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

 

 

 

 

Form 10-K

 

 

 

 

 

Commission file no. 001-14953

 

 

 

 

HealthMarkets, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

 

9151 Boulevard 26, North Richland Hills, Texas 76180

(Address of principal executive offices, zip code)

(817) 255-5200

(Registrant’s phone number, including area code)

 

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

None

 

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

Class A-2 common stock

(Title of class)

 

 

 

 

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

 

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

 

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

 

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

 

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 definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

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

 

Effective April 5, 2006, all of the registrant’s Class A-1 common stock (representing approximately 88.62% of its common equity at March 10, 2007) is owned by three private investor groups and members of management. The registrant’s Class A-2 common stock is owned by its independent insurance agents and is subject to transfer restrictions. Neither the Class-A-1 common stock nor the Class A-2 common stock is listed or traded on any exchange or market. Accordingly, as of June 30, 2008, the last business day of the registrant’s most recently completed second fiscal quarter, the aggregate market value of shares of Class A-1 and Class A-2 common stock held by non-affiliates was $-0-. As of March 2, 2009, there were 26,887,281 outstanding shares of Class A-1 common stock and 3,042,561 outstanding shares of Class A-2 common stock.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the annual information statement for the annual meeting of stockholders are incorporated by reference into Part III.

 

 

HEALTHMARKETS, INC.
and Subsidiaries

 

TABLE OF CONTENTS

 

Cautionary Statements Regarding Forward-Looking Statements

 

In this Annual Report on Form 10-K, unless the context otherwise requires, the terms “Company,” “HealthMarkets,” “we,” “us,” or “our” refer to HealthMarkets, Inc. and its subsidiaries. This report and other documents or oral presentations prepared or delivered by and on behalf of the Company contain or may contain “forward-looking statements” within the meaning of the safe harbor provisions of the United States Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements based upon management’s expectations at the time such statements are made. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Forward-looking statements are subject to risks and uncertainties that could cause the Company’s actual results to differ materially from those contemplated in the statements. Readers are cautioned not to place undue reliance on the forward-looking statements. All statements, other than statements of historical information provided or incorporated by reference herein, may be deemed to be forward-looking statements. Without limiting the foregoing, when used in written documents or oral presentations, the terms “anticipate,” “believe,” “estimate,” “expect,” “may,” “objective,” “plan,” “possible,” “potential,” “project,” “will” and similar expressions are intended to identify forward-looking statements. In addition to the assumptions and other factors referred to specifically in connection with such statements, factors that could impact the Company’s business and financial prospects include, but are not limited to, those discussed under the caption “Item 1 Business,” “Item 1A. Risk Factors” and “Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations” and those discussed from time to time in the Company’s various filings with the Securities and Exchange Commission or in other publicly disseminated written documents.

 

 

Introduction

 

HealthMarkets, Inc., a Delaware corporation incorporated in 1984, is a holding company, and we conduct our insurance businesses through our indirect, wholly owned insurance company subsidiaries. Through these subsidiaries, we issue primarily heath insurance policies covering individuals, families, the self — employed and small businesses.

 

Our insurance subsidiaries include The MEGA Life and Health Insurance Company (“MEGA”), Mid-West National Life Insurance Company of Tennessee (“Mid-West”) and The Chesapeake Life Insurance Company (“Chesapeake”). MEGA is an insurance company domiciled in Oklahoma and is licensed to issue health, life and annuity insurance policies in the District of Columbia and all states except New York. Mid-West is an insurance company domiciled in Texas and is licensed to issue health, life and annuity insurance policies in Puerto Rico, the District of Columbia, and all states except Maine, New Hampshire, New York and Vermont. Chesapeake is an insurance company domiciled in Oklahoma and is licensed to issue health and life insurance policies in the District of Columbia and all states except New Jersey, New York and Vermont. Effective December 1, 2007, the Company acquired Fidelity Life Insurance Company, an insurance company domiciled in Pennsylvania. Fidelity Life Insurance Company was redomesticated to Oklahoma on May 12, 2008 and its name was changed to HealthMarkets Insurance Company (“HMIC”) on July 15, 2008. HMIC is licensed to issue health and life insurance policies in the District of Columbia and all states except New York, Mississippi and New Hampshire.

 

The Company operates three business segments: the Insurance segment, Corporate and Disposed Operations. The Insurance segment includes the Company’s Self-Employed Agency Division (“SEA”), the Medicare Division and the Other Insurance Division. Corporate includes investment income not allocated to the Insurance segment, realized gains or losses, interest expense on corporate debt, general expenses relating to corporate operations, variable non-cash stock-based compensation and operations that do not constitute reportable operating segments. Disposed Operations includes the former Life Insurance Division, former Star HRG Division and former Student Insurance Division. See Note 18 of Notes to Consolidated Financial Statements for financial information regarding our segments.

 

Through our SEA Division, we offer a broad range of health insurance products for individuals, families, the self-employed and small businesses. We market these products through a dedicated agency field force — consisting of independent agents contracted with our insurance subsidiaries — that primarily sells the Company’s products. The Company has approximately 1,300 independent writing agents per week in the field selling health insurance in 44 states.

 

In 2007, we initiated efforts to expand into the Medicare market. In the fourth quarter of 2007, we began offering a new portfolio of Medicare Advantage Private-Fee-for-Service Plans (“PFFS”) in selected markets in 29 states with calendar year coverage effective for January 1, 2008. Policies were issued by our Chesapeake subsidiary, under a contract with the Centers for Medicare and Medicaid Services (“CMS”). In July 2008, the Company determined that it would not continue to participate in the Medicare Advantage market beyond the current plan year and our Chesapeake subsidiary terminated its agreement with CMS effective December 31, 2008. In connection with our exit from the Medicare market, we incurred employee termination costs of $2.8 million and recorded asset impairment charges of $1.1 million. See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 2 of Notes to Consolidated Financial Statements.

 

Our Other Insurance Division consists of ZON Re-USA, LLC (“ZON Re”), an 82.5%-owned subsidiary, which underwrites, administers and issues accidental death, accidental death and dismemberment (“AD&D”), accident medical, and accident disability insurance products, both on a primary and on a reinsurance basis. We distribute these products through professional reinsurance intermediaries and a network of independent commercial insurance agents, brokers and third party administrators.

 

On July 11, 2006 and December 1, 2006, we sold our former Star HRG Division and Student Insurance Division, respectively, resulting in total pre-tax gains of $201.7 million. See Note 2 of Notes to Consolidated

Financial Statements. On September 30, 2008, we exited our Life Insurance Division business through a reinsurance transaction pursuant to which Wilton Reassurance Company or its affiliates (“Wilton”) agreed to reinsure on a 100% coinsurance basis substantially all of the insurance policies associated with the Life Insurance Division, effective July 1, 2008. The reinsurance transaction resulted in a pre-tax loss of $21.5 million, of which $13.0 million was recorded as an impairment to the Life Insurance Division’s deferred acquisition costs with the remainder of $8.5 million recorded in “Realized gains (losses)” in the Company’s consolidated statement of income (loss). See Note 2 of Notes to Consolidated Financial Statements.

 

We sold these businesses and exited the Medicare Advantage market because these businesses were not part of the fundamental long term focus of the Company. We are now generally focused on business opportunities that allow us to maximize the value of our dedicated agency sales force and serve our target market of individuals, families, the self — employed and small businesses.

 

On April 5, 2006, we completed a merger (the “Merger”) providing for the acquisition of the Company by affiliates of a group of private equity investors, including affiliates of The Blackstone Group, Goldman Sachs Capital Partners and DLJ Merchant Banking Partners (the “Private Equity Investors”). As a result of the Merger, holders of our common stock received $37.00 in cash per share. In the transaction, HealthMarkets’ former public shareholders received aggregate cash consideration of $1.6 billion, of which approximates $985.0 million was contributed as equity by the Private Equity Investors. The balance of the Merger consideration was financed with the proceeds of a $500.0 million term loan facility, the proceeds of $100.0 million of trust preferred securities issued in a private placement, and Company cash on hand of approximately $42.8 million. See Note 12 of Notes to Consolidated Financial Statements.

 

Our principal executive offices are located at 9151 Boulevard 26, North Richland Hills, Texas 76180-5605, and our telephone number is (817) 255-5200.

 

As of March 2, 2009, approximately 89% of our common equity securities are held by affiliates of three private equity investors, with the balance of our common equity securities held by current and former members of management and independent insurance agents through the Company’s agent stock accumulation plans. As such, we remain subject to the periodic reporting and other requirements of the Securities Exchange Act of 1934, as amended. Our periodic SEC filings, including our annual reports on Form 10-K, quarterly reports on Form 10-Q, Current Reports on Form 8-K, and if applicable, amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available through our web site at www.healthmarketsinc.com free of charge as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC.

 

Ratings

 

Our principal insurance subsidiaries are rated by A.M. Best Company (“A.M. Best”), Fitch Ratings (“Fitch”) and Standard & Poor’s (“S&P”). Set forth below are the current financial strength ratings of the principal insurance subsidiaries.

 

 

In the table above, the A.M. Best, Fitch and S&P ratings carry a “negative” outlook.

 

In evaluating a company, independent rating agencies review such factors as the company’s capital adequacy, profitability, leverage and liquidity, book of business, quality and estimated market value of assets, adequacy of policy liabilities, experience and competency of management, and operating profile. A.M. Best’s ratings currently range from “A++” (“Superior”) to “F” (“In Liquidation”). A.M. Best’s ratings are based upon factors relevant to policyholders, agents, insurance brokers and intermediaries and are not directed to the protection of investors. Fitch’s ratings provide an overall assessment of an insurance company’s financial strength and security, and the ratings are used to support insurance carrier selection and placement decisions. Fitch’s ratings range from “AAA” (“Highest Credit Quality”) to “D” (“Default”). S&P’s financial strength rating is a current opinion of the financial

security characteristics of an insurance organization with respect to its ability to pay under its insurance policies and contracts in accordance with their terms. S&P’s financial strength ratings range from “AAA” (“Extremely Strong”) to “D” (“Default”).

 

A.M. Best has assigned to HealthMarkets, Inc. an issuer credit rating of “bb+” (“Fair”) with a “negative” outlook. A.M. Best’s issuer credit rating is a current opinion of an obligor’s ability to meet its senior obligations. A.M. Best’s issuer credit ratings range from “aaa” (“Exceptional”) to “d” (“In Default”).

 

Fitch has assigned to HealthMarkets, Inc. a long term issuer default rating of “BB” (“Speculative”) with a “negative” outlook. Fitch’s long term issuer default rating is a current opinion of an obligor’s ability to meet all of its most senior financial obligations on a timely basis over the term of the obligation. Fitch’s long term issuer default ratings range from “AAA” (“Highest Credit Quality”) to “D” (“Default”).

 

S&P’s Rating Services has assigned to HealthMarkets, Inc. a counterparty credit rating of “BB-” (“Less Vulnerable”) with a “negative” outlook. S&P’s counterparty credit rating is a current opinion of an obligor’s overall financial capacity to pay its financial obligations. S&P’s counterparty credit ratings range from “AAA” (“Extremely Strong”) to “D” (“Default”).

 

Insurance Segment

 

Self-Employed Agency Division

 

Through our SEA Division, we offer a broad range of health insurance products for individuals, families, the self-employed and small businesses. These products are issued by our subsidiaries, MEGA, Mid-West and Chesapeake, and are distributed through our dedicated agency field force consisting of independent agents contracted with these insurance subsidiaries. The SEA Division generated revenues of $1.2 billion, $1.4 billion and $1.5 billion, representing 88%, 90% and 69% of our total revenue from continuing operations in 2008, 2007 and 2006, respectively. We currently have approximately 514,000 members insured or reinsured by the Company.

