 of net favorable development related to prior years, of which $6,882 was recorded in the third quarter of 2010. The net favorable prior year development during the 2011 periods results primarily from unusually low utilization in our Medicaid segment.  The net amount of prior period developments in 2010 was primarily attributable to the reduction of the provision for moderately adverse conditions resulting from the exit of the PFFS product on December 31, 2009. The factors impacting the changes in the determination of medical benefits payable discussed above were not discernable in advance. The impact became clearer over time as claim payments were processed and more complete claims information was obtained.

 
8

 
Medicaid Premium Taxes

Certain state agencies place an assessment or tax on Medicaid premiums, which is included in the premium rates established in the Medicaid contracts with each applicable state agency.
 
In October 2009, Georgia stopped assessing taxes on Medicaid premiums remitted to us, which resulted in an equal reduction to Premium revenues and Medicaid premium taxes. Subsequently, in July 2010, Georgia resumed assessing premium taxes on Medicaid premiums. Therefore, from July 1, 2010 through September 30, 2011, we were assessed and remitted taxes on premiums in Georgia in addition to premium taxes in Hawaii, Missouri, New York and Ohio. Medicaid premium taxes incurred for the three and nine months ended September 30, 2011 were $18,869 and $55,838, respectively, compared to $18,950 and $38,078 for the three and nine months ended September 30, 2010, respectively.

Income Taxes

Our tax liability estimate is based on enacted tax rates, estimates of book-to-tax differences in income, and projections of income that will be earned in each taxing jurisdiction. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. A valuation allowance is recognized when, based on available evidence, it is more likely than not that the deferred tax assets may not be realized. After tax returns for the applicable year are filed, the estimated tax liability is adjusted to the actual liability per the filed state and federal tax returns. Historically, we have not experienced significant differences between our estimates of tax liability and our actual tax liability.

We sometimes face challenges from state and federal taxing authorities regarding the amount of taxes due. Positions taken on the tax returns are evaluated and benefits are recognized only if it is more likely than not that the position will be sustained on audit. Based on our evaluation of tax positions, we believe that potential tax exposures have been recorded appropriately. In addition, we are periodically audited by state and federal taxing authorities and these audits can result in proposed assessments. We believe that our tax positions comply with applicable tax law in all material aspects and, as such, will vigorously defend our positions on audit. We believe that we have adequately provided for any reasonably foreseeable outcome related to these matters. Although the ultimate resolution of these audits may require additional tax payments, it is not anticipated that any additional tax payments would have a material impact to our financial position, results of operations or cash flows. 

We are a member of the Internal Revenue Service (“IRS”) Compliance Assurance Program (“CAP”) for the 2011 tax year. The objective of CAP is to reduce taxpayer burden and uncertainty while assuring the IRS of tax return accuracy prior to filing, thereby reducing or eliminating the need for post-filing examinations.

Goodwill and Intangible Assets

We review goodwill and intangible assets for impairment at least annually, or more frequently if events or changes in our business climate occur that may potentially 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 perform our annual impairment test during the third quarter of each year based on information available as of the end of the second quarter, which generally coincides with the notification of contract renewals and/or finalization of federal and state contract negotiations and our initial budgeting process. As of our most recent testing date, we assessed the book value of goodwill and other intangible assets and determined that the fair value of these assets exceeds its carrying value and noted no indications that would require additional impairment testing as of September 30, 2011.

Recently Issued Accounting Standards
 
       In September 2011, the Financial Accounting Standards Board (the “FASB”) issued guidance that allows a qualitative assessment of whether the fair value of a reporting unit is less than its carrying amount. Based on the qualitative assessment, if it is more likely than not that the fair value of a reporting unit is less than its carrying value, the entity must then perform phase-one of the goodwill impairment test.  The entity however retains the option to forgo the qualitative assessment altogether and proceed directly to phase-one. Entities are permitted to make the election to perform the qualitative assessment on a period-by-period basis. This amended guidance will be effective prospectively for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The adoption of this guidance is not expected to have a material effect on our financial position or results of operations.

 
9

 
In July 2011, the FASB released new accounting guidance relating to mandated fees to be paid to the federal government by health insurers resulting from the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010. The guidance prescribes how to recognize and classify these fees in the statement of income. The guidance requires fees to be estimated and recorded in full as a liability once health insurers provide qualifying health insurance in the applicable year in which the fee is payable, with a corresponding charge to deferred cost. The deferred costs would then be amortized to expense using a straight line method of amortization, unless another method better allocates the fees. The new guidance is effective for calendar years beginning after December 31, 2013. We are unable to estimate the magnitude of this fee on our financial position or results of operations at this time.

In June 2011, the FASB issued new accounting guidance related to the presentation of other comprehensive income (“OCI”). This guidance eliminates the option to present components of OCI as part of the statement of changes in stockholders’ equity and comprehensive income, which is the option that we currently use to present OCI on an annual basis. The guidance allows us to present OCI using either a one- or two-statement approach. The guidance also requires us to present on the face of the financial statements any adjustments for items that are reclassified from OCI to net income. The guidance is effective for interim and annual periods beginning after December 15, 2011. The adoption of this guidance will not have an effect on our financial position or results of operations, but will only impact how certain information related to OCI is presented in the financial statements.
 
 
In May 2011, the FASB issued amendments to its accounting guidance related to fair value measurements in order to more closely align its disclosure requirements with those in International Financial Reporting Standards. This guidance clarifies the application of existing fair value measurement and disclosure requirements and also changes certain principles or requirements for measuring fair value or for disclosing information about fair value measurements. The guidance is effective for interim and annual periods beginning after December 15, 2011. The adoption of this guidance is not expected to have a material effect on our financial position or results of operations.

Recently Adopted Accounting Standards

In December 2010, the FASB issued new guidance on business combinations to clarify that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the prior annual reporting period and to include a description of the nature and amount of material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. This new guidance is effective prospectively for business combinations for which the acquisition date is on, or after, the beginning of the first annual reporting period beginning on or after December 15, 2010. Any future business combinations will be accounted for under this guidance. The adoption of this guidance did not have a material effect on our financial statements.

In December 2010, the FASB issued accounting guidance clarifying the requirement to test for goodwill impairment when the carrying amount of a reporting unit exceeds its fair value. Under this guidance, if the carrying amount of a reporting unit is zero or negative, an entity must assess whether any adverse qualitative factors exist that would indicate that goodwill impairment, more likely than not, exists. If it is determined that goodwill impairment would, more likely than not, be triggered, additional testing to determine whether goodwill has actually been impaired would be required and the amount of such impairment, if any, would accordingly be determined. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. The adoption of this guidance did not have a material effect on our financial statements.

We have reviewed all other recently issued accounting standards in order to determine their effects, if any, on our results of operations, financial position and cash flows. Based on that review, none of these pronouncements are expected to have a significant effect on our financial statements.

2. SEGMENT REPORTING
 
     Reportable operating segments are defined as components of an enterprise for which discrete financial information is available and evaluated on a regular basis by the chief operating decision-maker to determine how resources should be allocated to an individual segment and to assess performance of those segments. Accordingly, we have three reportable segments within our two main business lines: Medicaid, MA and PDP. Any residual impact of the PFFS product that we exited on December 31, 2009 is reported within the MA segment.

 
10

 
Medicaid
 
       Medicaid was established to provide medical assistance to low-income and disabled persons. It is state operated and implemented, although it is funded and regulated by both the state and federal governments. Our Medicaid segment includes TANF, Supplemental Security Income (“SSI”), ABD and state-based programs that are not part of the Medicaid program, such as CHIPs and Family Health Plus (“FHP”) for qualifying families who are not eligible for Medicaid because they exceed the applicable income thresholds. TANF generally provides assistance to low-income families with children; ABD and SSI generally provide assistance to low-income aged, blind or disabled individuals.

Medicare
 
        Medicare is a federal program that provides eligible persons age 65 and over and some disabled persons with a variety of hospital, medical and prescription drug benefits.

Medicare Advantage
 
        Our MA segment consists of MA plans, which, following our exit from the PFFS product on December 31, 2009, is comprised of CCPs. MA is Medicare’s managed care alternative to original Medicare fee-for-service (“Original Medicare”),  which provides individuals standard Medicare benefits directly through CMS. CCPs are administered through health maintenance organizations (“HMOs”) and generally require members to seek health care services, and select a primary care physician, from a network of health care providers. In addition, we offer Medicare Part D coverage, which provides prescription drug benefits, as a component of most of our MA plans.

As part of our MA segment, we continue to administer our expired PFFS plans including processing claims payments and providing member and provider services with respect to health care services provided prior to our exit from the PFFS program on December 31, 2009. As of September 30, 2011, the remaining medical benefits payable related to the PFFS program is not material relative to the total Medical benefits payable.

Prescription Drug Plans
 
        We offer stand-alone Medicare Part D coverage to Medicare-eligible beneficiaries in our PDP segment. The Medicare Part D prescription drug benefit is supported by risk sharing with the federal government through risk corridors designed to limit the losses and gains of the participating drug plans and by reinsurance for catastrophic drug costs. The government subsidy is based on the national weighted average monthly bid for this coverage, adjusted for risk factor payments. Additional subsidies are provided for dual-eligible beneficiaries and specified low-income beneficiaries. The Part D program offers national in-network prescription drug coverage that is subject to limitations in certain circumstances.

 
11

 
Segment Results
 
        We allocate goodwill, but no other assets, liabilities, investment and other income or expenses, other than medical benefits, to our reportable operating segments. A summary of financial information for our reportable operating segments as well as a reconciliation to Income (loss) before income taxes is presented in the table below.
 
  Three Months Ended     Nine Months Ended
 
September 30,
   
September 30,
  2011     2010     2011     2010
Premium revenue:
                     
Medicaid
$ 899,709     $ 854,893     $ 2,598,937     $ 2,464,624  
Medicare Advantage
  376,597       331,338       1,097,015       1,012,366  
PDP
  265,620       199,643       803,734       600,279  
Total premium revenue
  1,541,926       1,385,874       4,499,686       4,077,269  
                               
Medical benefits expense:
                             
Medicaid
  696,047       743,169       2,047,447       2,133,225  
Medicare Advantage
  304,649       260,890       879,744       795,906  
PDP
  196,312       143,048       699,151       506,739  
Total medical benefits expense
  1,197,008       1,147,107       3,626,342       3,435,870  
Gross margin:
                             
Medicaid
  203,662       111,724       551,490       331,399  
Medicare Advantage
  71,948       70,448       217,271       216,460  
PDP
  69,308       56,595       104,583       93,540  
Total gross margin
  344,918       238,767       873,344       641,399  
                               
Investment and other income
  2,433       2,299       7,050       7,506  
Other expenses
  (207,375 )     (167,902 )     (591,900 )     (757,699 )
Income (loss) before income taxes
$ 139,976     $ 73,164     $ 288,494     $ (108,794 )
 
3. EQUITY-BASED COMPENSATION
 
       Equity-based compensation expense is calculated based on awards ultimately expected to vest and has been adjusted to reflect our current estimate of forfeitures. We derive our forfeiture estimate at the time of grant and continuously reassess this estimate to determine if our assumptions are indicative of actual forfeitures.
 
       The compensation expense recorded related to our equity-based compensation awards, which correspondingly increased Paid-in capital, amounted to $3,285 and $13,160 for the three and nine months ended September 30, 2011, respectively, and $6,176 and $8,655 for the three and nine months ended September 30, 2010, respectively. As of September 30, 2011, there was $21,543 of unrecognized compensation cost related to non-vested equity-based compensation arrangements that is expected to be recognized over a weighted-average period of 1.6 years.
 
        A summary of our restricted stock, restricted stock unit (“RSU”) and stock option activity for the nine months ended September 30, 2011 is presented in the table below.
 
