SEC Filing | Molina Healthcare Inc.

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



☒	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2019



☐	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: 001-31719

https://cdn.kscope.io/e63aac0516561cbc70e048a6bd2352d7-molinalogo2016a26.jpg

MOLINA HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)



Delaware		13-4204626
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

200 Oceangate, Suite 100
Long Beach,	California	90802
(Address of principal executive offices)		(Zip Code)

(562) 435-3666

(Registrant’s telephone number, including area code)

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



Title of each class	Trading Symbol(s)	Name of each exchange on which registered
Common Stock, $0.001 Par Value	MOH	New York Stock Exchange

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 ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐

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

Large Accelerated Filer ☒ Accelerated Filer ☐ Non-Accelerated Filer ☐ Smaller reporting company ☐

Emerging growth company ☐

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 Section13(a) of the Exchange Act. ☐

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

The number of shares of the issuer’s Common Stock, $0.001 par value, outstanding as of October 25, 2019, was approximately 62,700,000.

Table of Contents

MOLINA HEALTHCARE, INC. FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2019

TABLE OF CONTENTS



ITEM NUMBER		Page

PART I - Financial Information

1.	Financial Statements	3

2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	28

3.	Quantitative and Qualitative Disclosures About Market Risk	47

4.	Controls and Procedures	48

Part II - Other Information

1.	Legal Proceedings	48

1A.	Risk Factors	48

2.	Unregistered Sales of Equity Securities and Use of Proceeds	49

3.	Defaults Upon Senior Securities	Not Applicable.

4.	Mine Safety Disclosures	Not Applicable.

5.	Other Information	Not Applicable.

6.	Exhibits	50

	Signatures	51

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CONSOLIDATED STATEMENTS OF INCOME



	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019			2018
	(In millions, except per-share amounts) (Unaudited)
Revenue:
Premium revenue	$	4,084	$	4,337	$	12,085		$	13,174
Premium tax revenue	119		110		367			320
Health insurer fees reimbursed	—		83		—			248
Service revenue	—		130		—			391
Investment income and other revenue	40		37		103			93
Total revenue	4,243		4,697		12,555			14,226
Operating expenses:
Medical care costs	3,523		3,790		10,360			11,362
General and administrative expenses	323		311		953			998
Premium tax expenses	119		110		367			320
Health insurer fees	—		87		—			261
Depreciation and amortization	21		25		68			76
Restructuring costs	—		5		5			38
Cost of service revenue	—		111		—			349
Total operating expenses	3,986		4,439		11,753			13,404
Gain on sale of subsidiary	—		37		—			37
Operating income	257		295		802			859
Other expenses, net:
Interest expense	22		26		67			91
Other expenses (income), net	2		10		(15		)	25
Total other expenses, net	24		36		52			116
Income before income tax expense	233		259		750			743
Income tax expense	58		62		181			237
Net income	$	175	$	197	$	569		$	506

Net income per share:
Basic	$	2.81	$	3.22	$	9.15		$	8.32
Diluted	$	2.75	$	2.90	$	8.80		$	7.60

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME



	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
	(In millions) (Unaudited)
Net income	$	175	$	197	$	569	$	506
Other comprehensive income (loss):
Unrealized investment income (loss)	—		1		17		(5		)
Less: effect of income taxes	—		—		4		(1		)
Other comprehensive income (loss), net of tax	—		1		13		(4		)
Comprehensive income	$	175	$	198	$	582	$	502

See accompanying notes.

Molina Healthcare, Inc. September 30, 2019 Form 10-Q | 3

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CONSOLIDATED BALANCE SHEETS



	September 30, 2019		December 31, 2018
	(Dollars in millions, except per-share amounts)
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	2,679	$	2,826
Investments	1,757		1,681
Receivables	1,280		1,330
Prepaid expenses and other current assets	140		149
Derivative asset	21		476
Total current assets	5,877		6,462
Property, equipment, and capitalized software, net	379		241
Goodwill and intangible assets, net	176		190
Restricted investments	79		120
Deferred income taxes	82		117
Other assets	108		24
	$	6,701	$	7,154