 

Traditional Health Insurance Products

 

Historically, our traditional health insurance product offerings have represented the focus of our product sales. Our basic hospital-medical and catastrophic hospital expense plans are designed to accommodate individual needs and include traditional fee-for-service indemnity (choice of doctor) plans and plans with preferred provider organization (“PPO”) features, as well as other supplemental types of coverage. Our traditional health insurance plan offerings include the following:

 

 

Each of our traditional health insurance products is available with a “menu” of various options (including various deductible levels, coinsurance percentages and limited riders that cover particular events such as outpatient, accidents, and doctors’ visits), enabling the insurance product to be tailored to meet the insurance needs and the budgetary constraints of the policyholder. We offer as an optional benefit the Accumulated Covered Expense (“ACE”) rider that provides for catastrophic coverage on our scheduled/basic plans for covered expenses under the contract that generally exceed $100,000 or, in certain cases, $75,000. The rider pays benefits at 100% after the stop loss amount is reached, up to the aggregate maximum amount of the contract for expenses covered by the rider.

 

CareOne and CareChoice Products

 

In 2006, we began shifting our product focus toward our CareOne products, some of which were designed to shift a higher proportion of premium dollars to benefits. In the states where these new products were introduced, they generally replaced the Company’s traditional health insurance product offerings as the focus of new product sales, although our traditional products continue to represent the majority of our policies in force and premium.

 

The CareOne product portfolio includes a basic medical/surgical expense plan, two versions of a catastrophic expense PPO plan and two versions of a catastrophic expense “consumer guided” health plan:

 

 

We also offer HSA-compatible versions of our CareOne products. These plans — known as “high deductible health plans” — can be used with tax-advantaged health savings accounts for healthcare expenses.

 

In 2008, we introduced a new calendar year deductible-based PPO product called CareChoice^®. The CareChoice product contains many of the same features as our CareOne and CareOne Plus Plans, but eliminates many of the internal benefit limits associated with such plans and simplifies some of the benefit structures.

 

2009 Product Initiatives

 

Our shift in market focus away from policies of a “scheduled benefit” nature toward our CareOne and CareChoice products, particularly those with a traditional PPO feature, resulted in the Company competing directly with a number of insurance companies focused on the larger employer group market. These companies often have a sizable market share which allows them to obtain favorable financial arrangements from healthcare providers that may not be available to us. As a result, with respect to their traditional PPO products, these companies may be able to offer more competitive pricing and/or have lower cost structures than the Company, making it difficult for the Company to compete in the markets where these companies operate. The Company is evaluating its product strategy for 2009 and expects to implement a number of changes, including a renewed emphasis on our traditional health products. In 2009 the Company expects to discontinue the marketing of its CareOne and CareChoice products in many of the states in which these plans are available. In their place, the Company intends to continue offering its traditional health products and expects to introduce several new products underwritten by Chesapeake, including a new “scheduled benefit” basic hospital-medical expense plan (the BasicFit^sm Plan) and a new high deductible catastrophic hospital expense plan, with deductibles ranging from $7,500 to $20,000 (the EssentialFit^sm Plan). Both new products will incorporate certain PPO features but without the added benefits of traditional, major medical PPO products.

 

The Company evaluates new product offerings on an ongoing basis. In the future, we may offer new product lines, including product lines focused on markets not traditionally served by the Company.

 

Ancillary Products

 

We have also developed and offer ancillary product lines designed to further protect against risks to which our core customer is typically exposed. These products are generally sold to purchasers of the Company’s health insurance products, although certain ancillary products are also offered on a stand-alone basis. Our ancillary product offerings include the following:

 

 

 

Third Party Product Distribution Arrangements

 

MEGA and Mid-West have entered into agreements to distribute health insurance products underwritten by other third-party insurance companies. The products sold under these arrangements focus on markets not traditionally served by the Company, including high risk customers. These products are distributed through our dedicated agency field force consisting of independent agents contracted with our insurance subsidiaries. Currently, the revenues generated by such arrangements are not material to the Company’s financial results. The Company evaluates new distribution arrangements on an ongoing basis and may, in the future, offer new third party products.

 

Marketing and Sales

 

Substantially all of the health insurance products issued by our insurance subsidiaries are sold through independent contractor agents. (With respect to references to our sales agents as independent contractors, see discussion of “Fair Labor Standards Act Agent Litigation” in Note 16 of Notes to Consolidated Financial Statements). We believe that we have the largest direct selling organization in the health insurance field, with approximately 1,300 independent writing agents per week in the field selling health insurance to the individual and self employed market.

 

Our agents are independent contractors and all compensation that agents receive from us for the sale of insurance is based upon the agents’ levels of sales production. Historically, our dedicated agency sales force consisted of UGA — Association Field Services (“UGA”) and Cornerstone America (“Cornerstone”) (the principal marketing divisions of MEGA and Mid-West, respectively). UGA and Cornerstone are organized into geographical regions, with each geographical region having a regional director, two additional levels of field leaders and writing agents (i.e., the agents that are not involved in leadership of other agents). In the fourth quarter 2008, we initiated efforts to reorganize UGA and Cornerstone into a single agency department (the “Agency Department”). The Company believes that the new structure will promote economic and administrative efficiencies, help solidify brand identity and best position the Company to recruit new agents and help agents sell the Company’s products in the future.

 

We maintain a recruiting and training program for field leaders and writing agents. The process of recruiting agents is extremely competitive. We believe that the primary factors in successfully recruiting and retaining effective agents and field leaders are our practices regarding advances on commissions, the quality of the sales leads provided to agents, the availability and accessibility of equity ownership plans, the quality of the products offered, proper training and agent incentives and support. Classroom and field training with respect to product content is required and made available to the agents under the direction of our regulated insurance subsidiaries.

 

We provide health insurance products covering individuals, families, the self-employed and small businesses in 44 states. As is the case with many of our competitors in this market, a substantial portion of our products are issued to members of various independent membership associations that act as the master policyholder for such products. The two principal membership associations in the self-employed market that make available to their members our health insurance products are the National Association for the Self-Employed and the Alliance for Affordable Services. The associations provide their membership access to a number of benefits and products, including health insurance underwritten by us. Subject to applicable state law, individuals generally may not obtain insurance under an association’s master policy unless they are also members of the association. The agreements with these associations, requiring the associations to continue as the master policyholder for our policies and to make our products available to their respective members, are terminable by us and the associations upon not less than one year’s advance notice to the other party. While we believe that we are providing association group coverage in full compliance with applicable law, changes in our relationship with the membership associations and/or changes in the laws and regulations governing so-called “association group” insurance (particularly changes that

would subject the issuance of policies to prior premium rate approval and/or require the issuance of policies on a “guaranteed issue” basis) could have a material adverse impact on our financial condition and results of operations.

 

The independent agents within our dedicated agency field force also act as field service representatives (“FSRs”) for the associations. In this capacity the FSRs enroll new association members and provide membership retention services. For such services, we and the FSRs receive compensation. One of our subsidiaries, HealthMarkets Lead Marketing Group Inc. (“LMG”), serves as our direct marketing group and generates new membership sales prospect leads for use by the FSRs (agents). LMG also provides video and print services to the associations. In addition to health insurance premiums derived from the sale of health insurance, we receive fee income from the associations, including fees associated with enrollment and member retention services, fees for association membership marketing and administrative services and fees for certain association member benefits.

 

LMG generates sales prospect leads for use by agents. LMG obtains leads from third party sources and utilizes a call center intended to generate leads. LMG has developed a marketing pool of approximately eighteen million prospects from various data sources. Prospects initially identified by LMG that are self-employed, small business owners or individuals may become a “qualified lead” by responding through one of LMG’s lead channels and by expressing an interest in learning more about health insurance. We believe that agents contracted with our insurance subsidiaries, possessing the qualified leads’ contact information, are able to achieve a higher “close” rate than is the case with unqualified prospects.

 

Policy Design and Claims Management

 

Our traditional health insurance products are principally designed to limit coverages to the occurrence of significant events that require hospitalization. This policy design, which includes high deductibles, reduces the number of covered claims requiring processing, thereby serving as a control on administrative expenses. We seek to price our products in a manner that accurately reflects our underwriting assumptions and targeted margins, and we rely on the marketing capabilities of independent insurance agents within our dedicated agency sales force to sell these products at prices consistent with these objectives.

 

We maintain administrative centers with full underwriting, claims management and administrative capabilities. The Company evaluates opportunities to subcontract services of this nature on an ongoing basis. If the Company determines that these function can be performed effectively and more efficiently by third parties, it may, in the future, choose to subcontract these functions.

 

We have also developed an actuarial data warehouse, which is a critical risk management tool that provides our actuaries with rapid access to detailed exposure, claim and premium data. This analysis tool enhances the actuaries’ ability to design, monitor and adequately price the SEA Division’s insurance products.

 

Provider Network Arrangements and Cost Management Measures

 

The Company utilizes a number of cost management programs to help it and its customers control medical costs. These measures include maintaining contracts with selected PPO provider networks through which our customers may obtain discounts on hospital and physician services that would otherwise not be available. Provider networks are made available on a regional basis, based on the coverage and discounts available within a particular geographic region. In situations where a customer does not obtain services from a contracted provider, the Company applies various usual and customary fees, which limit the amount paid to providers within specific geographic areas. We believe that access to provider network contracts is a critical factor in controlling medical costs, since there is often a significant difference between a network-negotiated rate and the non-discounted rate.

 

The Company utilizes other means to control medical costs, including providing customers with access to “supplemental” network discounts if savings are not obtained through a primary provider network contract; use of pre- and post-payment fee negotiation services; and use of code editing programs that evaluate claims prior to adjudication for inappropriate billing. In the first quarter of 2009, the Company introduced a new medical management program designed to coordinate care between members of its PPO products and their doctors and facilities to manage medical costs. In coordination with a third party care management vendor, the program provides these members with clinical oversight of hospital admissions.

In addition, to control prescription drug costs, the Company maintains a contract with a pharmacy benefits management company that has approximately 62,000 participating pharmacies nationwide. We also utilize copayments, coinsurance, deductibles and annual limits to manage prescription drug costs.

 

Medicare

 

In 2007, we initiated efforts to expand into the Medicare market by establishing a Medicare Division. In the fourth quarter of 2007, we began offering a new portfolio of Medicare Advantage PFFS — called HealthMarkets Care Assured Plans^sm (“HMCA Plans”) — in selected markets in 29 states with coverage effective for January 1, 2008. Policies were issued by our Chesapeake subsidiary, under a contract with CMS, and primarily marketed through our dedicated agency field force consisting of independent agents contracted with our insurance subsidiaries.

 

Our HMCA Plans were offered to Medicare eligible beneficiaries as a replacement for original Medicare and Medigap (Supplement) policies. They provided enrollees with the actuarial benefit equivalence they would receive under original Medicare, as well as certain additional benefits or benefit options, such as preventive care, pharmacy benefits and certain vision, dental and hearing services. Enrollees could obtain services from any Medicare-eligible provider who agrees to accept the HMCA Plan’s terms and conditions. Enrollees may or may not pay a premium in addition to the premium payable for original Medicare. The amount of the additional premium varied, based on the level of benefits and coverage. Our initial plan offerings included the HealthMarkets Care Assured Value Plan, which had a $3,500 annual maximum out-of-pocket for covered expenses, and the HealthMarkets Care Assured Premier Plan, which had a $1,500 annual maximum out-of-pocket for covered expenses. Each plan could be purchased with Medicare Part D prescription drug coverage as an optional benefit. Coinsurance and copayment requirements varied by plan and service received.