   
Restricted Stock
and RSU
   
Weighted Average
Grant-Date
Fair Value
   
Options
   
Weighted
Average
Exercise Price
 
                         
Outstanding as of January 1, 2011
    718,009     $ 28.69       1,008,757     $ 30.02  
Granted
    149,651  (1)     41.26       -       -  
Exercised
    -       -       (168,793 )     27.40  
Vested
    (300,975 )     29.38                  
Forfeited and expired
    (75,223 )     28.71       (54,491 )     54.36  
Outstanding at September 30, 2011
    491,462       32.10       785,473       28.89  
                                 
Exercisable at September 30, 2011
                    680,557       28.88  
Vested and expected to vest as of September 30, 2011
                    733,002       28.92  
____________
(1)
We granted 5,039 restricted share awards during the three months ended September 30, 2011.
 
12

 
Performance Stock Units

The Compensation Committee of our Board of Directors awards performance stock units (“PSUs”) under our long-term incentive program (“LTI Program”). PSUs generally cliff-vest approximately three years from the grant date and are subject to adjustment in the target range of 0% to 150%, based on the achievement of certain financial and quality-based performance goals set by the Compensation Committee over the performance period and conditioned on the employee’s continued service through the vest date. The actual number of PSUs that vest will be determined by the Compensation Committee at its sole discretion. As a result of the subjective nature of the PSUs, we have determined that, for accounting purposes, a mutual understanding of the key terms and conditions does not exist; and accordingly, these awards do not have an accounting grant date. The PSUs ultimately expected to vest will be recognized as expense over the requisite service period based on the estimated progress made towards the achievement of the pre-determined performance measures, as well as subsequent changes in the market price of our common stock since the awards do not have an accounting grant date. The compensation expense related to our PSUs and PSUs granted in the table below assume that targets will be met.

A summary of our PSU activity for the nine months ended September 30, 2011 is presented in the table below.
   
PSUs
       
Weighted
Average
Grant-Date
Fair Value
                   
Outstanding as of January 1, 2011
    144,801           $ 29.58  
Granted
    209,825   (1)            39.91  
Vested
    -               -  
Forfeited and expired
    (24,329 )             32.75  
Outstanding at September 30, 2011
    330,297               35.91  
                         
____________
(1)
We granted 3,345 PSUs during the three months ended September 30, 2011.

4. DEBT

Credit Agreement

On August 1, 2011, we entered into a $300,000 senior secured credit agreement (the “Credit Agreement”) that can be used for general corporate purposes. The Credit Agreement provides for a $150,000 term loan facility as well as a $150,000 revolving credit facility. Upon closing, we borrowed $150,000 pursuant to the term loan facility and incurred approximately $2,500 of debt issuance costs that have been deferred and will be amortized over the life of the agreement.

Both the term loan and revolving credit facility are set to expire in August 2016. Subject to adjustment for prepayments, the term loan will amortize in quarterly installments of $1,875 for the first four quarters, $3,750 for the next eight quarters, $5,625 for the next four quarters and $7,500 for the next three quarters, with the remaining balance due upon maturity. As of September 30, 2011, our remaining term loan balance was $148,125, which is included in the Current portion of long-term debt and Long-term debt line items in our Condensed Consolidated Balance Sheet.
 
        Our term loan currently bears interest at 2.25%. Loans designated by us at the time of borrowing as Alternate Base Rate (“ABR”) Loans that are outstanding under the credit facility bear interest at a rate per annum equal to (i) the greatest of (a) the prime rate in effect on such day; (b) the federal funds effective rate in effect on such day plus 1/2 of 1%; and (c) the adjusted London Inter-Bank Offered Rate (“Adjusted LIBOR”) for a one-month interest period on such day plus 1% plus (ii) the applicable margin. Loans designated by us at the time of borrowing as “Eurodollar Loans” that are outstanding under the credit agreement bear interest at a rate per annum equal to the Adjusted LIBOR for the interest period in effect for such borrowing plus the applicable margin. The “applicable margin” means a percentage ranging from 0.50% to 2.00% per annum for ABR Loans and a percentage ranging from 1.50% to 3.00% per annum for Eurodollar Loans, depending upon our ratio of total debt to consolidated earnings before interest, taxes, depreciation and amortization (“EBITDA”).
 
 
The Credit Agreement is subject to customary covenants and restrictions which, among other things, limit our ability to incur additional indebtedness. In addition, the Credit Agreement also includes certain financial covenants that require (a) a minimum ratio of total debt to consolidated EBITDA (as defined in the Credit Agreement); (b) a minimum interest expense and principal repayment coverage ratio; (c) a minimum level of statutory net worth for our HMO and insurance subsidiaries; and (d) a requirement to maintain cash in an amount equal to one year of payment obligations due and payable to the Department of Justice during the next twelve consecutive months, so long as such obligations remain outstanding.

The Credit Agreement also contains customary representations and warranties and events of default. The payment of outstanding principal under the Credit Agreement and accrued interest thereon may be accelerated and become immediately due and payable upon our default of payment or other performance obligations or our failure to comply with financial or other covenants in the Credit Agreement, subject to applicable notice requirements and cure periods as provided in the Credit Agreement.
 
As of the date of this filing, the revolving credit facility has not been drawn upon and we remain in compliance with all covenants.

Subordinated Notes

On September 30, 2011, we issued tradable unsecured subordinated notes having an aggregate par value of $112,500, with a fixed coupon of 6% and a maturity date of December 31, 2016. These notes were issued in connection with the stipulation and settlement agreement, which was approved in May 2011, to resolve the putative class action complaints previously filed against us in 2007. Interest of $2,815 was accrued as of September 30, 2011 and was retroactive to May 2011. The first interest payment is due in December 2011 and the next ten interest payments are due semi-annually, thereafter. The fair value of our subordinated notes is $111,946 and is included in the Subordinated notes line item in our Condensed Consolidated Balance Sheet as of September 30, 2011.

The subordinated notes contain certain events of default that will be triggered if (a) we default in payment of the principal or any interest on any note when such becomes due and payable; (b) we consolidate, merge or otherwise transfer our assets without the consent of the holders of the notes, other than as expressly permitted by the terms of the Indenture; (c) we fail to comply with any of our other covenants in the notes or the indenture and fail to cure such default within 60 days after we receive a notice of such default; (d) we (i) commence a voluntary bankruptcy proceeding; (ii) consent to the entry of an order for relief against us in an involuntary bankruptcy proceeding or the commencement of any case against us; or (iii) participate in certain other actions related to the relief of debtors; or (e) a court of competent jurisdiction enters a bankruptcy order that (i) is for relief against us in an involuntary proceeding, or adjudicates us insolvent or bankrupt; (ii) appoints any receiver, trustee or similar official for us or for any substantial part of our property; or (iii) orders the winding up or liquidation of us, and the order remains unstayed for 60 days. In addition, we agreed to not incur more than $425,000 of debt that is senior to the subordinated notes, while the subordinated notes remain outstanding. As of the date of this filing, we are not in default.
 
5. FAIR VALUE MEASUREMENTS
 
        Fair value measurements apply to all financial assets and financial liabilities that are being measured and reported on a fair value basis and are classified in one of the following three categories:  Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.
 
       Our Condensed Consolidated Balance Sheets include the following financial instruments: cash and cash equivalents, receivables, investments, accounts payable, amounts accrued related to the investigation resolution, long-term debt and subordinated notes.  The carrying amounts of current assets and liabilities approximate their fair value because of the relatively short period of time between the origination of these instruments and their expected realization.
 
 
14

 
Our Long-term investments include $41,650 and $46,150 of municipal note investments with an auction reset feature (“auction rate securities”), at par value, as of September 30, 2011 and December 31, 2010, respectively. Liquidity for these auction rate securities is typically provided by an auction process which allows holders to sell their notes and resets the applicable interest rate at pre-determined intervals, usually every seven or 35 days. Although we had auction rate securities that were redeemed during May 2011 by the issuer at par in the amount of $4,500, auctions continue to fail. An auction failure means that the parties wishing to sell their securities could not be matched with an adequate volume of buyers. As a result, our ability to liquidate and fully recover the carrying value of our remaining auction rate securities in the near term may be limited or non-existent. However, when there is a failed auction, the indenture governing the security requires the issuer to pay interest at a contractually defined rate that is generally above market rates for other types of similar instruments. We continue to receive interest payments on the auction rate securities we hold. Based on our analysis of anticipated cash flows, we have determined that it is more likely than not that we will be able to hold these securities until maturity or until market stability is restored.  Additionally, there are government guarantees or municipal bond insurance in place on the auction rate securities that we own. Therefore, we do not believe our auction rate securities are impaired and as a result, we have not recorded any impairment losses on these securities. However, as these securities are believed to be in an inactive market, we have estimated the fair value of these securities using a discounted cash flow model and update these estimates on a quarterly basis. Our analysis considered, among other things, the collateralization underlying the securities, the creditworthiness of the counterparty, the timing of expected future cash flows and the capital adequacy and expected cash flows of the subsidiaries that hold the securities. The estimated values of these securities were also compared, when possible, to valuation data with respect to similar securities held by other parties.

Our assets measured at fair value on a recurring basis subject to the disclosure requirements of fair value accounting guidance were as follows:
 
         
Fair Value Measurements at September 30, 2011:
         
Quoted Prices in
         
Significant
         
Active Markets for
   
Significant Other
   
Unobservable
   
September 30,
   
Identical Assets
   
Observable Inputs
   
Inputs
Description
 
2011
   
(Level 1)
   
(Level 2)
   
(Level 3)
Investments:
                       
Available-for-sale securities
                       
Municipal variable rate bonds
  $ 84,017     $ 84,017     $ -     $ -  
Variable rate bond fund
    50,000       50,000       -       -  
Money market funds
    41,720       41,720       -       -  
Corporate debt and other securities
    41,566       41,566       -       -  
Auction rate securities
    38,912       -       -       38,912  
Certificates of deposit
    24,404       24,404       -       -  
U.S. Government securities
    16,264       16,264       -       -  
Total investments
  $ 296,883     $ 257,971     $ -     $ 38,912  
Restricted investments:
                               
Available-for-sale securities
                               
Cash and cash equivalents
  $ 24,253     $ 24,253     $ -     $ -  
U.S. Government securities
    20,831       20,831       -       -  
Money market funds
    18,635       18,635       -       -  
Certificates of deposit
    1,053       1,053       -       -  
Total restricted investments
  $ 64,772     $ 64,772     $ -     $ -  
                                 
Amounts accrued related to investigation resolution(1)
  $ 144,847     $ -     $ 144,847     $ -  
                                 
Debt(2)
  $ 148,125     $ -     $ 148,125     $ -  
                                 
Subordinated notes(3)
  $ 111,946     $ -     $ 111,946     $ -  
 
 
15

 
         
Fair Value Measurements at December 31, 2010:
         
Quoted Prices in
         
Significant
         
Active Markets for
   
Significant Other
   
Unobservable
   
December 31,
   
Identical Assets
   
Observable Inputs
   
Inputs
Description
 
2010
   
(Level 1)
   
(Level 2)
   
(Level 3)
Investments:
                       
Available-for-sale securities
                       
Certificates of deposit
  $ 52,309     $ 52,309     $ -     $ -  
Auction rate securities
    42,245       -       -       42,245  
Municipal variable rate bonds
    29,120       29,120       -       -  
Corporate debt and other securities
    23,100       23,100       -       -  
Variable rate bond fund
    24,945       24,945       -       -  
Total investments
  $ 171,719     $ 129,474     $ -     $ 42,245  
Restricted investments:
                               
Available-for-sale securities
                               
Money market funds
  $ 54,908     $ 54,908     $ -     $ -  
Cash and cash equivalents
    27,581       27,581       -       -  
U.S. Government securities
    24,027       24,027       -       -  
Certificates of deposit
    1,053       1,053       -       -  
Total restricted investments
  $ 107,569     $ 107,569     $ -     $ -  
                                 
Amounts accrued related to investigation resolution(1)
  $ 337,542     $ -     $ 337,542     $ -  
____________
(1)
These amounts are included in the short- and long-term portions of amounts accrued related to investigation resolution line items in our Condensed Consolidated Balance Sheets as of September 30, 2011 and December 31, 2010, respectively.
(2)
This amount is included in the short- and long-term portions of Long-term debt line items in our Condensed Consolidated Balance Sheet as of September 30, 2011.
(3)
This amount is included in the Subordinated notes line item in our Condensed Consolidated Balance Sheet as of September 30, 2011.
 
