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EX-12.1 - RATIO OF EARNINGS TO FIXED CHARGES - CENTENE CORPexhibit121.htm
EX-32.2 - CERTIFICATION - CENTENE CORPexhibit322.htm
EX-32.1 - CERTIFICATION - CENTENE CORPexhibit321.htm
EX-31.2 - CERTIFICATION - CENTENE CORPexhibit312.htm
EX-31.1 - CERTIFICATION - CENTENE CORPexhibit311.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
____________________________________________
FORM 10-Q
____________________________________________
(Mark One)
[X]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2017
OR
[  ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                  to
____________________________________________
Commission file number: 001-31826
____________________________________________
CENTENE CORPORATION
(Exact name of registrant as specified in its charter)

Delaware
42-1406317
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification Number)
 
 
7700 Forsyth Boulevard
 
St. Louis, Missouri
63105
(Address of principal executive offices)
(Zip Code)

Registrant’s telephone number, including area code:
(314) 725-4477
 
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: x Yes o No

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). x Yes o No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “small reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer o Non-accelerated filer o (do not check if a smaller reporting company) Smaller reporting company o Emerging growth company o

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

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

As of July 14, 2017, the registrant had 172,475,653 shares of common stock outstanding.




CENTENE CORPORATION
QUARTERLY REPORT ON FORM 10-Q
TABLE OF CONTENTS

 
 
PAGE
 
 
 
 
Part I
 
 
Financial Information
 
Item 1.
 
 

 

 

 

 
Item 2.
Item 3.
Item 4.
 
Part II
 
 
Other Information
 
Item 1.
Item 1A.
Item 2.
Item 6.
 



CAUTIONARY STATEMENT ON FORWARD-LOOKING STATEMENTS

All statements, other than statements of current or historical fact, contained in this filing or incorporated by reference herein are forward-looking statements. We intend such forward looking statements to be covered by the safe-harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and we are including this statement for purposes of complying with these safe-harbor provisions. We have attempted to identify these statements by terminology including “believe,” “anticipate,” “plan,” “expect,” “estimate,” “intend,” “seek,” “target,” “goal,” “may,” “will,” “would,” “could,” “should,” “can,” “continue” and other similar words or expressions (and the negative thereof) in connection with, among other things, any discussion of future operating or financial performance. In particular, these statements include without limitation statements about our market opportunity, our growth strategy, competition, expected activities and future acquisitions, investments and the adequacy of our available cash resources. These statements may be found in the various sections of this filing, such as Part I, Item 2. “Management's Discussion and Analysis of Financial Condition and Results of Operations,” Part II, Item 1. “Legal Proceedings,” and Part II, Item 1A. “Risk Factors.” Readers are cautioned that matters subject to forward-looking statements involve known and unknown risks and uncertainties, including economic, regulatory, competitive and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions.

All forward-looking statements included in this filing are based on information available to us on the date of this filing. Except as may be otherwise required by law, we undertake no obligation to update or revise the forward-looking statements included in this filing, whether as a result of new information, future events or otherwise, after the date of this filing. You should not place undue reliance on any forward looking statements, as actual results may differ materially from projections, estimates, or other forward-looking statements due to a variety of important factors, including but not limited to:

our ability to accurately predict and effectively manage health benefits and other operating expenses and reserves;
competition;
membership and revenue declines or unexpected trends;
changes in healthcare practices, new technologies, and advances in medicine;
increased health care costs;
changes in economic, political or market conditions;
changes in federal or state laws or regulations, including changes with respect to government health care programs as well as changes with respect to the Patient Protection and Affordable Care Act and the Health Care and Education Affordability Reconciliation Act and any regulations enacted thereunder that may result from changing political conditions;
rate cuts or other payment reductions or delays by governmental payors and other risks and uncertainties affecting our government businesses;
our ability to adequately price products on federally facilitated and state based Health Insurance Marketplaces;
tax matters;
disasters or major epidemics;
the outcome of legal and regulatory proceedings;
changes in expected contract start dates;
provider, state, federal and other contract changes and timing of regulatory approval of contracts;
the expiration, suspension, or termination of our contracts with federal or state governments (including but not limited to Medicaid, Medicare, and TRICARE);
challenges to our contract awards;
cyber-attacks or other privacy or data security incidents;
the possibility that the expected synergies and value creation from acquired businesses, including, without limitation, the acquisition of Health Net, Inc. (Health Net), will not be realized, or will not be realized within the expected time period, including, but not limited to, as a result of conditions, terms, obligations or restrictions imposed by regulators in connection with their approval of, or consent to, the acquisition;
the exertion of management’s time and our resources, and other expenses incurred and business changes required in connection with complying with the undertakings in connection with certain regulatory approvals;
disruption from the acquisition making it more difficult to maintain business and operational relationships;
the risk that unexpected costs will be incurred in connection with, among other things, the acquisition and/or the integration;
changes in expected closing dates, estimated purchase price and accretion for acquisitions;
the risk that acquired businesses will not be integrated successfully;
our ability to maintain or achieve improvement in the Centers for Medicare and Medicaid Services (CMS) Star ratings and other quality scores that impact revenue;
availability of debt and equity financing, on terms that are favorable to us;

i


inflation; and
foreign currency fluctuations.

This list of important factors is not intended to be exhaustive. We discuss certain of these matters more fully, as well as certain other risk factors that may affect our business operations, financial condition and results of operations, in our filings with the Securities and Exchange Commission, including our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. Item 1A. “Risk Factors” of Part II of this filing contains a further discussion of these and other important factors that could cause actual results to differ from expectations. Due to these important factors and risks, we cannot give assurances with respect to our future performance, including without limitation our ability to maintain adequate premium levels or our ability to control our future medical costs.


ii


Non-GAAP Financial Presentation

The Company is providing certain non-GAAP financial measures in this report as the Company believes that these figures are helpful in allowing investors to more accurately assess the ongoing nature of the Company's operations and measure the Company's performance more consistently across periods. The Company uses the presented non-GAAP financial measures internally to allow management to focus on period-to-period changes in the Company's core business operations. Therefore, the Company believes that this information is meaningful in addition to the information contained in the GAAP presentation of financial information. The presentation of this additional non-GAAP financial information is not intended to be considered in isolation or as a substitute for the financial information prepared and presented in accordance with GAAP.