 

In October 2007, the Company voluntarily suspended its Medicare marketing and enrollment activities pending a review by CMS of our compliance with regulatory requirements. In connection with this review, the Company agreed with CMS to take certain actions to ensure that it met applicable Medicare program requirements and, in November 2007, we resumed marketing and enrollment activities related to its HMCA plans. The Company believes that the suspension of Medicare marketing and enrollment activities in the fourth quarter of 2007 adversely affected enrollment of beneficiaries into our HMCA Plans for the 2008 plan year. The Company’s Medicare marketing and enrollment activities were subject to ongoing review by CMS and, in April 2008, CMS requested additional materials from us as part of a follow-up review of our Medicare marketing and enrollment activities. As a result of that review, on June 6, 2008, CMS requested that the Company submit a Corrective Action Plan (“CAP”). The Company submitted the CAP on June 20, 2008. The CAP provided for the Company to: increase the number of providers willing to be deemed, implement a meaningful disciplinary process for agents, decrease the rate of complaints against the Company, and decrease the Company’s level of rapid disenrollment/cancellations.

 

On July 15, 2008, the Medicare Improvements for Patients and Providers Act of 2008 (HR. 6331) was enacted, resulting in significant changes to the Medicare program, including the phased elimination of Medicare Advantage PFFS deeming arrangements beginning in 2011. The Company believes that this new law would have made it difficult for the Company to operate effectively in the Medicare market. In light of this changing landscape within the Medicare regulations, in July 2008, the Company decided that it would not participate in the Medicare Advantage market beyond the 2008 plan year. In October 2008, CMS informed the Company that, due to the Company’s impending exit from the Medicare market, the CAP has been closed and no further reports under the CAP are required. The Company will continue to fulfill its remaining obligations under the 2008 calendar year Medicare contract with CMS.

 

Other Insurance

 

Through our 82.5%-owned subsidiary, ZON Re, we underwrite, administer and issue accidental death, AD&D, accident medical and accident disability insurance products, both on a primary and on a reinsurance basis. In the year ended December 31, 2008, ZON Re generated revenues of $29.2 million and operating income of $4.4 million.

 

ZON Re underwrites and manages a portfolio of personal accident reinsurance programs on behalf of MEGA for primary life, accident and health and property and casualty insurers that wish to transfer risks associated with

certain types of primary personal accident insurance programs. Accident reinsurance provides reimbursement to primary insurance carriers for covered losses resulting from accidental bodily injury or accidental death. For its reinsurance clients, ZON Re targets national, regional and middle market insurers in the United States and select international markets. ZON Re distributes accident reinsurance products through a network of professional reinsurance intermediaries. ZON Re underwrites both treaty and facultative accident reinsurance programs, which may be offered on either a quota share or excess of loss basis. The Company has determined, as a matter of policy, that MEGA’s exposure on any single reinsurance contract issued by it and underwritten by ZON Re will not exceed $1.0 million per person and $10.0 million per event.

 

ZON Re also underwrites and distributes a limited portfolio of primary accident insurance products issued by Chesapeake. These products are designed for direct purchase by banks, associations, employers and affinity groups and are distributed through a national network of independent commercial insurance agents, brokers and third party administrators. The Company has determined, as a matter of policy, that Chesapeake’s maximum exposure on any single primary insurance contract issued by it and underwritten by ZON Re will not exceed $1.0 million per person.

 

In 2008, our principal insurance subsidiaries experienced downgrades in their financial strength ratings which had a negative effect on the growth of this business and our ability to maintain ZON Re’s current level of operating income. As a result, we expect to exit this line of business in 2009, with the existing reinsurance business managed to final termination of substantially all liabilities.

 

Ceded Reinsurance

 

Our insurance subsidiaries reinsure portions of the coverages provided by their insurance products with other insurance companies on both an excess-of-loss and coinsurance basis. Reinsurance agreements are intended to limit an insurer’s maximum loss. The maximum retention by MEGA, Mid-West and Chesapeake on one individual in the case of a life insurance policy is generally $200,000. In connection with the sale of our Life Insurance Division, substantially all of the insurance policies associated with the Life Insurance Division were reinsured by Wilton Reassurance Company or its affiliates on a 100% coinsurance basis, effective July 1, 2008. In connection with the sales in 2006 of the Company’s Star HRG and Student Insurance Divisions, insurance subsidiaries of the Company entered into 100% coinsurance arrangements with each of the purchasers, pursuant to which the purchasers agreed to assume liability for future claims associated with the Star HRG Division and Student Insurance Division blocks of group accident and health insurance policies in force as of the respective closing dates. We use reinsurance for our health insurance business solely for limited purposes.

 

Competition

 

In each of our lines of business, we compete with other insurance companies or service providers. With respect to the business of our SEA Division, the market is characterized by many competitors, and our main competitors include health insurance companies, health maintenance organizations and the Blue Cross/Blue Shield plans in the states in which we write business.

 

Competition in our businesses is based on many factors, including quality of service, product features, price, scope of distribution, scale, financial strength ratings and name recognition. We compete, and will continue to compete, for customers and distributors with many insurance companies and other financial services companies. We compete not only for business, but also for agents and distribution relationships. Some of our competitors may offer a broader array of products than our specific subsidiaries with which they compete in particular markets, may have a greater diversity of distribution resources, may have better brand recognition, may, from time to time, have more competitive pricing, may have lower cost structures or, with respect to insurers, may have higher financial strength or claims paying ratings. Organizations with sizable market share or provider-owned plans may be able to obtain favorable financial arrangements from healthcare providers that are not available to us. Some may also have greater financial resources with which to compete. In addition, from time to time, companies enter and exit the markets in which we operate, thereby increasing competition at times when there are new entrants. For example, several large insurance companies have entered the market for individual health insurance products. The development and growth of companies offering Internet-based connections between health care professionals and individuals, along with a variety of services, could also create additional competitors. We may lose business to

competitors offering competitive products at lower prices, or for other reasons, which could materially adversely affect our future financial condition and results of operations.

 

Regulatory and Legislative Matters

 

Insurance Regulation

 

State Regulation — General

 

Our insurance subsidiaries are subject to extensive regulation in their respective state of domicile and the other states in which they do business. Insurance statutes typically delegate broad regulatory, supervisory and administrative powers to each state’s Commissioner of insurance. The method of regulation varies, but the subject matter of such regulation covers, among other things, the amount of dividends and other distributions that can be paid by the insurance subsidiaries without prior approval or notification; the granting and revoking of licenses to transact business; trade practices, including with respect to the protection of consumers; disclosure requirements; privacy standards; minimum loss ratios; premium rate regulation; underwriting standards; approval of policy forms and mandating benefits; claims payment practices; licensing of insurance agents and the regulation of agent conduct; the amount and type of investments that the insurance subsidiaries may hold; minimum reserve and surplus requirements; risk-based capital requirements; and mandatory participation in, and assessments for, risk sharing pools and guaranty funds. Such regulation is intended to protect policyholders rather than investors.

 

State regulation of health insurance products varies from state to state, although all states regulate premium rates, policy forms and underwriting and claims practices to one degree or another. Most states have special rules for health insurance sold to individuals or small employer groups. Many states have also adopted legislation that would make health insurance available to all small employer groups by requiring coverage of all employees and their dependents, by limiting the applicability of pre-existing conditions exclusions, by requiring insurers to offer a basic plan exempt from certain benefits as well as a standard plan, or by establishing a mechanism to spread the risk of high risk employees to all small group insurers.

 

Various states have, from time to time, proposed and/or enacted changes to the healthcare system that could affect the relationship between health insurers and their customers. For example, Massachusetts law requires all residents to obtain minimum levels of health insurance and requires employers with 11 or more full time employees to pay an assessment if they do not offer health insurance to these employees. Other states have adopted or proposed laws intended to require minimum levels of health insurance for previously uninsured residents, including “play or pay” laws requiring that employers either offer health insurance or pay a tax to cover the costs of public healthcare insurance. We cannot predict with certainty the effect that the Massachusetts law, or proposed legislation in other states, if adopted, could have on our insurance businesses and operations.

 

A number of states have enacted other new health insurance legislation over the past several years. These laws, among other things, mandate benefits with respect to certain medical conditions or procedures and require health insurers to offer an independent external review of certain coverage decisions. There has also been an increase in legislation regarding, among other things, prompt payment of claims, privacy of personal health information, health insurer liability, prohibition against insurers including discretionary clauses in their policy forms and relationships between health insurers and providers. We expect that this trend of increased legislation will continue. These laws may have the effect of increasing our costs and expenses.

 

We provide health insurance products to consumers in the individual and self-employed market. As is the case with many of our competitors in this market, a substantial portion of our products are issued to members of various independent membership associations that act as the master policyholder for such products. During 2004, we and our insurance company subsidiaries resolved a nationwide class action lawsuit challenging the nature of the relationship between our insurance companies and the membership associations that make available to their members our insurance companies’ health insurance products. A number of additional lawsuits challenging, among other things, the nature of the relationship between our insurance companies and such membership associations are ongoing. See Note 16 of Notes to Consolidated Financial Statements. While we believe that we are providing association group coverage in full compliance with applicable law, changes in our relationship with the membership associations and/or changes in the laws and regulations governing association group insurance (particularly changes

that would subject the issuance of policies to prior premium rate approval and/or require the issuance of policies on a “guaranteed issue” basis) could have a material adverse impact on our financial condition and results of operations.

 

Many states have also enacted insurance holding company laws that require registration and periodic reporting by insurance companies controlled by other corporations. Such laws vary from state to state, but typically require periodic disclosure concerning the corporation that controls the controlled insurer and prior notice to, or approval by, the applicable regulator of inter-corporate transfers of assets and other transactions (including payments of dividends in excess of specified amounts by the controlled insurer) within the holding company system. Such laws often also require the prior approval for the acquisition of a significant ownership interest (i.e., 10% or more) in the insurance holding company. HealthMarkets, Inc. (the holding company) and our insurance subsidiaries are subject to such laws, and we believe that we and such subsidiaries are in compliance in all material respects with all applicable insurance holding company laws and regulations.

 

Under the risk-based capital initiatives adopted in 1992 by the National Association of Insurance Commissioners (“NAIC”), insurance companies must calculate and report information under a risk-based capital formula. Risk-based capital formulas are intended to evaluate risks associated with asset quality, adverse insurance experience, losses from asset and liability mismatching, and general business hazards. This information is intended to permit regulators to identify and require remedial action for inadequately capitalized insurance companies, but it is not designed to rank adequately capitalized companies. At December 31, 2008, the risk-based capital ratio of each of our insurance subsidiaries exceeded the ratio for which regulatory corrective action would be required.

 

The states in which our insurance subsidiaries are licensed have the authority to change the minimum mandated statutory loss ratios to which they are subject, the manner in which these ratios are computed and the manner in which compliance with these ratios is measured and enforced. Loss ratios are commonly defined as incurred claims as a percentage of earned premiums. Most states in which our insurance subsidiaries write insurance have adopted the minimum loss ratios recommended by the NAIC, but frequently these loss ratio regulations do not apply to the types of health insurance issued by our subsidiaries. A number of states are considering the adoption of, or have adopted, laws that would mandate minimum statutory loss ratios, or increase existing minimum statutory loss ratios, for the products we offer. For example, on July 1, 2007, California regulations became effective that require a minimum medical loss ratio of 70% for individual health insurance issued after that date, as well as business issued prior to that date if it is subject to a rate revision. We have filed new products intended to address these California minimum medical loss ratio requirements. Our ability to offer these products is subject to receipt of applicable regulatory approvals, and there can be no assurance that approvals will be received. In the event that we are not in compliance with minimum statutory loss ratios mandated by regulatory authorities with respect to certain policies, we may be required to reduce or refund premiums, which could have a material adverse effect on our financial condition and results of operations.

 

In 2008, the California legislature passed a bill that would have required health insurers to maintain at least an 85% medical loss ratio across all lines of business by 2011. The bill was vetoed by the Governor, but similar legislation has been proposed in 2009. We believe that such legislation, if passed, would have a disproportionate effect on health insurers primarily offering products to the individual market. A number of other states in which we do business have considered, in legislation or regulation, increasing minimum medical loss ratios. We are unable to predict the impact of (i) any changes in the mandatory statutory loss ratios for individual or group policies to which we may become subject, or (ii) any change in the manner in which these minimums are computed or enforced in the future. Such changes could have a material adverse effect on our financial condition and results of operations by preventing us from doing business in certain states or resulting in a narrowing of profit margins.