The following tables present our auction rate securities measured at fair value on a recurring basis using significant unobservable inputs (i.e., Level 3 data) as of September 30, 2011 and 2010, respectively.

   
Fair Value Measurements Using Significant
   
Unobservable Inputs (Level 3)
   
Three Months Ended
   
Nine Months Ended
   
September 30,
   
September 30,
   
2011
   
2010
   
2011
   
2010
Beginning balance
  $ 38,745     $ 42,477     $ 42,245     $ 51,710  
Realized gains (losses) in earnings (or changes in net assets)
    -       -       -       -  
Unrealized gains (losses) in other comprehensive income(1)
    167       265       1,167       1,882  
Purchases, sales and redemptions(2)
    -       -       (4,500 )     (10,850 )
Transfers in and/or out of Level 3
    -       -       -       -  
Ending balance
  $ 38,912     $ 42,742     $ 38,912     $ 42,742  

____________
(1)
As a result of the increase in the fair value of our investments in auction rate securities, we recorded an unrealized gain to Accumulated other comprehensive loss which amounted to $167 and $265 during the three months ended September 30, 2011 and 2010, respectively, and $1,167 and $1,882 during the nine months ended September 30, 2011 and 2010, respectively.  The unrealized gain in both 2011 and 2010 was driven primarily by improvements in the municipal bond market during the year.
(2)
Auction rate securities were redeemed by the issuer at par in the amount of $4,500 during May 2011, $4,550 during May 2010 and $6,300 during March 2010. Accordingly, we recorded an adjustment to the fair market valuation of the issuers’ auction rate securities during each of the respective periods.

6. INCOME TAXES

Our effective income tax rate was 37.0% for the three months ended September 30, 2011 compared to 41.3% for the same period in the prior year. The effective tax rate was lower for the three months ended September 30, 2011 compared to the same period in 2010 primarily due to changes related to estimated non-deductible amounts associated with investigation resolution payments. Our effective income tax rate on pre-tax income was 37.9% for the nine months ended September 30, 2011 compared to 26.9% on pre-tax loss for the same period in the prior year. The comparability of the effective tax rates between the nine month periods ended 2011 and 2010 was impacted by the incurrence of a pre-tax loss in 2010. Additionally, the effective tax rate for the 2010 period was impacted by limitations on the deductibility of certain administrative expenses associated with the resolution of investigation-related matters.
 
 
16

 
We made payments of $87,500 in 2011 that were required in connection with an agreement to resolve certain class action complaints. Settlement payments are generally deductible when paid; therefore, the payment had the effect of decreasing the current portion of Deferred income tax assets as of September 30, 2011. There was no impact to the effective income tax rate since the settlement was included in the determination of taxable income in prior periods.

7. COMMITMENTS AND CONTINGENCIES

Government Investigations

Deferred Prosecution Agreement

We are currently operating under a Deferred Prosecution Agreement (the “DPA”) with the United States Attorney’s Office for the Middle District of Florida (the “USAO”) and the Florida Attorney General’s Office, resolving previously disclosed investigations by those offices.

Under the one-count criminal information (the “Information”) filed with the United States District Court for the Middle District of Florida (the “Federal Court”) by the USAO pursuant to the DPA, we were charged with one count of conspiracy to commit health care fraud against the Florida Medicaid Program in connection with reporting of expenditures under certain community behavioral health contracts, and against the Florida Healthy Kids programs, under certain contracts, in violation of 18 U.S.C. Section 1349. The USAO recommended to the Federal Court that the prosecution be deferred for the duration of the DPA. Within five days of the expiration of the DPA the USAO will seek dismissal with prejudice of the Information, provided we have complied with the DPA. The DPA expires in accordance with its terms in May 2012.

The DPA does not, nor should it be construed to, operate as a settlement or release of any civil or administrative claims for monetary, injunctive or other relief against us, whether under federal, state or local statutes, regulations or common law. Furthermore, the DPA does not operate, nor should it be construed, as a concession that we are entitled to any limitation of our potential federal, state or local civil or administrative liability. Pursuant to the terms of the DPA, we paid the USAO a total of $80,000 over the course of 2008 and 2009.

Civil Division of the United States Department of Justice

In October 2008, the Civil Division of the United States Department of Justice (the “Civil Division”) informed us that as part of its pending civil inquiry, it was investigating four qui tam complaints filed by relators against us under the whistleblower provisions of the False Claims Act, 31 U.S.C. sections 3729-3733. As previously disclosed, we also learned from a docket search that a former employee filed a qui tam action on October 25, 2007 in state court for Leon County, Florida against several defendants, including us and one of our subsidiaries (the "Leon County qui tam Action").

In June 2010, (i) the United States government filed its Notice of Election to Intervene in three of the qui tam matters (the “Florida Federal qui tam Actions”), and (ii) we announced that we reached a preliminary agreement with the Civil Division, the Civil Division of the USAO, and the Civil Division of the United States Attorney’s Office for the District of Connecticut to settle their pending inquiries. In April 2011, we entered into certain settlement agreements, described below, which will resolve the pending inquiries of the Civil Division, the USAO and the United States Attorney’s Office for the District of Connecticut (the “USAO Connecticut”). These settlement agreements are related to the Florida Federal qui tam Actions as well as another federal qui tam action that had been filed in the District of Connecticut (the “Connecticut Federal qui tam Action”) and the Leon County qui tam Action.

The settlement agreements are with (a) the United States, with signatories from the Civil Division, the Office of Inspector General of the Department of Health and Human Services (“OIG-HHS”) and the Civil Divisions of the USAO and the USAO Connecticut (the “Federal Settlement Agreement”) and (b) the following states (collectively, the “Settling States”): Connecticut, Florida, Georgia, Hawaii, Illinois, Indiana, Missouri, New York and Ohio (collectively, the “State Settlement Agreements”). The material terms of the Federal Settlement Agreement and the State Settlement Agreements are, collectively, substantively the same as the terms of the previously disclosed preliminary settlement with the Civil Division, the USAO and the USAO Connecticut. We have agreed, among other things, to pay the Civil Division $137,500 (the “Settlement Amount”), which is to be paid in installments over a period of up to 36 months after the effective date of the Federal Settlement Agreement (the “Payment Period”) plus interest accrued from December 2010 at the rate of 3.125% per year. The settlement includes an acceleration clause that would require immediate payment of the remaining balance of the Settlement Amount in the event that we are acquired or otherwise experience a change in control during the Payment Period. In addition, the settlement provides for a contingent payment of an additional $35,000 in the event that we are acquired or otherwise experience a change in control within three years of the effective date of the Federal Settlement Agreement and provided that the change in control transaction exceeds certain minimum transaction value thresholds as specified in the Federal Settlement Agreement.

 
17

 
In exchange for the payment of the Settlement Amount, the United States and the Settling States agreed to release us from any civil or administrative monetary claim under the False Claims Act and certain other legal theories for certain conduct that was at issue in their inquiries and the qui tam complaints. Likewise, in consideration of the obligations in the Federal Settlement Agreement and the Corporate Integrity Agreement (as described below under United States Department of Health and Human Services), OIG-HHS agreed to release and refrain from instituting, directing or maintaining any administrative action seeking to exclude us from Medicare, Medicaid and other federal health care programs.

The Federal Settlement Agreement has not been executed by one of the relators.  This relator has objected to the Federal Settlement Agreement.  Because of the objection, the Federal Court is required to conduct a hearing (a “Fairness Hearing”) to determine whether the proposed settlement is fair, adequate and reasonable under all the circumstances. The Federal Settlement Agreement and the State Settlement Agreements will not be effective until the earlier of (a) the execution of the Federal Settlement Agreement by the objecting relator or (b) entry by the Federal Court of a final order determining that the settlement is fair, adequate and reasonable under all the circumstances.

At a status conference held in June 2011, the Federal Court ruled that, before scheduling a Fairness Hearing, limited discovery between the United States and the objecting relator would be allowed and the parties would be required to file briefs regarding the reasonableness of the settlement. Given the schedule provided for discovery and briefing, we anticipate that the Fairness Hearing will be held in 2012.
 
We can make no assurances that the objecting relator will execute the Federal Settlement Agreement or that the Federal Court will approve the settlement at a Fairness Hearing and the actual outcome of these matters may differ materially from the terms of the settlement.

Our estimate of the resolution amount for these matters is $137,500. We have discounted the remaining liability for the resolution of these matters and accrued this amount, plus interest, at its estimated fair value, which amounted to approximately $139,817 at September 30, 2011.  In addition to the Settlement Amount, another $5,030 for estimated qui tam relators attorneys’ fees to be paid was accrued in the fourth quarter of 2010.  Approximately $38,902 and $100,915 has been included in the current and long-term portions, respectively, of Amounts accrued related to the investigation resolution in our Condensed Consolidated Balance Sheet as of September 30, 2011.

United States Department of Health and Human Services

In April 2011, we entered into a Corporate Integrity Agreement (the “Corporate Integrity Agreement”) with OIG-HHS. The Corporate Integrity Agreement has a term of five years and concludes the previously disclosed matters relating to the Company under review by OIG-HHS. The Corporate Integrity Agreement requires various ethics and compliance programs designed to help ensure our ongoing compliance with federal health care program requirements. The terms of the Corporate Integrity Agreement include certain organizational structure requirements, internal monitoring requirements, compliance training, screening processes for new employees, reporting requirements to OIG-HHS, and the engagement of an independent review organization to review and prepare written reports regarding, among other things, our reporting practices and bid submissions to federal health care programs.

Indemnification Obligations

Under Delaware law, our charter and bylaws and certain indemnification agreements to which we are a party, we have an obligation to indemnify, or we have otherwise agreed to indemnify, certain of our current and former directors, officers and associates with respect to current and future investigations and litigation, including the matters discussed in this Note 7.  In connection with some of these pending matters, we are required to, or we have otherwise agreed to, advance, and have advanced, significant legal fees and related expenses to several of our current and former directors, officers and associates and expect to continue to do so while these matters are pending.
 
 
18

 
Our obligations include the requirement to indemnify and advance legal fees and related expenses to three former officers and two additional associates who were criminally indicted in 2011 in connection with the government investigations of the Company that commenced in 2007.  We have exhausted our insurance policies related to this matter. The cost of our obligations to these five individuals in connection with their defense of criminal charges is expected to be significant and may continue for a number of years.  The total amount of these costs is not estimable and, accordingly, these costs are being expensed as incurred.  Our indemnification obligations may have a material adverse effect on our financial condition, results of operations and cash flows.

