Document

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 September 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, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer”, “small reporting company”, and “emerging growth 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 October 13, 2017, the registrant had 172,566,531 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.
 


Table of Contents

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, including our proposed acquisition of New York State Catholic Health Plan, Inc., d/b/a Fidelis Care New York (Fidelis Care) (Proposed Fidelis Acquisition or Fidelis Care Transaction), 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 or Fidelis Care's contracts with federal or state governments (including but not limited to Medicaid, Medicare, and TRICARE);
the difficulty of predicting the timing or outcome of pending or future litigation or government investigations;
challenges to our or Fidelis Care's 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 (Health Net Acquisition) of Health Net, Inc. (Health Net), and the Proposed Fidelis Acquisition, will not be realized, or will not be realized within the expected time period, including, but not limited to, as a result of any failure to obtain any regulatory, governmental or third party consents or approvals in connection with the proposed acquisition (including any such approvals under the New York Non-For-Profit Corporation Law) or any conditions, terms, obligations or restrictions imposed in connection with the receipt of such consents or approvals;
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 any regulatory, governmental or third party consents or approvals for the Health Net Acquisition;


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Table of Contents

the exertion of management’s time and our resources, and other expenses incurred and business changes required in connection with obtaining any regulatory, governmental or third party consents or approvals for the Proposed Fidelis Acquisition;
disruption caused by significant completed and pending acquisitions, including the Health Net Acquisition and the Proposed Fidelis Acquisition, making it more difficult to maintain business and operational relationships;
the risk that unexpected costs will be incurred in connection with the completion and/or integration of acquisition transactions, including among others, the Health Net Acquisition and the Proposed Fidelis Acquisition;
the risk that acquired businesses, including Health Net and Fidelis Care, will not be integrated successfully;
the risk that the conditions to the completion of the Proposed Fidelis Acquisition may not be satisfied or completed on a timely basis, or at all;
the risk that, following completion of the Proposed Fidelis Acquisition, the combined company may not be able to effectively manage its expanded operations;
changes in expected closing dates, estimated purchase price and accretion for acquisitions;
our ability to achieve improvement in the Centers for Medicare and Medicaid Services (CMS) Star ratings and maintain or achieve improvement in other quality scores in each case that can impact revenue and future growth;
availability of debt and equity financing, on terms that are favorable to us;
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

Table of Contents

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, 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
September 30,
 
Nine Months Ended
 September 30,
 
2017
 
2016
 
2017
 
2016
 
 
 
 
 
 
 
 
GAAP net earnings from continuing operations
$
205

 
$
148

 
$
598

 
$
304

Amortization of acquired intangible assets
38

 
43

 
117

 
95

Acquisition related expenses
7

 
10

 
13

 
224

Penn Treaty assessment expense
9

 

 
56

 

Income tax effects of adjustments (1)
(20
)
 
(5
)
 
(68
)
 
(106
)
Adjusted net earnings from continuing operations
$
239

 
$
196

 
$
716

 
$
517

 
 
 
 
 
 
 
 
GAAP diluted earnings per share (EPS)
$
1.16

 
$
0.84

 
$
3.39

 
$
1.90

Amortization of acquired intangible assets (2)
0.14

 
0.16

 
0.42

 
0.36

Acquisition related expenses (3)
0.02

 
0.12

 
0.05

 
0.97

Penn Treaty assessment expense (4)
0.03

 

 
0.20

 

Adjusted Diluted EPS from continuing operations
$
1.35

 
$
1.12

 
$
4.06

 
$
3.23

(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 $0.07 and $0.09 for the three months ended September 30, 2017 and 2016, respectively and $0.24 and $0.23 for the nine months ended September 30, 2017 and 2016, respectively.
(3)
Acquisition related expenses per diluted share are net of an income tax benefit (expense) of $0.02 and $(0.06) for the three months ended September 30, 2017 and 2016, respectively and $0.03 and $0.43 for the nine months ended September 30, 2017 and 2016, respectively.
(4)
The Penn Treaty assessment expense per diluted share is net of an income tax benefit of $0.02 and $0.12 for the three and nine months ended September 30, 2017, respectively. For a further discussion of the Penn Treaty assessment, see Note 11, Contingencies.
 
