| HOOPER HOLMES INC ITEM 1A Risk Factors Risks Relating to the Health Information Division’s Businesses We expect that the market for our life insurance risk assessment services will continue to contract |
| Each of our paramedical examination, tele-underwriting, attending physician statement (APS) retrieval, lab specimen testing and outsourced underwriting businesses is directly influenced by the level of life insurance application activity in the United States and in the United Kingdom |
| Based on available data, life insurance application activity in North America has declined in each of the last three years |
| The data are consistent with the fundamental changes that reportedly have been occurring within the life insurance industry over a number of years, changes that have resulted in the slow decline of the market for life insurance |
| Our paramedical examination, lab specimen testing and APS retrieval businesses are also affected by decisions of life insurance carriers as to the policy amount thresholds, and the age of applicants and other criterion for which life insurance carriers require such services |
| Our new senior management team is embarking on a number of initiatives in an effort to restore the operating margins of our core paramedical examination business and return the business to a growth path |
| The success of these initiatives depends on a number of factors, many of which are outside management’s control |
| In 2005, our US-based core paramedical examination business experienced a decline in revenues of dlra17dtta2 million, or 9dtta1prca, compared to 2004 |
| The business’ operating margins declined in each of 2005 and 2004 |
| To address the decline in operating results, our new management team intends to focus initially on expense management, seeking, in general, to align our costs with existing levels of revenues so as to restore the business’s operating margins |
| The second phase of the planned initiatives will focus on revenue enhancement |
| This process will entail a number of internal changes |
| The success of those changes will depend on the active input of our employees, and the willingness and ability of our employees and network of paramedical examiners to adapt to changes in the manner they go about their day-to-day activities |
| Success will also hinge on the receptivity of our current and target customers to our initiatives, as well as our ability to anticipate changes in the competitive landscape |
| We have experienced downward pricing pressure from our life insurance carrier customers, which has hurt our operating margins and otherwise adversely affected our operating results |
| We attribute this pressure to the carriers’ efforts to address cost items in a more rigorous manner in an attempt to maintain their profitability and level of return to their investors and other stakeholders in the face of (i) lower returns in the stock and bond markets, (ii) a shift in life insurance premium dollars away from higher-margin whole life products toward lower-margin term insurance policies, and (iii) a shift in consumers’ investment preferences toward accumulation and investment products, such as annuities and mutual funds |
| With price having become the primary basis of competition in the paramedical examination business, we have experienced declines in our average revenue per exam |
| This has been a significant factor in the decline in revenues derived by our core paramedical examination business in each of the last two years, and the related declines in operating margins and cash flow from operating activities |
| Our Health Information Division’s ten largest customers represented approximately 32prca of division revenues in 2005 |
| The loss of a significant volume of business from any of these customers could be expected to result in a material reduction in our revenues and negatively affect our cash flows from operating activities |
| In 2005, our Health Information Division’s top 10 customers represented, in the aggregate, approximately 32prca of the division’s revenues |
| The loss of a significant volume of business from any of these customers could be expected to result in a material reduction in our revenues and negatively affect our cash flows from operating activities |
| Improper actions by our paramedical examiners or our physician practitioners could cause us to lose business and result in claims against us or our incurring expenses to indemnify our life insurance carrier customers |
| In 2005, we believe we lost the business of one of our life insurance carrier customers as a result of events relating to the alleged improper actions of a paramedical examiner |
| In the many years we have been in the business of arranging for paramedical and medical examinations, incidents of improper actions on the part of a paramedical examiner or physician have been extremely rare |
| 16 ______________________________________________________________________ [41]Table of Contents When they have occurred, we have agreed, where appropriate, to indemnify or reimburse our insurance company clients for any expenses or other damages that they incur or suffer |
| However, the risk exists in these situations that the client relationship may be damaged, such that we experience a drop-off in the volume of business from such client or the loss of the client’s business |
| If life insurance carriers and the agents and brokers who sell life insurance make greater use of tele-interviewing/underwriting, we may experience reduced demand for our paramedical examination services and a lower volume of orders for attending physician statements |
| We believe that life insurance carriers and the agents and brokers who sell life insurance will over time make increasingly greater use of tele-interviewing/underwriting because of the ability of tele-interviewing/underwriting to further carriers’ two principal objectives: cost containment and reduced underwriting cycle time |
| While this represents a growth opportunity for us, it may also result in reduced demand for our paramedical examination services due to the screening out of life insurance applicants at an earlier stage in the medical-related information gathering process |