Risk Adjustment Data Validation Audits
   
    CMS has performed and continues to perform Risk Adjustment Data Validation (“RADV”) audits of selected MA plans to validate the provider coding practices under the risk adjustment model used to calculate the premium paid for each MA member. Our Florida MA plan was selected by CMS for audit for the 2007 contract year and we anticipate that CMS will conduct additional audits of other plans and contract years on an ongoing basis. The CMS audit process selects a sample of 201 enrollees for medical record review from each contract selected. We have responded to CMS’s audit requests by retrieving and submitting all available medical records and provider attestations to substantiate CMS-sampled diagnosis codes. CMS will use this documentation to calculate a payment error rate for our Florida MA plan 2007 premiums. CMS has not indicated a schedule for processing or otherwise responding to our submissions.
 
    CMS has indicated that payment adjustments resulting from its RADV audits will not be limited to risk scores for the specific beneficiaries for which errors are found, but will be extrapolated to the relevant plan population. In December 2010, CMS issued a draft audit sampling and payment error calculation methodology that it proposes to use in conducting these audits. CMS invited public comment on the proposed audit methodology and announced in February 2011 that it will revise its proposed approach based on the comments received. CMS has not given a specific timetable for issuing a final version of the audit sampling and payment error calculation methodology. Given that the RADV audit methodology is new and is subject to modification, there is substantial uncertainty as to how it will be applied to MA organizations like our Florida MA plan. At this time, we do not know whether CMS will require retroactive or subsequent payment adjustments to be made using an audit methodology that may not compare the coding of our providers to the coding of Original Medicare and other MA plan providers, or whether any of our other plans will be randomly selected or targeted for a similar audit by CMS. We are also unable to determine whether any conclusions that CMS may make, based on the audit of our plan and others, will cause us to change our revenue estimation process. Because of this lack of clarity from CMS, we are unable to estimate with any reasonable confidence a coding or payment error rate or predict the impact of extrapolating an applicable error rate to our Florida MA plan 2007 premiums and as a result, have not accrued a liability for the potential outcome. However, a payment adjustment may occur as a result of these audits, and that any such adjustment could have a material adverse effect on our results of operations, financial position, and cash flows, possibly in 2011 and beyond.

Other Lawsuits and Claims

Separate and apart from the legal matters described above, we are also involved in other legal actions in the normal course of our business, including, without limitation, wage and hour claims and provider disputes regarding payment of claims.  Some of these actions seek monetary damages, including claims for liquidated or punitive damages, which are not covered by insurance.  We accrue for contingent liabilities related to these matters if a loss is deemed probable and is estimable.  The actual outcome of these matters may differ materially from our current estimates and therefore could have a material adverse effect on our results of operations, financial position, and cash flows.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
 
Forward Looking Statements

This Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2011 (“2011 Form 10-Q”) may include “forward-looking statements” within the meaning of Section 21E of the Securities Act of 1934, as amended, including, in particular, estimates, projections, guidance or outlook. Generally the words “believe,” “expect,” “anticipate,” “may,” “intend,” “estimate,” “anticipate,” “plan,” “project,” “should” and similar expressions identify forward-looking statements, which generally are not historical in nature. These statements may contain information about financial prospects, economic conditions and trends that involve risks and uncertainties. Please refer to Risk Factors in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2010 (“2010 Form 10-K”) and in Part II, Item 1A of this 2011 Form 10-Q, for a discussion of certain risk factors which could materially affect our business, financial condition, cash flows, and results of operations. If any of those risks, or other risks not presently known to us or that we currently believe to not be significant, do materialize or develop into actual events, our business, financial condition, results of operations and prospects could be materially adversely affected. Given these risks and uncertainties, we can give no assurances that any results or events projected or contemplated by our forward-looking statements will in fact occur and we caution you not to place undue reliance on these statements. We caution you that we do not undertake any obligation to update forward-looking statements made by us.
 
 
19


Overview

Executive Summary
 
        We provide managed care services exclusively to government-sponsored health care programs, serving approximately 2.5 million members nationwide in our Medicaid and Medicare business lines as of November 1, 2011, including membership in the recently-launched Kentucky Medicaid program. We believe that our broad range of experience and exclusive government focus allows us to efficiently and effectively serve our members and providers, while managing our ongoing operations.  Our strategic priorities for 2011 include improving health care quality and access for our members, ensuring a competitive cost position and delivering prudent and profitable growth. We work closely with providers and government clients to further enhance health care delivery and improve the quality of, and enhance access to, health care services for our members. We are focused on programs that help governments provide quality care within their fiscal constraints and present us with long-term opportunities for prudent and profitable growth.

Health Care Quality & Access Initiatives
 
        Our Florida, Georgia and Missouri health plans have received accreditation from nationally-recognized, independent organizations that measure health plans’ commitment to high-quality care, effective management, and accountability. We remain dedicated to our long-term target of attaining accreditation for all of our health plans. Another important aspect of our work on quality was the finalization of our Healthcare Effectiveness Data and Information Set measures for 2010, which showed broad-based improvement across our lines of business.
 
During the 2011 third quarter, we successfully completed an upgrade of our core operating systems. This new technology will enable further progress in our work to improve service and productivity, and positions us to comply with future regulatory changes such as the implementation of ICD-10. The upgrade will also support our health care quality and access initiatives.
 
Cost Reduction Initiatives

Our cost management initiatives are concentrated on aligning our expense structure with our current revenue base through process improvement and other initiatives; focusing on ensuring a competitive cost position in terms of both administrative and medical expenses. We continually assess opportunities to improve the efficiency and effectiveness of our administrative processes in order to achieve our long-term target of an administrative expense ratio in the low 10% range based on our current business mix. In addition, as part of our medical cost initiatives, we have implemented provider contracting, case and disease management and pharmacy initiatives. These medical cost initiatives contributed to the year-over-year reduction we achieved for our Medicaid segment medical benefit ratios (“MBR”) and, in the case of MA, have moderated the year-over-year increase in MBR. 

Growth Initiatives

The Kentucky Cabinet for Health and Family Services has awarded us a contract to serve the commonwealth’s Medicaid program in seven of the commonwealth’s eight regions. We began serving approximately 117,000 beneficiaries across these seven regions on November 1, 2011. Our contract is for three years and may be extended for up to four one-year extension periods upon mutual agreement of the parties. Under this new program, we coordinate medical, behavioral and dental health care for eligible Kentucky Medicaid beneficiaries in the Temporary Assistance for Needy Families (“TANF”), Children’s Health Insurance Programs (“CHIP”) and aged, blind and disabled (“ABD”) programs.
 
 
20

 
We have expanded into three new Florida counties and are providing Medicaid services to an additional 5,000 Medicaid members. As a result, we now serve 35 counties in the State of Florida, more than any other Florida Medicaid plan. In addition, we are targeting expansion into additional Florida counties through the remainder of 2011.

As we look toward 2012, we are expanding the geographic footprint of our Medicare Advantage (“MA”) plans by 19 counties to a total of 138 counties. These expansions will occur within our existing states. In addition, we will offer special needs plans for dually-eligible beneficiaries in all of the markets we serve. This expansion is consistent with our focus on the lower-income demographic of the market and our ability over time to serve both the Medicaid and Medicare-related coverage of these members.

Business and Financial Outlook

Business Trends

Many states are proposing or implementing strategies that will significantly change their current Medicaid programs. These changes include moving programs into managed care; expanding existing programs to provide coverage to those who are currently uninsured; and reprocurement of existing managed care programs. State budget shortfalls in many states will be a significant consideration in any changes to existing Medicaid programs.

Hawaii, a state in which we have offered health plans for several years, has announced plans to expand Medicaid managed care programs that would be very complementary to our existing operations and infrastructure. Missouri and Ohio are also considering expansion of their Medicaid managed care programs.

Effective October 1, 2011, Ohio and New York implemented changes to their administration of prescription drug coverage for their Medicaid managed care enrollees. Pharmacy benefits that had been previously administered by the states will now be offered through health plans. This change is expected to result in approximately $80.0 million to $100.0 million in additional revenue on an annual basis.

The states in which we operate continue to experience fiscal challenges which have led to budget cuts and reductions in Medicaid premiums in certain states. In particular, we continue to experience pressure on rates in Florida and Georgia, two states from which we derive a substantial portion of our revenue.  Our rates increased approximately 2.5-3.0% in Georgia effective July 1, 2011. In Florida, changes that were effective September 1, 2011 had essentially no net impact on our overall rate. The ultimate premium rate is based on program type, demographic mix and geographic location.

As part of the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010, MA payment benchmarks for 2011 were frozen at 2010 levels. This places increased importance on administrative cost improvements and effective medical cost management.

Provider reimbursement levels are subject to change by the states and CMS. In addition, some hospital contracts are directly tied to state Medicaid fee schedules, resulting in reimbursement levels that may be adjusted up or down, generally on a prospective basis, based on adjustments made by the state to the fee schedule. We have experienced, and may continue to experience, such adjustments. Unless such adjustments are mitigated by corresponding changes in premiums, our profitability will be negatively impacted.

Beginning with the 2011 enrollment period, new laws have accelerated the time in which we can sell our MA coverage to potential beneficiaries from November 15 in prior year to October 15 in 2011. There can be no assurance that this change will not restrict our membership growth, impede our ability to enter new service markets, limit the viability of our sales efforts, or otherwise adversely affect our ability to market to or enroll new members in our existing markets.

Based on the outcome of our 2012 stand-alone prescription drug plan (“PDP”) bids, our plans will be below the benchmarks in five of the 34 Centers for Medicare & Medicaid Services (“CMS”) regions and within the de minimis range of the benchmark in 17 other CMS regions.  Comparatively, in 2011, our plans are below the benchmark in 20 regions and within the de minimis range in eight other regions.  We will retain our auto-assigned members in those 17 regions in which we bid within the de minimis range, however, we will not be auto-assigned new members in those regions during 2012.  Consequently, we expect membership to decline in 2012 from the reassignment of members to other plans that had been previously  auto-assigned to us, but we are uncertain as to whether the change will be material.
 
 
21

 
New Credit Agreement

On August 1, 2011, we entered into a $300.0 million senior secured credit agreement that can be used for general corporate purposes. The credit agreement includes a $150.0 million term loan as well as a $150.0 million revolving credit facility. Both the term loan and revolving credit facility expire in August 2016. The credit agreement contains customary covenants and restrictions, which, among other things, limit our ability to incur additional indebtedness. This new credit agreement replaces our previous $65.0 million credit agreement, which was never drawn upon. Our new credit agreement provides liquidity in support of the significant growth opportunities available to us. In particular, additions to statutory capital may be needed for new markets, such as the new Kentucky Medicaid program, or markets experiencing significant growth. For further information regarding the new credit agreement, refer to New Credit Agreement under Liquidity and Capital Resources below and Part I – Item 1 – Note 4 – Debt.
.
Financial Impact of Government Investigations and Litigation

For further discussion of government investigations and litigation including the associated financial impact, please refer to our Selling, general and administrative expense discussion under Results of Operations below and Part I – Item 1 – Note 7 – Commitments and Contingencies.

Basis of Presentation

Segments

Reportable operating segments are defined as components of an enterprise for which discrete financial information is available and evaluated on a regular basis by the chief operating decision-maker to determine how resources should be allocated to an individual segment and to assess performance of those segments. We have three reportable operating segments within our two main business lines: Medicaid, MA and PDP. The residual financial impact from the MA private fee-for-service (“PFFS”) product that we exited effective December 31, 2009, for which claims have substantially been paid out as of September 30, 2011, is reported within the MA segment.

Medicaid
 
Medicaid was established to provide medical assistance to low-income and disabled persons. It is state operated and implemented, although it is funded and regulated by both the state and federal governments. Our Medicaid plans include plans for beneficiaries of TANF programs, Supplemental Security Income (“SSI”) programs, ABD programs and state-based programs that are not part of the Medicaid program, such as CHIP and Family Health Plus (“FHP”) programs for qualifying families that are not eligible for Medicaid because they exceed the applicable income thresholds. TANF generally provides assistance to low-income families with children; ABD and SSI generally provide assistance to low-income aged, blind or disabled individuals.  