Three Months Ended
September 30,
 
Nine Months Ended
 September 30,
 
2017
 
2016
 
2017
 
2016
 
 
 
 
 
 
 
 
GAAP selling, general and administrative expenses
$
1,030

 
$
940

 
$
3,186

 
$
2,611

Acquisition related expenses
7

 
10

 
13

 
224

Penn Treaty assessment expense
9

 

 
56

 

Adjusted selling, general and administrative expenses
$
1,014

 
$
930

 
$
3,117

 
$
2,387


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Table of Contents

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)
 
September 30, 2017
 
December 31, 2016
 
(Unaudited)
 
 
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
4,281


$
3,930

Premium and related receivables
3,955


3,098

Short-term investments
595


505

Other current assets
829


832

Total current assets
9,660


8,365

Long-term investments
4,927


4,545

Restricted deposits
138


138

Property, software and equipment, net
1,003


797

Goodwill
4,712


4,712

Intangible assets, net
1,428


1,545

Other long-term assets
132


95

Total assets
$
22,000


$
20,197

 





LIABILITIES, REDEEMABLE NONCONTROLLING INTERESTS AND STOCKHOLDERS’ EQUITY


 

Current liabilities:
 


 

Medical claims liability
$
4,333


$
3,929

Accounts payable and accrued expenses
4,804


4,377

Unearned revenue
568


313

Current portion of long-term debt
4


4

Total current liabilities
9,709


8,623

Long-term debt
4,717


4,651

Other long-term liabilities
901


869

Total liabilities
15,327


14,143

Commitments and contingencies





Redeemable noncontrolling interests
20


145

Stockholders’ equity:
 


 

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



Common stock, $0.001 par value; authorized 400,000 shares; 179,033 issued and 172,566 outstanding at September 30, 2017, and 178,134 issued and 171,919 outstanding at December 31, 2016



Additional paid-in capital
4,310


4,190

Accumulated other comprehensive earnings (loss)
9


(36
)
Retained earnings
2,518


1,920

Treasury stock, at cost (6,467 and 6,215 shares, respectively)
(197
)

(179
)
Total Centene stockholders’ equity
6,640


5,895

Noncontrolling interest
13


14

Total stockholders’ equity
6,653


5,909

Total liabilities, redeemable noncontrolling interests and stockholders’ equity
$
22,000


$
20,197

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

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Table of Contents

CENTENE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In millions, except per share data in dollars)
(Unaudited)
 
Three Months Ended September 30,

Nine Months Ended September 30,
 
2017

2016

2017

2016
Revenues:







Premium
$
10,850


$
9,625


$
32,393


$
25,299

Service
571


590


1,634


1,603

Premium and service revenues
11,421


10,215


34,027


26,902

Premium tax and health insurer fee
477


631


1,549


1,794

Total revenues
11,898


10,846


35,576


28,696

Expenses:




 

 
Medical costs
9,543


8,376


28,278


22,072

Cost of services
437


504


1,334


1,386

Selling, general and administrative expenses
1,030


940


3,186


2,611

Amortization of acquired intangible assets
38


43


117


95

Premium tax expense
510


512


1,643


1,460

Health insurer fee expense


129




333

Total operating expenses
11,558


10,504


34,558


27,957

Earnings from operations
340


342


1,018


739

Other income (expense):




 

 
Investment and other income
51


33


137


80

Interest expense
(65
)

(57
)

(189
)

(142
)
Earnings from continuing operations, before income tax expense
326


318


966


677

Income tax expense
125


169


381


372

Earnings from continuing operations, net of income tax expense
201


149


585


305

Discontinued operations, net of income tax benefit


(1
)



(3
)
Net earnings
201


148


585


302

(Earnings) loss attributable to noncontrolling interests
4


(1
)

13


(1
)
Net earnings attributable to Centene Corporation
$
205


$
147


$
598


$
301









Amounts attributable to Centene Corporation common shareholders:
Earnings from continuing operations, net of income tax expense
$
205


$
148


$
598


$
304

Discontinued operations, net of income tax benefit


(1
)



(3
)
Net earnings
$
205


$
147


$
598


$
301









Net earnings (loss) per common share attributable to Centene Corporation:
Basic:











Continuing operations
$
1.19


$
0.87


$
3.47


$
1.95

Discontinued operations


(0.01
)



(0.02
)
Basic earnings per common share
$
1.19


$
0.86


$
3.47


$
1.93













Diluted:











Continuing operations
$
1.16


$
0.84


$
3.39


$
1.90

Discontinued operations






(0.02
)
Diluted earnings per common share
$
1.16


$
0.84


$
3.39


$
1.88









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

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Table of Contents

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

 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
Net earnings
$
201

 
$
148

 
$
585

 
$
302

Reclassification adjustment, net of tax

 
(1
)
 
(1
)
 

Change in unrealized gain on investments, net of tax
7

 
5

 
41

 
57

Foreign currency translation adjustments
1

 
(1
)
 
5

 
(1
)
Other comprehensive earnings
8

 
3

 
45

 
56

Comprehensive earnings
209

 
151

 
630

 
358

Comprehensive (earnings) loss attributable to noncontrolling interests
4

 
(1
)
 
13

 
(1
)
Comprehensive earnings attributable to Centene Corporation
$
213

 
$
150

 
$
643

 
$
357


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


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Table of Contents

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

Nine Months Ended September 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 (loss)

 

 

 

 
598

 

 

 
(1
)
 
597

Other comprehensive earnings, net of $23 tax

 

 

 
45

 

 

 

 

 
45

Common stock issued for employee benefit plans
899

 

 
8

 

 

 

 

 

 
8

Common stock repurchases

 

 

 

 

 
252

 
(18
)
 

 
(18
)
Stock compensation expense

 

 
99

 

 

 

 

 

 
99

Purchase of noncontrolling interest

 

 
13

 

 

 

 

 

 
13

Balance, September 30, 2017
179,033

 
$

 
$
4,310

 
$
9

 
$
2,518

 
6,467

 
$
(197
)
 
$
13

 
$
6,653

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



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CENTENE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In millions)
(Unaudited)
 
Nine Months Ended September 30,
 
2017

2016
Cash flows from operating activities:
 

 
Net earnings
$
585


$
302

Adjustments to reconcile net earnings to net cash provided by operating activities
Depreciation and amortization
264


189

Stock compensation expense
99


112

Deferred income taxes
(32
)

(17
)
Changes in assets and liabilities
 


 

Premium and related receivables
(749
)

(906
)
Other assets
(39
)

7

Medical claims liabilities
406


15

Unearned revenue
255


301

Accounts payable and accrued expenses
205


99

Other long-term liabilities
45


156

Other operating activities, net


1

Net cash provided by operating activities
1,039


259

Cash flows from investing activities:
 


 

Capital expenditures
(301
)

(211
)
Purchases of investments
(1,720
)

(1,528
)
Sales and maturities of investments
1,335


955

Investments in acquisitions, net of cash acquired


(848
)
Net cash used in investing activities
(686
)

(1,632
)
Cash flows from financing activities:
 


 

Proceeds from long-term debt
1,170


6,956

Payments of long-term debt
(1,124
)

(4,257
)
Common stock repurchases
(18
)

(29
)
Purchase of noncontrolling interest
(33
)

(14
)
Debt issuance costs


(59
)
Other financing activities, net
2


(3
)
Net cash (used in) provided by financing activities
(3
)

2,594

Effect of exchange rate changes on cash and cash equivalents
1


1

Net increase in cash and cash equivalents
351


1,222

Cash and cash equivalents, beginning of period
3,930


1,760

Cash and cash equivalents, end of period
$
4,281


$
2,982

Supplemental disclosures of cash flow information:
 


 

Interest paid
$
210


$
113

Income taxes paid
$
358


$
394

Equity issued in connection with acquisitions
$


$
3,105

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

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Table of Contents

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 $2 million and $4 million for the three and nine months ended September 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 nine months ended September 30, 2016 include the results of operations of Health Net from March 24, 2016 to September 30, 2016.

Accounting Guidance Not Yet Adopted

In August 2017, the Financial Accounting Standards Board (FASB) issued an ASU which amends the hedge accounting model to enable entities to better align the economics of risk management activities and financial reporting. In addition, the new standard enhances the understandability of hedge results and simplifies the application of hedge accounting in certain situations. 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.

