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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o

 

Indicate by check mark 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. As of June 30, 2009, 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 1, 2010, there were 27,608,370 outstanding shares of Class A-1 common stock and 2,912,638 outstanding shares of Class A-2 common stock.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the annual information statement for the 2010 annual meeting of stockholders are incorporated by reference into Part III.

 

 

HEALTHMARKETS, INC.
and Subsidiaries

 

TABLE OF CONTENTS

 

Cautionary Statements Regarding Forward-Looking Statements

 

When we use the terms “HealthMarkets”, “we”, “us”, “our”, and “the Company”, we mean 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, and supplemental products.

 

HealthMarkets, Inc. is a holding company, the principal asset of which is its investment in its wholly owned subsidiary, HealthMarkets, LLC. HealthMarkets, LLC’s principal assets are its investments in its separate operating subsidiaries, including its regulated insurance subsidiaries. HealthMarkets conducts its insurance businesses through its indirect wholly owned insurance company subsidiaries, The MEGA Life and Health Insurance Company (“MEGA”), Mid-West National Life Insurance Company of Tennessee (“Mid-West”), The Chesapeake Life Insurance Company (“Chesapeake”) and HealthMarkets Insurance Company (“HMIC”).

 

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. HMIC 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 York, Mississippi and New Hampshire.

 

In 2009, the Company formed Insphere Insurance Solutions, Inc. (“Insphere”), a Delaware corporation and a wholly owned subsidiary of HealthMarkets, LLC. Insphere is an authorized insurance agency in 50 states and the District of Columbia, specializing in small business and middle-income market life, health, long-term care and retirement insurance. Insphere distributes products underwritten by the Company’s insurance subsidiaries, as well as non-affiliated insurance companies. Insphere has entered into marketing agreements with a number of non-affiliated carriers, including health insurance carriers and intends to expand its portfolio of third party products in 2010.

 

The Company operates four business segments, the Insurance segment, Insphere, Corporate and Disposed Operations. The Insurance segment includes the Company’s Self-Employed Agency (“SEA”) Division. Corporate includes investment income not allocated to the Insurance segment, realized gains or losses, interest expense on corporate debt, the Company’s student loan business, 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 following former divisions: Medicare Division, Other Insurance, Life Insurance Division, Star HRG Division and Student Insurance Division (see Note 21 of Notes to Consolidated Financial Statements for financial information regarding our segments).

 

Through our SEA Division, we offer a broad range of health insurance and supplemental products for individuals, families, the self-employed and small businesses. Historically, we marketed these products through a dedicated agency field force — consisting of independent agents contracted with our insurance subsidiaries — that primarily sold the insurance products underwritten by the Company’s insurance subsidiaries. Beginning in 2010, in connection with the launch of Insphere, a new business model for future sales was implemented offering a variety of products and product lines of non-affiliated carriers.

 

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

 

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 of March 1, 2010,

approximately 87% of our common equity securities were held by the 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 HealthMarkets, Inc. 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 filings with the United States Securities and Exchange Commission (the “SEC”), 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.

 

Disposed Operations

 

We exited the Medicare Advantage market, sold ZON-Re USA, LLC (“ZON-Re”) and disposed of the businesses associated with our STAR HRG, Student Insurance and Life Insurance Divisions because they 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 the Insphere independent agent sales force, including sale of insurance products underwritten by the Company’s insurance subsidiaries as well as third party insurance companies.

 

 

Ratings

 

Insurance Companies

 

The Company’s 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 financial strength 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 financial strength ratings range from “AAA” (“Exceptionally Strong”) to “C” (“Distressed”). 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 financial security characteristics”) to “R” (“Under regulatory supervision owing to its financial condition”).

 

HealthMarkets, Inc.

 

A.M. Best has assigned to HealthMarkets, Inc. an issuer credit rating of “bb” (“Speculative”) 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 “rs” (“Regulatory Supervision/Liquidation”).

 

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 credit 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-” (“Speculative”) 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 long term issuer credit ratings range from “AAA” (“Extremely strong capacity to meet financial commitments”) to “D” (“Payment default on all or substantially all financial commitments”).

 

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. Historically, these products were distributed through our dedicated agency field force consisting of independent agents contracted with these insurance subsidiaries and, in connection with the formation of Insphere in 2009 and launch in 2010, are now sold by the Insphere independent agent sales force. The SEA Division generated revenues of $1.1 billion, $1.2 billion and $1.4 billion, representing 98%, 88% and 89% of our total revenue from continuing operations in 2009, 2008 and 2007, respectively. We currently have approximately 417,000 members insured or reinsured by the Company.

 

Traditional Health Insurance Products

 

Our traditional health insurance product offerings represent the focus of our insurance subsidiary product sales. They 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 these 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. Historically, our scheduled/basic plans were offered with an optional benefit, the Accumulated Covered Expense (“ACE”) rider, that provides for catastrophic coverage 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.

 

In the third quarter of 2009, the Company introduced a new “Fit” series of products underwritten by Chesapeake. These products include a new “scheduled benefit” basic hospital-medical expense plan (the BasicFit^sm Plan) designed to appeal to customers most concerned with affordability. The BasicFit product is a PPO insurance plan that provides policyholders with coverage for a variety of services, including inpatient hospitalization and outpatient surgery and emergency room care. Additional coverage is available for doctor office visits (including preventive care), outpatient diagnostics and prescription drugs. We also offer new high deductible catastrophic hospital expense plans, with deductibles ranging from $7,500 to $20,000 (the ClassicFit^sm Plan, which offers a lower deductible, and the EssentialFit^sm Plan, which offers a higher deductible). These products are PPO insurance plans. After the deductible and coinsurance maximum (if applicable) are met, services (including diagnostics, emergency, hospital and surgical) are covered 100%, up to the selected $1.0 million or $2.0 million calendar year maximum. Policyholders can choose to customize their plan by lowering their in-network coinsurance to 80% or 90% and/or by adding doctor office visits (including preventive care) and prescription drug coverage. These products incorporate certain PPO features, but without the added benefits of traditional, major medical PPO products.

 

The Company expects the Chesapeake “Fit” products to be the focus of new product sales. However, the Company evaluates new product offerings on an ongoing basis and, in the future, may offer new product lines, including product lines focused on markets not traditionally served by the Company.

CareOne^® and CareChoice^® Products

 

While our traditional insurance products continue to represent the majority of our policies in force and premium, from 2006 to 2009, the Company’s insurance subsidiaries offered CareOne and/or CareChoice products, some of which were designed to shift a higher proportion of premium dollars to benefits. The CareOne product offerings include the following:

 

 

Our CareChoice products contain many of the same features as the CareOne plans described above, but eliminate many of the internal benefit limits and simplify some of the benefit structures associated with such plans. HSA-compatible versions of these plans are also offered. These plans — known as “high deductible health plans” — can be used with tax-advantaged health savings accounts for health care expenses.

 

The CareOne and CareChoice products, particularly those with traditional PPO features, 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. As a result, in 2009, the Company placed a renewed emphasis on its traditional health insurance products (including the launch of the Chesapeake “Fit” products) and discontinued the marketing of its CareOne and CareChoice products in many of the states in which these plans were previously available.

 

Supplemental Products

 

We have also developed and offer supplemental product lines designed to further protect against risks to which our customer is typically exposed. These products are sold to purchasers of the Company’s health insurance products, as well as to purchasers of third party products underwritten by non-affiliated insurance carriers that are

distributed by Insphere. They are also sold on a stand-alone basis. In 2010, these products will be offered primarily by Chesapeake. Our supplemental product offerings include the following:

 

 

Third Party Product Distribution Arrangements

 

During 2009, MEGA and Mid-West maintained 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 were distributed through the Company’s dedicated agency field force of independent agents contracted with our insurance subsidiaries. The revenues generated by such arrangements are not material to the Company’s financial results. As discussed below, in 2010, new third party product sales are expected to occur through Insphere and its independent agents.

 

Marketing and Sales

 

Beginning in 2010, all of the health insurance products issued by our insurance subsidiaries are sold through independent agents currently contracted with Insphere who are compensated based upon level of sales production. Each of the Company’s insurance subsidiaries maintains a distribution agreement with Insphere for the sale of its insurance products. Insphere also distributes products underwritten by non-affiliated insurance companies through its contracted agents.

 

Historically, the Company maintained a dedicated agency sales force consisting of UGA — Association Field Services (“UGA”) and Cornerstone America (“Cornerstone”) (the principal marketing divisions of MEGA and Mid-West, respectively). All agents associated with UGA and Cornerstone were independent contractors. (With respect to references to sales agents as independent contractors, see discussion of “Fair Labor Standards Act Agent Litigation” in Note 18 of Notes to Consolidated Financial Statements). In the fourth quarter 2008, we initiated efforts to reorganize UGA and Cornerstone into a single agency department. Efforts were made in the third and fourth quarters of 2009 for the 2010 launch of Insphere to reorganize the sales force into an independent career-agent distribution company. Effective January 1, 2010, the field leadership hierarchy of the sales force was reorganized into eight geographical regions, each led by an Insphere Zone Manager, with several Agency Managers under each Zone Manager. Zone Managers and Agency Managers are full-time, salaried employees of Insphere,

responsible for agent recruiting, training, and oversight activities. Sales Leaders and writing agents, who operate under Agency Managers, remain independent contractors, responsible for sales production.

 

The process of recruiting agents is extremely competitive. We believe that the primary factors in successfully recruiting and retaining effective agents are Insphere’s commission levels and practices regarding advances on commissions, the availability of the HealthMarkets, Inc. agent stock accumulation plan, the quality of the products available in Insphere’s portfolio, proper training, agent incentives, and support. Agents participate in a training program tailored by product. Classroom and field training, with respect to product content, is required and made available to the agents under the direction of Insphere.

 

The HealthMarkets insurance subsidiaries provide health insurance products covering individuals, families, the self-employed and small businesses in 41 states. As is the case with many of our competitors in this market, a substantial portion of our products are issued to members of independent membership associations that act as the master policyholder for such products. In 2009, the principal membership associations in the self employed market through which HealthMarkets insurance products were made available were the Alliance for Affordable Services (“AAS”), the National Association for the Self-Employed (“NASE”) and Americans for Financial Security (“AFS”). The associations provide their members with access to a number of benefits and products, including health insurance underwritten by the HealthMarkets insurance subsidiaries. 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. In December 2009, the Company and NASE settled a legal action filed by Performance Driven Awards, Inc (“PDA”), a wholly owned subsidiary of HealthMarkets, LLC, against NASE. Pursuant to the terms of the settlement agreement, the NASE-PDA Field Services Agreement was terminated, as a result of which the Company’s field service representatives are no longer selling new NASE memberships and the Company’s independent insurance agents are no longer selling new certificates of insurance to NASE members. NASE memberships and certificates of insurance previously sold to NASE members remain in force (subject to ordinary course termination), and NASE is obligated to continue paying PDA for members previously enrolled in NASE by PDA. See Note 18 of Notes to Consolidated Financial Statements.

 

In 2009, HealthMarkets Lead Marketing Group Inc. (“LMG”), a wholly owned subsidiary of HealthMarkets, LLC, served as the Company’s direct marketing group and generated new membership sales prospect leads for use by HealthMarkets independent agents. LMG also provided video and print services to the independent marketing associations described above. LMG obtained leads from third party sources and developed a marketing pool of prospects, consisting of the self-employed, small business owners and individuals, from various data sources. Prospects initially identified by LMG could become “qualified leads” by responding through one of LMG’s lead channels and by expressing an interest in learning more about health insurance. We believe that providing agents with “qualified leads” enabled them to achieve a higher close rate than with unqualified prospects. In connection with the launch of Insphere and reorganization of the Company’s sales force, the Company dissolved LMG on December 31, 2009 and Insphere continues to obtain leads for its contracted agents from third party sources.

 

Policy Design and Claims Management

 

The traditional health insurance products underwritten by the Company’s insurance subsidiaries are principally designed to limit coverage 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 the independent insurance agents within the Insphere sales force to sell these products at prices consistent with these objectives.

We maintain an administrative center with underwriting, claims management and administrative capabilities. In 2009, the Company began outsourcing many of these functions, including new business processing, provider service calls and a larger portion of the claims processing functions, to third parties, including parties who may perform these functions offshore. With respect to the administrative capabilities that the Company has retained, we continue to evaluate opportunities to subcontract additional services of this nature on an ongoing basis. If the Company determines that these functions can be performed effectively and more efficiently by third parties, it may 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 insurance products underwritten by the Company’s insurance subsidiaries.

 

Provider Network Arrangements and Cost Management Measures

 

The Company’s insurance subsidiaries utilize a number of cost management programs to help them and their 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 claims 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 addition, to control prescription drug costs, the Company maintains a contract with a pharmacy benefits management company that has approximately 55,000 participating pharmacies nationwide. We also utilize copayments, coinsurance, deductibles and annual limits to manage prescription drug costs.

 

Insphere Insurance Solutions, Inc.

 

During the second quarter of 2009, the Company formed Insphere Insurance Solutions, Inc. (“Insphere”), a Delaware corporation and a wholly owned subsidiary of HealthMarkets, LLC. Insphere is an authorized insurance agency in 50 states and the District of Columbia, specializing in small business and middle-income market life, health, long-term care and retirement insurance. Insphere operates through independent insurance agents and is managed by licensed insurance agents employed by Insphere. Most of Insphere’s independent agents were previously associated with the Company’s UGA-Association Field Services (formerly the principal marketing division of MEGA) and Cornerstone America (formerly the principal marketing division of Mid-West). See Marketing and Sales discussion above. In February 2010, Insphere had a force of approximately 2,500 independent agents, of which 1,800 on average write health insurance applications each month and office in over 40 states. We believe that Insphere is one of the largest independent, career agent insurance distribution groups in the country.

 

Insphere distributes products underwritten by the Company’s insurance subsidiaries, as well as non-affiliated insurance companies. In the third quarter of 2009, Insphere completed marketing agreements with a number of life, long-term care and retirement insurance carriers, including, but not limited to, ING (term life, universal life and fixed annuity products), Minnesota Life Insurance Company (life and fixed annuity products) and John Hancock (long-term care products). Insphere also has a marketing arrangement with an intermediary under which Insphere’s agents obtain access to certain disability income insurance products. These products are sold both on a stand-alone basis and to purchasers of health insurance products underwritten by the Company’s insurance subsidiaries or non-affiliated insurance companies. In the third and fourth quarters of 2009, the Company completed marketing agreements with United Healthcare’s Golden Rule Insurance Company (“Golden Rule”) and Aetna for the sale of

individual health insurance products. Insphere is currently distributing Golden Rule individual health products in 34 states and Aetna individual health products in 11 states, with sales in additional states expected to occur in the future. The products offered by Golden Rule, Aetna and the Company’s insurance subsidiaries offer coverage and benefit variations that may fit one consumer better than another. In the markets where Insphere has commenced distribution of Golden Rule and Aetna products, these products have, to a great extent, replaced the sale of the Company’s own insurance products. In the first quarter of 2010, Insphere’s sale of Golden Rule and Aetna products, in the aggregate, exceeded the sale of the Company’s products by nearly a five-to-one margin. Insphere evaluates new distribution arrangements on an ongoing basis and, in 2010, intends to expand its portfolio and the size of its field force by developing additional marketing arrangements with insurance carriers or intermediaries representing such carriers. Insphere’s marketing agreements are generally non-exclusive and terminable on short notice by either party for any reason.

 

Insphere generates revenue primarily from base commissions and override commissions received from insurance carriers whose policies are purchased through Insphere’s independent agents. The commissions are typically based on a percentage of the premiums paid by insureds to the carrier. In some instances, Insphere also receives bonus payments for achieving certain sales volume thresholds. Insphere typically receives commission payments on a monthly basis for as long as a policy remains active. As a result, much of our revenue for a given financial reporting period relates to policies sold prior to the beginning of the period and is recurring in nature. Commission rates are dependent on a number of factors, including the type of insurance and the particular insurance company underwriting the policy.

 

In the first quarter of 2010, Insphere expects to enter into agreements with independent membership associations — AAS and AFS— pursuant to which Insphere’s agents would act as field service representatives (“FSRs”) for the associations. In this capacity, the FSRs would enroll new association members and provide membership retention services. Insphere would receive compensation 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. In addition, a substantial portion of the health insurance products underwritten by the HealthMarkets insurance subsidiaries that are distributed by Insphere are issued to members of these membership associations, which act as the master policyholder for such products.

 

On November 16, 2009, Insphere entered into a definitive stock purchase agreement with Beneficial Life Insurance Company and Beneficial Investment Services, Inc. (“BIS”) pursuant to which Insphere will acquire all of the outstanding capital stock of BIS (the “Purchase Agreement”). BIS is a securities broker-dealer licensed in 49 states. This transaction is subject to customary closing conditions, including the receipt of approval by the Financial Industry Regulatory Authority (“FINRA”) and the receipt of certain other required consents. The Purchase Agreement may be terminated by either party if the closing has not occurred by the earlier of (i) May 31, 2010 or (ii) six months after the initial application is filed with FINRA. Completion of this purchase would, among other things, enable Insphere to expand its product portfolio to include products for which a broker-dealer license is required. The Company does not anticipate that the purchase price will have a material impact on its financial position and results of operation.

 

Ceded Reinsurance

 

The Company’s insurance subsidiaries reinsure portions of the coverage 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 former 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 current health insurance business solely for limited purposes.

Competition

 

We compete with other companies in each of our lines of business. 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 is based on a number of factors, including quality of service, product features, price, scope of distribution, scale, financial strength ratings and name recognition. Some of our competitors may offer a broader array of products than our insurance subsidiaries, have a greater diversity of distribution resources, have better brand recognition, have more competitive pricing, have lower cost structures or, with respect to insurers, 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.

 

With respect to Insphere, we compete for business, as well as agents and distribution relationships, with other distributors. The business in which Insphere engages is highly competitive and there are many insurance agencies, brokers and intermediaries who actively compete with Insphere. We also compete with insurance companies that sell their products directly to customers, and do not use or pay commissions to third-party agents or brokers. In addition, the Internet continues to be a source for direct placement of business and creates additional competition for Insphere. Government benefits relating to health, disability and retirement are alternatives to private insurance and may indirectly compete with our businesses. Insphere believes that it can remain competitive due to several factors, including its size, the level of training and support provided to its agents, including technology-based support, compensation levels and the availability of the HealthMarkets, Inc. agent stock accumulation plan; however, there can be no assurance that Insphere will not lose business to competitors, which could materially adversely affect our future financial condition and results of operations.

 

Regulatory and Legislative Matters

 

State Insurance Regulation

 

HealthMarkets Insurance Subsidiaries

 

Our insurance subsidiaries and the products they offer 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 with respect to certain medical conditions or procedures; claims payment practices, including prompt payment of claims and independent external review of certain coverage decisions; 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.

 

Health insurance products underwritten by our insurance subsidiaries are offered 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. 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.

Various states have, from time to time, proposed and/or enacted changes to the health care 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 health care insurance. We expect state legislatures to continue pursuing such initiatives in 2010 and future years, depending on whether changes of this nature occur in connection with national health care reform. We cannot predict with certainty the effect that proposed state legislation, if adopted, could have on our insurance businesses and operations.

 

The states in which our insurance subsidiaries are licensed have the authority to change the minimum mandated 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 National Association of Insurance Commissioners (“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 loss ratios, or increase existing minimum 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. In 2009, we 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 addition, legislation has been proposed in the California legislature in each of the last two sessions that would require health insurers to maintain at least an 85% medical loss ratio across all lines of health business, both group and individual. Although the proposals failed we anticipate similar legislation will be considered again in 2010. We believe that such legislation, if passed, would have a disproportionate effect on health insurers primarily offering products to the individual market. In 2009, legislation proposing an increase in minimum loss ratio was introduced in a number of other states in which we do business. While these proposals were not enacted into law, we expect state legislatures to continue pursuing such initiatives in 2010 and future years, depending on whether changes in minimum loss ratios occur in connection with national health care reform. We are unable to predict the impact of (i) any changes in the mandatory 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 resulting in a narrowing of profit margins or preventing us from doing business in certain states

 

We evaluate legislative developments regarding mandatory loss ratios and other matters on an ongoing basis. If we determine that the legislative or regulatory environment in a particular state prevents us from doing business in the state on a profitable basis, we may determine that it is in the Company’s best interest to cease doing business in that state. For example, in Washington State, our association group business that is individually underwritten is considered to be “large group” business for purposes of the state minimum loss ratio standard. The minimum loss ratio standard is currently 80%. In addition, most of the Company’s business in Washington State was written on policy forms that the Washington State Insurance Commissioner had approved and then subsequently disapproved in 2007. As a result of these matters, the Company has determined that it cannot continue to operate profitably in Washington State. The Company and the Washington State Insurance Commissioner have reached a preliminary agreement in principle that the Company will non-renew its health benefit plan policies and withdraw from the health benefit plan market place in the next several months. The Company currently has over 9,000 certificate holders. We intend to work with the Washington State Insurance Commissioner to develop an orderly transition plan for our certificate holders which may include an opportunity for agents contracted with Insphere to market other coverage from non-affiliated carriers. Based on legislative and regulatory developments in other states, the Company may, from time to time, determine that it is in the Company’s best interest to discontinue business operations in another state.

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 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, 2009, the risk-based capital ratio of each of our insurance subsidiaries exceeded the ratio for which regulatory corrective action would be required. 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.

 

Insphere Insurance Solutions

 

Insphere and its independent agents are authorized to distribute insurance products in all 50 states and the District of Columbia and must maintain applicable agency and/or agent licenses. Licensing laws and regulations vary by individual state and are often complex and are subject to amendment or reinterpretation by state regulatory authorities. State insurance departments have relatively broad discretion to grant, revoke, suspend and renew licenses required by Insphere and/or its agents to conduct business. State insurance departments also have the authority to regulate advertising, marketing and trade practices, monitor agent conduct, impose continuing education requirements and limit the amount and/or type of commission paid to agents. Failure to comply with laws and regulations applicable to insurance agents could subject Insphere and/or its agents to fines and penalties or result in suspension of activity in, or exclusion from, a particular state.

 

Insphere and its agents are marketing the Company’s health insurance plans and plans from non-affiliated insurance companies, as well as the Company’s supplemental health products. Enactment of laws or regulations that reduce minimum loss ratios, either in connection with national health care reform or state action, may have a material adverse effect on the level of base commissions and override commissions Insphere receives carriers. In addition, various state insurance laws and regulations restrict or limit the manner in which supplemental health products may be offered, marketed, or sold. Insphere and its agents are also marketing life products, long-term-care products, disability products, and annuities. These products are subject to additional marketing laws and regulations, such as requirements for disclosures or prohibiting certain terminology during marketing presentations. Failure to comply with all applicable marketing laws and regulations could subject Insphere and its agents to fines, penalties, cease and desist orders, and loss of licensure by state insurance departments and by some state attorneys general, as well as result in possible litigation exposure for Insphere and its agents. In the event that Insphere markets variable annuity products, Insphere and its appropriately licensed agents will also be subject to regulation by the Securities and Exchange Commission (“SEC”) and state securities administrators. We expect Insphere to begin marketing additional product lines in the future which will present additional regulatory requirements on Insphere and its agents.

 

As discussed above, Insphere has entered into a definitive stock purchase agreement with Beneficial Life Insurance Company and BIS pursuant to which it would acquire all of the outstanding capital stock of BIS. BIS is a securities broker-dealer licensed in 49 states. This transaction is subject to customary closing conditions, including the receipt of approval by FINRA and the receipt of certain other required consents. As a registered broker-dealer, BIS is regulated by FINRA, the SEC and state securities administrators and the closing of this transaction would add complexity to the Company’s regulatory oversight and obligations.

State 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, Chesapeake’s and HMIC’s domicile state) and the Texas Department of Insurance (the regulator of Mid-West’s state of domicile) conduct regularly scheduled financial exams of the insurance subsidiaries. Our insurance subsidiaries, MEGA, Chesapeake and HMIC, have been notified by the Oklahoma Department of Insurance of the upcoming triennial examination for the three year period ended December 31, 2009.

 

State insurance departments periodically conduct, and will continue to conduct, market conduct examinations of HealthMarkets’ insurance subsidiaries. As reported in Note 18 of the Notes to Consolidated Financial Statements, such examinations have included the multi-state market conduct examination of MEGA, Mid-West and Chesapeake for the examination period January 1, 2000 through December 31, 2005, settled effective August 15, 2008 and the market conduct examination of MEGA, Mid-West and Chesapeake by the Massachusetts Division of Insurance, resulting in a 2006 regulatory settlement agreement, and subsequent re-examination of certain key provisions of the regulatory settlement agreement commencing in January 2009, which was settled on August 26, 2009. In addition to the examinations reported in Note 18, 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. In addition, Insphere could be subject to a market conduct examination as a result of its sales activities with respect to a non-affiliated insurance company. 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, individually or in combination, could injure the Company’s reputation, cause negative publicity, adversely affect the Company’s debt and financial strength ratings, place the Company at a competitive disadvantage in marketing or administering its products or impair the Company’s ability to sell insurance policies or retain customers, thereby adversely affecting its 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 the Company has engaged in improper conduct could also adversely affect its 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, including in the current Congress, the federal government generally does not directly regulate the insurance business. However, federal legislation and administrative policies in several areas, including Medicare and Medicaid programs, health care, HIPAA, ERISA, pension regulation, age and sex discrimination, financial services regulation, securities regulation, privacy laws, terrorism and federal taxation, do affect the insurance business. While the Company has taken what it believes are reasonable steps to ensure that it is in full compliance with these requirements, failure to comply could result in regulatory fines and civil lawsuits.

 

HIPAA and Other 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 laws and regulations. HIPAA includes requirements for maintaining the confidentiality and security of individually identifiable health information and standards for electronic health care transactions. 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. In January 2009, the Department of Health and Human Services proposed new rules that

would modify the current ICD-9 medical data code set standards and adopt new standards known as ICD-10 code sets, and would make related changes to the current HIPAA electronic transaction standards. The compliance date the new ICD-10 code sets is October 1, 2013; the compliance date for the updated electronic transaction standards is January 1, 2012. We expect that the new standards required by these rules will require implementation of new software and changes to our systems and processes, the cost of which may be significant. As have other entities in the health care industry, we have incurred substantial costs in meeting the requirements of the HIPAA regulations and expect to continue to incur costs to maintain compliance. 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. In addition to obligations on the part of the Company’s insurance subsidiaries, Insphere serves as a business associate of the non-affiliated insurance companies with which it does business. Insphere’s relationship with these non-affiliated insurance companies has added complexity to the Company’s privacy compliance obligations. 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.

 

In addition to imposing privacy requirements, 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. These aspects of HIPAA are regulated not only by federal laws and regulations, but also by state laws implementing HIPAA’s requirements. The Company and its agents are required to comply with these HIPAA requirements when marketing products to individuals or at a place of business.

 

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, administered and enforced by the Federal Trade Commission, establishes national standards for sending bulk, unsolicited commercial e-mail. The Company is also required to comply with federal “Do Not Call” regulations, enforced by the Federal Communications Commission, which require companies including insurers and insurance agencies to develop their own “do not call” lists and reference state and federal “do not call” registries before making calls to market insurance products. The Do Not Call regulations also contain prohibitions on unsolicited facsimiles. Insphere’s agents must be trained to comply with these CAN SPAM and Do Not Call requirements when marketing insurance products and association memberships. Failure to comply could result in enforcement actions by state attorneys general, regulatory fines and penalties and civil lawsuits.

 

USA PATRIOT Act

 

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 States 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 the DOL on terms that did not have a material adverse effect on the Company’s financial condition and results of operations.

 

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, guarantee coverage with no pre-existing condition exclusions, and compel individuals and employers to purchase health insurance coverage.

 

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. Many of the proposals, if adopted, could have a material adverse effect on our financial condition and results of operations.

 

National Healthcare Reform Legislation

 

On November 7, 2009, the U.S. House of Representatives passed the Affordable Health Care for America Act which would, among other things, authorize the creation of a national public plan that would be offered through a national health insurance exchange. On December 24, 2009, the U.S. Senate passed the Patient Protection and

Affordable Health Care Act. The Senate bill authorizes the creation of multi-state plans to be offered on a new national health insurance exchange and authorizes funding to support the creation of non-profit, member-run health insurance companies that would be offered through the exchange. If implemented, products available through these exchanges could partially or fully replace some of our current products. Provisions in both of the bills would also establish minimum loss ratios for health insurance policies that are significantly above the levels historically experienced by the Company’s insurance subsidiaries. Such minimum loss ratios could have a material adverse effect on the Company’s business. It remains unclear how and when these bills will be reconciled and we cannot predict whether legislation will be enacted, the final form any legislation might take or the effects of such legislation. Any health care reforms enacted may be phased in over a number of years, but, if enacted, could increase our costs, require us to revise the ways in which we conduct business or result in the loss of business for the Company’s insurance subsidiaries and Insphere. The changes resulting from such legislation could have a material adverse effect on our financial condition and results of operations.

 

The Senate bill provides that individual health insurance policies must have a minimum loss ratio of 80% and the House bill sets a minimum loss ratio for such policies at 85%. Historically, the Company has not been able to price premiums for its individual health insurance policies at these loss ratio levels. Enactment of minimum loss ratios at these levels could require us to discontinue marketing individual health insurance and/or to non-renew coverage of our existing individual health customers pursuant to applicable state and federal requirements. Enactment of minimum loss ratios at the levels in the Senate and House bills may also have a material adverse effect on the level of base commissions and override commissions Insphere receives from third party insurance carriers. We believe that these minimum loss ratios may be significantly above the levels historically experienced by Insphere’s third party insurance carriers. As a result, these carriers could be forced to reduce commissions, overrides and other administrative expenses in order to comply with the minimum loss ratio requirements.

 

Employees

 

We had approximately 1,100 employees at December 31, 2009. On February 18, 2010, the Company implemented a reduction of its existing workforce. The reduction reflects a drop in enrollment levels experienced by the Company’s insurance subsidiaries and is designed to better align the Company’s workforce to current business levels, properly manage the Company’s expenses and support the Company’s business strategy going forward. The reduction affected approximately 11% of the Company’s workforce or a total of approximately 125 employees and was substantially completed by February 19, 2010. We believe that the Company’s relations with its remaining employees are generally good.

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:

 

Enactment of national health care reform legislation could have a material adverse effect on our financial condition and results of operations, both for our Self-Employed Agency Division and Insphere Insurance Solutions, Inc.

 

On November 7, 2009, the U.S. House of Representatives passed the Affordable Health Care for America Act which would, among other things, authorize the creation of a national public plan that would be offered through a national health insurance exchange. On December 24, 2009, the U.S. Senate passed the Patient Protection and Affordable Health Care Act. The Senate bill authorizes the creation of multi-state plans to be offered on a new national health insurance exchange and authorizes funding to support the creation of non-profit, member-run health insurance companies that would be offered through the exchange. If implemented, products available through these exchanges could partially or fully replace some of our current products. Provisions in both of the bills would also establish minimum loss ratios for health insurance policies that are significantly above the levels historically experienced by the Company’s insurance subsidiaries. Such minimum loss ratios could have a material adverse effect on the Company’s business. It remains unclear how and when these bills will be reconciled and we cannot predict whether legislation will be enacted, the final form any legislation might take or the effects of such legislation. Any health care reforms enacted may be phased in over a number of years, but, if enacted, could increase our costs, require us to revise the ways in which we conduct business or result in the loss of business for the Company’s insurance subsidiaries. The changes resulting from such legislation could have a material adverse effect on our financial condition and results of operations.

 

The Senate bill provides that individual health insurance policies must have a minimum loss ratio of 80% and the House bill sets a minimum loss ratio for such policies at 85%. Historically, the Company has not been able to price premiums for its individual health insurance policies at these loss ratio levels. Enactment of minimum loss ratios at these levels could require us to discontinue marketing individual health insurance and/or to non-renew coverage of our existing individual health customers pursuant to applicable state and federal requirements.

 

Enactment of minimum loss ratios at the levels in the Senate and House bills may also have a material adverse effect on the level of base commissions and override commissions Insphere receives from third party insurance carriers. We believe that these minimum loss ratios may be significantly above the levels historically experienced by

Insphere’s third party insurance carriers. As a result, these carriers could be forced to reduce commissions, overrides and other administrative expenses in order to comply with the minimum loss ratio requirements.

 

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

 

We conduct business in a heavily regulated industry (see Item 1. Business — “Regulatory and Legislative Matters” for additional information). In addition to the national health care reform legislation discussed above, 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, guarantee coverage with no pre-existing condition exclusions, and compel individuals and employers to purchase health insurance coverage. The changes resulting from such legislation could have a material adverse effect on our financial condition and results of operations.

 

In addition, a number of states in which we do business are considering legislation intended to increase affordability or expand coverage of the uninsured, including laws that would mandate minimum loss ratios or increase existing minimum loss ratios for the products we offer. In 2009, legislation proposing an increase in minimum loss ratio was introduced in a number of states in which we do business. While these proposals were not enacted into law, we expect state legislatures to continue pursuing such initiatives in 2010 and future years, depending on whether changes in minimum loss ratios occur in connection with national health care reform. As discussed above in the national health care reform risk factor, such legislation, if passed, could have a material adverse effect on our financial condition and results of operations, both for our Self-Employed Agency Division and Insphere Insurance Solutions, Inc., including causing us to discontinue marketing our products in states where such legislation is passed or resulting in a material narrowing of profit margin.

 

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. Changes in the level of government regulation or in the laws and regulations themselves could substantially 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. For example, as a result of certain regulatory developments in Washington State, the Company has determined that it cannot continue to operate profitably in Washington State. The Company and the Washington State Insurance Commissioner have reached a preliminary agreement in principle that the Company will non-renew its health benefit plan policies and withdraw from the health benefit plan market place in the next several months. The Company currently has over 9,000 certificate holders in Washington State (see Item 1. Business — “Regulatory and Legislative Matters” for additional information). We evaluate legislative developments on an ongoing basis. If we determine that the legislative or regulatory environment in a particular state prevents us from doing business in a state on a profitable basis, we may determine that it is in the Company’s best interest to cease doing business in that state.

 

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 18 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 the CAN SPAM 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.

 

Current or future state and federal regulations could impede our ability to obtain effective leads and adversely affect our business

 

We utilize, either directly or through third party vendors, e-mails and telephone calls to identify prospective sales leads for use by our agents. Lead generation activities are subject to state and federal regulations, including, but not limited to, the federal CAN SPAM Act (which establishes national standards for sending bulk, unsolicited commercial e-mail) and the federal “Do Not Call” regulations (which require companies including insurers and insurance agencies to develop their own “do not call” lists and reference state and federal “do not call” registries before making calls to market insurance products, and prohibit unsolicited facsimiles) (see Item 1. Business — “Regulatory and Legislative Matters” for additional information). Failure to comply could result in enforcement actions by state attorneys general, regulatory fines and penalties and civil lawsuits. We believe that our ability to obtain quality sales leads plays a significant role in the generation of new business and our efforts to recruit and retain effective agents. To the extent that laws currently in effect, or passed in the future, make it more difficult or costly for us to obtain effective leads, or eliminate our ability to purchase or generate leads, our business could be materially and adversely affected.

 

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 state and federal law and 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. 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. 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, including imposition of varying civil monetary penalties, creation of a private cause of action for HIPAA violations, extension of HIPAA’s security provisions to business associates and creation of new security breach notification requirements. Compliance with HIPAA, the HITECH Act 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 filed the last of the semi-annual reports required by the RSA on February 15, 2010 and have taken actions to meet all the standards of the RSA on or before the due date. On or about March 15, 2010, the monitoring states are expected to initiate a re-examination to assess the standards for performance measurement. If the re-examination is unfavorable, the Insurance Subsidiaries are subject to additional penalties of up to $10 million. See Note 18 of Notes to Consolidated Financial Statements.

 

The Company’s insurance subsidiaries have periodically been the subject of other market conduct examinations conducted by state insurance departments. As reported in Note 18 of Notes to Consolidated Financial Statements, such examinations have included the market conduct examination of MEGA, Mid-West and Chesapeake by the Massachusetts Division of Insurance, resulting in a 2006 regulatory settlement agreement, and subsequent re-examination of certain key provisions of the regulatory settlement agreement commencing in January 2009, which was settled on August 26, 2009.

 

The Company’s insurance subsidiaries are also 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.

 

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. 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, have lower cost structures or, with respect to insurers, 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. Some may also have greater financial resources with which to compete. Other companies enter and exit the markets in which we operate, thereby increasing competition at times when there are new entrants.

Failure to recruit and retain agents could prevent us from competing successfully and could have a material adverse effect on our financial condition and results of operations.

 

We compete not only for the business of customers, but also for agents and distribution relationships with other distributors and insurance companies. We distribute our products as well as the products of non-affiliated insurance companies through independent agents contracted with Insphere. Insphere’s business is highly competitive and there are many insurance agencies, brokers and intermediaries who actively compete with us. We also compete with insurance companies that sell their products directly to customers and do not use or pay commissions to third-party agents or brokers. In addition, the Internet continues to be a source for direct placement of business and creates competition for Insphere. We compete for productive agents with other distributors based on a number of factors, including compensation structure, level of training and support services and product offerings. It can be difficult to successfully compete for agents with companies that have greater financial resources or name recognition. Our inability to recruit and retain productive insurance agents could adversely affect Insphere’s business prospects and could have a material adverse effect on our financial condition and results of operations.

 

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.

 

The Company’s independent agents act as field service representatives (FSRs) for various independent membership associations. In this capacity, the FSRs enroll new association members and provide membership retention services. For such services, the Company and the FSRs receive compensation. 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 such associations, which act as the master policyholder for such products. In 2009, the principal membership associations in the self employed market through which HealthMarkets insurance products were made available were the Alliance for Affordable Services, the National Association for the Self-Employed (“NASE”) and Americans for Financial Security. The associations provide their members with access to a number of benefits and products, including health insurance underwritten by the HealthMarkets insurance subsidiaries. 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.

 

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. In December 2009, the Company and NASE settled a legal action filed by Performance Driven Awards, Inc. against NASE. Pursuant to the terms of the settlement agreement, the NASE-PDA Field Services Agreement was terminated, as a result of which the Company’s FSR are no longer selling new NASE memberships and the Company’s independent insurance agents are no longer selling new certificates of insurance to NASE members. NASE memberships and certificates of insurance previously sold to NASE members remain in force (subject to ordinary course termination), and NASE is obligated to continue paying PDA for members previously enrolled in NASE by PDA. See Note 18 of Notes to Consolidated Financial Statements.

 

While we believe that we are providing association group coverage in full compliance with applicable law, further 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. Certain of the matters referred to in Note 18 of Notes to Consolidated Financial Statements, in particular the multi-state market conduct examination of our insurance subsidiaries led by the states of Washington and Alaska, the litigation filed by the Massachusetts Attorney General on behalf of the Commonwealth of Massachusetts and the market conduct examination of our insurance subsidiaries by the Massachusetts Division of Insurance, and the subsequent settlements of these matters, generated significantly adverse publicity for the Company. Matters of this nature in the future could result in the loss of reputation and business for the Company and could have a material adverse effect on our financial condition and results of operations.

 

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 investments in 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 through the payment of dividends. Our insurance subsidiaries are subject to regulations that limit their ability to transfer funds to us. 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.

 

We have a material amount of debt outstanding that contains restrictive covenants and our inability to service and repay our debt obligations could have a material adverse effect on our financial condition and results of operations

 

We have a material amount of debt outstanding (see Note 9 of Notes to Consolidated Financial Statements). In connection with the Merger on April 5, 2006, HealthMarkets, LLC entered into a credit agreement providing for, among other things, a $500 million term loan facility. The term loan facility will expire on April 5, 2012. At December 31, 2009, $362.5 million remained outstanding on the term loan facility. Our indebtedness could have an adverse effect on our business and future operations, including requiring us to dedicate a substantial portion of cash flow from operations to pay principal and interest on our debt, which would reduce funds available to fund working capital, capital expenditures and general operating requirements; increasing our vulnerability to general adverse economic and industry conditions or a downturn in our business; and placing us at a competitive disadvantage compared to competitors that have less debt. In addition, the credit agreement requires us to comply with various covenants that impose restrictions on our operations, including our ability to incur additional indebtedness, make

investments or other restricted payments, sell or otherwise dispose of assets and engage in certain other activities. The credit agreement also establishes a number of financial covenants, including maximum total leverage ratio requirements and minimum adjusted statutory surplus requirements. The restrictive covenants under our credit agreement could restrict our ability to pursue our business strategies. Any failure to comply with these restrictive covenants could result in an event of default under the credit agreement which could have a material adverse effect on our financial condition and results of operations.

 

Failure to accommodate redemption requests by agents participating in the HealthMarkets, Inc. InVest Stock Ownership Plan could result in dissatisfaction and attrition among our contracted independent agents.

 

Historically, we have generally accommodated requests to purchase Class A-2 shares upon the withdrawal of a participant from the stock accumulation plans established for the benefit of the Company’s agents, but are under no obligation to do so. Any repurchase of shares requires the Company’s consent, which may be withheld in our sole discretion. The ability to accommodate redemption requests is subject to a variety of factors, including the number of requests received and the Company’s capital position. The volume of redemption requests generally has been low. If the number of redemption requests increases as a result of an event that is perceived by agents to have a negative effect on the Company’s financial condition or operations (e.g. passage of national health care reform legislation or adverse publicity regarding the health insurance industry in general or our business specifically), the number of redemption requests could increase and the Company may elect not to accommodate such requests, which could result in dissatisfaction and substantial attrition among the agents within our agent field force as well as litigation risk.

 

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, rising and high unemployment, 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 $756.4 million and represented approximately 40% of our total

consolidated assets at December 31, 2009. 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. OTTI losses attributed to credit loss are recorded in earnings while OTTI losses attributed to other factors are recorded in “Accumulated other comprehensive income (loss)” and have no effect on 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, 2009, we recorded $4.5 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 2009. 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.

 

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.

 

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. The Company’s estimates with respect to claims liability and related benefit expenses are subject to an extensive degree of judgment and 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 18 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.

 

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 the $8.5 million loss recorded in “Realized gains, net” in the Company’s consolidated statement of income (loss) (see Note 20 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.

 

The Success of our Insphere Insurance Solutions Business is Uncertain.

 

The Company formed Insphere Insurance Solutions, Inc. in the second quarter of 2009 to serve as an insurance agency specializing in small business and middle-income market life, health, long-term care and retirement insurance. The success of this new line of business depends on a number of factors, including, but not limited to, the ability of Insphere to obtain and maintain applicable licenses, Insphere’s ability to enter into and maintain satisfactory relationships with insurance carriers and agents and the implementation of various information technology and administrative systems, platforms and processes necessary to successfully run the new business. Like any new business, the progress and success of Insphere entails substantial uncertainty. If the Company’s attempt to develop the Insphere business does not progress as planned, the Company may be materially and adversely affected by, among other things, capital, investments and operating expenses that have not led to the anticipated results.

 

The Company’s insurance subsidiaries may lose business to competitors whose products are sold by Insphere and its agents, and the loss of our healthiest customers would present adverse selection risks.

 

Insphere and its agents distribute insurance products underwritten by the Company’s insurance subsidiaries, as well as third-party insurance products underwritten by non-affiliated insurance carriers. These third-party products may be more competitive and attractive to customers than our own insurance products and may, over time, replace some or all of the sales of insurance products underwritten by our insurance subsidiaries. For example, in the markets where Insphere has commenced distribution of Golden Rule and Aetna products, these products have, to a great extent, replaced the sale of the Company’s own insurance products. In the first quarter of 2010, Insphere’s sale

of Golden Rule and Aetna products, in the aggregate, exceeded the sale of the Company’s products by nearly a five-to-one margin. If third party products replace the products underwritten by our insurance subsidiaries, the Company may not be able to maintain its current market share and, as a result, may see further declines in its premium revenue and underwriting profits from insurance product sales. These earnings may not be replaced by commission revenue generated from the distribution of third-party insurance products by Insphere, particularly in the early stages of Insphere’s operations. The movement of customers from policies underwritten by the Company’s insurance subsidiaries to products offered by non-affiliated insurance carriers also presents potential adverse selection risks. The Company’s insurance subsidiaries could be materially and adversely affected if their healthiest customers terminate or non-renew their policies in favor of policies offered by non-affiliated carriers, leaving less healthy customers who tend to incur higher health care costs.

 

Insphere faces risks related to its relationships with non-affiliated insurance carriers.

 

Insphere and its agents contract with non-affiliated carriers to distribute products underwritten by such carriers. These contracts generally provide that either party may terminate the contract for convenience by providing the other party with a relatively short period of advance notice. In any particular market, carriers could terminate their contracts with us (or refuse to contract with us), demand lower commissions or take other actions, including litigation, which could adversely affect our business. We are also dependent on non-affiliated carriers to pay Insphere in a timely and accurate manner and to provide Insphere with data required to support the sale of third party products and to timely and accurately pay its agents. The failure by a non-affiliated carrier to provide Insphere with the data and support necessary for Insphere to sell the carrier’s products and to pay its agents, resulting from a failure in data systems or otherwise, could materially and adversely affect Insphere’s business. Our business is also vulnerable to a non-affiliated carrier’s failure to administer underwritten business in an appropriate manner, which could lead to customer dissatisfaction and the lapse or cancellation of insurance policies for which Insphere receives commissions. Insphere could also be materially and adversely affected if a non-affiliated carrier with which it does business experiences a downgrade in its financial strength ratings which, for the affected carrier, could reduce Insphere’s level of business and commissions.

 

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.

 

Our reliance on outsourcing arrangements subjects us to risk and may disrupt or adversely affect our operations.

 

Historically, we have maintained an administrative center with underwriting, claims management and administrative capabilities performed in-house. In 2009, we began outsourcing many of these functions, including new business processing, provider service calls and a larger portion of the claims processing functions, to contracted third parties, including parties who may perform these functions offshore. Dependence on third parties for these services may make our operations vulnerable to the third party’s failure to perform as agreed. If these third parties fail to satisfy their obligations to us, including obligations with respect to the security and confidentiality of information and data of the Company and/or its customers, our operations may be adversely affected. Reliance on third parties also makes us vulnerable to changes in the vendors’ business, financial condition and other matters outside of our control. The failure to adequately monitor and regulate the performance of our third party vendors could subject us to additional risk. Violations of laws or regulations by third party vendors could increase our exposure to liability or otherwise increase the costs associated with the operation of our business. Some of our outsourced services are being performed offshore, which could expose us to risks inherent in conducting business outside of the United States, including international economic and political conditions and additional costs

associated with complying with foreign laws. If an outsourced relationship is terminated, we may not be able to find a replacement in a timely manner or on acceptable financial terms, and may incur significant costs in connection with the transition to a new vendor.

 

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.

 

If we are unable to retain key executives or appropriately manage succession, our business could be adversely affected.

 

We have experienced high turnover in our senior management team in recent years. Although we have employment arrangements in place with our key executives, these do no guarantee that the services of these executives will continue to be available to us, and we would be adversely affected if we fail to adequately plan for future turnover of our senior management team.

 

 

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. In the first quarter of 2010, the Company opened approximately 117 branch offices throughout the United States for its Insphere insurance agency operations. These offices comprise in the aggregate approximately 225,000 square feet.

 

 

See Note 18 of Notes to Consolidated Financial Statements, the terms of which are incorporated by reference herein.

 

 

None

 

 

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 1, 2010, there were approximately 24 holders of record of Class A-1 common stock and 788 holders of record of Class A-2 common stock.

 

Effective February 25, 2010, the Board of Directors of HealthMarkets, Inc. declared a special dividend in the amount of $3.94 per share for Class A-1 and Class A-2 common stock to holders of record as of the close of business

on March 1, 2010, payable on March 9, 2010. In connection with the special cash dividend, the Company paid dividends to stockholders in the aggregate of $120.3 million.

 

During the year ended December, 2009, the Company issued an aggregate of 5,263 unregistered shares of its Class A-1 common stock to executive officers of the Company. In particular, executive officers of the Company purchased 5,263 shares of the Company’s Class A-1 common stock for aggregate consideration of $100,000 (or $19.00 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-2 common stock during each of the months in the twelve-month period ended December 31, 2009:

 

 

 

 

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, 2009:

 

 

 

 

 

The following selected consolidated financial data as of and for each of the five years in the year ended December 31, 2009 has been derived from the audited consolidated financial statements of the Company. The Company has reclassified the results of operations of CFLD and UFC2 into continuing operations for all periods presented. Such reclassification resulted in an increased loss in “Income (loss) from continuing operations” of $5.3 million for the year ended December 31, 2008 and increased income in “Income (loss) from continuing operations” of $931,000 for the year ended December 31, 2007. 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.

Business Summary

 

HealthMarkets, Inc. is a holding company, the principal asset of which is its investment in its wholly owned subsidiary, HealthMarkets, LLC. HealthMarkets, LLC’s principal assets are its investments in its separate operating subsidiaries, including its regulated insurance subsidiaries. HealthMarkets conducts its insurance businesses through its indirect wholly owned insurance company subsidiaries, 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”).

 

We operate four business segments, the Insurance segment, Insphere, Corporate and Disposed Operations. The Insurance segment includes the Company’s Self-Employed Agency (“SEA”) Division. Insphere includes the activities of Insphere Insurance Solutions, Inc., an insurance agency which distributes insurance products underwritten by our insurance subsidiaries, as well as third-party insurance products underwritten by non-affiliated carriers. Insphere receives commission revenue and compensates its independent agents, as well as incurs costs associated with the start-up of the agency. The Company records selected other activities not allocated to the Insurance and Insphere segment in Corporate, including investment income not allocated to the Insurance segment, realized gains or losses, interest expense on corporate debt, the Company’s Student Loans business, 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 following former divisions: Medicare Division, Other Insurance Division, Life Insurance Division, Star HRG Division and Student Insurance Division. (See Note 21 of Notes to Consolidated Financial Statements for financial information regarding our segments).

 

During 2009, the Company formed Insphere Insurance Solutions, Inc., a Delaware corporation and a wholly owned subsidiary of HealthMarkets, LLC. Insphere is a distribution company that specializes in meeting the life, health, long-term care and retirement insurance needs of small business and middle-income individual and families through its portfolio of products from nationally recognized insurance carriers. Insphere is an authorized agency in all 50 states and the District of Columbia. As of February 2010, Insphere has approximately 2,500 independent agents, of which approximately 1,800 on average write health insurance applications each month, and offices in over 40 states. Insphere distributes products underwritten by the Company’s insurance company subsidiaries, as well as non-affiliated insurance companies. Insphere has completed marketing agreements with a number of life, health, long-term care and retirement insurance carriers, including, but not limited to, Aetna and UnitedHealthcare’s Golden Rule Insurance Company for individual health insurance products, John Hancock for long-term care products, ING for term life, universal life and fixed annuity products and Minnesota Life Insurance Company for life and fixed annuity products. Insphere also has a marketing arrangement with an intermediary under which Insphere’s agents obtain access to certain disability income insurance products.

 

Beneficial Life Insurance Company and Beneficial Investment Services, Inc.

 

On November 16, 2009, Insphere entered into a definitive stock purchase agreement with Beneficial Life Insurance Company and Beneficial Investment Services, Inc. (“BIS”) pursuant to which Insphere will acquire all of the outstanding capital stock of BIS (the “Purchase Agreement”). BIS is a securities broker-dealer licensed in 49 states. This transaction is subject to customary closing conditions, including the receipt of approval by the Financial Industry Regulatory Authority (“FINRA”) and the receipt of certain other required consents. The Purchase Agreement may be terminated by either party if the closing has not occurred by the earlier of (i) May 31, 2010 or (ii) six months after the initial application is filed with FINRA. The consolidated financial statements as of December 31, 2009 do not reflect any results of this acquisition.

 

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 Chesapeake, Mid-West and 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”). 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, net” in the Company’s consolidated statement of income (loss). See Note 6 of Notes to Consolidated Financial Statements for additional information regarding the coinsurance agreement with Wilton.

 

We 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.

 

Sale of ZON-Re

 

Our Other Insurance Division consisted of ZON-Re USA, LLC (“ZON-Re”), an 82.5%-owned subsidiary. Effective June 30, 2009, we sold our 82.5% membership interest in ZON-Re to Venue Re, LLC. The sale of our membership interest in ZON-Re resulted in a total pre-tax loss of $489,000 in 2009. See our discussion in the Disposed Operations below for additional information regarding our exit from the Other Insurance Division.

 

Exit from Medicare Market

 

In late 2007, we expanded into the Medicare market by offering a new portfolio of Medicare Advantage Private-Fee-for-Service Plans — called HealthMarkets Care Assured Plans^sm — in selected markets in 29 states with calendar year coverage effective for January 1, 2008. In July 2008, we determined we would not continue to participate in the Medicare business after the 2008 plan year. The Company will continue to reflect the existing insurance business in its financial statements to final termination of all remaining liabilities. See our discussion in the Disposed Operations below for additional information regarding our exit from the Medicare market.

 

2006 Sale of Star HRG Division

 

In July 2006, we sold substantially all of the assets formerly comprising our Star HRG Division. In connection with the sale of Star HRG, we recognized a pre-tax gain of $101.5 million. As consideration for the receipt of Star HRG assets, a unit of the CIGNA Corporation issued the CIGNA Note and the CIGNA Corporation entered into the Guaranty Agreement (see Note 11 of Notes to Consolidated Financial Statements for additional information regarding the CIGNA note and the Guaranty Agreement).

 

As part of the sale transaction, we entered into 100% coinsurance arrangements with the purchaser (see Note 6 of Notes to Consolidated Financial Statements for additional information regarding coinsurance agreements).

 

2006 Sale of Student Insurance Division

 

On December 1, 2006, we sold substantially all of the assets formerly comprising our Student Insurance Division. As consideration for the sale of our Student Insurance Division assets, we received a promissory note in the principal amount of $94.8 million issued by UnitedHealth Group Inc (see Note 20 of Notes to Consolidated Financial Statements). As part of the sale transaction, we entered into 100% coinsurance arrangements with the purchaser (see Note 6 of Notes to Consolidated Financial Statements for additional information regarding coinsurance agreements).

 

The purchase price was subject to downward or upward adjustment based on the amount of premium generated with respect to the 2007-2008 school year and actual claims experience with respect to the in-force block of student insurance business at the time of the sale. We recorded $5.5 million and $1.2 million of realized gains as adjustments to the purchase price during 2008 and 2007, respectively. The purchase price adjustment in 2008 was the final adjustment pursuant to the sale transaction agreement.

Results of Operations

 

We have reclassified certain amounts in the 2008 and 2007 financial statements to conform to the 2009 financial statement presentation.

 

Student Loans

 

In connection with our exit from the Life Insurance Division business, HealthMarkets, LLC entered into a definitive Stock Purchase Agreement (as amended, the “Stock Purchase Agreement”) pursuant to which Wilton agreed to purchase our student loan funding vehicles, CFLD-I, Inc. (“CFLD-I”) and UICI Funding Corp. 2 (“UFC2”), and the related student association. In our Annual Report on Form 10-K for the year ended December 31, 2008, the assets and liabilities of CFLD-I and UFC2 were presented as “Held for sale” on the consolidated balance sheets and the results of operations of CFLD-I and UFC2 were included in “Income (loss) from discontinued operations” on the consolidated statements of income (loss). As the Stock Purchase Agreement terminated in 2009 and the closing of the transaction did not occur, we reclassified the assets and liabilities and the results of operations of CFLD-I and UFC2 into continuing operations for all periods presented. Such reclassification resulted in an increased loss in “Income (loss) from continuing operations” of $5.3 million for the year ended December 31, 2008 and increased income in “Income (loss) from continuing operations” of $931,000 for the year ended December 31, 2007.

 

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 discussed above, we entered into Coinsurance Agreements in connection with our exit from the Life Insurance Division business and our sale of assets comprising the former Star HRG Division and the former Student Insurance Division. In addition, HealthMarkets is no longer generating business in its Medicare and Other Insurance Divisions. 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, as reflected in the table below:

 

 

Revenue

 

The majority of our 2009 revenue was earned on health premiums derived from sales of our indemnity and preferred provider organization (“PPO”) policies in our SEA Division. Premium revenue in our SEA Division was $973.3 million, $1,140.5 million, and $1,282.2 million for the years ended 2009, 2008, and 2007 respectively. Premiums on health insurance contracts are recognized as earned over the period of coverage on a pro rata basis. We also earned revenue on premiums from traditional life insurance polices, which are recognized as revenue when due.

 

Revenue also includes 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 our health insurance products.

As previously discussed, during 2009 we formed Insphere to serve as an insurance agency which will distribute insurance products underwritten by our insurance subsidiaries, as well as third-party insurance products underwritten by non-affiliated carriers. In addition to premiums revenue and underwriting profits on products written by our insurance subsidiaries, we also earned commission revenue generated from the distribution of third-party insurance products sold by Insphere agents. Commission revenue during 2009 was not material to our overall revenue however, we anticipate that such revenues will continue to grow.

 

Benefits and Expenses

 

Our expenses consist primarily of insurance claim 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. We also incur 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 our business segments and divisions. Allocations of investment income and certain general expenses are based on a number of assumptions and estimates, and the reported operating results for our business segments would change if different allocation methods were applied. Certain assets are not individually identifiable by segment and, accordingly, have been allocated by formulas. Segment revenues include premiums and other policy charges and considerations, net investment income, fees and other income. Management does not allocate income taxes to segments. Transactions between reportable segments are accounted for under respective agreements, which provide for such transactions generally at cost.

 

Revenue from continuing operations and income (loss) from continuing operations before federal income taxes (“Operating income”) for each of our business segments and divisions were as follows:

 

 

 

Assets by operating segment at December 31, 2009 and 2008 are set forth in the table below:

 

 

Disposed Operations assets at December 31, 2009 and 2008 primarily represent reinsurance recoverable for the Life Insurance Division of $353.7 million and $370.4 million associated with the Coinsurance Agreements entered into with Wilton (see Note 6 of Notes to Consolidated Financial Statements for additional information regarding such coinsurance agreements).

 

Self-Employed Agency Division

 

Through our SEA Division, we provide 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 features, catastrophic hospital expense plans, as well as other supplemental types of coverage. Prior to 2010 we marketed these products to the self-employed and individual markets through independent agents contracted with our insurance subsidiaries. In 2010, these products will be marketed through independent agents contracted with Insphere.

Set forth below is certain summary financial and operating data for the 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, 2009 versus December 31, 2008

 

The SEA Division reported earned premium revenue of $973.3 million in 2009 compared to $1.1 billion in 2008, a decrease of $167.2 million or 14.7%, which is due to a decrease in policies in force. Total policies in force decreased by 23% during the year to approximately 218,000 during 2009 as compared to approximately 281,700 during 2008. The decrease in policies in force reflects an attrition rate that exceeds the pace of new sales, and is evident in the reduction in submitted annualized premium volume from $455.9 million in 2008 to $321.9 million in 2009. Additionally, the decrease in policies in force is due to a decrease in the number of agents submitting business.

 

The SEA Division reported operating income of $117.5 million in 2009 compared to operating income of $55.6 million in 2008, an increase of $61.9 million or 111.2%. Operating income as a percentage of earned premium revenue (i.e., operating margin) for 2009 was 12.1% compared to the operating margin of 4.9% in 2008. The increase in operating margin during the current year period is generally attributable to a loss ratio reflecting better claims experience both for our new products, as well as for our legacy products and a shift away from CareOne products. The favorable claims development is partially offset by an estimated claims liability arising from a review of its claims processing for state mandated benefits, which review is expected to be completed by the first half of 2011.

As a result of the review, in the fourth quarter ended December 31, 2009, the Company refined its claim liability estimate related to state mandated benefits and recorded a claim liability estimate of $23.9 million. The impact to the loss ratio in 2009 was approximately 2.6% as a percentage of earned premium.

 

Underwriting, acquisition and insurance expenses decreased by $89.1 million, or 21.2% to $331.4 million in 2009 from $420.5 million in 2008. This decrease reflects the variable nature of commission expenses and premium taxes included in these amounts which generally vary in proportion to earned premium revenue and, in addition, the deferral of certain underwriting and policy issuance costs in 2009. Furthermore, we initiated certain cost reduction programs beginning in the fourth quarter of 2008, which are being reflected as a decrease in the expense ratio.

 

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 independent agents sales force for which other expenses are incurred for bonuses and other compensation provided to the agents. Sales of association memberships by our independent agents sales force tend to move in tandem with sales of health insurance policies; consequently, this decrease in other income and other expense is consistent with the decline in earned premium.

 

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 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 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, we experienced a decrease of $224.1 million, or 33.0% in 2008 from $680.1 million in 2007 to $455.9 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, we were experiencing increased competition in the marketplace, as well as a decrease of approximately 31.6% in the average number of writing agents in our independent 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. We exited the Medicare Advantage marketplace on December 31, 2008 and our focus for 2009 returned to our 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 our CareOne product suite and other PPO products, which are designed to provide a higher proportion of premium dollars as benefits. During the period, our sales efforts have been focused on new PPO type products, which, by design, have a higher loss ratio than our previous products that were largely per occurrence or scheduled benefit products. In addition, as previously disclosed, during 2007, we 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 us.

 

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 independent

agent sales force. Sales of association memberships by our independent agent 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.

 

Insphere

 

During the second quarter of 2009, we formed Insphere, an authorized insurance agency which will serve as an insurance agency specializing in small business and middle-income market life, health, long-term care and retirement insurance. Insphere distributes products underwritten by our insurance subsidiaries, as well as non-affiliated insurance companies. For 2009, Insphere reported an operating loss of $11.9 million comprised primarily of start up costs.

 

Year Ended December 31, 2009

 

During 2009, Insphere completed marketing agreements with a number of life, health, long-term care and retirement insurance carriers, including, but not limited to, ING, Minnesota Life Insurance Company, John Hancock, United Healthcare’s Golden Rule Insurance Company and Aetna. In the fourth quarter of 2009, Insphere began marketing individual health insurance products for United Healthcare’s Golden Rule Insurance Company and Aetna.

 

Insphere serves as an insurance agency, which distributes insurance products underwritten by our insurance subsidiaries, as well as third-party insurance products underwritten by non-affiliated carriers. In addition to premiums revenue and underwriting profits on products written by our insurance subsidiaries, we also earned commission revenue generated from the distribution of third-party insurance products sold by Insphere agents. Commission revenue of $1.1 million during 2009 was not material to our overall revenue; however, we anticipate that such revenues will continue to grow. For the year ended December 2009, Insphere reported $13.0 million of expenses related to the creation and development of Insphere.

 

Corporate

 

Corporate includes investment income not otherwise allocated to the Insurance segment, realized gains and losses on sales, interest expense on corporate debt, the Company’s Student Loan business, general expense relating to corporate operations, variable stock-based compensation and operations that do not constitute reportable operating segments.

 

Set forth below is a summary of the components of operating income (loss) at Corporate for each of the three most recent fiscal years:

 

Year Ended December 31, 2009 versus December 31, 2008

 

Corporate reported an operating loss in 2009 of $73.3 million compared to $106.9 million in 2008 for an overall decrease in operating expenses of $33.1 million. The decrease in operating expenses is primarily due to the following items:

 

 

Year Ended December 31, 2008 versus December 31, 2007

 

The Corporate segment reported an operating loss in 2008 of $106.9 million compared to $29.8 million in 2007 for an overall increase in operating expenses of $77.1 million. The increase in operating expenses is primarily due to the following items:

 

 

 

Disposed Operations

 

Our Disposed Operations segment includes our former Life Insurance Division, our former Star HRG Division, our former Student Insurance Division, our former Medicare Division and our former Other Insurance Division.

 

The table below sets forth income (loss) from continuing operations for our Disposed Operations for the years ended December 31, 2009, 2008 and 2007:

 

 

Life Insurance Division

 

Year Ended December 31, 2009 versus December 31, 2008

 

Our Life Insurance Division reported an operating loss in 2009 of $2.5 million compared to $23.4 million in 2008. The decrease in our operating loss from 2008 reflects expenses incurred as a result of our decision to exit this business in 2008, as discussed below.

 

Year Ended December 31, 2008 versus December 31, 2007

 

During 2008, we exited the Life Insurance Division business, and, effective July 1, 2008, we ceded substantially all of the insurance policies associated with our former Life Insurance Division. As such, the results of operations for 2008 are not comparable to results of operations for 2007.

 

The Life Insurance Division reported an operating loss in 2008 of $23.4 million compared to operating income of $2.6 million in 2007. The loss reported in 2008 reflects expenses incurred as a result of our decision to exit this

business in 2008 which costs are comprised of a $13.0 million impairment charge on deferred acquisition costs based upon the consideration expected to be received in connection with the coinsurance arrangement, $6.5 million in investment banker fees and legal fees, $4.1 million related to employee severance and $2.3 million related to facility lease termination costs. Also contributing to our operating loss in 2008 was the strengthening of our future policy and contract benefit reserves of $3.9 million incurred in the first half of 2008 for certain interest sensitive whole life products.

 

Student Insurance Division

 

Our Student Insurance Division, which offered tailored health insurance programs that generally provided single school year coverage to individual students at colleges and universities, reported operating income (losses) of $39,000, ($359,000) and $192,000 in the years ended 2009, 2008 and 2007, respectively. We have experienced very little activity in our Student Insurance Division since the sale on December 1, 2006.

 

Star HRG Division

 

Our former Star HRG Division, which designed, marketed and administered limited benefit health insurance plans for entry level, high turnover and hourly employees, reported operating income of $128,000, $118,000 and $199,000 in the years ended 2009, 2008 and 2007, respectively. We have experienced very little activity in our Star HRG Division since the sale on July 11, 2006.

 

Medicare Division

 

In 2007, we expanded into the Medicare market by offering a new portfolio of Medicare Advantage Private-Fee-for-Service Plans in selected markets in 29 states with calendar year coverage effective for January 1, 2008. In July 2008, we determined we would not continue to participate in the Medicare business after the 2008 plan year. As such, the results of operations for 2009 are not comparable to the results of operations for 2008.

 

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

 

 

Year Ended December 31, 2009

 

During early 2009, we experienced a higher than expected claim volume, as well as the submission of several large claims relating to the 2008 calendar year. As a result, we amended the completion factors used to calculate our reserves, and increased the overall projected lifetime loss ratio. As a result of our continued refinements of the completion factors throughout 2009, we increased the overall projected lifetime loss ratio from 83.3% as of December 31, 2008 to 88.2% as of December 31, 2009. At December 31, 2009, we have a remaining claims reserve of approximately $3.3 million.

Year Ended December 31, 2008

 

The Medicare Division produced $96.4 million in earned premium in 2008 on 118,961 member months. The Company had approximately 9,975 enrolled members as of December 31, 2008. Benefit expenses for 2008 of $80.3 million resulted in a loss ratio of 83.3%.

 

Underwriting, acquisition and insurance expenses of $31.3 million for 2008 include commissions, marketing costs, and all administrative and operating costs. In connection with our exit from the Medicare market, we incurred employee termination costs of $2.8 million and asset impairment charges of $1.1 million, which were recorded in “Underwriting, acquisition and insurance expenses” on the consolidated statement of income (loss). The asset impairment charges were primarily related to certain Medicare specific technology projects in development. Additionally, during 2008, we recognized a $4.9 million expense, recorded in “Underwriting, acquisition and insurance expenses,” associated with a minimum volume guarantee fee related to a contract with a third party administrator. This minimum volume guarantee fee was based on a minimum number of member months for the three year term of the contract covering calendar years 2008 through 2010.

 

Other Insurance

 

Our Other Insurance Division consisted of ZON-Re, an 82.5%-owned subsidiary, which underwrote, administered and issued accidental death, accidental death and dismemberment, accident medical, and accident disability insurance products, both on a primary and on a reinsurance basis. We distributed these products through professional reinsurance intermediaries and a network of independent commercial insurance agents, brokers and third party administrators. On June 5, 2009, HealthMarkets, LLC, entered into an Acquisition Agreement for the sale of its 82.5% membership interest in ZON-Re to Venue Re. The transaction contemplated by the Acquisition Agreement closed effective June 30, 2009. The sale of our membership interest in ZON-Re resulted in a total pre-tax loss of $489,000. We will continue to reflect the existing insurance business on our financial statements to final termination of substantially all liabilities.

 

Set forth below is certain summary financial and operating data for the Other Insurance Division for each of the three most recent fiscal years:

 

 

Year Ended December 31, 2009 versus December 31, 2008

 

In 2009, Other Insurance generated operating income of $3.9 on revenue of $7.9 million, compared to $4.4 million on revenue of $29.2 million for 2008. The overall decrease in operating income from the prior year is due to our exit from this line of business during the second quarter of 2009.

 

During 2009, we recognized positive experience related to benefits expense as a result of favorable claims experience on the policies maturing during the period, for which we have not renewed. Benefit expenses for 2008 include a large catastrophic claim on reinsured excess loss business in the amount of $1.9 million and a $900,000

loss on quota share disability business, which was partially offset by favorable claim experience during 2008. Underwriting, acquisition and insurance expenses were $4.8 million during 2009 compared to $10.6 million in 2008. The decrease in expenses during 2009 reflects our exit from this line of business during the second quarter of 2009.

 

Year Ended December 31, 2008 versus December 31, 2007

 

In 2008, Other Insurance generated operating income of $4.4 million compared to $7.9 million in 2007, a decrease of $3.5 million or 44.3%. The results for 2008 reflect adverse claim experience, in particular the impact of a large catastrophic claim on reinsured excess loss business in the amount of $2.3 million. The decrease in underwriting, acquisition and insurance expenses for the current year includes a decrease in the incentive compensation plan tied to the current period profitability and a decrease in litigation expenses compared to the prior year periods.

 

Earned premium revenues were $27.1 million in 2008 as compared with $30.0 million in 2007, a decrease of $2.9 million or 9.7%. 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.

 

Benefits expenses were $14.2 million in 2008 as compared with $12.6 million in 2007, an increase of $1.6 million or 12.7%. Benefits expenses increased in both dollars and in relation to earned premium revenue as expressed by the loss ratio of 52.4% in 2008, which is 24.2% higher than the loss ratio in 2007 of 42.2%. The increase in the loss ratio in 2008 reflected unfavorable claim experience in the current year related to a large catastrophic claim.

 

Liquidity and Capital Resources

 

We regularly monitor our liquidity position, including cash levels, principal investment commitments, interest and principal payments on debt, capital expenditures and compliance with regulatory requirements. We maintain liquidity at two levels: our insurance subsidiaries and our holding company.

 

Our regulated domestic insurance subsidiaries generate significant cash flows from operations. Liquidity requirements at the insurance subsidiaries generally consist of claim and benefit payments to policyholders and operating expenses, primarily for employee compensation and benefits. The Company meets such requirements by maintaining appropriate levels of cash, cash equivalents and short-term investments, using cash flows from operating activities and selling investments. After considering expected cash flows from operating activities, we generally invest cash at our regulated subsidiaries that exceeds our expected short-term obligations in longer term, investment-grade, marketable debt securities to improve our overall investment return. These investments are made after consideration of return objectives, regulatory limitations, tax implications and risk tolerances. Cash in excess of the capital needs of our domestic regulated insurance entities is paid to their non-regulated parent company, typically in the form of dividends, when and as permitted by applicable regulations.

 

The holding company generates cash flows primarily through dividends from its subsidiaries. Cash flows generated from dividends and through the issuance of long-term debt, further strengthen our operating and financial flexibility. Liquidity requirements at the holding company level generally consist of servicing debt, funding the start up costs of Insphere, reinvestments in our businesses through the expansion of our products and services and the repurchase of shares of our common stock.

 

Consolidated Cash Flows

 

Historically, our primary source of cash on a consolidated basis has been premium revenue from policies issued. The primary uses of cash on a consolidated basis have been for the payment for benefits, claims and commissions under those policies, as well as operating expenses, primarily employee compensation and benefits.

 

 

Operating Activities

 

Cash flows generated from operating activities are principally from net income, net of depreciation and amortization and other non-cash expenses. During 2009 and 2008, cash flows used in operating activities were $14.6 million and $219.6 million, respectively, compared to cash flows provided by operating activities of $78.8 million in 2007.

 

Investing Activities

 

Cash flows from investing activities primarily consist of net investment purchases or sales and net purchases of property and equipment, which includes capitalized software. During 2009, we had cash flows used in investing activities of $49.6 million compared to cash flows provided by investing activities of $364.4 million in 2008 and $323.0 million in 2007. In 2009 and 2008, we had net purchases of short-term and other investments of $161.3 million and $76.0 million, respectively, which were partially offset by net sales of available for sale securities of $111.8 million and $439.4 million, respectively. During 2007, we had net sales of short-term and other investments of $261.0 million and net sales of available for sale securities of $74.7 million.

 

Financing Activities

 

Cash flows used in financing activities primarily consist of repurchases of treasury stock, repayment of the student loan credit facility and dividends to shareholders. Cash flows provided by financing activities primarily consist of proceeds from shares issued to agent plans. During 2009, we had cash flows used in financing activities of $18.7 million compared to $58.9 million in 2008 and $420.2 million in 2007. In 2009 and 2008, cash flows used in financing activities were primarily related to the purchase of treasury stock for $21.2 million and $58.1 million, respectively. In 2007, our use of cash flows for financing activities were related to the purchase of treasury stock of $41.5 million, the repayment of notes payable of $75.0 million and the payment of dividends to shareholders of $317.0 million. The Company purchases stock primarily from current and former participants in the agent stock accumulation plan.

 

Holding Company

 

HealthMarkets, Inc. is a holding company, the principal asset of which is its investment in its wholly owned subsidiary, HealthMarkets, LLC (collectively referred to as the “holding company”). The holding company’s ability to fund its cash requirements is largely dependent upon its ability to access cash, by means of dividends or other means, from HealthMarkets, LLC. HealthMarkets, LLC’s principal assets are its investments in its separate operating subsidiaries, including its regulated domestic insurance subsidiaries.

At December 31, 2009, 2008 and 2007, the aggregate cash and cash equivalents and short-term investments held at HealthMarkets, Inc. and HealthMarkets, LLC was $242.2 million, $232.1 million and $42.5 million, respectively. Set forth below is a summary statement of aggregate cash flows for HealthMarkets, Inc. and HealthMarkets, LLC for each of the three most recent years:

 

 

Sources of Cash and Liquidity

 

 

Uses of Cash and Liquidity

 

 

2010 Dividend to Shareholders

 

Effective February 25, 2010, the Board of Directors of HealthMarkets, Inc. declared a special dividend in the amount of $3.94 per share for Class A-1 and Class A-2 common stock to holders of record as of the close of business on March 1, 2010, payable on March 9, 2010. In connection with the special cash dividend, the Company paid dividends to stockholders in the aggregate of $120.3 million.

 

Regulatory Requirements

 

The state of domicile of each of the Company’s domestic insurance subsidiaries imposes minimum risk-based capital requirements that were developed by the NAIC. The formulas for determining the amount of risk-based capital specify various weighting factors that are applied to financial balances and premium levels based on the perceived degree of risk. Regulatory compliance is determined by a ratio of a company’s regulatory total adjusted capital, as defined, to its authorized control level risk-based capital, as defined. Companies’ specific trigger points or ratios are classified within certain levels, each of which requires specified corrective action.

 

Generally, the total stockholders’ equity of domestic insurance subsidiaries (as determined in accordance with statutory accounting practices) in excess of minimum statutory capital requirements is available for transfer to the parent company, subject to the tax effects of distribution from the policyholders’ surplus account.

 

The required minimum aggregate statutory capital and surplus of our principal domestic insurance subsidiaries were as follows at December 31, 2009:

 

 

At December 31, 2009, the risk-based capital ratio of each of our insurance subsidiaries exceeds the ratio for which regulatory corrective action would be required.

 

Dividend Restrictions