The Medicaid programs and services we offer to our members vary by state and county and are designed to serve our various constituencies effectively in the communities we serve. Although our Medicaid contracts determine to a large extent the type and scope of health care services that we arrange for our members, in certain markets we 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 many facets of primary care and preventive programs to full hospitalization and tertiary care.

In general, members are required to use our network, except in cases of emergencies, transition of care or when network providers are unavailable to meet their medical needs, and generally must receive a referral from their primary care provider (“PCP”) in order to receive medical services from specialists, such as surgeons or neurologists. Members do not pay any premiums, deductibles or co-payments for most of our Medicaid plans.

MA
 
        Medicare is a federal program that provides eligible persons age 65 and over, and some disabled persons, a variety of hospital, medical and prescription drug benefits. Our MA segment consists of MA plans which, following the exit of our PFFS product on December 31, 2009, is comprised mainly of coordinated-care plans (“CCPs”). MA is Medicare’s managed care alternative to original Medicare fee-for-service (“Original Medicare”), which provides individuals standard Medicare benefits directly through CMS. CCPs are administered through health maintenance organizations (“HMOs”) and generally require members to seek health care services and select a PCP from a network of health care providers. In addition, we offer Medicare Part D coverage, which provides prescription drug benefits, as a component of most of our MA plans.
 
 
22

 
We cover a wide spectrum of medical services through our MA plans, including in some cases, additional benefits not covered by Original Medicare, such as vision, dental and hearing services. Through these enhanced benefits, the out-of-pocket expenses incurred by our members are reduced, which allows our members to better manage their health care costs.

Most of our MA plans require members to pay a co-payment, which varies depending on the services and level of benefits provided. Typically, members of our MA CCPs are required to use our network of providers except in cases such as emergencies, transition of care or when specialty providers are unavailable to meet a member’s medical needs. MA CCP members may see out-of-network specialists if they receive referrals from their PCPs and may pay incremental cost-sharing. In most of our markets, we also offer special needs plans to individuals who are dually eligible for Medicare and Medicaid. These plans, commonly called D-SNPs, are designed to provide specialized care and support for beneficiaries who are eligible for both Medicare and Medicaid and we will contract with state Medicaid agencies to coordinate care provided to these beneficiaries. We believe that our D-SNPs are attractive to these beneficiaries due to the enhanced benefit offerings and clinical support programs.

PDP

We offer stand-alone Medicare Part D coverage to Medicare-eligible beneficiaries through our PDP segment. The Medicare Part D prescription drug benefit is supported by risk sharing with the federal government through risk corridors designed to limit the losses and gains of the drug plans and by reinsurance for catastrophic drug costs. The government subsidy is based on the national weighted average monthly bid for this coverage, adjusted for risk factor payments. Additional subsidies are provided for dual-eligible beneficiaries and specified low-income beneficiaries. The Medicare Part D program offers national in-network prescription drug coverage that is subject to limitations in certain circumstances.
 
Depending on medical coverage type, a beneficiary has various options for accessing drug coverage. Beneficiaries enrolled in Original Medicare can either join a stand-alone PDP or forego Part D drug coverage. Beneficiaries enrolled in MA CCPs can join a plan with Part D coverage, select a separate Part D plan, or forego Part D coverage.

Segment Financial Performance Measures

We use three measures to assess the performance of our reportable operating segments: premium revenue, MBR and gross margin. MBR measures the ratio of our medical benefits expense to premiums earned, after excluding Medicaid premium taxes. Because Medicaid premium taxes are included in the premium rates established in certain of our Medicaid contracts, we exclude these taxes from premium revenue when calculating key ratios as we believe that their impact is not indicative of operating performance. Gross margin is defined as premium revenue less medical benefits expense.

Our profitability depends in large part on our ability to, among other things, effectively price our health and prescription drug plans; predict and effectively manage medical benefits expense relative to the primarily fixed premiums we receive, including reserve estimates and pharmacy costs; contract with health care providers; and attract and retain members. In addition, factors such as regulation, competition and general economic conditions affect our operations and profitability. The effect of escalating health care costs, as well as any changes in our ability to negotiate competitive rates with our providers may impose further risks to our profitability and may have a material impact on our business, financial condition and results of operations.

Premium Revenue

We receive premiums from state and federal agencies for the members that are assigned to, or have selected, us to provide health care services under Medicaid and Medicare. The primarily fixed premiums we receive for each member vary according to the specific government program. The premiums we receive under each of our government benefit plans are generally determined at the beginning of the contract period. However, these premiums are subject to adjustment throughout the term of the contract. Our Medicare premiums and certain of our Medicaid premiums are subject to subsequent modification based on the health status of each member. A portion of our premiums for certain Medicaid programs is also subject to refund if our medical costs for those programs are less than a specified minimum percentage. For further information regarding premium revenues, please refer below to Premium Revenue Recognition under Critical Accounting Estimates.
 
 
23

 
Medical Benefits Expense

        Our largest expense is the cost of medical benefits that we provide, which is based primarily on our arrangements with health care providers and utilization of health care services by our members. Our arrangements with providers primarily fall into two broad categories: capitation arrangements, pursuant to which we pay the capitated providers a fixed fee per member and in some instances, additional fees for certain services, as well as risk-sharing arrangements, pursuant to which the provider assumes a portion of the risk of the cost of the health care provided. Other components of medical benefits expense are variable and require estimation and ongoing cost management.

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 health care costs have been increasing at a higher rate than the general inflation rate 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 health care laws, regulations and practices, levels of use of health care 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.

Estimation of medical benefits payable and medical benefits expense is our most significant critical accounting estimate. For further information, please refer below to Estimating Medical Benefits Payable and Medical Benefits Expense under Critical Accounting Estimates.

Gross Margin and Medical Benefits Ratio

Our primary tools for measuring profitability are gross margin and MBR. Changes in gross margin and MBR 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 (“IBNR”) claims. We use gross margin and MBRs both to monitor our management of medical benefits and medical benefits expense and to make various business decisions, including what health care plans to offer, what geographic areas to enter or exit and which health care providers to select. Although gross margin and MBRs play an important role in our business strategy, we may be willing to enter new geographical markets and/or enter into provider arrangements that might produce a less favorable gross margin and MBR if those arrangements, such as capitation or risk sharing, would likely lower our exposure to variability in medical costs or for other reasons.
 
24

 
Results of Operations

For the Three and Nine Months Ended September 30, 2011 compared to the Three and Nine Months Ended September 30, 2010

Summary of Financial Information

The following table sets forth condensed consolidated statements of operations data, as well as other key data used in our results of operations discussion.  These historical results are not necessarily indicative of results to be expected for any future period.

Consolidated Statement of Operations Data
Three Months Ended
   
Nine Months Ended
 
September 30,
   
September 30,
 
2011
   
2010
   
2011
   
2010
Revenues:
(Dollars in millions, except per share data)
Premium
$
 1,542.0
   
$
 1,385.9
   
$
 4,499.6
   
$
 4,077.3
Investment and other income
 
 2.4
     
 2.3
     
 7.0
     
 7.5
Total revenues
 
 1,544.4
     
 1,388.2
     
 4,506.6
     
 4,084.8
Expenses:
                           
Medical benefits
 
 1,197.0
     
 1,147.1
     
 3,626.3
     
 3,435.9
Selling, general and administrative
 
 178.4
     
 142.7
     
 512.4
     
 701.6
Medicaid premium taxes
 
 18.9
     
 19.0
     
 55.8
     
 38.1
Depreciation and amortization
 
 6.5
     
 6.1
     
 19.8
     
 17.8
Interest
 
 3.6
     
0.1
     
 3.8
     
0.2
Total expenses
 
 1,404.4
     
 1,315.0
     
 4,218.1
     
 4,193.6
Income (loss) before income taxes
 
 140.0
     
 73.2
     
 288.5
     
 (108.8)
Income tax expense (benefit)
 
 51.7
     
 30.3
     
 109.3
     
 (29.3)
Net income (loss)
$
 88.3
   
$
 42.9
   
$
 179.2
     
 (79.5)
                             
Consolidated MBR
 
78.6%
     
83.9%
     
81.6%
     
85.1%

Membership

   
September 30,
 
December 31,
 
September 30,
Membership:
 
2011
 
2010
 
2010
Medicaid
   
 1,313,000
   
 1,340,000
   
 1,328,000
MA
   
 130,000
   
 116,000
   
 116,000
PDP
   
 967,000
   
 768,000
   
 756,000
Total Membership
   
 2,410,000
   
 2,224,000
   
 2,200,000
 
        As of September 30, 2011, we served approximately 2,410,000 members; an increase of approximately 186,000 members from December 31, 2010 and 210,000 members from September 30, 2010. We experienced membership growth in both our MA and PDP segments. For our MA segment, we focused on our membership growth activities during the annual election period in 2010. Our products have benefit designs that are attractive to both current and prospective members. We invested in strengthening our sales processes and organization and ensuring an effective on-boarding experience for our new members.  We added approximately 14,000 MA members from December 31, 2010 through September 30, 2011. In our PDP segment, our plans are below the benchmark in 20 of the 34 CMS regions, which is an increase of one region from 2010. Additionally, we are within the de minimis range in eight additional regions. As a result, we added approximately 199,000 members as of September 30, 2011 compared to December 31, 2010. These membership increases during the first three quarters of 2011 were partially offset by a decrease in Medicaid membership. We continue to believe Medicaid membership growth opportunities exist in the states in which we currently operate, as well as states that we may decide to enter as a new market. However, as a result of our 2012 PDP bids, we expect our PDP membership to decline in 2012, but we are uncertain as to whether the change will be material.

 
25

 
Summary of Consolidated Financial Results

Net income (loss)
 
       For the three and nine months ended September 30, 2011, our net income was $88.3 million and $179.2 million, respectively, compared to net income of $42.9 million and a net loss of $79.5 million for the same three and nine month periods in 2010. Excluding investigation-related and litigation costs that amounted to an expense of $4.9 million and a benefit of $5.1 million, net of tax, for the three months ended September 30, 2011 and 2010, respectively, net income increased by $55.3 million, or 146.1%, in 2011 compared to the same three month period in 2010. Excluding investigation-related and litigation costs of $18.8 million and $163.3 million, net of tax, for the nine months ended September 30, 2011 and 2010, respectively, net income increased by $114.2 million, or 136.3%, in 2011 compared to the same nine month period in 2010. The increase for the three and nine months ended September 30, 2011 resulted mainly from improved results in our Medicaid segment, largely driven by increased premium revenue and the impact of net favorable development of prior period medical benefits payable, rate increases in certain markets, and to a lesser extent, improved results in our PDP segment, mainly driven by an increase in membership. Such increases were partially offset by an increase in selling, general and administrative (“SG&A”) expense and interest on newly incurred debt.

Premium revenue

Premium revenue for the three months ended September 30, 2011 increased by approximately $156.1 million, or 11.3%, compared to the same period in the prior year and for the nine months ended September 30, 2011 premium revenue increased by approximately $422.4 million, or 10.4%, compared to the same period in the prior year. The increase in premium revenue for both the three and nine months ended September 30, 2011 is primarily attributable to membership growth during 2011 in our PDP and MA segments, rate increases in certain of our Medicaid markets and additional premiums recognized in connection with retrospective maternity claims in Georgia. Premium revenue includes $18.9 million and $55.8 million of Medicaid premium taxes for the three and nine months ended September 30, 2011, respectively, and $19.0 million and $38.0 million for the same three and nine month periods in 2010, respectively.