In March 2017, the 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.


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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 guidance is effective for annual and interim periods beginning after December 15, 2017. Early adoption is permitted. The Company 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. While the Company continues to analyze contracts within the scope of the standard, 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. Fidelis Care Transaction

In September 2017, the Company signed a definitive agreement under which Fidelis Care will become the Company's health plan in New York State. Under the terms of the agreement, the Company will acquire substantially all of the assets of Fidelis Care for $3.75 billion, subject to certain adjustments.

3. Acquisitions and Noncontrolling Interest

In August 2017, the Company acquired the remaining 32% interest of U.S. Medical Management (USMM), a management services organization and provider of in-home health services for high acuity populations, for $86 million in total consideration. The transaction consideration consisted of $33 million of cash, $33 million of deferred consideration and $20 million related to the settlement of a receivable from the former noncontrolling interest holder.

Redeemable Noncontrolling Interest

As a result of put option agreements, noncontrolling interest is considered redeemable and is classified in the Redeemable Noncontrolling Interest section of the Consolidated Balance Sheets.

A reconciliation of the changes in the Redeemable Noncontrolling Interest is as follows ($ in millions):

Balance, December 31, 2016
 
$
145

 
Noncontrolling interest purchased related to USMM
 
(115
)
 
Contribution from redeemable noncontrolling interest
 
2

 
Net losses attributable to noncontrolling interests
 
(12
)
Balance, September 30, 2017
 
$
20

 
 
 
 


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Table of Contents

4. 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):
 
September 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
$
330

 
$

 
$
(1
)
 
$
329

 
$
364

 
$

 
$
(1
)
 
$
363

Corporate securities
2,098

 
18

 
(6
)
 
2,110

 
1,933

 
12

 
(13
)
 
1,932

Restricted certificates of deposit
4

 

 

 
4

 
5

 

 

 
5

Restricted cash equivalents
6

 

 

 
6

 
6

 

 

 
6

Municipal securities
1,979

 
16

 
(6
)
 
1,989

 
1,767

 
1

 
(35
)
 
1,733

Asset-backed securities
376

 
2

 

 
378

 
317

 
1

 
(1
)
 
317

Residential mortgage-backed securities
309

 
1

 
(4
)
 
306

 
219

 
1

 
(5
)
 
215

Commercial mortgage-backed securities
238

 
1

 
(3
)
 
236

 
343

 

 
(5
)
 
338

Cost and equity method investments
171

 

 

 
171

 
163

 

 

 
163

Life insurance contracts
131

 

 

 
131

 
116

 

 

 
116

Total
$
5,642

 
$
38

 
$
(20
)
 
$
5,660

 
$
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 September 30, 2017, 95% of the Company’s investments in rated securities carry an investment grade rating by nationally recognized statistical rating organizations. At September 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 4.1 years at September 30, 2017.


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Table of Contents

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):
 
September 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
)
 
$
277

 
$

 
$
3

 
$
(1
)
 
$
215

 
$

 
$
2

Corporate securities
(4
)
 
587

 
(2
)
 
83

 
(12
)
 
1,020

 
(1
)
 
39

Municipal securities
(4
)
 
457

 
(2
)
 
96

 
(35
)
 
1,423

 

 
30

Asset-backed securities

 
126

 

 
13

 
(1
)
 
101

 

 
18

Residential mortgage-backed securities
(3
)
 
190

 
(1
)
 
49

 
(5
)
 
188

 

 

Commercial mortgage-backed securities
(1
)
 
99

 
(2
)
 
31

 
(5
)
 
271

 

 

Total
$
(13
)
 
$
1,736

 
$
(7
)
 
$
275

 
$
(59
)
 
$
3,218

 
$
(1
)
 
$
89


As of September 30, 2017, the gross unrealized losses were generated from 1,201 positions out of a total of 3,192 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):
 
September 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
$
533

 
$
533

 
$
65

 
$
65

 
$
500

 
$
500

 
$
91

 
$
91

One year through five years
2,149

 
2,162

 
73

 
73

 
1,982

 
1,974

 
47

 
47

Five years through ten years
1,680

 
1,687

 

 

 
1,101

 
1,089

 

 

Greater than ten years
219

 
220

 

 

 
633

 
617

 

 

Asset-backed securities
923

 
920

 

 

 
879

 
870

 

 

Total
$
5,504

 
$
5,522

 
$
138

 
$
138

 
$
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.

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Table of Contents

5. 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 September 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
$
4,281

 
$

 
$

 
$
4,281

Investments available for sale:
 

 
 

 
 

 
 

U.S. Treasury securities and obligations of U.S. government corporations and agencies
$
201

 
$

 
$

 
$
201

Corporate securities

 
2,110

 

 
2,110

Municipal securities

 
1,989

 

 
1,989

Asset-backed securities

 
378

 

 
378

Residential mortgage-backed securities

 
306

 

 
306

Commercial mortgage-backed securities

 
236

 

 
236

Total investments
$
201

 
$
5,019

 
$

 
$
5,220

Restricted deposits available for sale:
 

 
 

 
 

 
 

Cash and cash equivalents
$
6

 
$

 
$

 
$
6

Certificates of deposit
4

 

 

 
4

U.S. Treasury securities and obligations of U.S. government corporations and agencies
128

 

 

 
128

Total restricted deposits
$
138

 
$

 
$

 
$
138

Other long-term assets: Interest rate swap agreements
$

 
$
4

 
$

 
$
4

Total assets at fair value
$
4,620

 
$
5,023

 
$

 
$
9,643

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

 
$
53

 
$

 
$
53

Total liabilities at fair value
$

 
$
53

 
$

 
$
53



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Table of Contents

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 September 30, 2017, there were no transfers from Level I to Level II and $14 million of 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 $302 million and $279 million as of September 30, 2017 and December 31, 2016, respectively.

6. 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.


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Table of Contents

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

 
 
Nine Months Ended September 30,
 
 
2017
 
2016
Balance, January 1
 
$
3,929

 
$
2,298

Less: Reinsurance Recoverable
 
5

 

Balance, January 1, net
 
3,924

 
2,298

Acquisitions
 

 
1,453

Incurred related to:
 
 
 
 
          Current year
 
28,666

 
22,372

          Prior years
 
(388
)
 
(300
)
         Total incurred
 
28,278

 
22,072

Paid related to:
 
 
 
 
          Current year
 
24,787

 
20,121

          Prior years
 
3,099

 
1,935

         Total paid
 
27,886

 
22,056

Balance at September 30, net
 
4,316

 
3,767

Plus: Reinsurance Recoverable
 
17

 

Balance, September 30
 
$
4,333

 
$
3,767


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, as a result of development within "Incurred related to: Prior years" due to minimum HBR and other return of premium programs, we recorded approximately $4 million as an increase to premium revenues in the nine months ended September 30, 2017 and approximately $27 million as a reduction to premium revenues in the nine months ended September 30, 2016.

Incurred but not reported (IBNR) plus expected development on reported claims as of September 30, 2017 was $3,292 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.
 
7. 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.

During the second quarter of 2017, the Company recognized a $48 million net pre-tax benefit related to the reconciliation of the 2016 risk adjustment program compared to 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.


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Table of Contents

The Company's net receivables (payables) for each of these programs are as follows ($ in millions):
 
September 30, 2017
 
December 31, 2016
Risk adjustment
$
(609
)
 
$
(425
)
Reinsurance
15

 
122

Risk corridor
(8
)
 
(3
)
Minimum MLR
(1
)
 
(18
)
Cost sharing reductions
(180
)
 
(147
)

8. Debt
 
Debt consists of the following ($ in millions):
 
September 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
(49
)
 
(58
)
Total senior notes
4,558

 
4,550

Revolving credit agreement
150

 
100

Mortgage notes payable
62

 
64

Capital leases and other
17

 
18

Debt issuance costs
(66
)
 
(77
)
Total debt
4,721

 
4,655

Less current portion
(4
)
 
(4
)
 Long-term debt
$
4,717

 
$
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 September 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 September 30, 2017, the weighted average rate was 4.91%.


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Table of Contents

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 September 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 September 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 $51 million as of September 30, 2017, which were not part of the revolving credit facility. The Company also had letters of credit for $45 million (valued at September 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 1.33% as of September 30, 2017. The Company had outstanding surety bonds of $404 million as of September 30, 2017.

Construction Loan

In October 2017, the Company executed a $200 million non-recourse construction loan to fund the expansion of the Company's corporate headquarters. The loan bears interest based on the one month LIBOR plus 2.70% and matures in April 2021 with an optional one-year extension. The agreement contains financial and non-financial covenants aligning with the Company's revolving credit agreement. The Company has guaranteed completion of the construction project associated with the loan.
 

14

Table of Contents

9. 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 in dollars):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2017
 
2016
 
2017
 
2016
Earnings attributable to Centene Corporation:
 
 
 
 
 
 
 
Earnings from continuing operations, net of tax
$
205

 
$
148

 
$
598

 
$
304

Discontinued operations, net of tax

 
(1
)
 

 
(3
)
Net earnings
$
205

 
$
147

 
$
598

 
$
301

 
 
 
 
 
 
 
 
Shares used in computing per share amounts:
 

 
 
 
 
 
 
Weighted average number of common shares outstanding
172,508

 
170,775

 
172,314

 
155,681

Common stock equivalents (as determined by applying the treasury stock method)
4,407

 
4,720

 
4,100

 
4,376

Weighted average number of common shares and potential dilutive common shares outstanding
176,915

 
175,495

 
176,414

 
160,057

 
 
 
 
 
 
 
 
Net earnings (loss) per common share attributable to Centene Corporation:
Basic:
 
 
 
 
 
 
 
Continuing operations
$
1.19

 
$
0.87

 
$
3.47

 
$
1.95

Discontinued operations

 
(0.01
)
 

 
(0.02
)
Basic earnings per common share
$
1.19

 
$
0.86

 
$
3.47

 
$
1.93

 
 
 
 
 
 
 
 
Diluted:
 
 
 
 
 
 
 
Continuing operations
$
1.16

 
$
0.84

 
$
3.39

 
$
1.90

Discontinued operations

 

 

 
(0.02
)
Diluted earnings per common share
$
1.16

 
$
0.84

 
$
3.39

 
$
1.88


The calculation of diluted earnings per common share for the three and nine months ended September 30, 2017 excludes the impact of 4 thousand and 27 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 nine months ended September 30, 2016 excludes the impact of 57 thousand and 66 thousand shares, respectively, related to anti-dilutive stock options, restricted stock and restricted stock units.

10. 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.


15

Table of Contents

Segment information for the three months ended September 30, 2017, follows ($ in millions):
 
Managed Care
 
Specialty
Services
 
Eliminations
 
Consolidated
Total
Total revenues from external customers
$
11,248

 
$
650

 
$

 
$
11,898

Total revenues from internal customers
11

 
2,367

 
(2,378
)
 

Total revenues
$
11,259

 
$
3,017

 
$
(2,378
)
 
$
11,898

Earnings from operations
$
238

 
$
102

 
$

 
$
340


Segment information for the three months ended September 30, 2016, follows ($ in millions):
 
Managed Care
 
Specialty
Services
 
Eliminations
 
Consolidated
Total
Total revenues from external customers
$
10,175

 
$
671

 
$

 
$
10,846

Total revenues from internal customers
56

 
1,524

 
(1,580
)
 

Total revenues
$
10,231

 
$
2,195

 
$
(1,580
)
 
$
10,846

Earnings from operations
$
309

 
$
33

 
$

 
$
342


Segment information for the nine months ended September 30, 2017, follows ($ in millions):
 
Managed Care
 
Specialty
Services
 
Eliminations
 
Consolidated
Total
Total revenues from external customers
$
33,704

 
$
1,872

 
$

 
$
35,576

Total revenues from internal customers
33

 
7,112

 
(7,145
)
 

Total revenues
$
33,737

 
$
8,984

 
$
(7,145
)
 
$
35,576

Earnings from operations
$
799

 
$
219

 
$

 
$
1,018


Segment information for the nine months ended September 30, 2016, follows ($ in millions):
 
Managed Care
 
Specialty
Services
 
Eliminations
 
Consolidated
Total
Total revenues from external customers
$
26,926

 
$
1,770

 
$

 
$
28,696

Total revenues from internal customers
144

 
4,383

 
(4,527
)
 

Total revenues
$
27,070

 
$
6,153

 
$
(4,527
)
 
$
28,696

Earnings from operations
$
627

 
$
112

 
$

 
$
739


11. 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.

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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. In September 2017, the Company filed a demurrer seeking to dismiss the complaint, and a motion to strike the allegations seeking retroactive relief. 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. In July 2017, the lead plaintiff filed a Consolidated Class Action Complaint. The Company filed a motion to dismiss this complaint in September 2017. 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.

Medicare Parts C and D Matter

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 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.

Veterans Administrative Matter

In October 2017, a CID was issued to Health Net Federal Services, LLC (HNFS) by the United States Department of Justice. The CID seeks documents and interrogatory responses concerning whether HNFS submitted, or caused to be submitted, excessive, duplicative or otherwise improper claims to the U.S. Department of Veterans Affairs under a contract to arrange health care services for veterans. The contract began in late 2014. In 2016, modifications to the contract were made to allow for possible duplicate billings with a reconciliation period at the end of the contract term. The Company is complying with the CID and believes it has been meeting its contractual obligations. 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.


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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 nine months ended September 30, 2017, the Company recognized $56 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;

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.

12. Subsequent Event

On October 1, 2017, the Company acquired 80% of a national, full-service specialty pharmacy, providing service to patients with certain chronic respiratory and digestive conditions. The purchase price consists of $53 million in cash paid at closing, $7 million in deferred consideration, and up to an additional $32 million of contingent consideration to be paid upon meeting certain performance metrics.

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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.

Fidelis Care Transaction

In September 2017, we signed a definitive agreement under which New York State Catholic Health Plan, Inc., d/b/a Fidelis Care New York (Fidelis Care) will become the Company's health plan in New York State upon closing. Under the terms of the agreement, we will acquire substantially all of the assets of Fidelis Care for $3.75 billion, subject to certain adjustments. This transaction is expected to close in the first quarter of 2018, subject to various closing conditions and receipt of New York regulatory approvals, including approvals under the New York Not-for-Profit Corporation Law. In October 2017, we announced the early termination of the waiting period required under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended. Subject to market conditions, we expect to fund the transaction with approximately $2.3 billion of new equity, including share consideration, and approximately $1.6 billion of new long-term debt.

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 nine 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 September, four Senators released the newest version of a repeal and replace healthcare bill known as the Graham-Cassidy bill, which proposed a block grant program to shift health care administration from the Federal government to state governments. Ultimately, the bill was not voted on by the Senate in September as it met opposition from Senate Republicans.


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In October, the President signed an executive order, allowing trade associations and other groups to establish health plans exempt from certain ACA requirements, which may be sold across state lines. Also, in October, the Trump Administration announced that the federal government will stop funding cost sharing reduction (CSR) subsidies. Although the Federal Government has announced the discontinuance of CSR funding, various court challenges or actions by congress may continue the payments for all or a portion of the fourth quarter. Additionally, a deal was subsequently reached by bipartisan Senators to restore CSR payments for two years in exchange for more ACA state flexibility. There are no guarantees the deal will reach the Senate floor for vote. However, if the CSR payments from the Federal Government for the fourth quarter 2017 are not received, we expect the lack of those payments to have a $0.07 to $0.12 per diluted share impact on our 2017 earnings. This is the result of payments received through September 30, 2017 in our various states being sufficient to cover our full year CSR expectations. For 2018, all of our states have approved premium rates that assumed no CSR funding. Despite the removal of the CSRs, individuals below 400% of the federal poverty level (our target market) will still have access to subsidies through the Advance Premium Tax Credit (APTC).

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."

Third Quarter 2017 Highlights

Our financial performance for the third quarter of 2017 is summarized as follows:
Managed care membership of 12.3 million, an increase of 874,900 members, or 8% year over year.
Total revenues of $11.9 billion, representing 10% growth year over year.
Health benefits ratio of 88.0%, compared to 87.0% in 2016.
SG&A expense ratio of 9.0% for the third quarter of 2017, compared to 9.2% for the third quarter of 2016.
Adjusted SG&A expense ratio of 8.9% for the third quarter of 2017, compared to 9.1%