| Heritage Labs’ failure to provide accurate laboratory test results may result in claims against us |
| Our Heritage Labs subsidiary processes the blood, urine and other specimens obtained in connection with a portion of our paramedical examinations, as well as specimens provided by third-party health information service providers |
| Our insurance company clients and these third-party health information service providers rely on the accuracy of the test results and other data in connection with their insurance underwriting, treatment and other decisions |
| In addition, federal and state laws regulate the disclosure of specimen test results and other nonpublic medical-related personal information |
| If Heritage Labs does not provide accurate test results or does not protect the confidentiality of such results in accordance with applicable laws, we could face significant liability |
| Our classification of most of our paramedical examiners outside of the State of California as independent contractors, rather than employees, exposes us to possible litigation and legal liability |
| We classify most of our paramedical examiners outside the States of California, Montana and Oregon as independent contractors, making such examiners personally responsible for their employment taxes and workers’ compensation |
| In the past, some state agencies have claimed that we improperly classified our examiners as independent contractors, rather than employees, for purposes of state unemployment tax laws and that we were, therefore, liable for arrears of taxes or for penalties for failure to comply with these laws |
| In the State of California, we received an adverse determination as to the independent contractor status of our paramedical examiners, and, as a result, we now classify our examiners in California as employees |
| Should any other jurisdictions in which we conduct operations determine that our paramedical examiners are employees, we may be exposed to litigation and liability, as well as increased operating costs |
| Risks Related to Our Claims Evaluation Division There are signs that the outsourced medical claims management market in the United States may be contracting, which may limit the potential growth of our Claims Evaluation Division’s business |
| Our management perceives that the outsourced medical claims management market in the United States, including the market for our claims evaluation services, may be contracting |
| Property and casualty insurance is largely regulated on a state level, with most of the demand for medical claims management services being created by state insurance laws |
| These state regulatory regimes frequently change |
| These changes may reduce the demand for some or all of our Claims Evaluation Division’s services necessitate the lowering of the prices we charge for our services, increase our cost of operations, or require us to develop new or modified services in order to meet the needs of our customers or to compete effectively |
| For example, in New York, where a significant portion of the CED’s revenues have been derived since the Company entered this business in 2002, the demand for our claims evaluation services has been adversely affected by the implementation of regulatory changes and efforts to curb auto injury insurance fraud |
| If the market for our claims evaluation services contracts, the growth potential of the CED’s business may be limited |
| Further, the division may be at a competitive disadvantage in dealing with a contracting market as a result of the more narrow focus of its present business activities relative to certain of its larger competitors that are engaged in the other segments of the outsourced medical claims management market (eg, medical management services) |
| Our Claims Evaluation Division’s business is being affected by increased customer procurement demands, driven primarily by heightened federal laws and regulations, that are increasing operating costs |
| Our Claims Evaluation Division’s business is being affected by increased customer procurement demands |
| These demands are being primarily driven by heightened compliance and security standards being imposed at the federal and state levels |
| Compliance with these demands entails higher operating costs, which has contributed (and may continue to contribute) to reduced margins and profitability |
| 17 ______________________________________________________________________ [42]Table of Contents Our Claims Evaluation Division has a significant degree of customer concentration, such that the loss of any one of its larger customers would have a material effect on its operating results |
| Our Claims Evaluation Division’s 21 largest clients accounted for 83prca of the division’s revenues in 2005 |
| The loss of any of these customers would likely result in a drop-off in the Claims Evaluation Division’s revenues and profitability, and that drop-off may be material |
| The nature of the claims evaluation services we provide exposes us to possible litigation and liability |
| Through our network of physician practitioners, our Claims Evaluation Division provides assessments of the appropriateness of healthcare providers’ medical treatment plans |
| The nature of this work is such that we could be exposed to claims for adverse medical consequences |
| The Claims Evaluation Division does not grant or deny claims for payment of benefits and, to date has not been made a defendant in any litigation relating to any such decision |
| However, this does not preclude future exposure to claims that may arise or result from the decisions of our customers |
| Such litigation, even if determined to be without merit, could adversely affect our business, operating results and financial condition |
| We maintain professional liability insurance and such other coverage as we believe appropriate, but such insurance may prove insufficient |
| Healthcare providers are becoming increasingly resistant to the application of certain healthcare cost containment techniques |
| This could indirectly reduce the demand for our claims evaluation services |