Medical benefits expense
 
Total medical benefits expense for the three months ended September 30, 2011 increased $49.9 million, or 4.4%, compared to the same period in 2010, and for the nine months ended September 30, 2011, increased $190.4 million, or 5.5%, compared to the same period in 2010.  The increase in medical benefits expense for both the three and nine months ended September 30, 2011 is due mainly to the increase in PDP membership, the increase in MBR in the PDP segment that was consistent with our bids, and increased membership and higher MBR in the MA segment, partially offset by lower expense in the Medicaid segment resulting principally from the impact of net favorable prior period development in medical benefits payable. For the nine months ended September 30, 2011, medical benefits expense was impacted by approximately $154.8 million of net favorable development related to prior years, of which $36.7 million was recorded in the third quarter of 2011. For the nine months ended September 30, 2010, medical benefits expense was impacted by approximately $39.1 million of net favorable development related to prior years, of which $6.9 million was recorded in the third quarter of 2010. The increased net favorable development of prior years’ medical benefits payable experienced in 2011 compared to 2010 was primarily related to unusually low utilization in our Medicaid segment in 2010 that became clearer over time as claim payments were processed and more complete claims information was obtained.

Our consolidated MBR was 78.6% and 81.6% for the three and nine months ended September 30, 2011, respectively, and 83.9% and 85.1% for the same three and nine month periods in 2010. The change in MBR was primarily due to the higher net favorable prior period reserve development in 2011, rate increases in certain of our Medicaid markets, additional premiums recognized in connection with retrospective maternity claims in Georgia and the impact of our medical cost initiatives, partially offset by the higher MBR in our PDP segment that was consistent with our bid results.
 
 
26

 
Selling, general and administrative expense
 
SG&A expense includes aggregate costs related to the resolution of the previously disclosed governmental and Company investigations and related litigation, such as: legal fees, fair value accretion of settlement accruals, accrued interest and other related costs.  Refer to Part I – Item 1 – Note 7 – Commitments and Contingencies for further discussion of investigation related and litigation costs. We believe it is appropriate to evaluate SG&A expense exclusive of these investigation-related and litigation costs because we do not consider them to be indicative of our long-term business operations. A reconciliation of SG&A expense, including and excluding total investigation-related and litigation costs, is presented below.

   
Three Months Ended
   
Nine Months Ended
   
September 30,
   
September 30,
   
2011
   
2010
   
2011
   
2010
   
(In millions)
 
SG&A expense, as reported
  $ 178.4     $ 142.7     $ 512.4     $ 701.6  
Adjustments:
                               
Investigation-related and litigation costs
    (0.5 )     (3.1 )     (6.8 )     (251.5 )
Investigation-related administrative costs, net of directors and
                               
officers insurance policy recovery(1)
    (7.3 )     10.5       (23.9 )     1.1  
Total investigation-related and litigation costs
    (7.8 )     7.4       (30.7 )     (250.4 )
SG&A expense, excluding investigation-related and
                               
litigation costs
  $ 170.6     $ 150.1     $ 481.7     $ 451.2  
                                 
SG&A ratio
    11.7 %     10.4 %     11.5 %     17.3 %
SG&A ratio, excluding investigation-related and litigation costs
    11.2 %     11.0 %     10.8 %     11.2 %

____________
(1)
For the three and nine months ended September 30, 2010, investigation-related administrative costs include the recovery of $25.1 million and $25.8 million, respectively, from directors and officers liability insurance coverage.

        Excluding total investigation-related and litigation costs, our SG&A expense for the three months ended September 30, 2011, increased approximately $20.5 million, or 13.7%, to $170.6 million from $150.1 million for the same period in 2010. Similarly, our SG&A expense for the nine months ended September 30, 2011, increased approximately $30.5 million, or 6.7%, to $481.7 million from $451.2 million for the same period in 2010. Our SG&A expense as a percentage of total revenue, excluding premium taxes (“SG&A ratio”), was 11.7% for the three months ended September 30, 2011 compared to 10.4% for the same period in 2010. After excluding the investigation-related and litigation costs, our SG&A ratio for the three months ended September 30, 2011 was 11.2% compared to 11.0% for the same period in 2010. The increase in our SG&A ratio, excluding investigation-related and litigation costs, for the three month period was driven by increased spending related to the launch of our Kentucky Medicaid program, which accounted for approximately 30 percentage points of the increase, technology investments, including those required by regulatory changes, as well as investments in health care quality and medical cost initiatives, and the acceleration of marketing and related costs for the earlier MA CCP annual enrollment period. These increases were partially offset by improvements in operating efficiency. Our SG&A ratio for the nine months ended September 30, 2011 was 11.5% compared to 17.3% for the same period in 2010. After excluding total investigation-related and litigation costs, our SG&A ratio for the nine months ended September 30, 2011 was 10.8% compared to 11.2% for the same period in 2010. The improvement in our SG&A ratio, excluding investigation-related and litigation costs, represents solid progress toward our long-term goal of an adjusted SG&A ratio in the low 10% range, based on our current business mix. Business simplification projects, process management in our shared services functions, and continued evaluation of our organizational design continued to drive improvement in our administrative cost structure, partially offset by costs incurred for growth and regulatory and quality initiatives. An additional factor impacting the comparability of the nine month periods was the impact of relatively low equity-based compensation expense resulting from a larger impact from forfeiture activity in 2010 compared to 2011.

Medicaid premium taxes

Medicaid premium taxes incurred for the three and nine months ended September 30, 2011 were $18.9 million and $55.8 million, respectively, compared to $19.0 million and $38.1 million, respectively, for the same three and nine month periods in 2010. The increase in Medicaid premium taxes for the nine months ended September 30, 2011 was mainly due to the reinstatement of premium taxes by Georgia in July 2010. In October 2009, Georgia stopped assessing taxes on Medicaid premiums remitted to us, which resulted in an equal reduction to premium revenues and Medicaid premium taxes. However, effective July 1, 2010, Georgia began assessing premium taxes again on Medicaid premiums. Therefore, during the first half of 2010, we were not assessed, nor did we remit, any taxes on premiums in Georgia. We were assessed and remitted taxes on premiums in Hawaii, Missouri, New York and Ohio for both the 2011 and 2010 periods.

Interest expense
 
       Interest expense for the three and nine months ended September 30, 2011 was $3.6 million and $3.8 million, respectively, compared to $0.1 million and $0.2 million, respectively, for the same three and nine month periods in 2010. The increase in interest expense is mainly driven by $2.8 million of interest related to the $112.5 million subordinated notes issued in September 2011, that was retroactive to May 2011, and to a lesser extent, interest on the $150.0 million term loan, which also closed in the third quarter of 2011.

 
27


Income tax expense

Income tax expense for the three and nine months ended September 30, 2011 was $51.7 million and $109.3 million, respectively, compared to an income tax expense of $30.3 million and an income tax benefit of $29.3 million for the same three and nine month periods in 2010. Our effective income tax rate on pre-tax income was 37.0% and 37.9% for the three and nine months ended September 30, 2011, respectively, compared to 41.3% on pre-tax income and 26.9% on pre-tax loss for the same three and nine month periods in 2010.  The effective tax rate was lower for the three months ended September 30, 2011 compared to the same period in 2010 primarily due to changes related to estimated non-deductible amounts associated with investigation resolution payments. The comparability of the effective tax rates between the nine month periods ended 2011 and 2010 was impacted by the incurrence of a pre-tax loss in 2010. Additionally, the effective tax rate for the 2010 period was impacted by limitations on the deductibility of certain administrative expenses associated with the resolution of investigation-related matters.

Reconciling Segment Results

The following table reconciles our reportable segment results to income (loss) before income taxes, as reported under GAAP.


Reconciling Segment Results Data:
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2011
 
2010
 
2011
 
2010
Gross Margin:
(In millions)
Medicaid
$
 203.7
 
$
 111.7
 
$
 551.5
 
$
 331.4
MA
 
 71.9
   
 70.4
   
 217.3
   
 216.5
PDP
 
 69.3
   
 56.6
   
 104.6
   
 93.5
Total gross margin
 
 344.9
   
 238.7
   
 873.4
   
 641.4
Investment and other income
 
 2.4
   
 2.3
   
 7.0
   
 7.5
Other expenses
 
 (207.3)
   
 (167.8)
   
 (591.9)
   
 (757.7)
Income (loss) before income taxes
$
 140.0
 
$
 73.2
 
$
 288.5
 
$
 (108.8)
 
 
28


Medicaid Segment Results
 
Medicaid Segment Results Data:
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
 
                 2011   2010              2011  
2010
 
 
(In millions)
 
Premium, excluding Medicaid premium taxes(1)
  $ 880.8     $ 835.9     $ 2,543.1     $ 2,426.5  
Medicaid premium taxes(1)
    18.9       19.0       55.8       38.1  
Total premium revenue
    899.7       854.9       2,598.9       2,464.6  
Medical benefits expense
    696.0       743.2       2,047.4       2,133.2  
Gross margin
  $ 203.7     $ 111.7     $ 551.5     $ 331.4  
 
Medicaid Membership:
                           
Georgia
   
       561,000
   
         548,000
               
Florida
   
       395,000
   
         418,000
               
Other states
   
       357,000
   
         362,000
               
     
    1,313,000
   
      1,328,000
               
 
Medicaid MBR (excluding premium taxes)(1)
      79.0 %             88.9 %     80.5 %     87.9%  
 
(1)
MBR measures the ratio of our medical benefits expense to premiums earned, after excluding Medicaid premium taxes. Because Medicaid premium taxes are included in the premium rates established in certain of our Medicaid contracts, we exclude these taxes from premium revenue when calculating key ratios as we believe that their impact is not indicative of operating performance.
 
       Excluding Medicaid premium taxes, Medicaid premium revenue for the three and nine months ended September 30, 2011 increased 5.5% and 4.8%, respectively, when compared to the same periods in 2010. The increase in premium revenue was mainly due to rate increases in certain markets and additional premiums related to certain retrospective maternity claims that are due to a recent change that the Georgia Department of Community Health (“DCH”) made to its methodology for determining and accepting qualifying maternity claims. These increases were partially offset by the impact of lower membership.
 
       Medicaid medical benefits expense for the three and nine months ended September 30, 2011 decreased $47.2 million and $85.8 million, respectively, when compared to the same periods in 2010. The decrease was due mainly to the impact of net favorable development of prior period medical benefits payable and the impact of medical cost initiatives that we have implemented, partially offset by a change in member mix.  The net favorable development resulted primarily from unusually low utilization.  Our Medicaid MBR for the three and nine months ended September 30, 2011 was 79.0% and 80.5%, respectively, compared to 88.9% and 87.9% for the same periods in 2010. The decrease in MBR was also driven by the net favorable development of prior period medical benefits payable and the impact of medical cost initiatives, as well as rate increases in certain of our Medicaid markets and additional premiums recognized in connection with retrospective maternity claims in Georgia. We expect the full year MBR for our Medicaid segment to be lower in 2011 when compared to 2010, due to the higher amount of favorable development of medical benefits payable that we recognized during the first three quarters of 2011.