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Medical claims and benefits payable	$	1,975	$	1,961
Amounts due government agencies	612		967
Accounts payable and accrued liabilities	478		390
Deferred revenue	207		211
Current portion of long-term debt	15		241
Derivative liability	21		476
Total current liabilities	3,308		4,246
Long-term debt	1,239		1,020
Finance lease liabilities	233		197
Other long-term liabilities	90		44
Total liabilities	4,870		5,507
Stockholders’ equity:
Common stock, $0.001 par value, 150 million shares authorized; outstanding: 63 million shares at September 30, 2019, and 62 million shares at December 31, 2018	—		—
Preferred stock, $0.001 par value; 20 million shares authorized, no shares issued and outstanding	—		—
Additional paid-in capital	160		643
Accumulated other comprehensive income (loss)	5		(8		)
Retained earnings	1,666		1,012
Total stockholders’ equity	1,831		1,647
	$	6,701	$	7,154

See accompanying notes.

Molina Healthcare, Inc. September 30, 2019 Form 10-Q | 4

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CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY



	Common Stock			Additional Paid-in Capital			Accumulated Other Comprehensive Income (Loss)			Retained Earnings		Total
	Outstanding	Amount		Additional Paid-in Capital			Accumulated Other Comprehensive Income (Loss)			Retained Earnings		Total
	(In millions)
	(Unaudited)
Balance at December 31, 2018	62	$	—	$	643		$	(8	)	$	1,012	$	1,647
Net income	—	—		—			—			198		198
Adoption of new accounting standard	—	—		—			—			85		85
Partial termination of 1.125% Warrants	—	—		(103		)	—			—		(103		)
Other comprehensive income, net	—	—		—			5			—		5
Share-based compensation	1	—		3			—			—		3
Balance at March 31, 2019	63	—		543			(3		)	1,295		1,835
Net income	—	—		—			—			196		196
Partial termination of 1.125% Warrants	—	—		(321		)	—			—		(321		)
Other comprehensive income, net	—	—		—			8			—		8
Share-based compensation	—	—		18			—			—		18
Balance at June 30, 2019	63	—		240			5			1,491		1,736
Net income	—	—		—			—			175		175
Partial termination of 1.125% Warrants	—	—		(90		)	—			—		(90		)
Share-based compensation	—	—		10			—			—		10
Balance at September 30, 2019	63	$	—	$	160		$	5		$	1,666	$	1,831



	Common Stock			Additional Paid-in Capital			Accumulated Other Comprehensive Loss			Retained Earnings		Total
	Outstanding	Amount		Additional Paid-in Capital			Accumulated Other Comprehensive Loss			Retained Earnings		Total
	(In millions)
	(Unaudited)
Balance at December 31, 2017	60	$	—	$	1,044		$	(5	)	$	298	$	1,337
Net income	—	—		—			—			107		107
Adoption of new accounting standards	—	—		—			(1		)	7		6
Exchange of 1.625% Convertible Notes	2	—		108			—			—		108
Other comprehensive loss, net	—	—		—			(6		)	—		(6		)
Share-based compensation	—	—		1			—			—		1
Balance at March 31, 2018	62	—		1,153			(12		)	412		1,553
Net income	—	—		—			—			202		202
Partial termination of 1.125% Warrants	—	—		(113		)	—			—		(113		)
Other comprehensive income, net	—	—		—			1			—		1
Share-based compensation	—	—		15			—			—		15
Balance at June 30, 2018	62	—		1,055			(11		)	614		1,658
Net income	—	—		—			—			197		197
Partial termination of 1.125% Warrants	—	—		(306		)	—			—		(306		)
Conversion of 1.625% Convertible Notes	—	—		4			—			—		4
Other comprehensive income, net	—	—		—			1			—		1
Share-based compensation	—	—		7			—			—		7
Balance at September 30, 2018	62	$	—	$	760		$	(10	)	$	811	$	1,561

See accompanying notes.