Specifically, the Company believes the presentation of non-GAAP financial information that excludes amortization of acquired intangible assets, Health Net acquisition related expenses, as well as other items, allows investors to develop a more meaningful understanding of the Company's performance over time. The tables below provide reconciliations of non-GAAP items ($ in millions, except per share data):

 
Three Months Ended
June 30,
 
Six Months Ended
 June 30,
 
2017
 
2016
 
2017
 
2016
 
 
 
 
 
 
 
 
GAAP net earnings from continuing operations
$
254

 
$
171

 
$
393

 
$
156

Amortization of acquired intangible assets
39

 
43

 
79

 
52

Health Net acquisition related expenses
1

 
25

 
6

 
214

Penn Treaty assessment expense

 

 
47

 

Income tax effects of adjustments (1)
(14
)
 
(14
)
 
(48
)
 
(101
)
Adjusted net earnings from continuing operations
$
280

 
$
225

 
$
477

 
$
321

 
 
 
 
 
 
 
 
GAAP diluted earnings per share (EPS)
$
1.44

 
$
0.98

 
$
2.23

 
$
1.02

Amortization of acquired intangible assets (2)
0.14

 
0.15

 
0.28

 
0.20

Health Net acquisition related expenses (3)
0.01

 
0.16

 
0.03

 
0.89

Penn Treaty assessment expense (4)

 

 
0.17

 

Adjusted Diluted EPS from continuing operations
$
1.59

 
$
1.29

 
$
2.71

 
$
2.11

(1)
The income tax effects of adjustments are based on the effective income tax rates applicable to adjusted (non-GAAP) results.
(2)
The amortization of acquired intangible assets per diluted share are net of an income tax benefit of $0.08 and $0.10 for the three months ended June 30, 2017 and 2016, respectively and $0.17 and $0.14 for the six months ended June 30, 2017 and 2016, respectively.
(3)
The Health Net acquisition related expenses per diluted share are net of an income tax benefit (expense) of $0.00 and $(0.02) for the three months ended June 30, 2017 and 2016, respectively and $0.01 and $0.52 for the six months ended June 30, 2017 and 2016, respectively.
(4)
The Penn Treaty assessment expense per diluted share is net of an income tax benefit of $0.09 for the six months ended June 30, 2017. For a further discussion of the Penn Treaty assessment, see Note 9, Contingencies.
 
Three Months Ended
June 30,
 
Six Months Ended
 June 30,
 
2017
 
2016
 
2017
 
2016
 
 
 
 
 
 
 
 
GAAP selling, general and administrative expenses
$
1,065

 
$
949

 
$
2,156

 
$
1,671

Health Net acquisition related expenses
1

 
25

 
6

 
214

Penn Treaty assessment expense

 

 
47

 

Adjusted selling, general and administrative expenses
$
1,064

 
$
924

 
$
2,103

 
$
1,457


iii


PART I
FINANCIAL INFORMATION

ITEM 1. Financial Statements.
CENTENE CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In millions, except shares in thousands and per share data in dollars)
 
June 30, 2017
 
December 31, 2016
 
(Unaudited)
 
 
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
4,425

 
$
3,930

Premium and related receivables
3,901

 
3,098

Short-term investments
586

 
505

Other current assets
736

 
832

Total current assets
9,648

 
8,365

Long-term investments
4,816

 
4,545

Restricted deposits
137

 
138

Property, software and equipment, net
912

 
797

Goodwill
4,712

 
4,712

Intangible assets, net
1,466

 
1,545

Other long-term assets
149

 
95

Total assets
$
21,840

 
$
20,197

 
 
 
 
LIABILITIES, REDEEMABLE NONCONTROLLING INTERESTS AND STOCKHOLDERS’ EQUITY
 
 
 

Current liabilities:
 

 
 

Medical claims liability
$
4,170

 
$
3,929

Accounts payable and accrued expenses
4,238

 
4,377

Unearned revenue
554

 
313

Current portion of long-term debt
4

 
4

Total current liabilities
8,966

 
8,623

Long-term debt
4,716

 
4,651

Other long-term liabilities
1,630

 
869

Total liabilities
15,312

 
14,143

Commitments and contingencies


 


Redeemable noncontrolling interests
136

 
145

Stockholders’ equity:
 

 
 

Preferred stock, $0.001 par value; authorized 10,000 shares; no shares issued or outstanding at June 30, 2017 and December 31, 2016

 

Common stock, $0.001 par value; authorized 400,000 shares; 178,900 issued and 172,467 outstanding at June 30, 2017, and 178,134 issued and 171,919 outstanding at December 31, 2016

 

Additional paid-in capital
4,258

 
4,190

Accumulated other comprehensive earnings (loss)
1

 
(36
)
Retained earnings
2,313

 
1,920

Treasury stock, at cost (6,433 and 6,215 shares, respectively)
(194
)
 
(179
)
Total Centene stockholders’ equity
6,378

 
5,895

Noncontrolling interest
14

 
14

Total stockholders’ equity
6,392

 
5,909

Total liabilities, redeemable noncontrolling interests and stockholders’ equity
$
21,840

 
$
20,197

The accompanying notes to the consolidated financial statements are an integral part of these statements. 

1


CENTENE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In millions, except per share data in dollars)
(Unaudited)
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2017
 
2016
 
2017
 
2016
Revenues:
 
 
 
 
 
 
 
Premium
$
10,905

 
$
9,688

 
$
21,543

 
$
15,674

Service
536

 
588

 
1,063

 
1,013

Premium and service revenues
11,441

 
10,276

 
22,606

 
16,687

Premium tax and health insurer fee
513

 
621

 
1,072

 
1,163

Total revenues
11,954

 
10,897

 
23,678

 
17,850

Expenses:
 
 
 
 
 
 
 
Medical costs
9,413

 
8,385

 
18,735

 
13,696

Cost of services
456

 
515

 
897

 
882

Selling, general and administrative expenses
1,065

 
949

 
2,156

 
1,671

Amortization of acquired intangible assets
39

 
43

 
79

 
52

Premium tax expense
543

 
498

 
1,133

 
948

Health insurer fee expense

 
130

 

 
204

Total operating expenses
11,516

 
10,520

 
23,000

 
17,453

Earnings from operations
438

 
377

 
678

 
397

Other income (expense):
 
 
 
 
 
 
 
Investment and other income
45

 
32

 
86

 
47

Interest expense
(62
)
 
(52
)
 
(124
)
 
(85
)
Earnings from continuing operations, before income tax expense
421

 
357

 
640

 
359

Income tax expense
169

 
187

 
256

 
203

Earnings from continuing operations, net of income tax expense
252

 
170

 
384

 
156

Discontinued operations, net of income tax (benefit)

 
(1
)
 

 
(2
)
Net earnings
252

 
169

 
384

 
154

Loss attributable to noncontrolling interests
2

 
1

 
9

 

Net earnings attributable to Centene Corporation
$
254

 
$
170

 
$
393

 
$
154

 
 
 
 
 

 

Amounts attributable to Centene Corporation common shareholders:
Earnings from continuing operations, net of income tax expense
$
254

 
$
171

 
$
393

 
$
156

Discontinued operations, net of income tax (benefit)

 
(1
)
 

 
(2
)
Net earnings
$
254

 
$
170

 
$
393

 
$
154

 
 
 
 
 
 
 
 
Net earnings (loss) per common share attributable to Centene Corporation:
Basic:
 
 
 
 
 
 
 
Continuing operations
$
1.47

 
$
1.00

 
$
2.28

 
$
1.05

Discontinued operations

 

 

 
(0.01
)
Basic earnings per common share
$
1.47

 
$
1.00

 
$
2.28

 
$
1.04

 
 
 
 
 
 
 
 
Diluted:
 
 
 
 
 
 
 
Continuing operations
$
1.44

 
$
0.98

 
$
2.23

 
$
1.02

Discontinued operations

 
(0.01
)
 

 
(0.01
)
Diluted earnings per common share
$
1.44

 
$
0.97

 
$
2.23

 
$
1.01

 
 
 
 
 
 
 
 
The accompanying notes to the consolidated financial statements are an integral part of these statements.