 
29


MA Segment Results
MA Segment Results Data:
Three Months Ended
  September 30,
   
Nine Months Ended
September 30,
   2011      2010      2011      2010
  (In millions)
Premium revenue
$
 376.6
   
$
 331.3
 
 
$
 1,097.0
   
$
 1,012.4
Medical benefits expense
 
 304.7
     
 260.9
     
 879.7
     
 795.9
Gross margin
$
 71.9
   
$
 70.4
 
 
$
 217.3
   
$
 216.5
                             
MA Membership
130,000
   
116,000
               
                             
MA MBR
 
80.9%
     
78.7%
     
80.2%
     
78.6%
 
MA premium revenue for the three and nine months ended September 30, 2011 increased 13.7% and 8.4%, respectively, when compared to the same periods in 2010 and were mainly attributable to an increase in membership. Membership increased by approximately 14,000 members to 130,000 as of September 30, 2011, from 116,000 as of September 30, 2010. The increase in MA premium revenue and membership was attributable to our product design, strengthening of our sales processes and heightened focus on membership growth activities during the annual election period in 2010. MA gross margin did not materially change for the three and nine months ended September 30, 2011, respectively, compared to the same periods in 2010 due to an increase in the segment MBR. MA segment MBR increased by 2.2 percentage points and 1.6 percentage points for the three and nine months ended September 30, 2011, respectively, compared to the same periods in 2010. The increase in the 2011 MA MBRs was primarily due to the favorable reserve development we experienced in 2010 from the wind-down of our PFFS plans.

PDP Segment Results

PDP Segment Results Data:
Three Months Ended
   
Nine Months Ended
 
September 30,
   
September 30,
 
2011
   
2010
   
2011
 
 
2010
 
(In millions)
Premium revenue
$
 265.6
   
$
 199.6
   
$
 803.7
   
$
 600.3
Medical benefits expense
 
 196.3
     
 143.0
     
 699.1
     
 506.8
Gross margin
$
 69.3
   
$
 56.6
   
$
 104.6
   
$
 93.5
                             
PDP Membership
967,000
   
756,000
               
                             
PDP MBR
 
73.9%
     
71.7%
     
87.0%
     
84.4%
 
        PDP premium revenue for the three and nine months ended September 30, 2011 increased 33.1% and 33.9%, respectively, when compared to the same periods in 2010. The increase in premium revenue during these periods were primarily the result of increased membership largely due to an increase in auto-assigned members resulting from our 2011 bids and the addition of one CMS region. Membership increased approximately 211,000 members from September 30, 2010 to September 30, 2011. PDP MBR for the three and nine months ended September 30, 2011 increased 2.2 percentage points and 2.6 percentage points, respectively, over the same periods in 2010 due to our bid results, member mix and higher utilization. We expect PDP membership and premium revenues to decline in 2012 as a result of our 2012 bid results, but are uncertain as to whether the change will be material.

 
30

 
Liquidity and Capital Resources
 
Overview

Each of our existing and anticipated sources of cash is 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 affect our liquidity, see Part I – Item 1A – Risk Factors included in our 2010 Form 10-K and Part II – Item 1A – Risk Factors included in this 2011 Form 10-Q.

Cash & Investment Positions

We currently believe that we will be able to meet our known monetary obligations, including the terms of the settlement agreements reached to resolve the government and Company investigations and related litigation, and maintain sufficient liquidity to operate our business. However, one or more of our regulators could require one or more of our subsidiaries to maintain minimum levels of statutory net worth in excess of the amount required under the current applicable state laws if the regulators were to determine that such a requirement were in the interest of our members. Further, there may be other potential adverse developments that could impede our ability to meet our obligations. The table below presents our cash and investment positions, excluding restricted investments, as of September 30, 2011 and December 31, 2010.

   
September 30,
   
December 31,
   
2011
   
2010
Cash and cash equivalents:
 
(In millions)
Regulated
   $ 1,466.3      $ 1,168.9
Unregulated
    321.4       190.6
     $ 1,787.7      $ 1,359.5
               
Investments:
             
Regulated:
             
Auction rate securities
   $ 36.6      $ 40.2
Other
    257.9       129.1
     $ 294.5      $ 169.3
               
Unregulated:
             
Auction rate securities
   $ 2.3       2.3
Other
    -       0.1
      2.3      $ 2.4
     $ 296.8      $ 171.7
               
 
        Regulated cash and cash equivalents can fluctuate significantly in a particular period depending on the timing of receipts for premiums from our government partners, which occurred at September 30, 2011. Our unregulated cash and cash equivalents increased during the nine months ended September 30, 2011 primarily as a result of $147.7 million of net term loan proceeds and dividends received from certain of our regulated subsidiaries, offset in part by payments of certain investigation-related and litigation costs in connection with the resolution of certain class action complaints.
 
Regulatory Capital and Dividend Restrictions
 
Each of our HMO and insurance subsidiaries must maintain a minimum amount of statutory capital determined by statute or regulation, which represents the amount of capital required to support the regulated entity’s business. The minimum statutory capital requirements differ by state and are generally based on a percentage of annualized premium revenue, a percentage of annualized health care costs, a percentage of certain liabilities, a statutory minimum, risk-based capital requirements or other financial metrics. At September 30, 2011, our HMO and insurance subsidiaries were in compliance with these minimum capital requirements. We are operating the Kentucky Medicaid program from one of the insurance subsidiaries that previously offered PFFS plans. Consequently, we will not be obtaining an extraordinary dividend from this entity and we likely will need to contribute additional capital to this subsidiary in late 2011 or early 2012.
 
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. Dividend restrictions vary by state, but the maximum amount of dividends which can be paid without prior approval from the applicable state is subject to restrictions relating to statutory capital, surplus and net income for the previous year. States may disapprove any dividend that, together with other dividends paid by a subsidiary in the prior twelve months, exceeds the regulatory maximum as computed for the subsidiary based on its statutory surplus and net income. We have received approximately $62.0 million in dividends from certain of our regulated subsidiaries during the nine months ended September 30, 2011, which contributed to the increase in our unregulated cash position. 
 
 
31

 
New Credit Agreement

On August 1, 2011, we entered into a $300.0 million senior secured credit agreement (the “Credit Agreement”) that can be used for general corporate purposes. The Credit Agreement provides for a $150.0 million term loan facility as well as a $150.0 million revolving credit facility. Upon closing, we borrowed $150.0 million pursuant to the term loan facility and incurred approximately $2.5 million of debt issuance costs that have been deferred and will be amortized over the life of the agreement.

Both the term loan and revolving credit facility are set to expire in August 2016. Subject to adjustment for prepayments, the term loan will amortize in quarterly installments of $1.9 million for the first four quarters, $3.8 million for the next eight quarters, $5.6 million for the next four quarters and $7.5 million for the next three quarters, with the remaining balance due upon maturity.
 
        Our term loan currently bears interest at 2.25%. Loans designated by us at the time of borrowing as Alternate Base Rate (“ABR”) Loans that are outstanding under the credit facility bear interest at a rate per annum equal to (i) the greatest of (a) the prime rate in effect on such day; (b) the federal funds effective rate in effect on such day plus 1/2 of 1%; and (c) the adjusted London Inter-Bank Offered Rate (“Adjusted LIBOR”) for a one-month interest period on such day plus 1% plus (ii) the applicable margin. Loans designated by us at the time of borrowing as “Eurodollar Loans” that are outstanding under the credit agreement bear interest at a rate per annum equal to the Adjusted LIBOR for the interest period in effect for such borrowing plus the applicable margin. The “applicable margin” means a percentage ranging from 0.50% to 2.00% per annum for ABR Loans and a percentage ranging from 1.50% to 3.00% per annum for Eurodollar Loans, depending upon our ratio of total debt to consolidated earnings before interest, taxes, depreciation and amortization (“EBITDA”).

The Credit Agreement is subject to customary covenants and restrictions which, among other things, limit our ability to incur additional indebtedness. In addition, the Credit Agreement also includes certain financial covenants that require (a) a minimum ratio of total debt to consolidated EBITDA (as defined in the Credit Agreement); (b) a minimum interest expense and principal repayment coverage ratio; (c) a minimum level of statutory net worth for our HMO and insurance subsidiaries; and (d) a requirement to maintain cash in an amount equal to one year of payment obligations due and payable to the Department of Justice during the next twelve consecutive months, so long as such obligations remain outstanding.

The Credit Agreement also contains customary representations and warranties and events of default. The payment of outstanding principal under the Credit Agreement and accrued interest thereon may be accelerated and become immediately due and payable upon our default of payment or other performance obligations or our failure to comply with financial or other covenants in the Credit Agreement, subject to applicable notice requirements and cure periods as provided in the Credit Agreement.

We intend to use these funds to take advantage of any significant growth opportunities available to us. As of the date of this filing, the revolving credit facility has not been drawn upon and we remain in compliance with all covenants.

Issuance of Subordinated Notes

On September 30, 2011, we issued tradable unsecured subordinated notes having an aggregate par value of $112.5 million, with a fixed coupon of 6% and a maturity date of December 31, 2016. These notes were issued in connection with the stipulation and settlement agreement, which was approved in May 2011, to resolve the putative class action complaints previously filed against us in 2007. Interest of $2,815 was accrued as of September 30, 2011 and was retroactive to May 2011. The first interest payment is due in December 2011 and the next ten interest payments are due semi-annually, thereafter. For further information regarding the subordinated notes, refer to Part I – Item 1 – Note 4 – Debt.

Auction Rate Securities
 
        As of September 30, 2011, $38.9 million of our long-term investments were comprised of municipal note investments with an auction reset feature (“auction rate securities”). These notes are issued by various state and local municipal entities for the purpose of financing student loans, public projects and other activities, which carry investment grade credit ratings. Although we had auction rate securities that were redeemed by the issuer during May 2011 at par in the amount of $4.5 million, auctions continued to fail during the nine months ended September 30, 2011.  There is no assurance that auctions on the remaining auction rate securities in our investment portfolio will succeed in the future. An auction failure means that the parties wishing to sell their securities could not be matched with an adequate volume of buyers. In the event that there is a failed auction the indenture governing the security requires the issuer to pay interest at a contractually defined rate that is generally above market rates for other types of similar instruments. The securities for which auctions have failed will continue to accrue interest at the contractual rate and be auctioned every seven or 35 days until the auction succeeds, the issuer calls the securities, or they mature. As a result, our ability to liquidate and fully recover the carrying value of our remaining auction rate securities in the near term may be limited or non-existent. In addition, while all of our auction rate securities currently carry investment grade ratings, if the issuers are unable to successfully close future auctions and their credit ratings deteriorate, we may in the future be required to record an impairment charge on these investments.

 
32

 
Although auctions continue to fail, we currently believe these securities are not impaired, primarily due to our ability and present intent to hold these securities until maturity or market stability is restored and because of government guarantees or municipal bond insurance. However, it could take until the final maturity of the underlying securities to realize our investments’ recorded value.

Overview of Cash Flow Activities

For the nine months ended September 30, 2011 and 2010 our cash flows are summarized as follows:

   
For the Nine Months Ended September 30,
   
2011
   
2010
   
(In millions)
 
Net cash provided by (used in) operations
  $ 319.0     $ (72.0 )
Net cash used in investing activities
    (112.4 )     (13.5 )
Net cash provided by financing activities
    221.5       18.3  
 
Cash provided by (used in) Operations

We generally receive premiums in advance of payments of claims for health care services; however, cash flows related to our operations can fluctuate significantly in a particular period depending on the timing of premiums receipts from our government partners or payments related to resolving government investigations and related litigation. For the nine months ended September 30, 2011, cash provided by operations included $275.8 million in premium prepayments received from CMS and the Florida Agency for Health Care Administration for October premiums, a timing benefit to our cash flows related to $72.7 million of premiums estimated to be returned under the risk corridor provisions for our Part D products, partially offset by investigation-related and litigation resolution payments of $87.5 million.

Net cash used in operations in 2010 primarily reflects the pay down of outstanding claims associated with our exit from PFFS.

Cash used in Investing Activities

During the nine months ended September 30, 2011, cash used in investing activities primarily reflects our investment of proceeds provided by our term loan into higher yielding investment alternatives, which had a net impact totaling approximately $124.1 million, and purchases of software and equipment totaling approximately $30.8 million, partially offset by $42.6 million of proceeds from the maturities of restricted investments net of purchases.

Cash provided by Financing Activities
 
Included in financing activities are $147.7 million of proceeds from the issuance of the term loan, net of issuance costs, as well as funds held for the benefit of members, which increased approximately $74.1 million as of September 30, 2011. These funds represent reinsurance and low-income cost subsidies funded by CMS in connection with the Medicare Part D program, for which we assume no risk.
 
 
33

 
Contractual Obligations

In our 2010 Form 10-K, we reported our contractual obligations as of December 31, 2010. Since then, our estimate of the timing of our resolution for matters investigated by the Civil Division of the United States Department of Justice has been revised. For further information regarding the proposed settlement agreement related to this matter, please refer to Part I – Item 1 – Note 7 – Commitments and Contingencies. Upon closing of the Credit Agreement on August 1, 2011, we borrowed $150.0 million pursuant to the term loan facility. The term loan will expire in August 2016. In September 2011, we issued tradable unsecured subordinated notes having an aggregate par value of $112.5 million and a maturity date of December 31, 2016. These notes were issued in connection with the stipulation and settlement agreement to resolve the putative class action complaints previously filed against us in 2007. For further information regarding the Credit Agreement and the subordinated notes, refer above to New Credit Agreement and Issuance of Subordinated Notes. There have been no other material changes to our contractual obligations from the information we provided in our 2010 Form 10-K.

Critical Accounting Estimates

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 (“GAAP”). 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 our accounting estimates relating to premium revenue recognition, medical benefits expense and medical benefits payable, and goodwill and intangible assets, 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.  We have not changed our methodology in deriving these critical accounting estimates from those previously disclosed in our 2010 Form 10-K. Our critical accounting estimates relating to premium revenue recognition, medical benefits payable and medical benefits expense, and the quantification of the sensitivity of financial results to reasonably possible changes in underlying assumptions used in such estimation, as well as assumptions relating to our impairment assessment of goodwill and intangible assets as of September 30, 2011, is discussed below.

Premium Revenue Recognition

We receive premiums from state and federal agencies for the members that are assigned to, or have selected, us to provide health care services under Medicaid and Medicare. The premiums we receive for each member vary according to the specific government program and are generally determined at the beginning of the contract period. These premiums are subject to adjustment throughout the term of the contract by CMS and the states, although such adjustments are typically made at the commencement of each new contract renewal period. Annual rate changes are recorded when they become effective.
 
We recognize premium revenues in the period in which we are obligated to provide services to our members. Premiums are billed monthly for coverage in the following month and we are paid generally in the month in which we provide services. We estimate, on an ongoing basis, the amount of member billings that may not be fully collectible or that will be returned based on historical trends, compliance with requirements for certain contracts to expend a minimum percentage of premiums on eligible medical expense, and other factors. An allowance is established for the estimated amount that may not be collectible and a liability is established for premium expected to be returned. Historically, the allowance has not been significant relative to premium revenue.

Premium payments that we receive are based upon eligibility lists produced by the government. We verify these lists to determine whether we have been paid for the correct premium category and program. From time to time, the states or CMS require us to reimburse them for premiums that we received based on an eligibility list that a state, CMS or we later discover, through our audits or otherwise, contains individuals who were not eligible for any government-sponsored program, have been enrolled twice in the same program, or belong to a different health plan than ours. The verification and subsequent membership changes may result in additional amounts due to us or we may owe premiums back to the government. The mounts receivable or payable identified by us through reconciliation and verification of agency eligibility lists relate to current and prior periods. The amounts receivable from government agencies for reconciling items were $37.0 million and $0.3 million at September 30, 2011 and December 31, 2010, respectively. The amounts due to government agencies for reconciling items were $7.7 million and $63.3 million at September 30, 2011 and December 31, 2010, respectively. The Georgia DCH has made premium adjustments in the current and preceding quarters retroactive to the beginning of the program in 2006 for overpayments related to a reconciliation of duplicate member records. In accordance with the policy stated above, we had previously identified and accrued an estimated liability for overpayments that we believe will be returned to Georgia DCH. Considering the adjustments to historical capitation premium rates that the Georgia DCH is making for the periods affected by duplicative enrollment, the net impact to premium revenue resulting from the adjustments was immaterial to our results of operations for the three and nine months ended September 30, 2011.
 
 
34

 
We record adjustments to revenues based on member retroactivity. These adjustments reflect changes in the number and eligibility status of enrollees subsequent to when revenue was billed. We estimate the amount of outstanding retroactivity adjustments 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. Changes in member retroactivity adjustment estimates had a minimal impact on premiums recorded during the periods presented. Our government contracts establish monthly rates per member that varies based on member demographics such as age, working status or medical history.

In certain states, including Georgia, we are eligible to receive supplemental payments for newborns and/or obstetric deliveries. During the three months ended September 30, 2011, we recognized approximately $14.1 million in premium revenue related to certain retrospective maternity claims from 2010 and earlier 2011 periods, following a recent change that the Georgia DCH made in its methodology for accepting qualifying maternity claims.

Minimum loss ratio requirement
 
        Certain of our Medicaid contracts require us to expend a minimum percentage of premiums on eligible medical expense (“minimum loss ratio requirement”), and to the extent that we expend less than the minimum loss ratio requirement, we are required to refund all or some portion of the difference between the minimum and our actual allowable medical expense. We estimate the amounts due to the state as a return of premium each period based on the terms of our contract with the applicable state agency, and such amounts are included in our results of operations as adjustments to premium revenues. Our liability to states under their respective minimum medical expense provisions was $5.7 million as of September 30, 2011 and $10.7 million as of December 31, 2010.
   
Risk corridor
 
        The amount of premium relating to PDP coverage is subject to adjustment, positive or negative, based upon the application of risk corridors that compare our prescription drug costs estimated in our bids to CMS to our actual prescription drug costs. We estimate the amounts due to or from CMS for risk protection under the risk corridor provisions of our contract with CMS each period based on pharmacy claims experience to date as if the annual contract were to terminate at the end of the reporting period, and such amounts are included in our results of operations as adjustments to premium revenues. Our liability to CMS under the risk corridor provision was $72.7 million as of September 30, 2011 and $36.0 million as of December 31, 2010.  

Risk-Adjusted Premiums
 
CMS employs a risk-adjustment model to determine the premium amount it pays for each MA member.  This model apportions premiums paid to all MA plans according to the health status of each beneficiary enrolled. As a result, our CMS monthly premium payments per member may change materially, either favorably or unfavorably. The CMS risk-adjustment model pays more for Medicare members with predictably higher costs. Diagnosis data from inpatient and ambulatory treatment settings are used to calculate the risk-adjusted premiums we receive. We collect claims and encounter data and submit the necessary diagnosis data to CMS within prescribed deadlines. After reviewing the respective submissions, CMS establishes the premium payments to MA plans generally at the beginning of the calendar year, and then adjusts premium levels on two separate occasions on a retroactive basis. The first retroactive adjustment for a given fiscal year generally occurs during the third quarter of such fiscal year. This initial settlement (the "Initial CMS Settlement") represents the updating of risk scores for the current year based on the severity of claims incurred in the prior fiscal year. CMS then issues a final retroactive risk-adjusted premium settlement for that fiscal year in the following year (the "Final CMS Settlement").  We reassess the estimates of the Initial CMS Settlement and the Final CMS Settlement each reporting period and any resulting adjustments are made to MA premium revenue. 
 
 
35

 
We develop our estimates for risk-adjusted premiums utilizing historical experience and predictive models as sufficient member risk score data becomes available over the course of each CMS plan year. Our models are populated with available risk score data on our members. Risk premium adjustments are based on member risk score data from the previous year. Risk score data for members who entered our plans during the current plan year, however, is not available for use in our models; therefore, we make assumptions regarding the risk scores of this subset of our member population. All such estimated amounts are periodically updated as additional diagnosis code information is reported to CMS and adjusted to actual amounts when the ultimate adjustment settlements are either received from CMS or we receive notification from CMS of such settlement amounts. Our risk adjusted premiums receivable was $30.9 million as of September 30, 2011 and $56.4 million as of December 31, 2010.
 
As a result of the variability of factors that determine such estimates, including plan risk scores, the actual amount of the CMS retroactive payment could be materially more or less than our estimates. Consequently, our estimate of our plans’ risk scores for any period, and any resulting change in our accrual of MA premium revenues related thereto, could have a material adverse effect on our results of operations, financial position and cash flows. Historically, we have not experienced significant differences between the amounts that we have recorded and the revenues that we ultimately receive. The data provided to CMS to determine the risk score is subject to audit by CMS even after the annual settlements occur. These audits may result in the refund of premiums to CMS previously received by us.  While our experience to date has not resulted in a material refund, this refund could be significant in the future, which would reduce our premium revenue in the year that CMS determines repayment is required.

CMS has performed and continues to perform Risk Adjustment Data Validation (“RADV”) audits of selected MA plans to validate the provider coding practices under the risk adjustment model used to calculate the premium paid for each MA member. Our Florida MA plan was selected by CMS for audit for the 2007 contract year and we anticipate that CMS will conduct additional audits of other plans and contract years on an ongoing basis. The CMS audit process selects a sample of 201 enrollees for medical record review from each contract selected. We have responded to CMS’s audit requests by retrieving and submitting all available medical records and provider attestations to substantiate CMS-sampled diagnosis codes. CMS will use this documentation to calculate a payment error rate for our Florida MA plan 2007 premiums. CMS has not indicated a schedule for processing or otherwise responding to our submissions.
 
        CMS has indicated that payment adjustments resulting from its RADV audits will not be limited to risk scores for the specific beneficiaries for which errors are found, but will be extrapolated to the relevant plan population. In December 2010, CMS issued a draft audit sampling and payment error calculation methodology that it proposes to use in conducting these audits. CMS invited public comment on the proposed audit methodology and announced in early February 2011 that it will revise its proposed approach based on the comments received. CMS has not given a specific timetable for issuing a final version of the audit sampling and payment error calculation methodology. Given that the RADV audit methodology is new and is subject to modification, there is substantial uncertainty as to how it will be applied to MA organizations like our Florida MA plan. At this time, we do not know whether CMS will require retroactive or subsequent payment adjustments to be made using an audit methodology that may not compare the coding of our providers to the coding of Original Medicare and other MA plan providers, or whether any of our other plans will be randomly selected or targeted for a similar audit by CMS. We are also unable to determine whether any conclusions that CMS may make, based on the audit of our plan and others, will cause us to change our revenue estimation process. Because of this lack of clarity from CMS, we are unable to estimate with any reasonable confidence a coding or payment error rate or predict the impact of extrapolating an applicable error rate to our Florida MA plan 2007 premiums. However, a payment adjustment may occur as a result of these audits, and that any such adjustment could have a material adverse effect on our results of operations, financial position, and cash flows, possibly in 2011 and beyond.

 
36


Estimating Medical Benefits Payable and Medical Benefits Expense

The cost of medical benefits is recognized in the period in which services are provided and includes an estimate of the cost of IBNR medical benefits. Medical benefits payable has two main components: direct medical expenses and medically-related administrative costs. Direct medical expenses include amounts paid or payable to hospitals, physicians and providers of ancillary services, such as laboratories and pharmacies. Medically-related administrative costs include items such as case and disease management, utilization review services, quality assurance and on-call nurses, which are recorded in Selling, general, and administrative expense. Medical benefits payable on our Consolidated Balance Sheets represents amounts for claims fully adjudicated awaiting payment disbursement and estimates for IBNR. The following table provides a reconciliation of the total medical benefits payable balances as of September 30, 2011 and December 31, 2010:
   
September 30,
   
% of
   
December 31,
   
% of