Molina Healthcare, Inc. September 30, 2019 Form 10-Q | 5

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CONSOLIDATED STATEMENTS OF CASH FLOWS



	Nine Months Ended September 30,
	2019			2018
	(In millions) (Unaudited)
Operating activities:
Net income	$	569		$	506
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization	68			104
Deferred income taxes	7			(32		)
Share-based compensation	29			20
Amortization of convertible senior notes and finance lease liabilities	5			18
(Gain) loss on debt extinguishment	(15		)	25
Non-cash restructuring costs	—			17
Gain on sale of subsidiary	—			(37		)
Other, net	(5		)	6
Changes in operating assets and liabilities:
Receivables	50			(507		)
Prepaid expenses and other current assets	(6		)	(117		)
Medical claims and benefits payable	14			(144		)
Amounts due government agencies	(355		)	(511		)
Accounts payable and accrued liabilities	37			398
Deferred revenue	(4		)	(55		)
Income taxes	4			118
Net cash provided by (used in) operating activities	398			(191		)
Investing activities:
Purchases of investments	(1,938		)	(1,202		)
Proceeds from sales and maturities of investments	1,890			2,070
Purchases of property, equipment and capitalized software	(30		)	(24		)
Other, net	(2		)	(23		)
Net cash (used in) provided by investing activities	(80		)	821
Financing activities:
Repayment of principal amount of 1.125% Convertible Notes	(240		)	(236		)
Cash paid for partial settlement of 1.125% Conversion Option	(578		)	(477		)
Cash received for partial termination of 1.125% Call Option	578			477
Cash paid for partial termination of 1.125% Warrants	(514		)	(419		)
Proceeds from borrowings under Term Loan Facility	220			—
Repayment of Credit Facility	—			(300		)
Repayment of 1.625% Convertible Notes	—			(64		)
Other, net	24			7
Net cash used in financing activities	(510		)	(1,012		)
Net decrease in cash, cash equivalents, and restricted cash and cash equivalents	(192		)	(382		)
Cash, cash equivalents, and restricted cash and cash equivalents at beginning of period	2,926			3,290
Cash, cash equivalents, and restricted cash and cash equivalents at end of period	$	2,734		$	2,908

Molina Healthcare, Inc. September 30, 2019 Form 10-Q | 6

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CONSOLIDATED STATEMENTS OF CASH FLOWS

(continued)



	Nine Months Ended September 30,
	2019			2018
	(In millions) (Unaudited)
Supplemental cash flow information:

Schedule of non-cash investing and financing activities:
Common stock used for share-based compensation	$	(7	)	$	(6	)

Details of sale of subsidiary:
Decrease in carrying amount of assets	$	—		$	(243	)
Decrease in carrying amount of liabilities	—			59
Transaction costs	—			(12		)
Receivable from buyer - recorded in prepaid expenses and other current assets	—			233
Gain on sale of subsidiary	$	—		$	37

Details of change in fair value of derivatives, net:
Gain on 1.125% Call Option	$	124		$	321
Loss on 1.125% Conversion Option	(124		)	(321		)
Change in fair value of derivatives, net	$	—		$	—

1.625% Convertible Notes exchange transaction:
Common stock issued in exchange for 1.625% Convertible Notes	$	—		$	131
Component allocated to additional paid-in capital, net of income taxes	—			(23		)
Net increase to additional paid-in capital	$	—		$	108

See accompanying notes.

Molina Healthcare, Inc. September 30, 2019 Form 10-Q | 7

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

September 30, 2019

1. Organization and Basis of Presentation

Organization and Operations

Molina Healthcare, Inc. provides managed healthcare services under the Medicaid and Medicare programs and through the state insurance marketplaces (the “Marketplace”). We currently have two reportable segments: our Health Plans segment and our Other segment. We manage the vast majority of our operations through our Health Plans segment. The Other segment includes the historical results of the Medicaid management information systems (“MMIS”) and behavioral health subsidiaries we sold in late 2018, as well as certain corporate amounts not allocated to the Health Plans segment.

The Health Plans segment consists of health plans operating in 14 states and the Commonwealth of Puerto Rico. As of September 30, 2019, these health plans served approximately 3.3 million members eligible for Medicaid, Medicare, and other government-sponsored healthcare programs for low-income families and individuals including Marketplace members, most of whom receive government subsidies for premiums. The health plans are generally operated by our respective wholly owned subsidiaries in those states, each of which is licensed as a health maintenance organization (“HMO”).

Our health plans’ state Medicaid contracts generally have terms of three to five years. These contracts typically contain renewal options exercisable by the state Medicaid agency, and allow either the state or the health plan to terminate the contract with or without cause. Such contracts are subject to risk of loss in states that issue requests for proposal (“RFPs”) open to competitive bidding by other health plans. If one of our health plans is not a successful responsive bidder to a state RFP, its contract may not be renewed.