| Our customers utilize our claims evaluation services to reduce the costs of the claims they process and/or have financial responsibility for |
| Healthcare providers have stepped up their efforts to minimize the use of certain cost containment techniques, including initiating litigation against insurers to challenge insurers’ claims adjudication and reimbursement decisions |
| The healthcare providers’ actions could indirectly result in reduced demand by our customers for our services |
| In such event, we would expect to experience a decline in revenues, lower operating margins and reduced profitability |
| Our Claims Evaluation Division could be negatively affected by changes in what is a fragmented, but highly competitive market |
| The market for claims evaluation services market is fragmented, but competitive |
| We compete with many smaller vendors who generally provide such services on a local level, particularly companies with established relationships with one or more local insurance company claims adjusters |
| We also compete with larger companies that offer a broader selection of complementary services |
| Changes in the competitive landscape, including the performance by our Property and Casualty carrier customers of a greater degree of claims evaluation services in-house, could negatively affect our business |
| If any of the members of our physician panel were to be found to lack proper credentials or be determined to be less than “independent,” the damage to our reputation and business could be considerable |
| The nature of the Claims Evaluation Division’s business is such that the proper credentialing and “independence” of each member of the division’s panel of physicians that perform IMEs has been, and remains, of paramount importance |
| Although the division is in the process of enhancing its background checks with respect to its roughly 9cmam000-strong panel physicians, there remains an exposure to liability resulting from improper conduct during an examination encounter even with the most rigorous of credentialing processes |
| The division must also be vigilant in monitoring the amount of work directed to any particular physician, taking into consideration not just the absolute amount of the fees paid to that physician for his or her services but also how those fees compare with the physician’s income from other sources |
| Further, the division’s quality reviewers must ensure that the IME reports we arrange on behalf of our customers are comprehensive and complete, and that the factual results support the conclusions drawn in such reports |
| If any of the members of our physician panel were to be found to lack proper credentials, be determined to be less than independent and/or to engage in improper conduct during the course of an IME, we would be exposed to potential claims and liability |
| Further, as this is an industry-wide issue, we could also experience a significant drop-off in the demand for IME-related services even if the physician or physicians found to be lacking proper credentials or independence, or engaging in improper conduct, were not part of our physician panel |
| Risks Relating to Our Company Generally Our management has determined that there are material weaknesses in our system of internal control over financial reporting, such that we have determined that such internal control was not effective as of December 31, 2005 |
| If we are unable to address these weaknesses in our internal controls, we may not be able to report our future operating results and financial condition in an accurate and timely manner |
| Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2005 |
| This assessment identified material weaknesses in our internal control over financial reporting as of that date |
| For more information, see Item 9A “Controls and Procedures” of this annual report on Form 10K Accordingly, our management determined that our internal 18 ______________________________________________________________________ [43]Table of Contents control over financial reporting was not effective as of December 31, 2005 |
| Further, the analysis that led to our determination to restate our consolidated financial statements for prior periods led to management’s concluding that our internal control over financial reporting was not effective as of December 31, 2004, as well |
| Although we are in the process of taking steps to correct the weaknesses in our internal control over financial reporting, determining whether these steps are efficacious will require continuing review and testing |
| Any failure to maintain adequate internal control over financial reporting could prevent us from accurately reporting our financial results or cause us to fail to meet our reporting obligations in the future |
| If we are not able to report our future operating results and financial condition in an accurate and timely manner, we could face litigation or regulatory action |
| Further, investors could lose confidence in our reported financial information |
| Any of such consequences could adversely affect our business and result in a decline in the market price of our common stock |
| Our senior credit facility is scheduled to expire in January 2007 |
| Our existing senior credit facility is scheduled to expire in January 2007 |
| Although we currently have no outstanding indebtedness under our existing credit facility, if we are unable to enter into a new or amended credit facility prior to the expiration of the existing credit facility, our options to finance our operations will be more limited |
| A new or amended credit facility may reflect a lower amount of permitted borrowings, higher interest rates and/or more restrictive financial covenants than under the terms of our existing credit facility |
| A continuation of the decline in our operating results may contribute to a decline in our cash flows from operating activities, further limiting our ability to finance our operations |
| If the Company is unable to meet the terms of its recently amended revolving credit facility dated April 25, 2006, the Company may not have sufficient cash to meet its operating and capital requirement needs |
| The April 25, 2006 amendment to our credit agreement, which now expires on January 2, 2007, requires the Company to adhere to certain covenants, which are fully discussed in Note 10 to the consolidated financial statements contained in this annual report on Form 10-K Certain operating financial covenants the Company must meet are: i) a minimum consolidated monthly pre-tax income, ii) a minimum quarterly fixed charge coverage ratio and iii) a quarterly funded debt to EBITDA ratio |
| If the Company fails to produce the required results to remain in compliance with the terms of its credit facility and if the Company is not successful in obtaining a waiver of a covenant violation from the lenders, any amounts outstanding under the credit agreement become due immediately, and the Company’s ability to borrow under this facility is terminated, which could limit the Company’s ability to finance its operations |
| If we are not able to maintain and upgrade our information technology platform so that our customers are able to readily access critical data related to their underwriting decisions or processing of claims, the competitiveness of our businesses will suffer |
| In each of our businesses, the speed with which we make information available to our customers is critical |
| As a result, we are dependent on our information technology platform and our ability to store, retrieve, process, manage and enable timely customer access to the health-related and other data we gather on behalf of our customers |
| Disruption of the operation of our IT systems for any extended period of time, loss of stored data, programming errors or other system failures could cause customers to turn elsewhere to address their service needs |
| In addition, we must continue to enhance our IT systems to keep pace with our competitors’ service and product enhancements |
| Our expensing of stock options will negatively affect our operating results |
| The Financial Accounting Standards Board has recently issued Statement of Financial Accounting Standards (“SFAS”) Nodtta 123R, Share Based Payment which requires that stock-based compensation be accounted for at fair value and expensed over the service period for financial reporting purposes |
| SFAS Nodtta 123R is effective for the Company beginning January 1, 2006 |
| Such stock option expensing will require the Company to value its employee stock option grants in accordance with a either the Black-Scholes formula or the binomial valuation formula, and then amortize that value against the Company’s reported earnings over the vesting period in effect for those options |
| The Company currently accounts for stock-based awards to employees in accordance with Accounting Principles Board (“APB”) Opinion Nodtta 25, Accounting for Stock Issued to Employees, and has adopted the disclosure-only alternative of SFAS Nodtta 123, Accounting for Stock-Based Compensation |
| When the Company begins to expense employee stock options, the stock-based compensation expense will be charged directly against the Company’s reported earnings |
| For an illustration of the effect of such a change on the Company’s recent results of operations, see Note 1(t) of Notes to Consolidated Financial Statements contained in this report |
| Acquisitions or other investments present many risks, and we may not realize the anticipated financial and strategic goals of any of our acquisitions or other investments |
| As part of our business strategy, we have pursued and expect to continue to pursue acquisitions and other strategic investments that will complement our existing services and leverage our existing capabilities |
| There is no guarantee that these activities will be profitable, or that we will continue to offset the decline in operating results of our Portamedic business through these types of activities |
| Any such acquisition or other investment involves a number of risks, including: • we may find that the acquired company or assets do not further our business strategy, or that we overpaid for the company or assets, or that economic conditions have changed, all of which may result in a future impairment charge; 19 ______________________________________________________________________ [44]Table of Contents • we may have difficulty integrating the operations (including IT systems) and personnel of an acquired business and may have difficulty retaining its customers and/or key personnel; • our ongoing business and management’s attention may be disrupted or diverted by transition or integration issues and the complexity of managing diverse locations; and • we may have difficulty maintaining uniform standards, controls, procedures and policies across locations |
| An ill-advised acquisition or other investment could hurt our business, results of operations and financial condition or cash flows, particularly in the case of a significant acquisition or multiple acquisitions in a short period of time |
| From time to time, we may enter into negotiations for acquisitions or other investments that are not ultimately consummated |
| Such negotiations could result in significant diversion of management’s time from our business as well as significant out-of-pocket costs |
| The consideration that we pay in connection with an acquisition or other investment could affect our financial condition |
| If we were to proceed with one or more significant acquisitions or other investments in which the consideration included cash, we could be required to use a substantial portion of our available cash to consummate such acquisitions |
| To the extent we issue shares of stock or other rights to purchase stock, including options or other rights, our then-existing shareholders may experience dilution in their share ownership in our company and their earnings per share may decrease |
| In addition, acquisitions or other investments may result in the incurrence of debt, large one-time write-offs and restructuring charges |
| They may also result in goodwill and other intangible assets that are subject to impairment tests, which could result in future impairment charges |