2


CENTENE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE EARNINGS
(In millions)
(Unaudited)

 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2017
 
2016
 
2017
 
2016
Net earnings
$
252

 
$
169

 
$
384

 
$
154

Reclassification adjustment, net of tax
(1
)
 

 
(1
)
 
1

Change in unrealized gain on investments, net of tax
20

 
34

 
34

 
52

Foreign currency translation adjustments
3

 
(1
)
 
4

 

Other comprehensive earnings
22

 
33

 
37

 
53

Comprehensive earnings
274

 
202

 
421

 
207

Comprehensive loss attributable to noncontrolling interests
2

 
1

 
9

 

Comprehensive earnings attributable to Centene Corporation
$
276

 
$
203

 
$
430

 
$
207


The accompanying notes to the consolidated financial statements are an integral part of these statements.


3


CENTENE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(In millions, except shares in thousands and per share data in dollars)
(Unaudited)

Six Months Ended June 30, 2017

 
Centene Stockholders’ Equity
 
 
 
 
 
Common Stock
 
 
 
 
 
 
 
Treasury Stock
 
 
 
 
 
$.001 Par
Value
Shares
 
Amt
 
Additional
Paid-in
Capital
 
Accumulated
Other
Comprehensive
Earnings (Loss)
 
Retained
Earnings
 
$.001 Par
Value
Shares
 
Amt
 
Non-
controlling
Interest
 
Total
Balance, December 31, 2016
178,134

 
$

 
$
4,190

 
$
(36
)
 
$
1,920

 
6,215

 
$
(179
)
 
$
14

 
$
5,909

Comprehensive Earnings:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net earnings

 

 

 

 
393

 

 

 

 
393

Other comprehensive earnings, net of $19 tax

 

 

 
37

 

 

 

 

 
37

Common stock issued for employee benefit plans
766

 

 
6

 

 

 

 

 

 
6

Common stock repurchases

 

 

 

 

 
218

 
(15
)
 

 
(15
)
Stock compensation expense

 

 
62

 

 

 

 

 

 
62

Balance, June 30, 2017
178,900

 
$

 
$
4,258

 
$
1

 
$
2,313

 
6,433

 
$
(194
)
 
$
14

 
$
6,392

 
The accompanying notes to the consolidated financial statements are an integral part of this statement.



4


CENTENE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In millions)
(Unaudited)
 
Six Months Ended June 30,
 
2017
 
2016
Cash flows from operating activities:
 
 
 
Net earnings
$
384

 
$
154

Adjustments to reconcile net earnings to net cash provided by (used in) operating activities
Depreciation and amortization
173

 
111

Stock compensation expense
62

 
83

Deferred income taxes
(58
)
 
(13
)
Changes in assets and liabilities
 

 
 

Premium and related receivables
(696
)
 
(1,121
)
Other assets
65

 
(36
)
Medical claims liabilities
243

 
188

Unearned revenue
241

 
(50
)
Accounts payable and accrued expenses
(257
)
 
(8
)
Other long-term liabilities
781

 
463

Other operating activities, net
4

 
6

Net cash provided by (used in) operating activities
942

 
(223
)
Cash flows from investing activities:
 

 
 

Capital expenditures
(181
)
 
(94
)
Purchases of investments
(1,294
)
 
(956
)
Sales and maturities of investments
990

 
593

Investments in acquisitions, net of cash acquired

 
(862
)
Other investing activities, net
(1
)
 

Net cash used in investing activities
(486
)
 
(1,319
)
Cash flows from financing activities:
 

 
 

Proceeds from long-term debt
810

 
5,711

Payments of long-term debt
(762
)
 
(3,124
)
Common stock repurchases
(15
)
 
(27
)
Debt issuance costs

 
(59
)
Other financing activities, net
6

 
(9
)
Net cash provided by financing activities
39

 
2,492

Net increase in cash and cash equivalents
495

 
950

Cash and cash equivalents, beginning of period
3,930

 
1,760

Cash and cash equivalents, end of period
$
4,425

 
$
2,710

Supplemental disclosures of cash flow information:
 

 
 

Interest paid
$
99

 
$
36

Income taxes paid
$
205

 
$
222

Equity issued in connection with acquisitions
$

 
$
3,105

 
The accompanying notes to the consolidated financial statements are an integral part of these statements.

5


CENTENE CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in millions, except share data)
(Unaudited)
   
1. Organization and Operations

Basis of Presentation

The accompanying interim financial statements have been prepared under the presumption that users of the interim financial information have either read or have access to the audited financial statements included in the Form 10-K for the fiscal year ended December 31, 2016. The unaudited interim financial statements herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, footnote disclosures which would substantially duplicate the disclosures contained in the December 31, 2016 audited financial statements have been omitted from these interim financial statements where appropriate. In the opinion of management, these financial statements reflect all adjustments, consisting only of normal recurring adjustments, which are necessary for a fair presentation of the results of the interim periods presented.
 
Certain 2016 amounts in the consolidated financial statements and notes to the consolidated financial statements have been reclassified to conform to the 2017 presentation. The Company adopted Accounting Standards Update (ASU) 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting during the fourth quarter of 2016. The ASU simplifies several aspects of the accounting for employee share-based payment transactions. Among other elements, the ASU requires an entity to recognize all excess tax benefits and deficiencies related to stock-based compensation expense as income tax expense or benefit in the statements of operations. The ASU requires adjustments be reflected as of the beginning of the fiscal year of adoption and as a result, prior periods have been adjusted accordingly. The adoption resulted in a decrease to income tax expense of $1 million and $2 million for the three and six months ended June 30, 2016.

In January 2017, the Company reclassified Cenpatico Behavioral Health of Arizona, LLC and the related Cenpatico Integrated Care health plan from the Specialty Services segment to the Managed Care segment due to a reorganization of the Arizona management structure following the Health Net integration. As a result, the financial results of Cenpatico Behavioral Health of Arizona, LLC and the related Cenpatico Integrated Care health plan have been reclassified from the Specialty Services segment to the Managed Care segment for all periods presented.

On March 24, 2016, the Company completed the acquisition of Health Net, Inc. (Health Net) for $6.0 billion, including the assumption of debt. The acquisition was accounted for as a business combination, which requires that assets acquired and liabilities assumed be recognized at their fair values as of the acquisition date. The valuation of all the assets acquired and liabilities assumed was finalized in the fourth quarter of 2016. As a result of the completion of the Health Net acquisition, the Company's results of operations for the six months ended June 30, 2016 include the results of operations of Health Net from March 24, 2016 to June 30, 2016.

Accounting Guidance Not Yet Adopted

In March 2017, the Financial Accounting Standards Board (FASB) issued an ASU which changes the period over which premiums on callable debt securities are amortized. The new standard requires the premiums on callable debt securities to be amortized to the earliest call date rather than to the contractual maturity date of the instrument. The new guidance more closely aligns the amortization period of premiums to expectations incorporated in the market pricing on the underlying securities. The new guidance is effective for annual and interim periods beginning after December 15, 2018. Early adoption is permitted. The new guidance is not expected to have a material impact on the Company's consolidated financial position, results of operations or cash flows.


6


In May 2014, the FASB issued an ASU which supersedes existing revenue recognition standards with a single model unless those contracts are within the scope of other standards (e.g., an insurance entity's insurance contracts). Under the new standard, recognition of revenue occurs when a customer obtains control of promised goods or services in an amount that reflects the consideration which the entity expects to receive in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing and uncertainty of revenues and cash flows arising from contracts with customers. The new effective date is for annual and interim periods beginning after December 15, 2017. Early adoption is permitted. The Company is currently analyzing selected contracts to determine the impact of the new guidance and anticipates adopting the new guidance in the first quarter of 2018 using the modified retrospective approach with a cumulative-effect adjustment to retained earnings in the period of initial application. The Company also plans to elect the practical expedient of applying the new guidance only to contracts that are not completed as of the date of initial application. The majority of the Company's revenues are derived from insurance contracts and are excluded from the new standard; therefore, the new guidance is not expected to have a material impact on the Company's consolidated financial position, results of operations or cash flows.

2. Short-term and Long-term Investments, Restricted Deposits

Short-term and long-term investments and restricted deposits by investment type consist of the following ($ in millions):
 
June 30, 2017
 
December 31, 2016
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized Losses
 
Fair
Value
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized Losses
 
Fair
Value
U.S. Treasury securities and obligations of U.S. government corporations and agencies
$
329

 
$

 
$
(1
)
 
$
328

 
$
364

 
$

 
$
(1
)
 
$
363

Corporate securities
2,048

 
17

 
(6
)
 
2,059

 
1,933

 
12

 
(13
)
 
1,932

Restricted certificates of deposit
4

 

 

 
4

 
5

 

 

 
5

Restricted cash equivalents
8

 

 

 
8

 
6

 

 

 
6

Municipal securities
1,923

 
11

 
(8
)
 
1,926

 
1,767

 
1

 
(35
)
 
1,733

Asset-backed securities
373

 
1

 

 
374

 
317

 
1

 
(1
)
 
317

Residential mortgage-backed securities
231

 
1

 
(4
)
 
228

 
219

 
1

 
(5
)
 
215

Commercial mortgage-backed securities
322

 
1

 
(4
)
 
319

 
343

 

 
(5
)
 
338

Cost and equity method investments
167

 

 

 
167

 
163

 

 

 
163

Life insurance contracts
126

 

 

 
126

 
116

 

 

 
116

Total
$
5,531

 
$
31

 
$
(23
)
 
$
5,539

 
$
5,233

 
$
15

 
$
(60
)
 
$
5,188


The Company’s investments are classified as available-for-sale with the exception of life insurance contracts and certain cost and equity method investments. The Company’s investment policies are designed to provide liquidity, preserve capital and maximize total return on invested assets with the focus on high credit quality securities. The Company limits the size of investment in any single issuer other than U.S. treasury securities and obligations of U.S. government corporations and agencies. As of June 30, 2017, 94% of the Company’s investments in rated securities carry an investment grade rating by S&P and Moody’s. At June 30, 2017, the Company held certificates of deposit, life insurance contracts and cost and equity method investments which did not carry a credit rating.

The Company's residential mortgage-backed securities are primarily issued by the Federal National Mortgage Association, Government National Mortgage Association or Federal Home Loan Mortgage Corporation, which carry implicit or explicit guarantees of the U.S. government. The Company's commercial mortgage-backed securities are primarily senior tranches with a weighted average rating of AA+ and a weighted average duration of 3.9 years at June 30, 2017.


7


The fair value of available-for-sale investments with gross unrealized losses by investment type and length of time that individual securities have been in a continuous unrealized loss position were as follows ($ in millions):
 
June 30, 2017
 
December 31, 2016
 
Less Than 12 Months
 
12 Months or More
 
Less Than 12 Months
 
12 Months or More
 
Unrealized Losses
 
Fair
Value
 
Unrealized Losses
 
Fair
Value
 
Unrealized Losses
 
Fair
Value
 
Unrealized Losses
 
Fair
Value
U.S. Treasury securities and obligations of U.S. government corporations and agencies
$
(1
)
 
$
263

 
$

 
$
3

 
$
(1
)
 
$
215

 
$

 
$
2

Corporate securities
(6
)
 
662

 

 
22

 
(12
)
 
1,020

 
(1
)
 
39

Municipal securities
(8
)
 
743

 

 
36

 
(35
)
 
1,423

 

 
30

Asset-backed securities

 
146

 

 
13

 
(1
)
 
101

 

 
18

Residential mortgage-backed securities
(3
)
 
154

 
(1
)
 
16

 
(5
)
 
188

 

 

Commercial mortgage-backed securities
(2
)
 
188

 
(2
)
 
14

 
(5
)
 
271

 

 

Total
$
(20
)
 
$
2,156

 
$
(3
)
 
$
104

 
$
(59
)
 
$
3,218

 
$
(1
)
 
$
89


As of June 30, 2017, the gross unrealized losses were generated from 1,375 positions out of a total of 3,096 positions. The change in fair value of fixed income securities is primarily a result of movement in interest rates subsequent to the purchase of the security.

For each security in an unrealized loss position, the Company assesses whether it intends to sell the security or if it is more likely than not the Company will be required to sell the security before recovery of the amortized cost basis for reasons such as liquidity, contractual or regulatory purposes. If the security meets this criterion, the decline in fair value is other-than-temporary and is recorded in earnings. The Company does not intend to sell these securities prior to maturity and it is not likely that the Company will be required to sell these securities prior to maturity; therefore, there is no indication of other-than-temporary impairment for these securities.

The contractual maturities of short-term and long-term investments and restricted deposits are as follows ($ in millions):
 
June 30, 2017
 
December 31, 2016
 
Investments
 
Restricted Deposits
 
Investments
 
Restricted Deposits
 
Amortized
Cost
 
Fair
Value
 
Amortized
Cost
 
Fair
Value
 
Amortized
Cost
 
Fair
Value
 
Amortized
Cost
 
Fair
Value
One year or less
$
524

 
$
524

 
$
82

 
$
82

 
$
500

 
$
500

 
$
91

 
$
91

One year through five years
2,058

 
2,066

 
55

 
55

 
1,982

 
1,974

 
47

 
47

Five years through ten years
1,674

 
1,678

 

 

 
1,101

 
1,089

 

 

Greater than ten years
212

 
213

 

 

 
633

 
617

 

 

Asset-backed securities
926

 
921

 

 

 
879

 
870

 

 

Total
$
5,394

 
$
5,402

 
$
137

 
$
137

 
$
5,095

 
$
5,050

 
$
138

 
$
138

 
Actual maturities may differ from contractual maturities due to call or prepayment options. Cost and equity method investments and life insurance contracts are included in the five years through ten years category. The Company has an option to redeem at amortized cost substantially all of the securities included in the greater than ten years category listed above.