 

The NAIC and state insurance departments are continually reexamining existing laws and regulations, including those related to reducing the risk of insolvency and related accreditation standards. To date, the increase in solvency-related oversight has not had a significant impact on our insurance business.

 

State Regulation — Financial and Market Conduct Examinations

 

Our insurance subsidiaries are required to file detailed annual statements with the state insurance regulatory departments and are subject to periodic financial and market conduct examinations by such departments. The

Oklahoma Insurance Department (the regulator of MEGA’s and Chesapeake’s domicile state) and the Texas Department of Insurance (the regulator of Mid-West’s state of domicile) completed during 2008 the regularly scheduled tri-annual financial exams for the year ended December 31, 2006.

 

State insurance departments have also periodically conducted and continue to conduct market conduct examinations of HealthMarkets’ insurance subsidiaries. In March 2005, HealthMarkets received notification that the Market Analysis Working Group of the NAIC had chosen the states of Washington and Alaska to lead a multi-state market conduct examination of HealthMarkets’ principal insurance subsidiaries (the “Insurance Subsidiaries”) for the examination period January 1, 2000 through December 31, 2005. The examiners issued a final examination report on December 20, 2007. See Note 16 of Notes to Consolidated Financial Statements.

 

The findings of the final examination report cite deficiencies in five major areas of operation: (i) insufficient training of agents and lack of oversight of agent activities, (ii) deficient claims handling practices, (iii) insufficient disclosure of the relationship with affiliates and the membership associations, (iv) deficient handling of complaints and grievances, and (v) failure to maintain a formal corporate compliance plan and centralized corporate compliance department.

 

In connection with the issuance of the final examination report, the Washington Office of Insurance Commissioner issued an order adopting the findings of the final examination report and ordering the Insurance Subsidiaries to comply with certain required actions set forth in the report. As part of the order, the Insurance Subsidiaries were required to file a detailed report specifying the business reforms, improvements and changes to policies and procedures implemented by the Insurance Subsidiaries as of March 20, 2008. This report was sent to all jurisdictions on March 28, 2008.

 

On May 29, 2008, the Insurance Subsidiaries entered into a regulatory settlement agreement (“RSA”) with the states of Washington and Alaska, as lead regulators, and three other “monitoring” states. Thereafter, all states (other than Massachusetts and Delaware) and the District of Columbia, Puerto Rico and Guam signed the RSA, which became effective on August 15, 2008. In connection with the RSA, the Insurance Subsidiaries paid a penalty of $20 million. The RSA includes standards for performance measurement for 13 different required actions which must be implemented on or before December 31, 2009. The Insurance Subsidiaries timely filed semi-annual reports on November 14, 2008 and February 13, 2009. On or before July 1, 2010, the monitoring states will initiate a re-examination to assess the standard for performance measurement. If the re-examination is unfavorable, the Insurance Subsidiaries are subject to additional penalties of up to $10 million.

 

As reported in Note 16 of the Notes to Consolidated Financial Statements, the Insurance Subsidiaries were subject to a number of other market conduct examinations or proceedings during 2008. In addition, the Insurance Subsidiaries are subject to various other pending market conduct and other regulatory examinations, inquiries or proceedings arising in the ordinary course of business. State insurance regulatory agencies have authority to levy monetary fines and penalties resulting from findings made during the course of such matters. Historically, our insurance subsidiaries have, from time to time, been subject to such fines and penalties, none of which, individually or in the aggregate, have had a material adverse effect on our financial condition and results of operations. However, the multi-state examination and other regulatory examinations, inquiries or proceedings could result in, among other things, changes in business practices that require the Company to incur substantial costs. Such results, singly or in combination, could injure our reputation, cause negative publicity, adversely affect our debt and financial strength ratings, place us at a competitive disadvantage in marketing or administering our products, or impair our ability to sell or retain insurance policies, thereby adversely affecting our business, and potentially materially adversely affecting the results of operations in a period, depending on the results of operations for the particular period. Determination by regulatory authorities that we have engaged in improper conduct could also adversely affect our defense of various lawsuits.

 

Federal Regulation

 

In 1945, the U.S. Congress enacted the McCarran-Ferguson Act, which declared the regulation of insurance to be primarily the responsibility of the individual states. Although repeal of McCarran-Ferguson is debated in the U.S. Congress from time to time, the federal government generally does not directly regulate the insurance business. However, federal legislation and administrative policies in several areas, including healthcare (including Medicare),

pension regulation, age and sex discrimination, financial services regulation, securities regulation, privacy laws, terrorism and federal taxation, do affect the insurance business.

 

Privacy Regulations

 

The use, disclosure and secure handling of individually identifiable health information by our business is subject to federal regulations, including the privacy provisions of the federal Gramm-Leach-Bliley Act and the privacy and security regulations of the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”). In addition, our privacy and security practices are subject to various state law and regulations.

 

HIPAA includes requirements for maintaining the confidentiality and security of individually identifiable health information and new standards for electronic healthcare transactions. The Department of Health and Human Services promulgated final HIPAA regulations in 2002. The privacy regulations required compliance by April 2003, the electronic transactions regulations by October 2003, and the security regulations by April 2005. As have other entities in the healthcare industry, we have incurred substantial costs in meeting the requirements of these HIPAA regulations and expect to continue to incur costs to maintain compliance. We have worked diligently to comply with these regulations within the time periods required and believe that we have complied.

 

HIPAA also requires certain guaranteed issuance and renewability of health insurance coverage for individuals and small employer groups (generally 50 or fewer employees) and limits exclusions based on pre-existing conditions.

 

The Health Information Technology for Economic and Clinical Health Act (“HITECH Act”) was enacted into law on February 17, 2009 as part of the American Recovery and Reinvestment Act of 2009. The HITECH Act contains a number of provisions that significantly expand the reach of HIPAA. For example, the law imposes varying civil monetary penalties and creates a private cause of action for HIPAA violations, extends HIPAA’s security provisions to business associates, and creates new security breach notification requirements. We may incur significant costs in implementing the policies and systems required to comply with these new requirements.

 

HIPAA and other federal and state privacy regulations continue to evolve as a result of new legislation, regulations and judicial and administrative interpretations. Consequently, our efforts to measure, monitor and adjust our business practices to comply with these requirements are ongoing. Failure to comply could result in regulatory fines and civil lawsuits. Knowing and intentional violations of these rules may also result in federal criminal penalties.

 

CAN SPAM Act and Do Not Call Regulations

 

From time to time, the Company utilizes, either directly or through third party vendors, e-mail and telephone calls to identify prospective sales leads for use by our agents. The federal CAN SPAM Act, which became effective January 1, 2004 and is administered and enforced by the Federal Trade Commission, establishes national standards for sending bulk, unsolicited commercial e-mail. While targeting and prohibiting e-marketers to send unsolicited commercial e-mail with falsified headers, the CAN SPAM Act permits the use of unsolicited commercial e-mail if and as long as the message contains an opt-out mechanism, a functioning return e-mail address, a valid subject line indicating the e-mail is an advertisement and the legitimate physical address of the mailer. The Company is also required to comply with federal “Do Not Call” regulations, which require insurance companies to develop their own “do not call” lists and reference state and federal “do not call” registries before making calls to market insurance products.

 

While the Company has taken what it believes are reasonable steps to ensure that it, and the various third party vendors with which it does business, are in full compliance with these requirements, failure to comply could result in regulatory fines and civil lawsuits.

 

USA PATRIOT Act

 

On October 26, 2001, the International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001 was enacted into law as part of the USA PATRIOT Act. The law requires, among other things, that financial institutions adopt anti-money laundering programs that include policies, procedures and controls to detect and

prevent money laundering, designate a compliance officer to oversee the program and provide for employee training, and periodic audits in accordance with regulations proposed by the U.S. Treasury Department. The Office of Federal Asset Control requirements prohibit business dealings with entities identified as threats to national security. We have licensed software designed to help maintain compliance with these requirements and we continually evaluate our policies and procedures to comply with these regulations.

 

Employee Retirement Income Security Act of 1974

 

The Employee Retirement Income Security Act of 1974, as amended (“ERISA”), regulates how goods and services are provided to or through certain types of employer-sponsored health benefit plans. ERISA is a set of laws and regulations subject to periodic interpretation by the United Stated Department of Labor (“DOL”) as well as the federal courts. ERISA places controls on how our insurance subsidiaries may do business with employers who sponsor employee health benefit plans. We believe that many of our products are not subject to ERISA because they are offered to and used by individuals, self-employed persons or employers with less than two participants who are employees as of the start of any plan year. However, some of our products or services may be subject to the ERISA regulations. During 2005 and 2006, we received inquiries from the Boston and Dallas offices of the DOL that alleged, among other things, that certain policy forms in use by our insurance subsidiaries are not ERISA compliant. The Company has resolved this matter with DOL on terms that did not have a material adverse effect on the Company’s financial condition and results of operations.

 

Medicare

 

Medicare is a complex and highly regulated federal program that provides eligible persons age 65 and over and some disabled persons a variety of hospital and medical insurance benefits. During 2008, our Chesapeake subsidiary issued Medicare Advantage Private-Fee-for-Service Plans to Medicare beneficiaries under a contract with CMS. CMS performs audits of each health plan operating under a Medicare contract to determine the plan’s compliance with federal regulations and contractual obligations. These audits include review of the plan’s administration and management, including marketing, enrollment and disenrollment activities, claims processing and complaint systems and management information and data collection systems. CMS regulations also require submission of annual financial statements. Chesapeake terminated its agreement with CMS effective December 31, 2008, which resulted in the Company’s exit from the Medicare market.

 

Legislative Developments

 

The federal and state governments continue to consider legislative and regulatory proposals that could materially impact health insurance companies and various aspects of the current health care system, including, among other things, modifications to the existing employer-based insurance system, a quasi-regulated system of “managed competition” among health insurers and a single-payer, public program in which the government would oversee or manage the provision of health insurance coverage. Many of these proposals attempt to reduce the number of uninsured by increasing affordability and expanding access to health insurance, including proposals intended to expand eligibility for public programs and compel individuals and employers to purchase health insurance coverage. As discussed above, Massachusetts has enacted an individual health coverage mandate, and a number of other states are considering similar significant reforms In November of 2008, America’s Health Insurance Plans (“AHIP”, a health insurance trade association) endorsed the concept of universal health insurance coverage through an individual mandate and guarantee issue coverage with no pre-existing condition exclusions. In addition, a number of states, including California, are considering legislation that would require health insurers to maintain a minimum medical loss ratio across all lines of business (in the case of California — 85%). We believe that such legislation, if passed, would have a disproportionate effect on health insurers primarily offering products to the individual market and could have a material adverse effect on our business.

 

Some of the more significant legislative and regulatory developments that could potentially affect our business include the following:

 

 

 

We expect the trend of increased legislative activity concerning health care reform to continue and cannot predict with certainty the effect that such proposals, if adopted, could have on our health insurance business and operations. Changes in health care policy could significantly affect our business. For example, federally mandated, comprehensive major medical insurance, if proposed and implemented, could partially or fully replace some of our current products. Many of the proposals, if adopted, could have a material adverse effect on our financial condition and results of operations.

 

Employees

 

We had approximately 1,450 employees at December 31, 2008. In connection with the sale of our Life Insurance Division, on September 30, 2008, approximately 170 employees separated from employment with the Company. On November 18, 2008, the Company implemented a strategic reduction of its remaining workforce designed to increase administrative efficiencies and better align the workforce to support the Company’s business strategy going forward. The reduction affected approximately 13% of the Company’s workforce or a total of approximately 225 employees and was substantially completed by December 31, 2008. We believe that the Company’s relations with current employees are generally good. The agents within our dedicated agency field force are independent contractors of our insurance subsidiaries and are not employees of the Company.