In addition to contract renewal, our state Medicaid contracts may be periodically amended to include or exclude certain health benefits (such as pharmacy services, behavioral health services, or long-term care services); populations such as the aged, blind or disabled; and regions or service areas.

Subsequent Events

Texas Health Plan. On October 29, 2019, the Texas Health and Human Services Commission (HHSC) notified our Texas health plan, Molina Healthcare of Texas, Inc., that HHSC intends to award contracts to Molina Healthcare of Texas, Inc. for the STAR+PLUS program in the Hidalgo and North East service areas. The awards will be for an initial contract term of 3 years, and anticipated to have an operational effective date of September 1, 2020. STAR+PLUS is a Texas Medicaid Managed Care program integrating the delivery of Acute Care services and Long-Term Services and Supports (LTSS) for people who are age 65 or older, blind, or disabled. Currently, our Texas health plan services the Bexar, Dallas, El Paso, Harris, Hidalgo, and Jefferson service areas, with total membership of approximately 86,000 enrollees. Under the existing STAR+PLUS contract, the premium revenue for this program amounted to approximately $1.2 billion for the nine months ended September 30, 2019.

New York Health Plan. On October 10, 2019, we entered into a definitive agreement to acquire certain assets of YourCare Health Plan, Inc. Upon the closing of this transaction, expected to occur in early 2020, we will serve approximately 46,000 Medicaid members in seven counties in Western New York. The purchase price of approximately $40 million will be funded with available cash, and the closing is subject to customary closing conditions.

Consolidation and Interim Financial Information

The consolidated financial statements include the accounts of Molina Healthcare, Inc., and its subsidiaries. In the opinion of management, all adjustments considered necessary for a fair presentation of the results as of the date and for the interim periods presented have been included; such adjustments consist of normal recurring adjustments. All significant intercompany balances and transactions have been eliminated. The consolidated results of operations for the nine months ended September 30, 2019, are not necessarily indicative of the results for the entire year ending December 31, 2019.

The unaudited consolidated interim financial statements have been prepared under the assumption that users of the interim financial data have either read or have access to our audited consolidated financial statements for the fiscal year ended December 31, 2018. Accordingly, certain disclosures that would substantially duplicate the disclosures contained in our December 31, 2018, audited consolidated financial statements have been omitted.

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These unaudited consolidated interim financial statements should be read in conjunction with our audited consolidated financial statements for the fiscal year ended December 31, 2018.

Use of Estimates

The preparation of consolidated financial statements in conformity with generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities. Estimates also affect the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. Principal areas requiring the use of estimates include:


•	The determination of medical claims and benefits payable of our Health Plans segment;


•	Health plans’ contractual provisions that may limit revenue recognition based upon the costs incurred or the profits realized under a specific contract;


•	Health plans’ quality incentives that allow us to recognize incremental revenue if certain quality standards are met;


•	Settlements under risk or savings sharing programs;


•	The assessment of long-lived and intangible assets, and goodwill for impairment;


•	The determination of reserves for potential absorption of claims unpaid by insolvent providers;


•	The determination of reserves for litigation outcomes;


•	The determination of valuation allowances for deferred tax assets; and


•	The determination of unrecognized tax benefits.

2. Significant Accounting Policies

Cash and Cash Equivalents

Cash and cash equivalents consist of cash and short-term, highly liquid investments that are both readily convertible into known amounts of cash and have a maturity of three months or less on the date of purchase. The following table provides a reconciliation of cash, cash equivalents, and restricted cash and cash equivalents reported within the accompanying consolidated balance sheets that sum to the total of the same such amounts presented in the accompanying consolidated statements of cash flows. The restricted cash and cash equivalents presented below are included in non-current “Restricted investments” in the accompanying consolidated balance sheets.



	September 30,
	2019		2018
	(In millions)
Cash and cash equivalents	$	2,679	$	2,814
Restricted cash and cash equivalents	55		94
Total cash, cash equivalents, and restricted cash and cash equivalents presented in the statements of cash flows	$	2,734	$	2,908

Premium Revenue

Premium revenue is fixed in advance of the periods covered and, except as described below, is not generally subject to significant accounting estimates. Premium revenues are recognized in the month that members are entitled to receive healthcare services, and premiums collected in advance are deferred. Certain components of premium revenue are subject to accounting estimates and fall into the following categories:

Contractual Provisions That May Adjust or Limit Revenue or Profit

Medicaid Program

Medical Cost Floors (Minimums), and Medical Cost Corridors. A portion of our premium revenue may be returned if certain minimum amounts are not spent on defined medical care costs. In the aggregate, we recorded liabilities under the terms of such contract provisions of $95 million and $103 million at September 30, 2019 and December 31, 2018, respectively. Approximately $78 million and $87 million of the liabilities accrued at September 30, 2019 and December 31, 2018, respectively, relate to our participation in Medicaid Expansion programs.

In certain circumstances, the health plans may receive additional premiums if amounts spent on medical care costs exceed a defined maximum threshold. Receivables relating to such provisions were insignificant at September 30, 2019 and December 31, 2018.

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Profit Sharing and Profit Ceiling. Our contracts with certain states contain profit-sharing or profit ceiling provisions under which we refund amounts to the states if our health plans generate profit above a certain specified percentage. In some cases, we are limited in the amount of administrative costs that we may deduct in calculating the refund, if any. Liabilities for profits in excess of the amount we are allowed to retain under these provisions were insignificant at September 30, 2019 and December 31, 2018.

Retroactive Premium Adjustments. State Medicaid programs periodically adjust premium rates on a retroactive basis. In these cases, we must adjust our premium revenue in the period in which we learn of the adjustment, based on our best estimate of the ultimate premium we expect to realize for the period being adjusted.

Medicare Program

Risk Adjusted Premiums. Our Medicare premiums are subject to retroactive increase or decrease based on the health status of our Medicare members (as measured by member risk score). We estimate our members’ risk scores and the related amount of Medicare revenue that will ultimately be realized for the periods presented based on our knowledge of our members’ health status, risk scores and Centers for Medicare and Medicaid Services (“CMS”) practices. Consolidated balance sheet amounts related to anticipated Medicare risk adjusted premiums and Medicare Part D settlements were insignificant at September 30, 2019 and December 31, 2018.

Minimum MLR. The Affordable Care Act (“ACA”) has established a minimum annual medical loss ratio (“Minimum MLR”) of 85% for Medicare. The medical loss ratio represents medical costs as a percentage of premium revenue. Federal regulations define what constitutes medical costs and premium revenue. If the Minimum MLR is not met, we may be required to pay rebates to the federal government. We recognize estimated rebates under the Minimum MLR as an adjustment to premium revenue in our consolidated statements of income. The amounts payable for the Medicare Minimum MLR were not significant at September 30, 2019 and December 31, 2018.

Marketplace Program

Risk Adjustment. Under this program, our health plans’ composite risk scores are compared with the overall average risk score for the relevant state and market pool. Generally, our health plans will make a risk adjustment payment into the pool if their composite risk scores are below the average risk score (risk adjustment payable), and will receive a risk adjustment payment from the pool if their composite risk scores are above the average risk score (risk adjustment receivable). We estimate our ultimate premium based on insurance policy year-to-date experience, and recognize estimated premiums relating to the risk adjustment program as an adjustment to premium revenue in our consolidated statements of income. As of September 30, 2019, Marketplace risk adjustment payables amounted to $285 million and related receivables amounted to $76 million, for a net payable of $209 million. As of December 31, 2018, Marketplace risk adjustment payables amounted to $466 million and related receivables amounted to $34 million, for a net payable of $432 million.

Minimum MLR. The ACA has established a Minimum MLR of 80% for the Marketplace. If the Minimum MLR is not met, we may be required to pay rebates to our Marketplace policyholders. The Marketplace risk adjustment program is taken into consideration when computing the Minimum MLR. We recognize estimated rebates under the Minimum MLR as an adjustment to premium revenue in our consolidated statements of income. Aggregate balance sheet amounts related to the Minimum MLR were insignificant at September 30, 2019 and December 31, 2018.

A summary of the categories of amounts due government agencies follows:



	September 30, 2019		December 31, 2018
	(In millions)
Medicaid program:
Medical cost floors and corridors	$	95	$	103
Other amounts due to states	69		81
Marketplace program:
Risk adjustment	285		466
Cost sharing reduction (“CSR”)	—		183
Other	163		134
Total amounts due government agencies	$	612	$	967

Molina Healthcare, Inc. September 30, 2019 Form 10-Q | 10

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Quality Incentives

At many of our health plans, revenue ranging from approximately 1% to 4% of certain health plan premiums is earned only if certain performance measures are met. Such performance measures are generally found in our Medicaid and MMP contracts. As described in Note 1, “Organization and Basis of Presentation–Use of Estimates,” recognition of quality incentive premium revenue is subject to the use of estimates.

We believe that the adjustments to prior years noted below are generally indicative of the potential future changes in our estimates as of September 30, 2019. The following table quantifies the quality incentive premium revenue recognized for the periods presented, including the amounts earned in the periods presented and prior periods.



	Three Months Ended September 30,						Nine Months Ended September 30,
	2019			2018			2019			2018
	(In millions)
Maximum available quality incentive premium - current period	$	47		$	48		$	138		$	135

Quality incentive premium revenue recognized in current period:
Earned current period	$	46		$	39		$	109		$	97
Earned prior periods	5			9			35			32
Total	$	51		$	48		$	144		129

Quality incentive premium revenue recognized as a percentage of total premium revenue	1.2		%	1.1		%	1.2		%	1.0		%

Medical Care Costs

Marketplace Program

In the nine months ended September 30, 2018, we recognized a benefit of approximately $81 million in reduced medical care costs related to 2017 dates of service, including $5 million in the third quarter of 2018, as a result of the federal government’s confirmation that the reconciliation of 2017 Marketplace CSR subsidies would be performed on an annual basis. In the fourth quarter of 2017, we had assumed a nine-month reconciliation of this item pending confirmation of the time period to which the 2017 reconciliation would be applied.

Leases

Right-of-use (“ROU”) assets represent our right to use the underlying assets over the lease term, and lease liabilities represent our obligation for lease payments arising from the related leases. ROU assets and lease liabilities are recognized at the lease commencement date based on the present value of lease payments over the lease term. Lease terms may include options to extend or terminate the lease when we believe it is reasonably certain that we will exercise such options. If applicable, we account for lease and non-lease components within a lease as a single lease component.

Because most of our leases do not provide an implicit interest rate, we generally use our incremental borrowing rate to determine the present value of lease payments. Lease expenses for operating lease payments are recognized on a straight-line basis over the lease term, and the related ROU assets and liabilities are reduced to the present value of the remaining lease payments at the end of each period. Finance lease payments reduce finance lease liabilities, the related ROU assets are amortized on a straight-line basis over the lease term, and interest expense is recognized using the effective interest method.

The significant majority of our operating leases consist of long-term operating leases for office space. Short-term leases (those with terms of 12 months or less) are not recorded as ROU assets or liabilities in the consolidated balance sheets. For certain leases that represent a portfolio of similar assets, such as a fleet of vehicles, we apply a portfolio approach to account for the related operating lease ROU assets and liabilities, rather than account for such assets and the related liabilities individually. A nominal number of our lease agreements include rental payments that adjust periodically for inflation. Our lease agreements do not contain any material residual value guarantees or material restrictive covenants.

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For further information, including the amount and location of the ROU assets and lease liabilities recognized in the accompanying consolidated balance sheet, see Note 13, “Leases.” For further information regarding our adoption and implementation of Accounting Standards Update (“ASU”) 2016-02, Leases (Topic 842), see Recent Accounting Pronouncements Adopted, below.

Concentrations of Credit Risk

Financial instruments that potentially subject us to concentrations of credit risk consist primarily of cash and cash equivalents, investments, receivables, and restricted investments. Our investments and a portion of our cash equivalents are managed by professional portfolio managers operating under documented investment guidelines. Our portfolio managers must obtain our prior approval before selling investments where the loss position of those investments exceeds certain levels. Our investments consist primarily of investment-grade debt securities with a maximum maturity of 10 years, or 10 years average life for structured securities. Restricted investments are invested principally in cash, cash equivalents, and U.S. Treasury securities. Concentration of credit risk with respect to accounts receivable is generally limited because our payors consist principally of the federal government, and governments of each state or commonwealth in which our health plan subsidiaries operate.

Income Taxes

The provision for income taxes is determined using an estimated annual effective tax rate, which generally differs from the U.S. federal statutory rate primarily because of foreign and state taxes, nondeductible expenses such as the Health Insurer Fee (“HIF”), certain compensation, and other general and administrative expenses. The effective tax rate will not be impacted by HIF in 2019 given the 2019 HIF moratorium.

The effective tax rate may be subject to fluctuations during the year as new information is obtained. Such information may affect the assumptions used to estimate the annual effective tax rate, including projected pretax earnings, the mix of pretax earnings in the various tax jurisdictions in which we operate, valuation allowances against deferred tax assets, the recognition or the reversal of the recognition of tax benefits related to uncertain tax positions, and changes in or the interpretation of tax laws in jurisdictions where we conduct business. We recognize deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of our assets and liabilities, along with net operating loss and tax credit carryovers.

Recent Accounting Pronouncements Adopted

Leases. In February 2016, the Financial Accounting Standards Board (“FASB”) issued Topic 842, which was subsequently modified by several ASUs issued in 2017 and 2018. Topic 842 was issued to increase transparency and comparability among organizations by requiring the recognition of ROU assets and lease liabilities on the balance sheet. Most prominent among the changes in Topic 842 is the recognition of ROU assets and lease liabilities by lessees for those leases classified as operating leases. In addition, Topic 842’s disclosures are required to meet the objective of enabling users of financial statements to assess the amount, timing and uncertainty of cash flows arising from leases. Topic 842’s transition provisions are applied using a modified retrospective approach; entities may elect whether to apply the transition provisions, including disclosure requirements, at the beginning of the earliest comparative period presented or on the adoption date.

We adopted Topic 842 effective January 1, 2019, and elected to apply the transition provisions as of that date. Accordingly, we recognized the cumulative effect of initially applying the standard as an adjustment to the opening balance of retained earnings on January 1, 2019. In addition, we elected the available practical expedients and implemented internal controls and key system functionality to enable the preparation of financial information on adoption.

As indicated in the accompanying consolidated statements of stockholders’ equity, the cumulative effect adjustment was an increase of $85 million to retained earnings, relating primarily to the transition provisions for sale-leaseback arrangements that did not qualify for sale treatment. Accordingly, such arrangements for certain office buildings were de-recognized and recorded as finance lease ROU assets and lease liabilities. The difference between the de-recognized assets and lease financing obligations resulted in an increase to retained earnings. The recognition of these arrangements as finance lease ROU assets and lease liabilities will not materially impact our consolidated results of operations over the terms of the leases.

Software Licenses. In August 2018, the FASB issued ASU 2018-15, Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract, which aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. We early adopted ASU 2018-15 effective January 1, 2019, using the prospective method, with no material impact to our financial condition,

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results of operations or cash flows. Adoption of this guidance may be significant to us in the future depending on the extent to which we use cloud computing arrangements that qualify as service contracts.

Recent Accounting Pronouncements Not Yet Adopted

Credit Losses. In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, as modified by:


•	ASU 2018-19, Codification Improvements to Topic 326, Financial Instruments - Credit Losses;


•	ASU 2019-04, Codification Improvements to Topic 326, Financial Instruments - Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments; and


•	ASU 2019-05, Financial Instruments - Credit Losses (Topic 326), Targeted Transition Relief.

This standard introduces a new current expected credit loss (“CECL”) model for measuring expected credit losses for certain types of financial instruments and replaces the incurred loss model. The CECL model requires companies to recognize an allowance for credit losses for the difference between the amortized cost basis of a financial instrument and the amount companies expect to collect over the instrument’s contractual life after consideration of historical experience, current conditions, and reasonable and supportable forecasts. This standard also introduces targeted changes to the available-for-sale (“AFS”) debt securities impairment model. ASU 2016-13 is effective beginning January 1, 2020, and must be adopted as a cumulative effect adjustment to retained earnings; early adoption is permitted.

The most significant type of financial instrument reported in our consolidated balance sheets, subject to the CECL model, is Receivables. As of September 30, 2019, over 70%, or approximately $970 million of the Receivables balance constitutes receivables from state and federal government agencies. Based on our preliminary analysis, we believe that the credit risk associated with such receivables is nominal due to a very low risk of default.

The AFS debt securities impairment model will apply to “Investments” reported in our consolidated balance sheets. We believe that the credit risk associated with our non-government issued Investments is nominal due to the high quality of such investments.

We are currently evaluating the processes and controls necessary to adopt and implement ASU 2016-13, along with the effects the adoption will have on our consolidated results of operations and financial condition.

Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the American Institute of Certified Public Accountants, and the Securities and Exchange Commission (“SEC”) did not have, nor does management expect such pronouncements to have, a significant impact on our present or future consolidated financial statements.

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3. Net Income per Share

The following table sets forth the calculation of net income per share:



	Three Months Ended September 30,				Nine Months Ended September 30,
	2019		2018		2019		2018
	(In millions, except net income per share)
Numerator:
Net income	$	175	$	197	$	569	$	506
Denominator:
Shares outstanding at the beginning of the period	62.2		61.3		62.1		59.3
Weighted-average number of shares issued:
Exchange of 1.625% Convertible Notes	—		—		—		1.3
Stock-based compensation	—		—		0.1		0.2
Denominator for net income per share, basic	62.2		61.3		62.2		60.8
Effect of dilutive securities:
1.125% Warrants ⁽¹⁾	0.8		5.6		1.8		5.0
1.625% Convertible Notes	—		0.6		—		0.5
Stock-based compensation	0.6		0.4		0.6		0.3
Denominator for net income per share, diluted	63.6		67.9		64.6		66.6

Net income per share: ⁽²⁾
Basic	$	2.81	$	3.22	$	9.15	$	8.32
Diluted	$	2.75	$	2.90	$	8.80	$	7.60

______________________________


(1)	For more information and definitions regarding the 1.125% Warrants, including partial termination transactions, refer to Note 9, “Stockholders' Equity.” The dilutive effect of all potentially dilutive common shares is calculated using the treasury stock method.


(2)	Source data for calculations in thousands.

4. Fair Value Measurements

We consider the carrying amounts of current assets and current liabilities (not including derivatives and the current portion of long-term debt) to approximate their fair values because of the relatively short period of time between the origination of these instruments and their expected realization or payment. For our financial instruments measured at fair value on a recurring basis, we prioritize the inputs used in measuring fair value according to the three-tier fair value hierarchy. For a description of the methods and assumptions that we use to a) estimate the fair value; and b) determine the classification according to the fair value hierarchy for each financial instrument, see Note 4, “Fair Value Measurements,” in our 2018 Annual Report on Form 10-K.

Derivative financial instruments include the 1.125% Call Option derivative asset and the 1.125% Conversion Option derivative liability (see Note 8 “Derivatives,” for definitions and further information). These derivatives are not actively traded and are valued based on an option pricing model that uses observable and unobservable market data for inputs. Significant market data inputs used to determine fair value as of September 30, 2019, included the price of our common stock, the time to maturity of the derivative instruments, the risk-free interest rate, and the implied volatility of our common stock. The 1.125% Call Option derivative asset and the 1.125% Conversion Option derivative liability were designed such that changes in their fair values would offset, with minimal impact to the consolidated statements of income. Therefore, the sensitivity of changes in the unobservable inputs to the option pricing model for such derivative instruments is mitigated.

The net changes in fair value of Level 3 financial instruments were insignificant to our results of operations for the nine months ended September 30, 2019.

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Our financial instruments measured at fair value on a recurring basis at September 30, 2019, were as follows:



	Total		Observable Inputs (Level 1)		Directly or Indirectly Observable Inputs (Level 2)		Unobservable Inputs (Level 3)
	(In millions)
Corporate debt securities	$	1,129	$	—	$	1,129	$	—
Mortgage-backed securities	303		—		303		—
Asset-backed securities	110		—		110		—
Government-sponsored enterprise securities (“GSEs”)	97		—		97		—
Municipal securities	68		—		68		—
U.S. Treasury notes	40		—		40		—
Foreign securities	7		—		7		—
Certificates of deposit	3		—		3		—
Subtotal - current investments	1,757		—		1,757		—
1.125% Call Option derivative asset	21		—		—		21
Total assets	$	1,778	$	—	$	1,757	$	21

1.125% Conversion Option derivative liability	$	21	$	—	$	—	$	21
Total liabilities	$	21	$	—	$	—	$	21

Our financial instruments measured at fair value on a recurring basis at December 31, 2018, were as follows:



	Total		Observable Inputs (Level 1)		Directly or Indirectly Observable Inputs (Level 2)		Unobservable Inputs (Level 3)
	(In millions)
Corporate debt securities	$	1,123	$	—	$	1,123	$	—
Asset-backed securities	82