The Company continuously monitors investments for other-than-temporary impairment. Certain investments have experienced a decline in fair value due to changes in credit quality, market interest rates and/or general economic conditions. The Company recognizes an impairment loss for cost and equity method investments when evidence demonstrates that it is other-than-temporarily impaired. Evidence of a loss in value that is other-than-temporary may include the absence of an ability to recover the carrying amount of the investment or the inability of the investee to sustain a level of earnings that would justify the carrying amount of the investment.

8


3. Fair Value Measurements

Assets and liabilities recorded at fair value in the Consolidated Balance Sheets are categorized based upon observable or unobservable inputs used to estimate fair value. Level inputs are as follows:
 
Level Input:
 
Input Definition:
Level I
 
Inputs are unadjusted, quoted prices for identical assets or liabilities in active markets at the measurement date.
 
 
 
Level II
 
Inputs other than quoted prices included in Level I that are observable for the asset or liability through corroboration with market data at the measurement date.
 
 
 
Level III
 
Unobservable inputs that reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date.
 
The following table summarizes fair value measurements by level at June 30, 2017, for assets and liabilities measured at fair value on a recurring basis ($ in millions):  
 
Level I
 
Level II
 
Level III
 
Total
Assets
 
 
 
 
 
 
 
Cash and cash equivalents
$
4,425

 
$

 
$

 
$
4,425

Investments available for sale:
 

 
 

 
 

 
 

U.S. Treasury securities and obligations of U.S. government corporations and agencies
$
137

 
$
66

 
$

 
$
203

Corporate securities

 
2,059

 

 
2,059

Municipal securities

 
1,926

 

 
1,926

Asset-backed securities

 
374

 

 
374

Residential mortgage-backed securities

 
228

 

 
228

Commercial mortgage-backed securities

 
319

 

 
319

Total investments
$
137

 
$
4,972

 
$

 
$
5,109

Restricted deposits available for sale:
 

 
 

 
 

 
 

Cash and cash equivalents
$
8

 
$

 
$

 
$
8

Certificates of deposit
4

 

 

 
4

U.S. Treasury securities and obligations of U.S. government corporations and agencies
125

 

 

 
125

Total restricted deposits
$
137

 
$

 
$

 
$
137

Other long-term assets: Interest rate swap agreements
$

 
$
5

 
$

 
$
5

Total assets at fair value
$
4,699

 
$
4,977

 
$

 
$
9,676

Liabilities
 
 
 
 
 
 
 
Other long-term liabilities:
 
 
 
 
 
 
 
Interest rate swap agreements
$

 
$
53

 
$

 
$
53

Total liabilities at fair value
$

 
$
53

 
$

 
$
53



9


The following table summarizes fair value measurements by level at December 31, 2016, for assets and liabilities measured at fair value on a recurring basis ($ in millions): 
 
Level I
 
Level II
 
Level III
 
Total
Assets
 
 
 
 
 
 
 
Cash and cash equivalents
$
3,930

 
$

 
$

 
$
3,930

Investments available for sale:
 

 
 

 
 

 
 

U.S. Treasury securities and obligations of U.S. government corporations and agencies
$
221

 
$
15

 
$

 
$
236

Corporate securities

 
1,932

 

 
1,932

Municipal securities

 
1,733

 

 
1,733

Asset-backed securities

 
317

 

 
317

Residential mortgage-backed securities

 
215

 

 
215

Commercial mortgage-backed securities

 
338

 

 
338

Total investments
$
221

 
$
4,550

 
$

 
$
4,771

Restricted deposits available for sale:
 

 
 

 
 

 
 

Cash and cash equivalents
$
6

 
$

 
$

 
$
6

Certificates of deposit
5

 

 

 
5

U.S. Treasury securities and obligations of U.S. government corporations and agencies
127

 

 

 
127

Total restricted deposits
$
138

 
$

 
$

 
$
138

Other long-term assets:
 
 
 
 
 
 
 
Interest rate swap agreements
$

 
$
4

 
$

 
$
4

Total assets at fair value
$
4,289

 
$
4,554

 
$

 
$
8,843

Liabilities
 
 
 
 
 
 
 
Other long-term liabilities:
 
 
 
 
 
 
 
Interest rate swap agreements
$

 
$
62

 
$

 
$
62

Total liabilities at fair value
$

 
$
62

 
$

 
$
62

 
The Company periodically transfers U.S. Treasury securities and obligations of U.S. government corporations and agencies between Level I and Level II fair value measurements dependent upon the level of trading activity for the specific securities at the measurement date. The Company’s policy regarding the timing of transfers between Level I and Level II is to measure and record the transfers at the end of the reporting period. At June 30, 2017, there were $55 million of transfers from Level I to Level II and no transfers from Level II to Level I. The Company utilizes matrix pricing services to estimate fair value for securities which are not actively traded on the measurement date. The Company designates these securities as Level II fair value measurements. The aggregate carrying amount of the Company’s life insurance contracts and other non-majority owned investments, which approximates fair value, was $293 million and $279 million as of June 30, 2017 and December 31, 2016, respectively.

4. Medical Claims Liability

In January 2017, the Company reclassified Cenpatico Behavioral Health of Arizona, LLC and the related Cenpatico Integrated Care health plan from the Specialty Services segment to the Managed Care segment due to a reorganization of the Arizona management structure following the Health Net integration. As a result, the financial results of Cenpatico Behavioral Health of Arizona, LLC and the related Cenpatico Integrated Care health plan have been reclassified from the Specialty Services segment to the Managed Care segment for all periods presented. Due to this change in segment reporting, the Specialty Services segment now has an insignificant amount of medical claims liability and therefore disclosures related to medical claims liabilities have been aggregated and are presented on a consolidated basis.


10


The following table summarizes the change in medical claims liability ($ in millions):

 
 
Six Months Ended June 30,
 
 
2017
 
2016
Balance, January 1
 
$
3,929

 
$
2,298

Less: Reinsurance Recoverable
 
5

 

Balance, January 1, net
 
3,924

 
2,298

Acquisitions
 

 
1,462

Incurred related to:
 
 
 
 
          Current year
 
19,087

 
13,940

          Prior years
 
(352
)
 
(244
)
         Total incurred
 
18,735

 
13,696

Paid related to:
 
 
 
 
          Current year
 
15,477

 
11,626

          Prior years
 
3,022

 
1,880

         Total paid
 
18,499

 
13,506

Balance at June 30, net
 
4,160

 
3,950

Plus: Reinsurance Recoverable
 
10

 

Balance, June 30
 
$
4,170

 
$
3,950


Reinsurance recoverables related to medical claims are included in premium and related receivables. Changes in estimates of incurred claims for prior years are primarily attributable to reserving under moderately adverse conditions. Additionally, in the six months ended June 30, 2017 and 2016, respectively, approximately $4 million and $16 million was recorded as a reduction from premium revenues resulting from development within "Incurred related to: Prior years" due to minimum HBR and other return of premium programs.

Incurred but not reported (IBNR) plus expected development on reported claims as of June 30, 2017 was $3,124 million. Total IBNR plus expected development on reported claims represents estimates for claims incurred but not reported, development on reported claims, and estimates for the costs necessary to process unpaid claims at the end of each period. We estimate our liability using actuarial methods that are commonly used by health insurance actuaries and meet Actuarial Standards of Practice. These actuarial methods consider factors such as historical data for payment patterns, cost trends, product mix, seasonality, utilization of healthcare services and other relevant factors.
 
5. Affordable Care Act

The Affordable Care Act (ACA) established risk spreading premium stabilization programs effective January 1, 2014. These programs, commonly referred to as the “three Rs,” include a permanent risk adjustment program, a transitional reinsurance program, and a temporary risk corridor program. Additionally, the ACA established a minimum annual medical loss ratio (MLR) and cost sharing reductions. Each of the three R programs are taken into consideration to determine if the Company’s estimated annual medical costs are less than the minimum loss ratio and require an adjustment to Premium revenue to meet the minimum MLR. The 2016 benefit year was the final year for transitional reinsurance and risk corridor. No additional balances were recorded for the 2017 benefit year for these programs.

The Company recognized a $48 million net pre-tax benefit related to the reconciliation of the 2016 risk adjustment program during the second quarter of 2017 and a $70 million net pre-tax benefit related to the reconciliation of the 2015 risk adjustment and reinsurance programs during the second quarter of 2016.


11


The Company's receivables (payables) for each of these programs are as follows ($ in millions):
 
June 30, 2017
 
December 31, 2016
Risk adjustment
$
(866
)
 
$
(425
)
Reinsurance
90

 
122

Risk corridor
(7
)
 
(3
)
Minimum MLR
(27
)
 
(18
)
Cost sharing reductions
(280
)
 
(147
)

6. Debt
 
Debt consists of the following ($ in millions):
 
June 30, 2017
 
December 31, 2016
$1,400 million 5.625% Senior notes, due February 15, 2021
$
1,400

 
$
1,400

$1,000 million 4.75% Senior notes, due May 15, 2022
1,007

 
1,008

$1,000 million 6.125% Senior notes, due February 15, 2024
1,000

 
1,000

$1,200 million 4.75% Senior notes, due January 15, 2025
1,200

 
1,200

Fair value of interest rate swap agreements
(48
)
 
(58
)
Total senior notes
4,559

 
4,550

Revolving credit agreement
150

 
100

Mortgage notes payable
63

 
64

Capital leases and other
18

 
18

Debt issuance costs
(70
)
 
(77
)
Total debt
4,720

 
4,655

Less current portion
(4
)
 
(4
)
 Long-term debt
$
4,716

 
$
4,651


Senior Notes

The indentures governing the senior notes listed in the table above, contain non-financial and financial covenants of Centene Corporation, including requirements of a minimum fixed charge coverage ratio. At June 30, 2017, the Company was in compliance with all covenants.

Interest Rate Swaps

In February 2017 and in connection with the November 2016 issuance of $1,200 million of 4.75% Senior Notes, due January 15, 2025 ($1,200 Million Notes), the Company entered into interest rate swap agreements for a notional amount of $600 million, at floating rates of interest based on the one month LIBOR plus 2.53%. Gains and losses due to the changes in the fair value of the interest rate swaps completely offset changes in the fair value of the hedged portion of the underlying debt and are recorded as an adjustment to the $1,200 Million Notes.

The Company uses interest rate swap agreements to convert a portion of its interest rate exposure from fixed rates to floating rates to more closely align interest expense with interest income received on its cash equivalent and variable rate investment balances. The Company has $2,700 million of notional amount of interest rate swap agreements consisting of:

$600 million expiring on February 15, 2021;
$500 million expiring on May 15, 2022;
$1,000 million expiring on February 15, 2024; and
$600 million expiring on January 15, 2025.

Under the Swap Agreements, the Company receives a fixed rate of interest and pays an average variable rate of either the three or one month LIBOR plus 3.61% adjusted monthly or quarterly, based on the terms of the individual swap agreements. At June 30, 2017, the weighted average rate was 4.75%.


12


The Swap Agreements are formally designated and qualify as fair value hedges and are recorded at fair value in the Consolidated Balance Sheets in other assets or other liabilities. Gains and losses due to changes in fair value of the interest rate swap agreements completely offset changes in the fair value of the hedged portion of the underlying debt. Therefore, no gain or loss has been recognized due to hedge ineffectiveness. Offsetting changes in fair value of both the interest rate swaps and the hedged portion of the underlying debt both were recognized in interest expense in the Consolidated Statements of Operations. The Company does not hold or issue any derivative instrument for trading or speculative purposes.

Revolving Credit Agreement

The Company has an unsecured $1,000 million revolving credit facility. Borrowings under the agreement bear interest based upon LIBOR rates, the Federal Funds Rate or the Prime Rate. The agreement has a maturity date of March 24, 2021. As of June 30, 2017, the Company had $150 million of borrowings outstanding under the agreement with a weighted average interest rate of 4.75%.

The revolving credit facility contains non-financial and financial covenants, including requirements of minimum fixed charge coverage ratios and maximum debt-to-EBITDA ratios. The Company is required to not exceed a maximum debt-to-EBITDA ratio of 3.0 to 1.0 on and subsequent to December 31, 2016. As of June 30, 2017, there were no limitations on the availability under the revolving credit agreement as a result of the debt-to-EBITDA ratio, and the Company was in compliance with all covenants.

Letters of Credit & Surety Bonds

The Company had outstanding letters of credit of $52 million as of June 30, 2017, which were not part of the revolving credit facility. The Company also had letters of credit for $42 million (valued at June 30, 2017 conversion rate), or €38 million, representing its proportional share of the letters of credit issued to support Ribera Salud’s outstanding debt, which are a part of the revolving credit facility. Collectively, the letters of credit bore interest at 1.32% as of June 30, 2017. The Company had outstanding surety bonds of $390 million as of June 30, 2017.
 

13


7. Earnings Per Share

The following table sets forth the calculation of basic and diluted net earnings (loss) per common share ($ in millions, except shares in thousands and per share data):
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2017
 
2016
 
2017
 
2016
Earnings attributable to Centene Corporation:
 
 
 
 
 
 
 
Earnings from continuing operations, net of tax
$
254

 
$
171

 
$
393

 
$
156

Discontinued operations, net of tax

 
(1
)
 

 
(2
)
Net earnings
$
254

 
$
170

 
$
393

 
$
154

 
 
 
 
 
 
 
 
Shares used in computing per share amounts:
 

 
 
 
 
 
 
Weighted average number of common shares outstanding
172,357

 
170,559

 
172,215

 
148,051

Common stock equivalents (as determined by applying the treasury stock method)
4,063

 
4,290

 
3,905

 
4,147

Weighted average number of common shares and potential dilutive common shares outstanding
176,420

 
174,849

 
176,120

 
152,198

 
 
 
 
 
 
 
 
Net earnings (loss) per common share attributable to Centene Corporation:
Basic:
 
 
 
 
 
 
 
Continuing operations
$
1.47

 
$
1.00

 
$
2.28

 
$
1.05

Discontinued operations

 

 

 
(0.01
)
Basic earnings per common share
$
1.47

 
$
1.00

 
$
2.28

 
$
1.04

 
 
 
 
 
 
 
 
Diluted:
 
 
 
 
 
 
 
Continuing operations
$
1.44

 
$
0.98

 
$
2.23

 
$
1.02

Discontinued operations

 
(0.01
)
 

 
(0.01
)
Diluted earnings per common share
$
1.44

 
$
0.97

 
$
2.23

 
$
1.01


The calculation of diluted earnings per common share for the three and six months ended June 30, 2017 excludes the impact of 5 thousand and 40 thousand shares, respectively, related to anti-dilutive stock options, restricted stock and restricted stock units. The calculation of diluted earnings per common share for the three and six months ended June 30, 2016 excludes the impact of 48 thousand and 51 thousand shares, respectively, related to anti-dilutive stock options, restricted stock and restricted stock units.

8. Segment Information

Centene operates in two segments: Managed Care and Specialty Services. The Managed Care segment consists of Centene’s health plans including all of the functions needed to operate them. The Specialty Services segment consists of Centene’s specialty companies offering auxiliary healthcare services and products.

In January 2017, the Company reclassified Cenpatico Behavioral Health of Arizona, LLC and the related Cenpatico Integrated Care health plan from the Specialty Services segment to the Managed Care segment due to a reorganization of the Arizona management structure following the Health Net integration. As a result, the financial results of Cenpatico Behavioral Health of Arizona, LLC and the related Cenpatico Integrated Care health plan have been reclassified from the Specialty Services segment to the Managed Care segment for all periods presented.


14


Segment information for the three months ended June 30, 2017, follows ($ in millions):
 
Managed Care
 
Specialty
Services
 
Eliminations
 
Consolidated
Total
Total revenues from external customers
$
11,341

 
$
613

 
$

 
$
11,954

Total revenues from internal customers
11

 
2,412

 
(2,423
)
 

Total revenues
$
11,352

 
$
3,025

 
$
(2,423
)
 
$
11,954

Earnings from operations
$
374

 
$
64

 
$

 
$
438


Segment information for the three months ended June 30, 2016, follows ($ in millions):
 
Managed Care
 
Specialty
Services
 
Eliminations
 
Consolidated
Total
Total revenues from external customers
$
10,234

 
$
663

 
$

 
$
10,897

Total revenues from internal customers
54

 
1,411

 
(1,465
)
 

Total revenues
$
10,288

 
$
2,074

 
$
(1,465
)
 
$
10,897

Earnings from operations
$
337

 
$
40

 
$

 
$
377


Segment information for the six months ended June 30, 2017, follows ($ in millions):
 
Managed Care
 
Specialty
Services
 
Eliminations
 
Consolidated
Total
Total revenues from external customers
$
22,456

 
$
1,222

 
$

 
$
23,678

Total revenues from internal customers
22

 
4,745

 
(4,767
)
 

Total revenues
$
22,478

 
$
5,967

 
$
(4,767
)
 
$
23,678

Earnings from operations
$
561

 
$
117

 
$

 
$
678


Segment information for the six months ended June 30, 2016, follows ($ in millions):
 
Managed Care
 
Specialty
Services
 
Eliminations
 
Consolidated
Total
Total revenues from external customers
$
16,751

 
$
1,099

 
$

 
$
17,850

Total revenues from internal customers
88

 
2,859

 
(2,947
)
 

Total revenues
$
16,839

 
$
3,958

 
$
(2,947
)
 
$
17,850

Earnings from operations
$
318

 
$
79

 
$

 
$
397


9. Contingencies

Overview

The Company records reserves and accrues costs for certain legal proceedings and regulatory matters to the extent that it determines an unfavorable outcome is probable and the amount of the loss can be reasonably estimated. While such reserves and accrued costs reflect the Company's best estimate of the probable loss for such matters, the recorded amounts may differ materially from the actual amount of any such losses. In some cases, no estimate of the possible loss or range of loss in excess of amounts accrued, if any, can be made because of the inherently unpredictable nature of legal and regulatory proceedings, which may be exacerbated by various factors, including but not limited to, they may involve indeterminate claims for monetary damages or may involve fines, penalties or punitive damages; present novel legal theories or legal uncertainties; involve disputed facts; represent a shift in regulatory policy; involve a large number of parties, claimants or regulatory bodies; are in the early stages of the proceedings; involve a number of separate proceedings and/or a wide range of potential outcomes; or result in a change of business practices.

As of the date of this report, amounts accrued for legal proceedings and regulatory matters were not material. However, it is possible that in a particular quarter or annual period the Company’s financial condition, results of operations, cash flow and/or liquidity could be materially adversely affected by an ultimate unfavorable resolution of or development in legal and/or regulatory proceedings, including as described below. Except for the proceedings discussed below, the Company believes that the ultimate outcome of any of the regulatory and legal proceedings that are currently pending against it should not have a material adverse effect on financial condition, results of operations, cash flow or liquidity.

15



California

The Company's California subsidiary, Health Net of California, Inc. (Health Net California), has been named as a defendant in a California taxpayer action filed in Los Angeles County Superior Court, captioned as Michael D. Myers v. State Board of Equalization, et al., Los Angeles Superior Court Case No. BS158655. This action is brought under a California statute that permits an individual taxpayer to sue a governmental agency when the taxpayer believes the agency has failed to enforce governing law. Plaintiff contends that Health Net California, a California licensed Health Care Service Plan (HCSP), is an “insurer” for purposes of taxation despite acknowledging it is not an “insurer” under regulatory law. Under California law, “insurers” must pay a gross premiums tax (GPT), calculated as 2.35% on gross premiums. As a licensed HCSP, Health Net California has paid the California Corporate Franchise Tax (CFT), the tax generally paid by California businesses. Plaintiff contends that Health Net California must pay the GPT rather than the CFT. Plaintiff seeks a writ of mandate directing the California taxing agencies to collect the GPT, and seeks an order requiring Health Net California to pay GPT, interest and penalties for a period dating to eight years prior to the October 2015 filing of the complaint. This lawsuit is being coordinated with similar lawsuits filed against other entities. An initial status conference was held in June 2017 wherein the Court set a schedule for challenges to the pleadings. The Company intends to vigorously defend itself against these claims; however, this matter is subject to many uncertainties, and an adverse outcome in this matter could potentially have a materially adverse impact on our financial position, results of operations and cash flows.

Federal Securities Class Action

In November 2016, a putative federal securities class action was filed against the Company and certain of its executives in the U.S. District Court for the Central District of California. In March 2017, the court entered an order transferring the matter to the U.S. District Court for the Eastern District of Missouri. The plaintiffs in the lawsuit allege that the Company's accounting and related disclosures for certain liabilities acquired in the acquisition of Health Net violated federal securities laws. The Company denies any wrongdoing and is vigorously defending itself against these claims. Nevertheless, this matter is subject to many uncertainties and the Company cannot predict how long this litigation will last or what the ultimate outcome will be, and an adverse outcome in this matter could potentially have a materially adverse impact on our financial position and results of operations.

Civil Investigative Demand

In December 2016, a Civil Investigative Demand (CID) was issued to Health Net by the United States Department of Justice regarding Health Net’s submission of risk adjustment claims to the CMS under Parts C and D of Medicare. The CID may be related to a federal qui tam lawsuit filed under seal in 2011 naming more than a dozen health insurers including Health Net. The lawsuit was unsealed in February 2017 when the Department of Justice intervened in the case with respect to one of the insurers (not Health Net). The Company is complying with the CID and will vigorously defend any lawsuits. At this point, it is not possible to determine what level of liability, if any, the Company may face as a result of this matter.

Guaranty Fund Assessment

Under state guaranty association laws, certain insurance companies can be assessed for certain obligations to the policyholders and claimants of impaired or insolvent insurance companies that write the same line or similar lines of business. In 2009, the Pennsylvania Insurance Commissioner placed long-term care insurer Penn Treaty Network America Insurance Company and its subsidiary (Penn Treaty), neither of which is affiliated with the Company, in rehabilitation and petitioned a state court for approval to liquidate Penn Treaty. In March 2017, the court issued the final liquidation order, and as a result, during the first quarter of 2017, the Company recognized $47 million representing its undiscounted estimated share of the guaranty association assessment as selling, general and administrative expenses.

Miscellaneous Proceedings

Excluding the matters discussed above, the Company is also routinely subjected to legal and regulatory proceedings in the normal course of business. These matters can include, without limitation:

periodic compliance and other reviews and investigations by various federal and state regulatory agencies with respect to requirements applicable to the Company's business, including, without limitation, those related to payment of out-of-network claims, submissions to CMS for risk adjustment payments or the False Claims Act, pre-authorization penalties, timely review of grievances and appeals, timely and accurate payment of claims, and the Health Insurance Portability and Accountability Act of 1996;


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litigation arising out of general business activities, such as tax matters, disputes related to health care benefits coverage or reimbursement, putative securities class actions and medical malpractice, privacy, real estate, intellectual property and employment-related claims;

disputes regarding reinsurance arrangements, claims arising out of the acquisition or divestiture of various assets, class actions and claims relating to the performance of contractual and non-contractual obligations to providers, members, employer groups and others, including, but not limited to, the alleged failure to properly pay claims and challenges to the manner in which the Company processes claims, and claims alleging that the Company has engaged in unfair business practices.

Among other things, these matters may result in awards of damages, fines or penalties, which could be substantial, and/or could require changes to the Company’s business. The Company intends to vigorously defend itself against the miscellaneous legal and regulatory proceedings to which it is currently a party; however, these proceedings are subject to many uncertainties. In some of the cases pending against the Company, substantial non-economic or punitive damages are being sought.


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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this filing. The discussion contains forward-looking statements that involve known and unknown risks and uncertainties, including those set forth under Part II, Item 1A. “Risk Factors” of this Form 10-Q. The following discussion and analysis, with the exception of cash flow information, is presented in the context of continuing operations unless otherwise identified.

EXECUTIVE OVERVIEW

General

We are a diversified, multi-national healthcare enterprise that provides services to government sponsored and commercial healthcare programs, focusing on under-insured and uninsured individuals. We provide member-focused services through locally based staff by assisting in accessing care, coordinating referrals to related health and social services and addressing member concerns and questions.

Results of operations depend on our ability to manage expenses associated with health benefits (including estimated costs incurred) and selling, general and administrative (SG&A) costs. We measure operating performance based upon two key ratios. The health benefits ratio (HBR) represents medical costs as a percentage of premium revenues, excluding premium tax and health insurer fee revenues that are separately billed, and reflects the direct relationship between the premium received and the medical services provided. The SG&A expense ratio represents SG&A costs as a percentage of premium and service revenues, excluding premium tax and health insurer fee revenues that are separately billed.

Health Net Acquisition

On March 24, 2016, the Company acquired all of the issued and outstanding shares of Health Net, a publicly traded managed care organization that delivers healthcare services through health plans and government-sponsored managed care plans. The transaction was valued at $6.0 billion, including the assumption of debt. The acquisition allows the Company to offer a more comprehensive and scalable portfolio of solutions and provides opportunity for additional growth across the combined company's markets. Due to the size of this acquisition, one of the primary drivers of the six month ended variances discussed throughout this section are related to the acquisition of Health Net.

Regulatory Trends and Uncertainties

The U.S. Presidential administration and certain members of Congress had affirmatively indicated that they would pursue full repeal of or significant amendment to the Affordable Care Act (ACA). In May, the House of Representatives approved legislation, known as the American Health Care Act, to repeal and replace major components of the ACA. In June, the Senate released its draft of the new national healthcare legislation, known as the Better Care Reconciliation Act (BCRA) of 2017. In July, the Senate majority leader released revisions to the BCRA. There are still complex steps needed to be taken before any form of the new healthcare legislation becomes final. Most recently, the Senate majority leader indicated the BCRA will not be successful in repealing and replacing the ACA as the bill faces opposition in the Senate. We continue to believe we have both the capacity and capability to successfully navigate industry changes to the benefit of our members, customers and shareholders.

For additional information regarding regulatory trends and uncertainties, see Part II, Item 1A, "Risk Factors."

Second Quarter 2017 Highlights

Our financial performance for the second quarter of 2017 are summarized as follows:
Managed care membership of 12.2 million, an increase of 788,300 members, or 7% year over year.
Total revenues of $12.0 billion, representing 10% growth year over year.
Health benefits ratio of 86.3%, compared to 86.6% in 2016.
SG&A expense ratio of 9.3% for the second quarter of 2017, compared to 9.2% for the second quarter of 2016.
Adjusted SG&A expense ratio of 9.3% for the second quarter of 2017, compared to 9.0% for the second quarter of 2016.
Operating cash flows of $(306) million, primarily reflecting an increase in premium and related receivables due to the timing of June capitation payments from several of our states.

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Diluted earnings per share (EPS) for the second quarter of 2017 of $1.44, compared to $0.98 for the second quarter of 2016. The second quarter of 2017 includes a $0.17 per diluted share net benefit related to the 2016 risk adjustment reconciliation under the ACA in connection with our Health Insurance Marketplace business. In comparison, the second quarter of 2016 includes a $0.19 per diluted share net benefit related to the 2015 risk adjustment and reinsurance reconciliations under the ACA in connection with our Health Insurance Marketplace business.
Adjusted Diluted EPS for the second quarter of 2017 of $1.59, compared to $1.29 for the second quarter