Executive Officers of the Company

 

The Chairman of the Company and all other executive officers listed below are elected by the Board of Directors of the Company at its Annual Meeting each year to hold office until the next Annual Meeting or until their successors are elected or appointed. None of these officers have family relationships with any other executive officer or director.

 

 

 

The following factors could impact our business and financial prospects:

 

We may lose business to competitors offering competitive products at lower prices.

 

We compete, and will continue to compete, for customers and distributors with many insurance companies and other financial services companies. We compete not only for the business of customers, but also for agents and distribution relationships. Our competitors may offer a broader array of products than we do, have a greater diversity of distribution resources, have better brand recognition, have more competitive pricing or have higher financial strength or claims paying ratings. Competitors with sizable market share or provider-owned plans may be able to obtain favorable financial arrangements from healthcare providers that are not available to us.

Failure to accurately estimate medical claims and healthcare costs may have a significant impact on our financial condition and results of operations.

 

If we are unable to accurately estimate medical claims and control healthcare costs, our results of operations may be materially and adversely affected. We estimate the cost of future medical claims and other expenses using actuarial methods based upon historical data, medical inflation, product mix, seasonality, utilization of healthcare services and other relevant factors. We establish premiums based on these methods. The premiums we charge our customers generally are fixed for six-month or one-year periods, and costs we incur in excess of our medical claim projections generally are not recovered in the contract year through higher premiums.

 

Failure to comply with extensive state and federal regulations could subject us to fines, penalties and suspensions, which could have a material adverse effect on our financial condition and results of operations.

 

We are subject to extensive governmental regulation and supervision. See Item 1. Business — “Regulatory and Legislative Matters” for additional information. Most insurance regulations are designed to protect the interests of policyholders rather than stockholders and other investors. This regulation, generally administered by a department of insurance in each state in which we do business, relates to, among other things:

 

 

State insurance departments also conduct periodic examinations of the affairs of insurance companies through, among other things, financial and market conduct examinations, and require the filing of annual and other reports relating to the financial condition of insurance companies, holding company issues and other matters. Regulatory agencies have imposed substantial fines against us in the past, and may impose substantial fines against us in the future if they determine that we have not complied with applicable laws and regulations. See Note 16 to Notes to Consolidated Financial Statements.

 

There is also substantial federal regulation of our business. Laws and regulations adopted by the federal government, including the Sarbanes-Oxley Act of 2002, the Gramm-Leach-Bliley Act, HIPAA, the USA PATRIOT Act and Do Not Call regulations, establish administrative and compliance requirements applicable to the Company.

 

Our business depends on compliance with applicable laws and regulations and our ability to maintain valid licenses and approvals for our operations. Regulatory authorities have broad discretion to grant, renew or revoke licenses and approvals. Regulatory authorities may deny or revoke licenses for various reasons, including the violation of regulations. In some instances, we follow practices based on our interpretations of regulations, or those that we believe to be generally followed by the industry, which may be different from the requirements or

interpretations of regulatory authorities. If we do not have the requisite licenses and approvals and do not comply with applicable regulatory requirements, the insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities or otherwise penalize us. That type of action could have a material adverse effect on our business. Our failure to comply with new or existing government regulation could subject us to significant fines and penalties. Our efforts to measure, monitor and adjust our business practices to comply with current laws are ongoing. Failure to comply with enacted regulations could result in significant fines, penalties or the loss of one or more of our licenses.

 

Changes in government regulation could increase the costs of compliance or cause us to discontinue marketing our products in certain states.

 

We conduct business in a heavily regulated industry. See Item 1. Business — “Regulatory and Legislative Matters” for additional information. Changes in the level of government regulation or in the laws and regulations themselves could increase the costs of compliance and result in significant changes to our operations, including potentially causing us to discontinue marketing our products in certain states. Such changes could have a material adverse effect on our financial condition and results of operations.

 

The new Presidential administration and members of Congress have indicated that they intend to enact federal health care reform measures in the near future. Many of these proposals attempt to reduce the number of uninsured by increasing affordability and expanding access to health insurance, including proposals intended to expand eligibility for public programs and compel individuals and employers to purchase health insurance coverage. Certain of these proposals, if implemented, could partially or fully replace some of our current products.

 

In addition, a number of states in which we do business are considering legislation intended to increase affordability or expand coverage of the uninsured. For example, in 2008, the California legislature passed a bill that would have required health insurers to maintain at least an 85% medical loss ratio across all lines of business by 2011. The bill was vetoed by the Governor, but similar legislation has been proposed in 2009. We believe that such legislation, if passed, would have a disproportionate effect on health insurers primarily offering products to the individual market and could have a material adverse effect on our business, including causing us to discontinue marketing our products in states where such legislation is passed.

 

Some of the more significant additional legislative and regulatory developments that could potentially affect our business include the following:

 

 

 

We expect the trend of increased legislative activity concerning health care reform to continue and cannot predict with certainty the effect that such proposals, if adopted, could have on our health insurance business and operations. Changes in health care policy could significantly affect our business. Many of the proposals, if adopted, could have a material adverse effect on our financial condition and results of operations.

 

We must comply with restrictions on customer privacy and information security, including taking steps to ensure compliance by our business associates with HIPAA.

 

The use, disclosure and secure handling of individually identifiable health information by our business is subject to federal regulations, including the privacy provisions of the federal Gramm-Leach-Bliley Act and the privacy and security regulations promulgated under HIPAA. See Item 1. Business — “Regulatory and Legislative Matters” for additional information. The HIPAA regulations establish significant criminal penalties and civil sanctions for non-compliance. Our privacy and security practices are also subject to various state laws and regulations. The HIPAA regulations require, among other things, that we enter into specific written agreements with business associates to whom individually identifiable health information is disclosed. Although our contracts with business associates provide for appropriate protections of such information, we may have limited control over the actions and practices of our business associates. Compliance with HIPAA and other state and federal privacy and security regulations have required us to implement changes in our programs and systems to maintain compliance and may in the future result in significant expenditures due to necessary systems changes, the development of new administrative processes and the effects of potential noncompliance by our business associates.

 

Failure to comply with the terms of the regulatory settlement agreement arising out of the multi-state market conduct examination of our principal insurance subsidiaries could have a material adverse effect on our financial condition and results of operations.

 

In March 2005, we received notification that the Market Analysis Working Group of the NAIC had chosen the states of Washington and Alaska to lead a multi-state market conduct examination of our principal insurance subsidiaries, MEGA, Mid-West and Chesapeake (the “Insurance Subsidiaries”). On May 29, 2008, the Insurance Subsidiaries entered into a regulatory settlement agreement (“RSA”) with the states of Washington and Alaska, as lead regulators, and three other “monitoring” states. Thereafter, all states (other than Massachusetts and Delaware) and the District of Columbia, Puerto Rico and Guam signed the RSA, which became effective on August 15, 2008. In connection with the RSA, the Insurance Subsidiaries paid a penalty of $20 million. The RSA includes standards for performance measurement for 13 different required actions which must be implemented on or before December 31, 2009. The Insurance Subsidiaries timely filed semi-annual reports on November 14, 2008 and February 13, 2009. On or before July 1, 2010, the monitoring states will initiate a re-examination to assess the standard for performance measurement. If the re-examination is unfavorable, the Insurance Subsidiaries are subject to additional penalties of up to $10 million. See Note 16 of Notes to Consolidated Financial Statements.

 

The Company’s insurance subsidiaries are subject to various other pending market conduct and other regulatory examinations, inquiries or proceedings arising in the ordinary course of business. State insurance regulatory agencies have authority to levy significant fines and penalties and require remedial action resulting from findings made during the course of such matters. Market conduct or other regulatory examinations, inquiries or proceedings could result in, among other things, changes in business practices that require the Company to incur substantial costs. Such results, singly or in combination, could injure our reputation, cause negative publicity, adversely affect our debt and financial strength ratings, place us at a competitive disadvantage in marketing or administering our products or impair our ability to sell or retain insurance policies, thereby adversely affecting our business, and potentially materially adversely affecting the results of operations in a period, depending on the results of operations for the particular period. Determination by regulatory authorities that we have engaged in improper conduct could also adversely affect our defense of various lawsuits.

Changes in our relationship with membership associations that make available to their members our health insurance products and/or changes in the laws and regulations governing so-called “association group” insurance could have a material adverse effect on our financial condition and results of operations.

 

As is the case with many of our competitors in the self-employed market, a substantial portion of our health insurance products are issued to members of various independent membership associations that act as the master policyholder for such products. The two principal membership associations in the self-employed market that make available to their members our health insurance products are the National Association for the Self-Employed and the Alliance for Affordable Services. The associations provide their members access to a number of benefits and products, including health insurance underwritten by us. Subject to applicable state law, individuals generally may not obtain insurance under an association’s master policy unless they are also members of the association. The agreements with these associations requiring the associations to continue as the master policyholder for our policies and to make our products available to their respective members are terminable by us or the association upon not less than one year’s advance notice to the other party. A termination of our agreements with these associations would be fundamentally disruptive to our marketing efforts. We would be unable to offer products through the association master policy and, in certain states, could be required to seek approval of new policy forms and premium rates before resuming marketing efforts. In the event of a termination, the associations could market alternative health insurance products to their association members.

 

The independent agents within our dedicated agency field force also act as field service representatives (FSRs) for the associations. In this capacity, the FSRs enroll new association members and provide membership retention services. For such services, we and the FSRs receive compensation. One of our subsidiaries, HealthMarkets Lead Marketing Group, Inc., serves as our direct marketing group and generates new membership sales prospect leads for use by the FSRs. HealthMarkets Lead Marketing Group also provides video and print services to the associations. In addition to health insurance premiums derived from the sale of health insurance, we receive fee income from the associations, including fees associated with enrollment and member retention services, fees for association membership marketing and administrative services and fees for certain association member benefits.

 

While we believe that we are providing association group coverage in full compliance with applicable law, changes in our relationship with the membership associations and/or changes in the laws and regulations governing so-called “association group” insurance, particularly changes that would subject the issuance of policies to prior premium rate approval and/or require the issuance of policies on a “guaranteed issue” basis, could have a material adverse impact on our financial condition and results of operations.

 

Negative publicity regarding our business practices and about the health insurance industry in general may harm our business and could have a material adverse effect on our financial condition and results of operations.

 

The health and life insurance industry and related products and services we provide attracts negative publicity from consumer advocate groups and the media. Negative publicity regarding the industry generally or our Company in particular may result in increased regulation and legislative scrutiny as well as increased litigation, which may further increase our costs of doing business and adversely affect our profitability by impeding our ability to market our products and services, requiring us to change our products or services or increasing the regulatory burdens under which we operate.

 

Our failure to secure and enhance cost-effective healthcare provider network contracts may result in a loss of insureds and/or higher medical costs and could have a material adverse effect on our financial condition and results of operations.

 

Our results of operations and competitive position could be adversely affected by our inability to enter into or maintain satisfactory relationships with networks of hospitals, physicians, dentists, pharmacies and other healthcare providers. The failure to secure cost-effective healthcare provider network contracts, the inability to maintain “rental” access to health care provider networks, or the refusal of health care providers to honor the discounts obtained through such networks, may result in a loss of insureds or higher medical costs. In addition, the inability to

contract with provider networks, the inability to terminate contracts with existing provider networks and enter into arrangements with new provider networks to serve the same market, and/or the inability of providers to provide adequate care, could have a material adverse effect on our financial condition and results of operations.

 

HealthMarkets’ inability to obtain funds from its insurance subsidiaries may cause it to experience reduced cash flow, which could affect the Company’s ability to pay its obligations to creditors as they become due.

 

We are a holding company, and our principal assets are our investments in our separate operating subsidiaries, including our regulated insurance subsidiaries. Our ability to fund our cash requirements is largely dependent upon our ability to access cash from our subsidiaries. Our insurance subsidiaries are subject to regulations that limit their ability to transfer funds to us. We have a significant amount of debt outstanding that contains restrictive covenants. If we are unable to obtain funds from our insurance subsidiaries, we will experience reduced cash flow, which could affect our ability to pay our obligations to creditors as they become due.

 

Current unfavorable economic conditions could adversely affect our business.

 

General economic, financial market and political conditions could have a material adverse effect on our financial condition and results of operations. Recently, concerns over inflation, energy costs, geopolitical issues, the availability and cost of credit, the global mortgage market, a declining global real estate market, and the loss of consumer confidence and a reduction in consumer spending have contributed to increased volatility and diminished expectations for the economy and the markets going forward. These market conditions expose us to a number of risks, including risks associated with the potential financial instability of our customers. If our customer base experiences cash flow problems and other financial difficulties, it could, in turn, adversely impact the sale of our insurance products. For example, our customers may modify, delay or cancel plans to purchase our products, or may choose to reduce the level of coverage purchased from us. In addition, if our customers experience financial issues, they may not be able to pay, or may delay payment of, accounts receivable that are owed to us. Further, our customers or potential customers may force us to compete more vigorously on factors such as price and service to retain or obtain their business. A significant decline in the sale of our products and the inability of current and/or potential customers to pay their premiums as a result of unfavorable economic conditions may adversely affect our business, including our revenues, profitability and cash flow. In addition, general inflationary pressures may affect the costs of health care, increasing the costs of paying claims.

 

In addition, we are subject to extensive laws and regulations that are administered and enforced by a number of different governmental authorities, including, but not limited to, state insurance regulators, the U.S. Securities and Exchange Commission and state attorneys general. In light of the difficult economic conditions, some of these authorities are considering or may in the future consider enhanced or new regulatory requirements intended to prevent future crises or to otherwise assure the stability of institutions under their supervision. These authorities may also seek to exercise their supervisory or enforcement authority in new or more robust ways. All of these possibilities, if they occurred, could affect the way we conduct our business and manage our capital, either of which in turn could have a material adverse effect on our financial condition and results of operations.

 

The value of our investments is influenced by varying economic and market conditions and a decrease in value could have an adverse effect on our financial condition and results of operations and liquidity.

 

Our investment portfolio is comprised primarily of investments classified as securities available for sale. The fair value of our available for sale securities was $805.2 million and represented approximately 42% of our total consolidated assets at December 31, 2008. These investments are carried at fair value, and the unrealized gains or losses are included in accumulated other comprehensive loss as a separate component of shareholders’ equity, unless the decline in value is deemed to be other than temporary. For our available for sale investments, if a decline in value is deemed to be other than temporary, the security is deemed to be other than temporarily impaired and it is written down to fair value and the loss is recorded as an expense in earnings. In accordance with applicable accounting standards, we review our investment securities to determine if declines in fair value below cost are other than temporary. This review is subjective and requires a high degree of judgment. We conduct this review on a quarterly basis (or more frequently if certain indicators arise), using both quantitative and qualitative factors, to

determine whether a decline in value is other than temporary. In its review, management considers the following indicators of impairment: fair value significantly below cost; decline in fair value attributable to specific adverse conditions affecting a particular investment; decline in fair value attributable to specific conditions, such as conditions in an industry or in a geographic area; decline in fair value for an extended period of time; downgrades by rating agencies from investment grade to non-investment grade; financial condition deterioration of the issuer and situations where dividends have been reduced or eliminated or scheduled interest payments have not been made.

 

The current economic environment and recent volatility of the securities markets increase the difficulty of assessing investment impairment and the same influences tend to increase the risk of potential impairment of these assets. During the year ended December 31, 2008, we recorded $26.0 million of charges for other than temporary impairment of securities. Given the current volatile market conditions and the significant judgments involved, there is continuing risk that further declines in fair value may occur and material other than temporary impairments may result in realized losses in future periods which could have a material adverse effect on our financial condition and results of operations.

 

Adverse securities and credit market conditions could have a material adverse affect on our liquidity or our ability to obtain credit on acceptable terms.

 

The securities and credit markets have been experiencing extreme volatility and disruption. In some cases, the markets have exerted downward pressure on the availability of liquidity and credit capacity for certain issuers. We need liquidity to make payments for benefits, claims and commissions, service the Company’s debt obligations and pay operating expenses. Our primary sources of cash on a consolidated basis have been premium revenue from policies issued, investment income, and fees and other income. In the event we need access to additional capital to pay our operating expenses, make payments on our indebtedness, pay capital expenditures or fund acquisitions, our ability to obtain such capital may be limited and the cost of any such capital may be significant. Our access to additional financing will depend on a variety of factors such as market conditions, the general availability of credit, the overall availability of credit to our industry, our credit ratings and credit capacity, as well as the possibility that customers or lenders could develop a negative perception of our long- or short-term financial prospects. Similarly, our access to funds may be impaired if regulatory authorities or rating agencies take negative actions against us. If a combination of these factors were to occur, our internal sources of liquidity may prove to be insufficient, and, in such case, we may not be able to successfully obtain additional financing on favorable terms.

 

Failure of our insurance subsidiaries to maintain their current insurance ratings could have a material adverse effect on our financial condition and results of operations.

 

Our principal insurance subsidiaries are currently rated by A.M. Best, Fitch and S&P and experienced downgrades in financial strength ratings during 2008. These ratings are subject to periodic review by the ratings agencies and there can be no assurances that we will be able to maintain these current ratings. A downward adjustment in rating by A.M. Best, Fitch and/or S&P of our insurance subsidiaries could have a material adverse effect on our financial condition and results of operations. If our ratings are lowered from their current levels, our competitive position could be materially adversely affected and it could be more difficult for us to market our products. Rating agencies may take action to lower our ratings in the future due to, among other things, perceived concerns about our liquidity or solvency, the competitive environment in the insurance industry, which may adversely affect our revenues, the inherent uncertainty in determining reserves for future claims, which may cause us to increase our reserves for claims, the outcome of pending litigation and regulatory investigations, which may adversely affect our financial position and reputation and possible changes in the methodology or criteria applied by the rating agencies. In addition, rating agencies have come under recent scrutiny over their ratings practices and could, as a result, become more conservative in their methodology and criteria, which could adversely affect our ratings. Finally, rating agencies or regulators could increase capital requirements for the Company or its subsidiaries which in turn, could negatively affect our financial position as well.

 

We may not have enough statutory capital and surplus to continue to write business.

 

Our continued ability to write business is dependent on maintaining adequate levels of statutory capital and surplus to support the policies we write. Our new business writing typically results in net losses on a statutory basis

during the early years of a policy. The resulting reduction in statutory surplus, or surplus strain, limits our ability to seek new business due to statutory restrictions on premium to surplus ratios and statutory surplus requirements. If we cannot generate sufficient statutory surplus to maintain minimum statutory requirements through increased statutory profitability, reinsurance or other capital generating alternatives, we will be limited in our ability to realize additional premium revenue from new business writing, which could have a material adverse effect on our financial condition and results of operations or, in the event that our statutory surplus is not sufficient to meet minimum premium to surplus and risk-based capital ratios in any state, we could be prohibited from writing new policies in such state.

 

Our reserves for current and future claims may be inadequate and any increase to such reserves could have a material adverse effect on our financial condition and results of operations.

 

We calculate and maintain reserves for current and future claims using assumptions about numerous variables, including our estimate of the probability of a policyholder making a claim, the severity and duration of such claim, the mortality rate of our policyholders, the persistency or renewal of our policies in force and the amount of interest we expect to earn from the investment of premiums. The adequacy of our reserves depends on the accuracy of our assumptions. We cannot assure you that our actual experience will not differ from the assumptions used in the establishment of reserves. Any variance from these assumptions could have a material adverse effect on our financial condition and results of operations.

 

Litigation or settlements thereof may result in financial losses or harm our reputation and may divert management resources.

 

Current and future litigation with private parties or governmental authorities may result in financial losses, harm our reputation and require the dedication of significant management resources. We are regularly involved in litigation. The litigation naming us as a defendant ordinarily involves our activities as an insurer. In recent years, many insurance companies, including us, have been named as defendants in class actions relating to market conduct or sales practices.

 

For our general claim litigation, we establish reserves based on experience to satisfy judgments and settlements in the normal course. Management expects that the ultimate liability, if any, with respect to general claim litigation, after consideration of the reserves maintained, will not be material to the consolidated financial condition of the Company. Nevertheless, given the inherent unpredictability of litigation, it is possible that an adverse outcome in certain claim litigation involving punitive damages could, from time to time, have a material adverse effect on our consolidated results of operations in a period, depending on the results of our operations for the particular period.

 

Given the expense and inherent risks and uncertainties of litigation, we regularly evaluate litigation matters pending against us, including those described in Note 16 of Notes to Consolidated Financial Statements, to determine if settlement of such matters would be in the best interests of the Company and its stockholders. The costs associated with any such settlement could be substantial and, in certain cases, could result in an earnings charge in any particular quarter in which we enter into a settlement agreement. Although we have recorded litigation reserves which represent our best estimate on probable losses, our recorded reserves might prove to be inadequate to cover an adverse result or settlement for extraordinary matters. Therefore, costs associated with the various litigation matters to which we are subject and any earnings charge recorded in connection with a settlement agreement could have a material adverse effect on our consolidated results of operations in a period, depending on the results of our operations for the particular period.

 

Changes in our relationship with the agents who sell our products resulting from Fair Labor Standards Act litigation could require us to revise our business practices.

 

HealthMarkets is a party to actions filed under the Fair Labor Standards Act (“FLSA”) in which plaintiffs (consisting of former district sales leaders and regional sales leaders in the Cornerstone America independent agent hierarchy) allege that that they were employees within the meaning of the FLSA and are therefore entitled to recover unpaid overtime wages under the terms of the FLSA. In October 2008, the United States Fifth Circuit Court of Appeals affirmed the trial court’s ruling in favor of plaintiffs on the issue of their status as employees under the

FLSA and remanded the case to the trial court for further proceedings. See Note 16 of Notes to Consolidated Financial Statements. As a result of this ruling, the Company is in the process of evaluating various changes in its relationship with agents, including the structure of its sales force and the manner in which we contract, communicate and interact with agents. At present, it is unclear what effect these matters, and the changes under consideration by the Company, may have on the Company’s consolidated financial condition and results of operations.

 

We have recently experienced significant turnover in senior management. If we are unable to manage the succession of our key executives, it could adversely affect our business.

 

Over the past year, we have experienced a high turnover in our senior management team. Although we have succession plans in place and have employment arrangements with our key executives, these do not guarantee that the services of these key executives will continue to be available to us. We would be adversely affected if we fail to adequately plan for future turnover of our senior management team.

 

Acquisitions, divestitures and other significant transactions may adversely affect our business.

 

We continue to evaluate the profitability of our existing businesses and operations. From time to time, we review potential acquisitions and divestitures in light of our core businesses and growth strategies. The success of any such acquisition or divestiture depends, in part, upon our ability to identify suitable buyers or sellers, negotiate favorable contract terms and, in many cases, obtain governmental approval. For acquisitions, success is also dependent upon efficiently integrating the acquired business into the Company’s existing operations. For divestures, in the event the structure of the transaction results in continuing obligations by the buyer to us or our customers, a buyer’s inability to fulfil these obligations could lead to future financial loss on our part. In addition, any divestiture could result in significant asset impairment charges, including those related to goodwill and other intangible assets. For example, the reinsurance transaction involving our former Life Insurance Division resulted in a pre-tax loss of $21.5 million, of which $13.0 million was recorded as an impairment to the Life Insurance Division’s deferred acquisition costs with the remainder of $8.5 million recorded in “Realized gains (losses)” in the Company’s consolidated statement of income (loss). See Note 2 of Notes to Consolidated Financial Statements. In addition, potential acquisitions or divestitures present financial, managerial and operational challenges, including diversion of management attention from existing businesses, difficulty with integrating or separating personnel and financial and other systems, increased expenses, assumption of unknown liabilities, indemnities and potential disputes with the buyers or sellers.

 

A failure of our information systems to provide timely and accurate information could have a material adverse effect on our financial condition and results of operations.

 

Information processing is critical to our business, and a failure of our information systems to provide timely and accurate information could have a material adverse effect on our financial condition and results of operations. The failure to maintain an effective and efficient information system or disruptions in our information system could cause disruptions in our business operations, including (a) failure to comply with prompt pay laws; (b) loss of existing insureds; (c) difficulty in attracting new insureds; (d) disputes with insureds, providers and agents; (e) regulatory problems; (f) increases in administrative expenses; and (g) other adverse consequences.

 

Natural disasters, could severely damage or interrupt our systems and operations and result in an adverse effect on our business.

 

Natural disasters such as fire, flood, earthquake, tornado, power loss, virus, telecommunications failure, break-in or similar event could severely damage or interrupt our systems and operations, result in loss of data, and/or delay or impair our ability to service our customers. We have in place a disaster recovery plan which is intended to provide us with the ability to maintain our operations in the event of a natural disaster. However, there can be no assurance that such adverse effects will not occur in the event of a disaster. Any such disaster or similar event could have a material adverse effect on our financial condition and results of operations.

 

None

 

 

We currently own and occupy our executive offices located at 9151 Boulevard 26, North Richland Hills, Texas 76180-5605 and 8825 Bud Jensen Drive, North Richland Hills, Texas 76180-5605 comprising in the aggregate approximately 281,000 and 30,000 square feet, respectively, of office and warehouse space. In addition, we lease office space at various locations.

 

 

See Note 16 of Notes to Consolidated Financial Statements, the terms of which are incorporated by reference herein.

 

 

The Company held a Special Meeting of Stockholders on November 21, 2008. As of September 30, 2008 (the record date for the meeting) 31,026,166 shares of common stock were issued and 29,779,355 shares of common stock were outstanding, consisting of 26,896,325 shares of Class A-1 common stock and 2,883,030 shares of Class A-2 common stock.

 

The only matter submitted to a vote of security holders at the Special Meeting of Stockholders was a proposal seeking approval of an amendment to the HealthMarkets 2006 Management Stock Option Plan (the “2006 Plan”), in order to increase the number of shares of the Company’s Class A-1 common stock issuable under the 2006 Plan, the number of shares issuable to any individual participant in any year and the number of shares that may be granted as “incentive stock options” within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended, in each case, by 1,750,000 shares, from 1,489,741 to 3,239,741. The results of the voting for the proposal to amend the 2006 Plan were as follows:

 

 

 

Shares of the Company’s Class A-1 and Class A-2 common stock are not listed for trading on The New York Stock Exchange or any other exchange and are not readily tradable or salable in any public market. As of March 2, 2009, there were approximately 30 holders of record of Class A-1 common stock and 1,035 holders of record of Class A-2 common stock.

 

On May 3, 2007, the Company’s Board of Directors declared an extraordinary cash dividend of $10.51 per share for Class A-1 and Class A-2 common stock to holders of record as of close of business on May 9, 2007, payable on May 14, 2007. In connection with the extraordinary cash dividend, the Company paid dividends to stockholders in the aggregate of $317.0 million. The Company did not declare or pay dividends on shares of its common stock in 2008.

 

During the year ended December, 2008, the Company issued an aggregate of 112,354 unregistered shares of its Class A-1 common stock to newly-appointed executive officers of the Company. In particular, the Company issued 40,901 unregistered non-vested shares in accordance with employment agreements and executive officers of the Company purchased 71,453 shares of the Company’s Class A-1 common stock for aggregate consideration of $2.3 million (or $32.66 per share). Such sale of securities was made in reliance upon the exemption from registration provided by Section 4(2) of the Securities Act of 1933, as amended (and/or Regulation D promulgated

thereunder) for transactions by an issuer not involving a public offering. The proceeds of such sale were used for general corporate purposes.

 

Issuer Purchases of Equity Securities

 

Set forth below is a summary of the Company’s purchases of shares of HealthMarkets, Inc. Class A-1 common stock during each of the months in the twelve-month period ended December 31, 2008.

 

 

 

 

Set forth below is a summary of the Company’s purchases of shares of HealthMarkets, Inc. Class A-2 common stock during each of the months in the twelve-month period ended December 31, 2008:

 

 

 

 

Securities Authorized for Issuance under Equity Compensation Plans

 

The following table sets forth certain information with respect to shares of the Company’s Class A-1 and Class A-2 common stock that may be issued under HealthMarkets’ equity compensation plans as of December 31, 2008:

 

 

 

 

 

The following selected consolidated financial data as of and for each of the five years in the period ended December 31, 2008 has been derived from the audited consolidated financial statements of the Company. The following data should be read in conjunction with the consolidated financial statements and the notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations included herein.

 

 

Loss ratio.  The loss ratio is defined as benefits, claims and settlement expenses as a percentage of earned premiums (excludes Life Insurance Division).

 

Expense ratio.  The expense ratio is defined as underwriting, acquisition and insurance expenses as a percentage of earned premiums (excludes Life Insurance Division).

 

 

The following discussion should be read in conjunction with HealthMarkets’ consolidated financial statements and the related notes included elsewhere in this Form 10-K. This discussion contains certain statements which may be considered forward-looking. Actual results and the timing of events may differ significantly from those expressed or implied in such forward-looking statements due to a number of factors, including those set forth in the section entitled “Risk Factors” and elsewhere in this Form 10-K.

 

Additionally, the Company may also disclose financial information on a non-GAAP basis when management uses this information and believes this information will be valuable to investors in measuring the quality of our

financial performance, identifying trends in our results and providing more meaningful period-to-period comparisons.

 

Overview

 

The Company operates three business segments, the Insurance segment, Corporate and Disposed Operations. The Insurance segment includes the Company’s Self-Employed Agency Division (“SEA”), the Medicare Division and the Other Insurance Division. Corporate includes investment income not allocated to the Insurance segment, realized gains or losses, interest expense on corporate debt, general expenses relating to corporate operations, variable non-cash stock-based compensation and operations that do not constitute reportable operating segments. Disposed Operations includes the former Life Insurance Division, former Star HRG Division and former Student Insurance Division.

 

Through our SEA Division, we offer a broad range of health insurance products for individuals, families, the self-employed and small businesses. Our plans are designed to accommodate individual needs and include basic hospital-medical expense plans, plans with preferred provider organization (“PPO”) features, catastrophic hospital expense plans, as well as other supplemental types of coverage.

 

We market these products to the self-employed and individual markets through independent agents contracted with our insurance subsidiaries. The Company has approximately 1,300 independent writing agents per week in the field selling health insurance in 44 states.

 

In 2007, we initiated efforts to expand into the Medicare market. In the fourth quarter of 2007, we began offering a new portfolio of Medicare Advantage Private-Fee-for-Service Plans (“PFFS”) — called HealthMarkets Care Assured PlansSM (“HMCA Plans”) — in selected markets in 29 states with calendar year coverage effective for January 1, 2008. Policies were issued by our Chesapeake subsidiary, under a contract with the Centers for Medicare and Medicaid Services (“CMS”). The HMCA Plans were offered to Medicare eligible beneficiaries as a replacement for original Medicare and Medigap (Supplement) policies. They provided enrollees with the actuarial benefit equivalence they would receive under original Medicare, as well as certain additional benefits or benefit options, such as preventive care, pharmacy benefits, and vision, dental and hearing services. In July 2008, the Company determined it would not continue to participate in the Medicare business after the 2008 plan year.

 

Our Other Insurance Division consists of ZON Re-USA, LLC (“ZON Re”), an 82.5%-owned subsidiary, which underwrites, administers and issues accidental death, accidental death and dismemberment (“AD&D”), accident medical, and accident disability insurance products, both on a primary and on a reinsurance basis. We distribute these products through professional reinsurance intermediaries and a network of independent commercial insurance agents, brokers and third party administrators. We expect to exit this line of business in 2009, with the existing reinsurance business managed to final termination of substantially all liabilities.

 

Exit from Life Insurance Division Business

 

On September 30, 2008 (the “Closing Date”), HealthMarkets, LLC, a subsidiary of the Company, completed the transactions contemplated by the Agreement for Reinsurance and Purchase and Sale of Assets dated June 12, 2008 (the “Master Agreement”). Pursuant to the Master Agreement, Wilton Reassurance Company or its affiliates (“Wilton”) acquired substantially all of the business of the Company’s Life Insurance Division, which operated through The Chesapeake Life Insurance Company (“Chesapeake”), Mid-West National Life Insurance Company of Tennessee (“Mid-West”) and The MEGA Life and Health Insurance Company (“MEGA”) (collectively the “Ceding Companies”), and all of the Company’s 79% equity interest in each of U.S. Managers Life Insurance Company, Ltd. and Financial Services Reinsurance, Ltd. As part of the transaction, under the terms of the Coinsurance Agreements (the “Coinsurance Agreements”) entered into with each of the Ceding Companies on the Closing Date, Wilton has agreed, effective July 1, 2008 (the “Coinsurance Effective Date”), to reinsure on a 100% coinsurance basis substantially all of the insurance policies associated with the Company’s Life Insurance Division (the “Coinsured Policies”).

 

Under the terms of the Coinsurance Agreements, Wilton has assumed responsibility for all insurance liabilities associated with the Coinsured Policies. The Ceding Companies have transferred to Wilton cash in an amount equal

to the net statutory reserves and liabilities corresponding to the Coinsured Policies, which amount was approximately $344.5 million. Wilton has agreed to be responsible for administration of the Coinsured Policies, subject to certain transition services to be provided by the Ceding Companies to Wilton. The Ceding Companies remain primarily liable to the policyholders on those policies with Wilton assuming the risk from the Ceding Companies pursuant to the terms of the Coinsurance Agreements. As a result, in accordance with guidance provided in Financial Accounting Standard No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts, the Company reported and will continue to report the policy liabilities ceded to Wilton under “Policy liabilities” and record a corresponding asset as “Reinsurance recoverable — ceded policy liabilities” on its consolidated balance sheet.

 

The Company and the Ceding Companies received total consideration of approximately $139.2 million, including $134.5 million in aggregate ceding allowances with respect to the reinsurance of the Coinsured Policies. Under certain circumstances, the Master Agreement also provides for the payment of additional consideration to the Company following the closing based on the five year financial performance of the Coinsured Policies. The reinsurance transaction resulted in a pre-tax loss of $21.5 million, of which $13.0 million was recorded as an impairment to the Life Insurance Division’s deferred acquisition costs (“DAC”) with the remainder of $8.5 million recorded in “Realized gains (losses)” in the Company’s consolidated statement of income (loss).

 

The Master Agreement and Coinsurance Agreements provide for certain financial settlements following the Closing Date, including, without limitation, settlements with respect to the cash transferred to Wilton for statutory reserves and liabilities corresponding to the Coinsured Policies, and the cash flows arising out of the Coinsured Policies between the Coinsurance Effective Date and the Closing Date. We are currently in the process of resolving the financial settlements with Wilton; however, there can be no assurance that the financial settlements will be favorably resolved. The failure to favorably resolve the financial settlements could result in additional expense recorded; however, we do not currently believe that the outcome of the financial settlements will have a material adverse effect on the Company’s financial condition and results of operations.

 

In connection with these transactions the Company incurred $6.5 million in investment banker fees and legal fees recorded as “Other expense” on the Company’s consolidated statement of income (loss) for the year ended December 31, 2008. The Company also incurred $6.4 million of employee and lease termination costs and other costs recorded in “Underwriting, acquisition and insurance expenses,” on its consolidated statement of income (loss) during 2008. In addition, the Company incurred interest expense of $3.1 million during 2008 associated with the use of the cash transferred to Wilton during the period from the Coinsurance Effective Date to the Closing Date. The Ceding Companies also wrote-off DAC of $101.1 million, representing all of the deferred acquisition costs associated with the Coinsured Policies subject to the transaction, which is included in the realized loss on the transaction. This write-off of DAC correspondingly reduced the related deferred tax assets by $36.7 million. See Note 2 of Notes to Consolidated Financial Statements for additional information.

 

Exit from the Medicare Market

 

In late 2007, we expanded into the Medicare market by offering a new portfolio of Medicare Advantage PFFS — called HMCA Plans — in selected markets in 29 states with calendar year coverage effective for January 1, 2008. On July 15, 2008, the Medicare Improvements for Patients and Providers Act of 2008 (HR. 6331) was enacted, resulting in significant changes to the Medicare program. These changes include, among other things, the phased elimination of Medicare Advantage PFFS “deeming” arrangements with providers beginning in 2011. Based on our determination that this new law would make it difficult for the Company to operate effectively in the Medicare market, in July 2008, we decided that the Company would not participate in the Medicare Advantage marketplace beyond the current year. We will continue to fulfill our remaining obligations under the 2008 calendar year Medicare contract with CMS.

 

2006 Sales of Student Insurance Division and Star HRG Division

 

In July 2006 and December 2006, in two separate transactions, we sold the assets comprising our former Star HRG Division and our former Student Insurance Division. In connection with these sales, we recorded an aggregate

pre-tax gain in 2006 of $201.7 million, of which $101.5 million was attributable to the Star HRG transaction and $100.2 million was attributable to the Student Insurance transaction.

 

As part of the sale transactions, insurance subsidiaries of the Company entered into 100% coinsurance arrangements with each of the purchasers, pursuant to which (a) the purchasers agreed to assume liability for all future claims associated with the policies in force as of the respective closing dates and (b) the Company’s insurance subsidiaries transferred to the purchasers cash in an amount equal to the actuarial estimate of those future claims. While under the terms of the coinsurance agreements the Company’s insurance subsidiaries have recorded a ceded liability for all future claims made on the insurance policies in force at the closing date, as the insurance subsidiaries remain primarily liable on those policies. Accordingly, at December 31, 2008 and 2007 the Company continues to report the policy liabilities ceded to and assumed by the purchasers under the coinsurance agreements as “Policy liabilities”, with a corresponding “Reinsurance recoverable — ceded policy liabilities” asset on its consolidated balance sheet. In addition, the Company will continue to report in future periods the residual results of operations of these businesses (anticipated to consist solely of residual wind-down expenses and any true-up provision associated with the sales, primarily of the Student Insurance Division) in continuing operations and classified as Disposed Operations. See Note 2 of Notes to Consolidated Financial Statements for additional information regarding the terms of the sales of the Star HRG Division and Student Insurance Division assets.

Results of Operations

 

The table below sets forth certain summary information about our consolidated operating results for each of the three most recent fiscal years:

 

As more fully discussed above, the Company entered into Coinsurance Agreements in connection with its exit from the Life Insurance Division business during 2008 and sold the assets comprising our former Star HRG Division and our former Student Insurance Division in 2006. HealthMarkets management believes that comparisons between years are most meaningful after the reclassification and netting of the operating revenues and expenses attributable to these divisions to the line item “Income (loss) from disposed operations, net of income tax,” which is a non-GAAP measure:

 

 

Revenue

 

Our revenues consist primarily of premiums derived from sales of our indemnity, PPO and life insurance policies. Premiums on health insurance contracts are recognized as earned over the period of coverage on a pro rata basis. Premiums on traditional life insurance are recognized as revenue when due. Revenues also include investment income derived from our investment portfolio and other income, which consists primarily of income derived by the SEA Division from ancillary services and membership marketing and administrative services provided to the membership associations that make available to their members the Company’s health insurance products.

The table below sets forth premium by insurance division for each of the three most recent fiscal years (excluding for all periods presented premium associated with our former Life Insurance Division, Star HRG Division and Student Insurance Division):

 

 

Benefits and Expenses

 

The Company’s expenses consist primarily of insurance claims expense and expenses associated with the underwriting and acquisition of insurance policies. Claims expenses consist primarily of payments to physicians, hospitals and other healthcare providers under health policies and include an estimated amount for incurred but not reported and unpaid claims. Underwriting, acquisition and insurance expenses consist of direct expenses incurred across all insurance lines in connection with issuance, maintenance and administration of in-force insurance policies, including amortization of deferred policy acquisition costs, commissions paid to agents, administrative expenses and premium taxes. The Company also incurs other direct expenses in connection with generating income derived by the SEA Division from ancillary services and membership marketing and administrative services provided to the membership associations that make available to their members the Company’s health insurance products.

 

Business Segments

 

The following is a comparative discussion of results of operations for the Company’s business segments and divisions — the Insurance segment, Corporate and Disposed Operations, which consists of the Life Insurance Division, the Student Insurance Division and the Star HRG Division.

Revenues and income (loss) from continuing operations before federal income taxes (“operating income (loss)”) for each of the Company’s business segments and divisions in 2008, 2007 and 2006 was as follows:

 

 

Insurance

 

Set forth below is certain summary financial and operating data for the Company’s Insurance segment for each of the three most recent fiscal years:

 

 

The Insurance segment includes the Company’s SEA Division, the Medicare Division and Other Insurance Division. Management reviews results of operations for the Insurance segment by reviewing each of the above mentioned divisions.

Self-Employed Agency Division

 

Set forth below is certain summary financial and operating data for the Company’s SEA Division for each of the three most recent fiscal years:

 

 

Loss Ratio.  The loss ratio is defined as benefits expense as a percentage of earned premium revenue.

 

Expense Ratio.  The expense ratio is defined as underwriting, acquisition and insurance expenses as a percentage of earned premium revenue.

 

Operating Margin.  Operating margin is defined as operating income as a percentage of earned premium revenue.

 

Submitted Annualized Volume.  Submitted annualized premium volume in any period is the aggregate annualized premium amount associated with health insurance applications submitted by the Company’s agents in such period for underwriting by the Company.

 

Year Ended December 31, 2008 versus December 31, 2007

 

For 2008, the SEA Division reported operating income of $55.6 million compared to $150.4 million in 2007, a decrease of $94.8 million or 63.0%. The decrease in operating income is primarily attributable to a decrease in earned premium revenue of 11.1% and a decrease in investment and other income of 20.5%, which was slightly offset by a decrease in total expenses of 6.0%. Operating income in the SEA Division as a percentage of earned premium revenue (i.e., operating margin) in 2008 was 4.9% compared to 11.7% in 2007.

Earned premium revenue at the SEA Division was $1.1 billion in 2008 compared to $1.3 billion in 2007, a decrease of $141.8 million or 11.1%. This decrease is primarily attributable to a decrease in submitted annualized premium volume and a decrease in the average number of policies in force during the year. With respect to submitted annualized premium volume, the Company experienced a decrease of $218.8 million, or 32.2% in 2008 from $680.1 million in 2007 to $461.3 million in 2008. The decrease in earned premium revenue reflects an attrition rate that exceeds the pace of new sales. With respect to new sales, the Company is experiencing increased competition in the marketplace, as well as a decrease of approximately 32.6% in the average number of writing agents in our dedicated agency sales force. In addition, there was an increased focus, particularly in the first quarter of 2008, on our new Medicare products offered, which led to a decreased focus on our core health products in the SEA Division. The Company exited the Medicare Advantage marketplace on December 31, 2008 and its focus for 2009 will return to the Company’s core health products. With respect to the average number of polices in force during the year, the decrease is attributable to a decrease in new policies issued during 2008 compared to prior year and lower persistency on existing policies. Total policies in force decreased by 42,700 policies or 13.2% during the year to approximately 281,700 during 2008 as compared to approximately 324,400 during 2007.

 

The increase in the loss ratio reflects an ongoing gradual shift in product mix to the Company’s CareOne product suite and other PPO products which are designed to provide a higher proportion of premium dollars as benefits. For the last two years the Company’s sales efforts have been focused on new PPO type products, which, by design, have a higher loss ratio than the Company’s previous products that were largely per occurrence or scheduled benefit products. In addition, as previously disclosed, during 2007, the Company made various refinements to the claim liability estimates.

 

Underwriting, acquisition and insurance expenses decreased to $420.5 million in 2008 from $478.1 million in 2007, a decrease of $57.6 million or 12.0%. The decrease partially reflects the variable nature of certain expenses, including commission expenses and premium taxes, which are included in these amounts. Commission expenses and premium taxes generally vary in proportion to earned premium revenue. This decrease from 2007 also resulted from a $20.0 million expense associated with the settlement of the multi-state market conduct examination recognized in 2007 and an $8.0 million asset impairment charge in 2007 associated with two technology assets that we determined were no longer of value to the Company.

 

Other income and other expenses both decreased in the current period compared to the prior year period. Other income largely consists of fee and other income received for sales of association memberships by our dedicated agency sales force. Sales of association memberships by our dedicated agency sales force tend to move in tandem with sales of health insurance policies; consequently, this decrease in other income is consistent with the decline in earned premiums and new sales. Other expenses consist of amounts incurred for bonuses and other compensation provided to the agents, which are based on policy sales during the current year.

 

Year Ended December 31, 2007 versus December 31, 2006

 

For 2007, the SEA Division reported operating income of $150.4 million compared to $236.5 million in 2006, a decrease of $86.1 million or 36.4%. Operating margin in 2007 was 11.7% compared to 17.8% in 2006. Operating income for the SEA Division in 2007 was negatively impacted by a decrease in earned premium revenue, an increase in the loss ratio, and an increase in underwriting, acquisition and insurance expenses.

 

Earned premium revenue at the SEA Division decreased by $48.0 million or 3.6% to $1.3 billion in 2007 compared to $1.3 billion in 2006. This decrease in earned premium revenue was primarily attributable to a slight decrease in policy persistency rates, a decline in submitted annualized premium volume, and a decrease in the conversion rate of submitted policies to issue policies. The period over period decrease in submitted annualized premium volume was due to a decrease in the average number of writing agents in the field from 2,143 during 2006 to 1,874 during 2007. In addition, the productivity of the writing agents decreased 6.6% based on the average number of weekly applications submitted per writing agent. The decrease in conversion experience on submitted policies was at least partly expected as it reflects the implementation of more rigorous underwriting procedures.

 

Benefits expense increased in 2007 compared to 2006 as reflected in the loss ratio of 57.4% versus 54.3%, respectively. The increase in the loss ratio reflects an ongoing gradual shift in product mix to the Company’s CareOne product suite and other PPO products which are designed to provide a higher proportion of premium

dollars as benefits. The amount of benefit expenses reported each year is impacted by the estimate of claim liabilities. See discussion below in “Critical Accounting Policies” in the sections titled “Estimates of Claim Liabilities” and “Changes in SEA Claim Liability Estimates.”

 

Underwriting, acquisition and insurance expenses increased to $478.1 million in 2007 from $444.0 million in 2006, an increase of $34.1 million or 7.7%. In 2007, the Company recognized a $20.0 million expense associated with the potential settlement of the multi-state market conduct examination (See Note 16 of Notes to Consolidated Financial Statements) and an $8.0 million asset impairment charge in 2007 associated with two technology assets that we determined were no longer of value to the Company. In addition, we incurred consulting and professional fees for various operational and technology focused initiatives that were new in 2007.

 

Medicare Division

 

Set forth below is certain summary financial and operating data for the Company’s Medicare Division for each of the two most recent fiscal years: