10-Q 1 form10q.htm form10q.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

x     Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2011

or

o     Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number: 1-12040

SUN HEALTHCARE GROUP, INC.
(Exact name of Registrant as specified in its charter)

Delaware
13-4230695
(State of Incorporation)
(I.R.S. Employer Identification No.)

18831 Von Karman, Suite 400
Irvine, CA  92612
(949) 255-7100
(Address, zip code and telephone number of Registrant)


Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  x   No  o

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer    o
Accelerated filer    x
   
Non-accelerated filer    o
Smaller reporting company    o
(Do not check if a smaller reporting company)
 

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 November 1, 2011, there were 25,146,378 shares of the Registrant’s $.01 par value Common Stock outstanding.


 
1

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

Index
   
Page
Numbers
PART I.  FINANCIAL INFORMATION
 
     
Item 1.
Financial Statements:
 
     
 
Consolidated Balance Sheets (unaudited)
3-4
 
As of September 30, 2011
 
 
As of December 31, 2010
 
     
 
Consolidated Income Statements (unaudited)
5-6
 
For the three months ended September 30, 2011 and 2010
 
 
For the nine months ended September 30, 2011 and 2010
 
     
 
Consolidated Statements of Cash Flows (unaudited)
7
 
For the three months ended September 30, 2011 and 2010
 
 
For the nine months ended September 30, 2011 and 2010
 
     
 
Notes to Consolidated Financial Statements (unaudited)
8-25
     
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
26-46
     
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
46
     
Item 4.
Controls and Procedures
47
     
Item 5.
Other Information
47
     
PART II.  OTHER INFORMATION
 
     
Item 1.
Legal Proceedings
47
     
Item 1A.
Risk Factors
47-48
     
Item 6.
Exhibits
48
     
Signature
 
48

References throughout this document to the Company, “we,” “our” and “us” refer to Sun Healthcare Group, Inc. and its direct and indirect consolidated subsidiaries and not any other person.

STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

Certain statements in this Quarterly Report on Form 10-Q (this “Form 10-Q”) contain “forward-looking” information as that term is defined by the Private Securities Litigation Reform Act of 1995 (the “Act”) and the federal securities laws.  Any statements that do not relate to historical or current facts or matters are forward-looking statements. Examples of forward-looking statements include all statements regarding our expected future financial position, results of operations, cash flows, liquidity, financing plans, business strategy, budgets, the impact of reductions in reimbursements and other changes in government reimbursement programs,  the scope, timing and effectiveness of our efforts to mitigate the impact on our business of the CMS Final Rule (described below), the outcome and costs of litigation, projected expenses and capital expenditures, growth opportunities, ability to refinance our indebtedness on favorable terms, plans and objectives of management for future operations, and compliance with and changes in governmental regulations.  You can identify some of the forward-looking statements by the use of forward-looking words such as “anticipate,” “believe,” “plan,” “estimate,” “expect,” “intend,” “should,” “may” and other similar expressions, although not all forward-looking statements contain these identifying words.
 
The forward-looking statements are based on the information currently available and are applicable only as of the date of this report. Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results in future periods to differ materially from those projected or contemplated in the forward-looking statements.  You are urged to carefully review the disclosures we make concerning risks and other factors that may affect our business and operating results, including those made in Item 1A of this Form 10-Q and in our other reports filed with the Securities and Exchange Commission, including our Annual Report on Form 10-K for the fiscal year ended December 31, 2010.  The forward-looking statements are qualified in their entirety by these cautionary statements, which are being made pursuant to the provisions of the Act and with the intention of obtaining the benefits of the “safe harbor” provisions of the Act.  We caution you that any forward-looking statements made in this Form 10-Q are not guarantees of future performance and that you should not place undue reliance on any of such forward-looking statements, which speak only as of the date of this document.  There may be additional risks of which we are presently unaware or that we currently deem immaterial.  We do not intend, and undertake no obligation, to update our forward-looking statements to reflect future events or circumstances.
_______________________

 
2

 

PART I.     FINANCIAL INFORMATION

ITEM 1.     FINANCIAL STATEMENTS

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (unaudited)

ASSETS
(in thousands)


   
September 30, 2011
   
December 31, 2010
 
             
Current assets:
           
Cash and cash equivalents
  $ 91,179     $ 81,163  
Restricted cash
    16,382       15,329  
Accounts receivable, net of allowance for doubtful accounts of $67,501
           
and $66,607 at September 30, 2011 and December 31, 2010, respectively
213,858       218,040  
Prepaid expenses and other assets
    26,380       16,859  
Deferred tax assets
    71,996       69,800  
                 
Total current assets
    419,795       401,191  
                 
Property and equipment, net
    145,611       139,860  
Intangible assets, net
    35,317       41,967  
Goodwill
    35,679       348,047  
Restricted cash, non-current
    352       350  
Deferred tax assets
    115,243       126,540  
Other assets
    45,606       23,803  
Total assets
  $ 797,603     $ 1,081,758  




See accompanying notes.


 
3

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (unaudited) (CONTINUED)

LIABILITIES AND STOCKHOLDERS’ EQUITY
(in thousands, except per share data)

   
September 30, 2011
   
December 31, 2010
 
             
Current liabilities:
           
Accounts payable
  $ 49,659     $ 49,993  
Accrued compensation and benefits
    49,328       61,518  
Accrued self-insurance obligations, current portion
    62,038       52,093  
Other accrued liabilities
    56,457       53,945  
Current portion of long-term debt and capital lease obligations
    11,033       11,050  
                 
Total current liabilities
    228,515       228,599  
                 
Accrued self-insurance obligations, net of current portion
    153,471       133,405  
Long-term debt and capital lease obligations, net of current portion
    131,548       144,930  
Unfavorable lease obligations, net
    7,771       9,815  
Other long-term liabilities
    52,394       52,566  
                 
Total liabilities
    573,699       569,315  
                 
Commitments and contingencies (Note 6)
               
                 
Stockholders' equity:
               
Preferred stock of $.01 par value, authorized 3,333
               
shares, zero shares issued and outstanding as of
               
September 30, 2011 and December 31, 2010
    -       -  
Common stock of $.01 par value, authorized  41,667
               
shares, 25,146 and 24,974 shares issued and outstanding
               
as of September 30, 2011 and December 31, 2010, respectively
    251       250  
Additional paid-in capital
    724,814       720,854  
Accumulated deficit
    (500,008 )     (208,661 )
Accumulated other comprehensive loss, net
    (1,153 )     -  
Total stockholders' equity
    223,904       512,443  
Total liabilities and stockholders' equity
  $ 797,603     $ 1,081,758  





See accompanying notes.

 
4

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)
(in thousands, except per share data)


   
For the
 
   
Three Months Ended
 
   
September 30, 2011
   
September 30, 2010
 
             
Total net revenues
  $ 485,850     $ 473,411  
Costs and expenses:
               
Operating salaries and benefits
    273,223       268,501  
Self-insurance for workers’ compensation and general and
               
professional liability insurance
    15,250       14,531  
Operating administrative expenses
    13,157       13,343  
Other operating costs
    100,636       97,333  
Center rent expense
    37,184       18,954  
General and administrative expenses
    14,825       14,146  
Depreciation and amortization
    8,295       12,639  
Provision for losses on accounts receivable
    4,916       5,098  
Interest, net of interest income of $103 and $59, respectively
    4,835       10,527  
Transaction costs
    -       4,747  
Loss on sale of assets, net
    809       -  
Restructuring costs
    2,426       -  
    Loss on asset impairment
    317,091       -  
Total costs and expenses
    792,647       459,819  
                 
(Loss) income before income taxes and discontinued operations
    (306,797 )     13,592  
    Income tax expense
    1,569       5,559  
(Loss) income from continuing operations
    (308,366 )     8,033  
                 
Discontinued operations:
               
Loss from discontinued operations, net of related taxes
    (359 )     (477 )
Loss on disposal of discontinued operations, net of related taxes
    (681 )     -  
Loss from discontinued operations, net
    (1,040 )     (477 )
                 
Net (loss) income
  $ (309,406 )   $ 7,556  
                 
                 
                 
Basic earnings per common and common equivalent share:
               
(Loss) income from continuing operations
  $ (11.77 )   $ 0.39  
Loss from discontinued operations, net
    (0.04 )     (0.02 )
Net (loss) income
  $ (11.81 )   $ 0.37  
                 
Diluted earnings per common and common equivalent share:
               
(Loss) income from continuing operations
  $ (11.77 )   $ 0.39  
Loss from discontinued operations, net
    (0.04 )     (0.02 )
Net (loss) income
  $ (11.81 )   $ 0.37  
                 
Weighted average number of common and common
               
equivalent shares outstanding:
               
Basic
    26,203       20,529  
Diluted
    26,203       20,550  


See accompanying notes.

 
5

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)
(in thousands, except per share data)


   
For the
 
   
Nine Months Ended
 
   
September 30, 2011
   
September 30, 2010
 
             
Total net revenues
  $ 1,457,421     $ 1,415,734  
Costs and expenses:
               
Operating salaries and benefits
    818,248       799,603  
Self-insurance for workers’ compensation and general and
               
professional liability insurance
    45,779       43,433  
Operating administrative expenses
    39,913       38,932  
Other operating costs
    298,213       289,079  
Center rent expense
    111,110       56,306  
General and administrative expenses
    45,156       44,570  
Depreciation and amortization
    23,636       37,449  
Provision for losses on accounts receivable
    14,960       15,811  
Interest, net of interest income of $244 and $222, respectively
    14,689       34,105  
Transaction costs
    -       6,995  
    Loss on sale of assets, net
    809       -  
Restructuring costs
    2,728       -  
    Loss on asset impairment
    317,091       -  
Total costs and expenses
    1,732,332       1,366,283  
                 
(Loss) income before income taxes and discontinued operations
    (274,911 )     49,451  
Income tax expense
    14,642       19,990  
(Loss) income from continuing operations
    (289,553 )     29,461  
                 
Discontinued operations:
               
Loss from discontinued operations, net of related taxes
    (1,113 )     (1,734 )
Loss on disposal of discontinued operations, net
    (681 )     -  
Loss from discontinued operations, net
    (1,794 )     (1,734 )
                 
Net (loss) income
  $ (291,347 )   $ 27,727  
                 
                 
                 
Basic earnings per common and common equivalent share:
               
(Loss) income from continuing operations
  $ (11.12 )   $ 1.69  
Loss from discontinued operations, net
    (0.07 )     (0.10 )
Net (loss) income
  $ (11.19 )   $ 1.59  
                 
Diluted earnings per common and common equivalent share:
               
Income from continuing operations
  $ (11.12 )   $ 1.68  
Loss from discontinued operations, net
    (0.07 )     (0.09 )
Net (loss) income
  $ (11.19 )   $ 1.59  
                 
Weighted average number of common and common
               
equivalent shares outstanding:
               
Basic
    26,038       17,418  
Diluted
    26,038       17,485  


See accompanying notes.

 
6

 

SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)
(in thousands)


   
For the
   
For the
 
   
Three Months Ended
   
Nine Months Ended
 
   
September 30, 2011
 
September 30, 2010
 
September 30, 2011
 
September 30, 2010
Cash flows from operating activities:
                       
Net (loss) income
  $ (309,406 )   $ 7,556     $ (291,347 )   $ 27,727  
Adjustments to reconcile net (loss) income to net cash provided by
                       
operating activities, including discontinued operations:
                               
Depreciation and amortization
    8,335       12,736       23,879       37,744  
Amortization of favorable and unfavorable lease intangibles
(492 )     (504 )     (1,466 )     (1,452 )
Provision for losses on accounts receivable
    4,975       5,289       15,479       16,428  
Loss on sale of assets, including discontinued operations, net
1,925       -       1,925       -  
Loss on asset impairment
    317,091       -       317,091       -  
Stock-based compensation expense
    2,359       1,661       5,160       4,748  
Deferred taxes
    (105 )     3,286       9,871       14,976  
Changes in operating assets and liabilities, net of acquisitions:
                   
Accounts receivable
    23       (1,307 )     (12,555 )     (12,500 )
Restricted cash
    52       2,769       (1,876 )     5,040  
Prepaid expenses and other assets
    (1,600 )     5,399       (1,410 )     8,012  
Accounts payable
    1,595       (4,909 )     (1,906 )     (3,628 )
Accrued compensation and benefits
    (11,717 )     (2,117 )     (12,298 )     1,945  
Accrued self-insurance obligations
    3,618       199       (294 )     5,041  
Income taxes payable
    -       1,267       -       1,605  
Other accrued liabilities
    2,104       4,429       1,158       4,442  
Other long-term liabilities
    (880 )     (676 )     (2,098 )     (5,775 )
Net cash provided by operating activities
    17,877       35,078       49,313       104,353  
                                 
Cash flows from investing activities:
                               
Capital expenditures
    (14,190 )     (13,774 )     (32,346 )     (41,488 )
Proceeds from sale of assets
    1,809       -       1,809       -  
Acquisitions, net of cash acquired
    -       -       (356 )     -  
Net cash used for investing activities
    (12,381 )     (13,774 )     (30,893 )     (41,488 )
                                 
Cash flows from financing activities:
                               
Borrowings of long-term debt
    -       20,500       -       20,500  
Principal repayments of long-term debt and capital lease
                               
obligations
    (2,806 )     (234,116 )     (8,404 )     (271,093 )
Payment to non-controlling interest
    -       -       -       (2,025 )
Distribution to non-controlling interest
    -       -       -       (69 )
    Net proceeds from issuance of common stock
    -       226,001       -       226,001  
    Deferred financing costs
    -       (2,312 )     -       (2,312 )
Net cash (used for) provided by financing activities
    (2,806 )     10,073       (8,404 )     (28,998 )
                                 
Net increase in cash and cash equivalents
    2,690       31,377       10,016       33,867  
Cash and cash equivalents at beginning of period
    88,489       106,973       81,163       104,483  
Cash and cash equivalents at end of period
  $ 91,179     $ 138,350     $ 91,179     $ 138,350  
                                 
 
 
See accompanying notes.

 
7

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
(UNAUDITED)

(1)  Nature of Business

References throughout this document to the Company include Sun Healthcare Group, Inc. and our consolidated subsidiaries. In accordance with the Securities and Exchange Commission’s “Plain English” guidelines, this report has been written in the first person. In this document, the words “we,” “our” and “us” refer to Sun Healthcare Group, Inc. and its direct and indirect consolidated subsidiaries and not any other person.

Business

Our subsidiaries provide long-term, post-acute and related specialty healthcare in the United States.  We operate through three principal business segments: (i) inpatient services, (ii) rehabilitation therapy services, and (iii) medical staffing services.  Inpatient services represent the most significant portion of our business.  We operated 199 healthcare centers in 25 states as of September 30, 2011.

Restructuring Costs

On July 29, 2011, the Centers for Medicare and Medicaid Services (“CMS”) released its final rule for skilled nursing facilities for the 2012 federal fiscal year, which became effective on October 1, 2011 (the “CMS Final Rule”).  After the application of the market basket increase of 2.7%, the productivity adjustment of -1.0% and the parity adjustment of -12.6%, the prospective net decrease in Medicare reimbursement rates is 11.1%.  Additionally, the CMS Final Rule changed group therapy reimbursement and introduced new change-of-therapy provisions as patients move through their post-acute stay that will further reduce our revenues from the Medicare program and/or increase our costs of providing such services.  As a result of the expected negative impact of the CMS Final Rule on our business, we commenced a broad-based mitigation initiative, which includes infrastructure cost reductions without affecting the quality of our patient care.  During our third quarter ended September 30, 2011, we incurred $2.4 million of restructuring costs in connection with our mitigation initiative, which consisted primarily of severance benefits resulting from reductions of staff.  We will continue to focus on reducing costs to further mitigate the impact on our business of the reduced Medicare reimbursement rates.

Other Information

The accompanying unaudited consolidated financial statements have been prepared in accordance with our customary accounting practices and accounting principles generally accepted in the United States (“GAAP”) for interim financial statements.  In our opinion, the accompanying interim consolidated financial statements are a fair statement of our financial position at September 30, 2011, and our consolidated results of operations and cash flows for the three-month and nine-month periods ended September 30, 2011 and 2010, respectively.  These statements are unaudited, and certain information and footnote disclosures normally included in our annual consolidated financial statements have been condensed or omitted, as permitted under the applicable rules and regulations of the Securities and Exchange Commission.  The accompanying unaudited consolidated financial statements reflect all adjustments, consisting of only normal recurring items.  Readers of these statements should refer to our audited consolidated financial statements and notes thereto for the year ended December 31, 2010, which are included in our Annual Report on Form 10-K for the year ended December 31, 2010 (the “2010 Form 10-K”).

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of significant contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates include determination of impairment for goodwill and other long-lived assets, third-party payor settlements, allowances for doubtful accounts, self-insurance obligations, loss accruals and income taxes. Actual results could differ from those estimates.

 
8

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

Recent Accounting Pronouncements

The Emerging Issues Task Force of the FASB issued an Accounting Standards Update in August 2010 regarding the balance sheet presentation of medical malpractice claims and similar contingent liabilities and related insurance recoveries.  The updated guidance requires the insurance recovery receivable to be presented as a gross asset instead of netting it against the related liability.  The updated presentation was effective for us on January 1, 2011, is reflected in the accompanying consolidated balance sheet and has resulted in the reclassification of anticipated insurance recoverables to assets as of January 1, 2011 of $2.1 million and $28.1 million for general and professional liabilities and workers’ compensation liabilities, respectively.  There was no impact on our accumulated deficit due to adoption of this new standard.  See the Insurance portion of Note 6 – “Commitments and Contingencies” for additional information.

The FASB issued an Accounting Standards Update in June 2011 regarding the presentation of comprehensive income within financial statements.  GAAP now requires that comprehensive income and its components of net income and other comprehensive income be presented in either (1) a single continuous statement of comprehensive income or (2) two separate but consecutive statements.  This new guidance will be effective for us beginning with our March 31, 2012 interim reporting with retrospective presentation.

The FASB issued an Accounting Standards Update in September 2011 regarding the testing of goodwill for impairment.  The update permits the assessment of qualitative factors, to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. This new guidance is effective for periods beginning after December 15, 2011.  Early adoption is permitted.

Reclassifications

Certain reclassifications have been made to the prior period financial statements to conform to the 2011 financial statement presentation.  We have reclassified the results of operations of the nurse practitioner services group and one skilled nursing center of our Inpatient Services segment (see Note 5 – “Discontinued Operations”) for all periods presented to discontinued operations within the income statement, in accordance with GAAP.

(2)  Asset Impairment

In addition to the annual testing requirements discussed in Note 6 – “Goodwill, Intangible Assets and Long-Lived Assets” of our 2010 Form 10-K, GAAP requires that goodwill, intangible assets and other long-lived assets be evaluated for potential impairment when a triggering event occurs during an interim time period.  As a result of the CMS Final Rule, the prospective net decrease in Medicare reimbursement rates is 11.1%, after the application of the market basket increase of 2.7%, the productivity adjustment of -1.0% and the parity adjustment of -12.6%.  Additionally, the CMS Final Rule changed group therapy reimbursement and introduced new change-of-therapy provisions as patients move through their post-acute stay that will further reduce our revenues from the Medicare program and/or increase our costs of providing such services.  We determined that the CMS Final Rule announcement constituted a triggering event for evaluating whether the recoverability of goodwill, intangible assets and other long-lived assets in the operating segments of our Inpatient Services reportable segment affected by the CMS Final Rule was impaired.

During the three months ended September 30, 2011, we recognized $317.1 million of non-cash loss on asset impairment for the healthcare facilities operating segments in our Inpatient Services reportable segment.  The non-cash charges consisted of $314.7 million of goodwill impairment and $2.4 million of asset impairment for intangible assets for favorable lease obligations.  The charges were determined in the following manner:

 
9

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

Finite-Lived Intangibles

Our finite-lived intangibles include tradenames and favorable lease obligations.

When evaluating the recoverability of tradenames, we considered projections of future profitability and undiscounted cash flows for the affected portions of the Inpatient Services operating segments as compared to the carrying value of the tradenames assets.  We determined that projected undiscounted cash flows were sufficient to recover the assets’ carrying value.  As a result, there was no impairment of tradenames during the three months ended September 30, 2011.

When evaluating the recoverability of favorable lease obligations, we considered projections of future profitability and undiscounted cash flows for the affected portions of the Inpatient Services operating segments as compared to the carrying value of the favorable lease obligation intangible assets.  We determined that projected undiscounted cash flows were not sufficient to recover the full carrying value of the assets and proceeded to determine a fair value of each asset.

We determined fair value based upon estimates of market rental values for the centers associated with the favorable lease intangibles using valuations techniques broadly accepted by the long-term care industry in which we operate.  We applied an industry average discount factor to the difference of this estimated market rental values to our contractually obligated lease payments over the remaining term of the leases, resulting in an appropriate estimate of fair value for the favorable lease intangible.  We determined that certain favorable lease obligations had fair values less than their carrying values and recognized the $2.4 million loss on asset impairment described above.

Indefinite-Lived Intangibles

Our indefinite-lived intangibles consist of certificates of need (“CON”) obtained through our acquisitions.  We evaluate the recoverability of our CON intangibles by comparing the assets' respective carrying value to estimates of fair value. We determine the estimated fair value of these intangible assets through an estimate of incremental cash flows with the intangible assets versus cash flows without the intangible assets in place coupled with estimates of market pricing to determine the highest and best use for purposes of determining fair value.  The resulting fair values exceeded the assets’ carrying value and thus no impairment was recognized.

Long-Lived Assets

GAAP requires impairment losses to be recognized for long-lived assets used in operations when indicators of impairment are present and the estimated undiscounted cash flows associated with these assets are not sufficient to recover the assets' carrying amounts.  In estimating the undiscounted projected cash flows for our impairment assessment, we primarily used our internally prepared projections and forecast information, including adjustments for the estimated impact of the CMS Final Rule.  We determined that undiscounted projected cash flows were sufficient to ensure recoverability of our long-lived assets.

Goodwill

GAAP requires that impairment be assessed for reporting units of the affected operating segments.  A reporting unit is a business for which discrete financial information is produced and reviewed by operating segment management and provides services that are distinct from the other components of the operating segment.  For our Inpatient Services reportable segment, the reporting units for our annual goodwill impairment analysis were determined to be at the operating segment level, which were the divisional operating levels.  The divisional operating levels of the Inpatient Services reportable segment include the northeast, southeast, central and west geographic divisions of SunBridge Healthcare Corporation (“SunBridge”) as well as the SolAmor Hospice Corporation (“SolAmor”) division and the Americare nutritional supplement division.
 
We determine potential impairment by comparing the net assets of each reporting unit to their respective fair values, which GAAP describes as Step 1 of goodwill impairment testing. We determine the estimated fair value of each reporting
 
10

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

unit using a discounted projected cash flow analysis and other appropriate valuation methodologies.  In the event a unit's net assets exceed its fair value, an implied fair value of goodwill must be determined by assigning the unit's fair value to each asset and liability of the unit, which is referred to in GAAP as Step 2 of the impairment analysis. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill.  An impairment loss is measured by the difference between the goodwill’s carrying value and its implied fair value.

In estimating the projected cash flows for our impairment assessment, we primarily used our internally prepared projections and forecast information including adjustments for the estimated impact of the CMS Final Rule.  Other factors in the cash flow projections include anticipated funding from other payor sources such as Medicaid funding plus our plans to manage overhead costs, capital expenditures and patient care liability costs.

The discounted cash flow model utilizes five years of projected cash flows for each reporting unit. The projected financial results are created from critical assumptions and estimates based upon management’s business plan and historical trends while giving consideration to the overall economic environment. Determining fair value requires the exercise of significant judgments about appropriate discount rates, business growth rates, the amount and timing of expected future cash flows and market information relevant to our overall company value. In addition, to validate the reasonableness of our assumptions, we utilized our discounted cash flow model on a consolidated basis and compared the estimated fair value to our market capitalization as of September 30, 2011.  Key assumptions in the discounted cash flow model are as follows:

Business Growth Assumptions – In determining our projected Inpatient Services revenue growth rates for our discounted cash flow model, we focus on the two primary drivers: average daily census (“ADC”) and reimbursement rates, particularly those rates impacted by the CMS Final Rule. Key revenue inputs include historical ADC adjusted for known trends and current Medicare and Medicaid rates adjusted for anticipated changes. ADC trends have been reasonably constant within a narrow range and may be influenced over the long run by a number of factors, including demographic changes in the population we serve and our ability to deliver quality service in an attractive environment. Generally long term care reimbursement rates are set annually by the payor. To estimate these rates, we evaluate the current reimbursement climate and adjust historical trends where appropriate. Significant adverse rate changes in any one year would cause us to reevaluate our projected rates.  In recent years we have generated historical revenue growth of 1.4% to 6.2% annually.  Expenses generally vary with ADC and have historically grown by approximately 2.9% to 5.6% annually.  Labor is the largest component of our expenses.  We consider labor market trends and staffing needs for the projected ADC levels in determining labor growth rates to be used in our projections. The projected growth rates used in our discounted cash flow model took into account the potential adverse effects of the current economic downturn on our projected revenue and expenses.

Terminal Value EBITDAR Multiple – Consistent with commonly accepted valuation techniques, a terminal multiple for the final year’s projected results is applied to estimate our value in the final year of the analysis. That multiple is applied to the final year’s projected EBITDAR from continuing operations.

Discount Rate – Market conditions indicated that a discount rate of 10.5% was appropriate at September 30, 2011.  This discount rate is consistent with our overall market capitalization comparison. We consistently apply the same discount rate to the evaluation of each reporting unit.

The goodwill impairment analysis is subject to impact from uncertainties arising from such events as changes in economic or competitive conditions, the current general economic environment, material changes in Medicare and Medicaid reimbursement that could positively or negatively impact anticipated future operating conditions and cash flows, and the impact of strategic decisions.  The results of our interim 2011 impairment analysis showed that goodwill in each of reporting units tested was impaired.  Based on the analysis performed, we recognized a loss on impairment of $314.7 million for the three months ended September 30, 2011, which represents the full carrying value of goodwill for the SunBridge divisional operating segments of our Inpatient Services reportable segment.  The SolAmor division’s prospective Medicare reimbursement rates were not impacted by the CMS Final Rule and thus no interim 2011 impairment event arose for SolAmor and Americare.

 
11

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

(3)  Long-Term Debt and Capital Lease Obligations

Long-term debt and capital lease obligations consisted of the following as of the periods indicated (in thousands):

   
September 30, 2011
   
December 31, 2010
 
             
Revolving loans
  $ -     $ -  
Mortgage notes payable due monthly through 2014, interest at
               
a rate of 8.5%, collateralized by real property with
               
carrying values totaling $1.8 million
    2,260       7,979  
Term loans
    139,922       147,492  
Capital leases
    399       509  
Total long-term obligations
    142,581       155,980  
Less amounts due within one year
    (11,033 )     (11,050 )
Long-term obligations, net of current portion
  $ 131,548     $ 144,930  

The scheduled or expected maturities of long-term obligations as of September 30, 2011, were as follows (in thousands):

For the twelve months ending September 30:
 
       
2012
  $ 11,033  
   2013
    10,947  
   2014
    10,679  
   2015
    10,000  
   2016
    10,000  
Thereafter
    89,922  
    $ 142,581  


We manage interest expense using a mix of fixed and variable rate debt, and, to help manage borrowing costs, we may enter into interest rate swap agreements. Under these arrangements, we agree to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to an agreed-upon notional principal amount.   We also may enter into interest rate cap agreements that effectively limit the maximum interest rate that we pay on an agreed to notional principal amount.  We use interest rate hedges to manage interest rate risk related to borrowings.  Our intent is to only enter into such arrangements that qualify for hedge accounting treatment in accordance with GAAP.  Accordingly, we designate all such arrangements as cash-flow hedges and perform initial and quarterly effectiveness testing using the hypothetical derivative method.  To the extent that such arrangements are effective hedges, changes in fair value are recognized through other comprehensive income.  Ineffectiveness, if any, would be recognized in earnings.

Our credit agreement requires that at least 50% of our term loans be subject to at least a three-year hedging agreement. To satisfy this requirement, we executed two hedging instruments on January 18, 2011; a two-year interest rate cap and a two-year “forward starting” interest rate swap.  The two-year interest rate cap limits our exposure to increases in interest rates for $82.5 million of debt through December 31, 2012.  This cap is effective when LIBOR rises above 1.75%, effectively fixing the interest rate on $82.5 million of our term loans at 7.5% for two years.  The fee for this interest rate cap arrangement was $0.3 million, which will be amortized to interest expense over the life of the arrangement.  The two-year “forward starting” interest rate swap effectively converts the interest rate on $82.5 million of our term loans to a fixed rate from January 1, 2013 through December 31, 2014.  LIBOR is fixed at 3.185%, making the all-in rate effectively a fixed 8.935% for this portion of the term loans.  There was no fee for this swap agreement.  Both arrangements qualify for hedge accounting treatment.
 
12

 
 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

The fair values of our hedging agreements as presented in the consolidated balance sheets are as follows (in thousands):

   
Derivatives
   
September 30, 2011
 
December 31, 2010
   
Balance Sheet
       
Balance Sheet
       
   
Location
   
Fair Value
 
Location
   
Fair Value
 
Derivatives designated as
                     
hedging instruments:
                     
Interest rate hedging
 
Other Long-Term
                 
agreements
 
Liabilities
 
$
1,922
 
N/A
 
$
-
 

The effect of the interest rate swap agreements on our consolidated comprehensive income, net of related taxes, for the three months ended September 30 is as follows (in thousands):

         
Gain Reclassified from Accumulated
 
   
Amount of (Loss)/Gain in
   
Other Comprehensive Income
 
   
Other Comprehensive (Loss)/Income
   
to Income (ineffective portion)
 
   
2011
   
2010
   
2011
   
2010
 
Derivatives designated as cash
                       
flow hedges:
                       
Interest rate hedging agreements
$
(535
)
$
1,020
 
$
-
 
$
-
 

The effect of the interest rate hedging agreements on our consolidated comprehensive income, net of related taxes, for the nine months ended September 30 is as follows (in thousands):

         
Gain Reclassified from Accumulated
 
   
Amount of (Loss)/Gain in
   
Other Comprehensive Income
 
   
Other Comprehensive (Loss)/Income
   
to Income (ineffective portion)
 
   
2011
   
2010
   
2011
   
2010
 
Derivatives designated as cash
                       
flow hedges:
                       
Interest rate hedging agreements
$
(1,153
)
$
3,029
 
$
-
 
$
-
 

The amounts stated above for (loss)/gain from changes in the fair value of our hedging agreements are our only sources of other comprehensive (loss)/income, resulting in comprehensive income of $4.6 million and $22.1 million for the three and nine months ended September 30, 2011, respectively.  Comprehensive income for the three and nine months ended September 30, 2010 was $8.6 million and $30.8 million, respectively.
 
 
13

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)
(4)  Fair Value of Financial Instruments

The estimated fair values of our financial instruments were as follows (in thousands):

   
September 30, 2011
   
December 31, 2010
 
   
Carrying
         
Carrying
       
   
Amount
   
Fair Value
   
Amount
   
Fair Value
 
                         
Cash and cash equivalents
  $ 91,179     $ 91,179     $ 81,163     $ 81,163  
Restricted cash
  $ 16,734     $ 16,734     $ 15,679     $ 15,679  
Long-term debt and capital lease obligations,
                               
including current portion
  $ 142,581     $ 110,972     $ 155,980     $ 156,084  
Interest rate hedging agreements
  $ 1,922     $ 1,922     $ -     $ -  

The cash and cash equivalents and restricted cash carrying amounts approximate fair value because of the short maturity of these instruments. At September 30, 2011 and December 31, 2010, the fair value of our long-term debt, including current maturities, and our interest rate hedging agreements was based on estimates using present value techniques that are significantly affected by the assumptions used concerning the amount and timing of estimated future cash flows and discount rates that reflect varying degrees of risk.

GAAP establishes a hierarchy for ranking the quality and reliability of the information used to determine fair values.  The applicable guidance requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:

Level 1:
Unadjusted quoted market prices in active markets for identical assets or liabilities.
   
Level 2:
Unadjusted quoted prices in active markets for similar assets or liabilities, unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.
   
Level 3:
Unobservable inputs for the asset or liability.

We endeavor to utilize the best available information in measuring fair value.  The following tables summarize the valuation of our financial instruments by the above pricing levels as of September 30, 2011 and December 31, 2010, respectively (in thousands):

   
September 30, 2011
 
       
Unadjusted Quoted
 
Significant Other
 
       
Market Prices
 
Observable Inputs
 
   
Total
 
(Level 1)
 
(Level 2)
 
               
Interest rate hedging agreements – liability
$
1,922
$
-
$
1,922
 

   
December 31, 2010
 
       
Unadjusted Quoted
 
Significant Other
 
       
Market Prices
 
Observable Inputs
 
   
Total
 
(Level 1)
 
(Level 2)
 
               
Restricted cash – money market funds
$
1,465
$
1,465
$
-
 

We currently have no other financial instruments subject to fair value measurement on a recurring basis.
 
14

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)
(5) Discontinued Operations

The results of operations of assets to be disposed of, disposed assets and the losses related to these divestitures have been classified as discontinued operations for all periods presented in the accompanying consolidated income statements as their operations and cash flows have been (or will be) eliminated from our ongoing operations and we will not have any significant continuing involvement in their operations after their disposal.

During the nine months ended September 30, 2011, we disposed of a Maryland skilled nursing center in our Inpatient Services segment, whose results have been reclassified to discontinued operations for all periods presented in accordance with GAAP.  The disposition, which was effective on August 1, 2011, resulted in cash proceeds to us of $1.8 million, net of the payoff of the $5.2 million mortgage payable for the center.  During August 2011, we also divested two hospice operations in Oklahoma for a nominal price plus the assumption of certain liabilities by the buyer. The disposition resulted in a net loss of $0.7 million, net of related tax benefit.

A summary of the discontinued operations for the periods presented is as follows (in thousands):

   
For the Three Months Ended
 
   
September 30, 2011
   
September 30, 2010
 
   
Inpatient
               
Inpatient
             
   
Services
   
Other
   
Total
   
Services
   
Other
   
Total
 
                                     
Net operating revenues
$
823
 
$
-
 
$
823
 
$
2,865
 
$
-
 
$
2,865
 
                                     
Loss from discontinued operations, net (1)
$
(1,029
)
$
(11
)
$
(1,040
)
$
(468
)
$
(9
)
$
(477
)
   
(1)
Net of related tax benefit of $679 and $307, respectively


   
For the Nine Months Ended
 
   
September 30, 2011
   
September 30, 2010
 
   
Inpatient
               
Inpatient
             
   
Services
   
Other
   
Total
   
Services
   
Other
   
Total
 
                                     
Net operating revenues
$
5,813
 
$
-
 
$
5,813
 
$
8,442
 
$
-
 
$
8,442
 
                                     
Loss from discontinued operations, net (1)
$
(1,764
)
$
(30
)
$
(1,794
)
$
(1,674
)
$
(60
)
$
(1,734
)
   
(1)
Net of related tax benefit of $1,203 and $721, respectively


 
15

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

(6)  Commitments and Contingencies

(a) Insurance

We self-insure for certain insurable risks, including general and professional liabilities, workers' compensation liabilities and employee health insurance liabilities, through the use of self-insurance or retrospective and self-funded insurance policies and other hybrid policies, which vary by the states in which we operate. There is a risk that amounts funded to our self-insurance programs may not be sufficient to respond to all claims asserted under those programs. Insurance reserves represent estimates of future claims payments.  This liability includes an estimate of the development of reported losses and losses incurred but not reported.  Provisions for changes in insurance reserves are made in the period of the related coverage.  An independent actuarial analysis is prepared twice a year to assist management in determining the adequacy of the self-insurance obligations booked as liabilities in our financial statements.  The methods of making such estimates and establishing the resulting reserves are reviewed periodically and are based on historical paid claims information and nationwide nursing home trends. Any adjustments resulting from such reviews are reflected in current earnings. Claims are paid over varying periods, and future payments may be different than the estimated reserves.

We evaluate the adequacy of our self-insurance reserves on a quarterly basis and perform detailed actuarial analyses semi-annually in the second and fourth quarters. The analyses use generally accepted actuarial methods in evaluating the workers’ compensation reserves and general and professional liability reserves.  For both the workers’ compensation reserves and the general and professional liability reserves, those methods include reported and paid loss development methods, expected loss method and the reported and paid Bornhuetter-Ferguson methods.  Reported loss methods focus on development of case reserves for incurred losses through claims closure.  Paid loss methods focus on development of claims actually paid to date.  Expected loss methods are based upon an anticipated loss per unit of measure.  The Bornhuetter-Ferguson method is a combination of loss development methods and expected methods.

The foundation for most of these methods is our actual historical reported and/or paid loss data, over which we have effective internal controls.  We utilize third-party administrators (“TPAs”) to process claims and to provide us with the data utilized in our semi-annual actuarial analyses.  The TPAs are under the oversight of our in-house risk management and legal functions.  The purpose of these functions is to properly administer the claims so that the historical data is reliable for estimation purposes.  Case reserves, which are approved by our legal and risk management departments, are determined based on our estimate of the ultimate settlement of individual claims.  In instances where our historical data are not statistically credible, stable, or mature, we supplement our experience with skilled nursing industry benchmark reporting and payment patterns.

The use of multiple methods tends to eliminate any biases that one particular method might have.  Management’s judgment based upon each method’s inherent limitation is applied when weighting the results of each method.  The results of each of the methods are estimates of ultimate losses which include the case reserves plus an estimate for future development of these reserves based on past trends, and an estimate for losses incurred but not reported. These results are compared by accident year, and an estimated unpaid loss and allocated loss adjustment expense is determined for the open accident years based on judgment reflecting the range of estimates produced by the methods.
 
16

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)
 
Activity in our professional liability and workers’ compensation self-insurance reserves as of and for the periods ended September 30, 2011 and 2010 is as follows (in thousands):

   
Professional
   
Workers’
       
   
Liability
   
Compensation
   
Total
 
                   
Balance as of January 1, 2010
$
94,930
 
$
67,506
 
$
162,436
 
Current year provision, continuing operations
 
7,341
   
7,100
   
14,441
 
Current year provision, discontinued operations
 
43
   
54
   
97
 
Claims paid, continuing operations
 
(4,219
)
 
(4,555
)
 
(8,774
)
Claims paid, discontinued operations
 
(563
)
 
(633
)
 
(1,196
)
Amounts paid for administrative services and other
 
(850
)
 
(1,696
)
 
(2,546
)
Balance as of March 31, 2010
$
96,682
 
$
67,776
 
$
164,458
 
                   
Current year provision, continuing operations
 
7,339
   
7,122
   
14,461
 
Current year provision, discontinued operations
 
43
   
54
   
97
 
Claims paid, continuing operations
 
(3,605
)
 
(3,906
)
 
(7,511
)
Claims paid, discontinued operations
 
(1,552
)
 
(690
)
 
(2,242
)
Amounts paid for administrative services and other
 
(724
)
 
(1,620
)
 
(2,344
)
Balance as of June 30, 2010
$
98,183
 
$
68,736
 
$
166,919
 
                   
Current year provision, continuing operations
 
7,128
   
7,403
   
14,531
 
Current year provision, discontinued operations
 
43
   
54
   
97
 
Claims paid, continuing operations
 
(5,533
)
 
(5,376
)
 
(10,909
)
Claims paid, discontinued operations
 
(378
)
 
(438
)
 
(816
)
Amounts paid for administrative services and other
 
(489
)
 
(1,585
)
 
(2,074
)
Balance as of September 30, 2010
$
98,954
 
$
68,794
 
$
167,748
 
                   

 
17

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)
 
   
For the Three Months Ended
   
For the Nine Months Ended
 
   
September 30, 2011
   
September 30, 2011
 
   
Professional
   
Workers’
         
Professional
   
Workers’
       
   
Liability
   
Compensation
   
Total
   
Liability
   
Compensation
   
Total
 
                                     
Gross balance, beginning of period
$
109,315
 
$
96,186
 
$
205,501
 
$
113,971
 
$
96,585
 
$
210,556
 
Less: anticipated insurance recoveries
(2,273
)
 
(26,150
)
 
(28,423
)
 
(2,100
)
 
(28,100
)
 
(30,200
)
Net balance, beginning of period
$
107,042
 
$
70,036
 
$
177,078
 
$
111,871
 
$
68,485
 
$
180,356
 
                                     
Current year provision, continuing
                                   
operations
 
8,056
   
7,194
   
15,250
   
24,189
   
21,590
   
45,779
 
Current year provision, discontinued
                                   
operations
 
90
   
75
   
165
   
255
   
222
   
477
 
Claims paid, continuing operations
 
(6,959
)
 
(3,944
)
 
(10,903
)
 
(25,890
)
 
(12,817
)
 
(38,707
)
Claims paid, discontinued operations
 
(27
)
 
(281
)
 
(308
)
 
(614
)
 
(986
)
 
(1,600
)
Amounts paid for administrative
                                   
services and other
 
(790
)
 
(1,717
)
 
(2,507
)
 
(2,399
)
 
(5,131
)
 
(7,530
)
                                     
Net balance, end of period
$
107,412
 
$
71,363
 
$
178,775
 
$
107,412
 
$
71,363
 
$
178,775
 
Plus: anticipated insurance recoveries
2,273
   
26,150
   
28,423
   
2,273
   
26,150
   
28,423
 
Gross balance, end of period
$
109,685
 
$
97,513
 
$
207,198
 
$
109,685
 
$
97,513
 
$
207,198
 
 
    The anticipated insurance recoveries relate primarily to our workers’ compensation programs associated with policy years 1996 through 2001 where the claim losses have exceeded the policies' aggregate retention limits. Obligations above these retention limits are covered by our excess insurance carriers, which all have carrier ratings of at least “A,” “XIV” or better.

 
18

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

 
A summary of the assets and liabilities related to insurance risks at September 30, 2011 and December 31, 2010 is as indicated below (in thousands):

   
September 30, 2011
     
December 31, 2010
 
   
Professional
   
Workers’
       
|
 
Professional
   
Workers’
       
   
Liability
   
Compensation
   
Total
 
|
 
Liability
   
Compensation
   
Total
 
Assets:
                 
|
                 
Restricted cash (1)
             
|
                 
Current
$
6,232
 
$
10,056
 
$
16,288
 
|
$
3,659
 
$
10,864
 
$
14,523
 
Non-current
 
-
   
-
   
-
 
|
 
-
   
-
   
-
 
 
$
6,232
 
$
10,056
 
$
16,288
 
|
$
3,659
 
$
10,864
 
$
14,523
 
                   
|
                 
Anticipated insurance recoveries (2)
       
|
                 
Current
$
573
 
$
3,750
 
$
4,323
 
|
$
-
 
$
-
 
$
-
 
Non-current
 
1,700
   
22,400
   
24,100
 
|
 
-
   
-
   
-
 
 
$
2,273
 
$
26,150
 
$
28,423
 
|
$
-
 
$
-
 
$
-
 
                                       
Total Assets
$
8,505
 
$
36,206
 
$
44,711
 
|
$
3,659
 
$
10,864
 
$
14,523
 
                                       
Liabilities (3)(4):
             
|
                 
Self-insurance liabilities
             
|
                 
Current
$
30,763
 
$
22,964
 
$
53,727
 
|
$
25,942
 
$
21,009
 
$
46,951
 
Non-current
 
78,922
   
74,549
   
153,471
 
|
 
85,929
   
47,476
   
133,405
 
Total Liabilities
$
109,685
 
$
97,513
 
$
207,198
 
|
$
111,871
 
$
68,485
 
$
180,356
 
 
(1)
 
Total restricted cash includes cash collateral deposits and other cash held by third parties.  Total restricted cash above excludes $446 and $1,156 at September 30, 2011 and December 31, 2010, respectively, held for bank collateral, various mortgages, bond payments and capital expenditures on HUD insured buildings.
     
(2)
 
Anticipated insurance recovery assets are presented as Other Assets (both current and long-term) in our September 30, 2011 consolidated balance sheet.  See the Recent Accounting Pronouncements discussed in Note 1- “Nature of Business” for additional information.
     
(3)
 
Total self-insurance liabilities above exclude $8,311 and $5,142 at September 30, 2011 and December 31, 2010, respectively, related to our employee health insurance liabilities.
     
(4)
 
Total self-insurance liabilities for workers’ compensation claims are collateralized, in addition to the restricted cash, by letters of credit of $58,077 as of September 30, 2011 and $59,066 as of December 31, 2010.

(b)  Litigation

We are a party to various legal actions and administrative proceedings and are subject to various claims arising in the ordinary course of our business, including claims that our services have resulted in injury or death to the residents of our centers and claims relating to employment and commercial matters.  The ability to predict the ultimate outcome of such matters involves judgments, estimates and inherent uncertainties.  Although we intend to vigorously defend ourselves in these matters, there can be no assurance that the outcomes of these matters will not have a material adverse effect on our results of operations, financial condition or cash flows.

We operate in industries that are extensively regulated. As such, in the ordinary course of business, we are continuously subject to state and federal regulatory scrutiny, supervision and control. Such regulatory scrutiny often includes inquiries, investigations, examinations, audits, site visits and surveys, some of which are non-routine. In addition to being subject to direct regulatory oversight of state and federal regulatory agencies, the industries in which we operate are frequently subject to the regulatory supervision of fiscal intermediaries. If a provider is found to have engaged in improper practices, it could be subject to civil, administrative or criminal fines, penalties or restitutionary relief; and reimbursement authorities could also seek the suspension or exclusion of the provider or individual from participation in their program. We believe that there

 
19

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)
 
has been, and will continue to be, an increase in governmental investigations of long-term care providers, particularly in the area of Medicare/Medicaid false claims, as well as an increase in enforcement actions resulting from these investigations. Adverse determinations in legal proceedings or governmental investigations, whether currently asserted or arising in the future, could have a material adverse effect on our financial position, results of operations or cash flows.

In September 2010, a lawsuit was filed in the Superior Court of California, County of Los Angeles, by a former employee of a subsidiary of our medical staffing company, alleging violation of various wage and hour provisions of the California Labor Code. We deny all of the allegations in the employee’s complaint.  The lawsuit, which was filed as a purported class action on behalf of the former employee and all those similarly situated, has been settled. The terms of the settlement are confidential pending court approval. We believe our reserves are adequate for this matter.

In November 2010, a jury verdict was rendered in a Kentucky state court against us for $2.75 million in compensatory damages and $40 million in punitive damages. On February 25, 2011, the trial court judge reduced the punitive damage award to $24.75 million.  The case involves claims for professional negligence resulting in wrongful death.  We disagree with the jury’s verdict and believe that it is not supported by the facts of the case or applicable law.  We have appealed this judgment to the Kentucky Court of Appeals.  We believe our reserves are adequate for this matter.

(c)  Other Inquiries

From time to time, fiscal intermediaries and Medicaid agencies examine cost reports filed by predecessor operators of our skilled nursing centers. If, as a result of any such examination, it is concluded that overpayments to a predecessor operator were made, we, as the current operator of such centers, may be held financially responsible for such overpayments. At this time, we are unable to predict the outcome of any existing or future examinations.

(7)  Income Taxes

       The provision for income taxes totaled $1.6 million and $14.6 million for the three and nine months ended September 30, 2011, respectively. The loss on asset impairment was substantially nondeductible for tax purposes, thereby significantly impacting the income tax expense shown on the accompanying statements of operations relative to the pre-tax loss for the three and nine months ended September 30, 2011.  Excluding the impact of the $317.1 million loss on asset impairment (see Note 2 – “Asset Impairment”) and its related $1.8 million income tax benefit, the effective tax rates would have been 33% and 39% for the three and nine months ended September 30, 2011, respectively. The provision for income taxes of $5.6 million and $20.0 million for the three and nine months ended September 30, 2010 resulted in effective tax rates of approximately 41% and 40%, respectively.

The realization of our deferred tax assets is dependent upon generation of taxable income during periods in which deductions and/or credits can be utilized.  As a result, we consider the level of historical taxable income, historical non-recurring credits and charges, the scheduled reversal of deferred tax liabilities, tax-planning strategies and projected future taxable income in determining the amount of the valuation allowance.  The valuation allowance of $18.1 million at September 30, 2011 and December 31, 2010 relates primarily to state net operating loss (“NOL”) carryforwards and other deferred tax assets for which realization is uncertain.

After consideration of the November 2010 restructuring of our former parent company, which, among other matters resulted in Sabra Health Care REIT, Inc. holding substantially all of our former parent’s owned real property, and utilization of NOL carryforwards through 2010, the Internal Revenue Code (“IRC”) Section 382 annual base limitation to be applied to our tax attribute carryforwards is approximately $7.4 million. Accordingly, our NOL, capital loss, and tax credit carryforwards have been reduced to take into account this limitation and the respective carryforward periods for these tax attributes.  As a result of unused IRC Section 382 limitations from prior years and post-ownership change NOLs, we estimate there is approximately $65.1 million of NOLs which can be used to offset U.S. taxable income in 2011.  Considering annual IRC Section 382 limitations and built-in gains, we estimate a total of approximately $170.8 million of utilizable NOL carryforwards to offset taxable income in 2011 and future years.

 
20

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

 
(8)  Segment Information

We operate predominantly in the long-term care segment of the healthcare industry. We are a provider of long-term, sub-acute and related ancillary care services to nursing home patients.  Our reportable segments are composed of operating segments, which are aggregated, comprising strategic business units that provide different products and services. They are managed separately because each business has different marketing strategies due to differences in types of customers, distribution channels and capital resource needs.  More complete descriptions and accounting policies of the segments are described in Note 13 – “Segment Information” and  Note 2 – “Summary of Significant Accounting Policies” of our 2010 Form 10-K.  The following tables summarize, for the periods indicated, operating results and other financial information, by business segment (in thousands):

As of and for the
                                   
Three Months Ended
                                   
September 30, 2011
                                   
         
Rehabilitation
   
Medical
                   
   
Inpatient
   
Therapy
   
Staffing
         
Intersegment
       
   
Services
   
Services
   
Services
   
Corporate
   
Eliminations
   
Consolidated
 
                                     
Revenues from external customers
$
435,271
 
$
29,568
 
$
20,996
 
$
15
 
$
-
 
$
485,850
 
                                     
Intersegment revenues
 
-
   
32,791
   
757
   
-
   
(33,548
)
 
-
 
                                     
Total net revenues
 
435,271
   
62,359
   
21,753
   
15
   
(33,548
)
 
485,850
 
                                     
Operating salaries and benefits
 
202,694
   
54,298
   
16,231
   
-
   
-
   
273,223
 
                                     
Self-insurance for workers’
                                   
compensation and general and
                                   
professional liability insurance
 
14,206
   
633
   
344
   
67
   
-
   
15,250
 
                                     
Other operating costs
 
128,821
   
2,374
   
2,989
   
-
   
(33,548
)
 
100,636
 
                                     
General and administrative expenses(1)
 
10,308
   
2,309
   
540
   
14,825
   
-
   
27,982
 
                                     
Provision for losses on
                                   
accounts receivable
 
4,772
   
73
   
71
   
-
   
-
   
4,916
 
                                     
Segment operating income (loss)
$
74,470
 
$
2,672
 
$
1,578
 
$
(14,877
)
$
-
 
$
63,843
 
                                     
Center rent expense
 
36,874
   
140
   
170
   
-
   
-
   
37,184
 
                                     
Depreciation and amortization
 
6,902
   
236
   
187
   
970
   
-
   
8,295
 
                                     
Interest, net
 
(32
)
 
-
   
-
   
4,867
   
-
   
4,835
 
                                     
Net segment income (loss)
$
30,726
 
$
2,296
 
$
1,221
 
$
(20,714
)
$
-
 
$
13,529
 
                                     
Identifiable segment assets
$
395,840
 
$
16,254
 
$
20,039
 
$
343,550
 
$
20,881
 
$
796,564
 
                                     
Goodwill
$
31,071
 
$
75
 
$
4,533
 
$
-
 
$
-
 
$
35,679
 
                                     
Segment capital expenditures
$
12,934
 
$
149
 
$
63
 
$
1,044
 
$
-
 
$
14,190
 
______________________________________
 
(1) General and administrative expenses include operating administrative expenses.
 
The term “segment operating income (loss)” is defined as earnings before center rent expense, depreciation and amortization, interest, transaction costs, restructuring costs, loss on asset impairment, income tax expense and discontinued operations.
 
The term “net segment income (loss)” is defined as earnings before transaction costs, restructuring costs, loss on asset impairment, income tax expense and discontinued operations.

 
21

 
SUN HEALTHCARE GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(UNAUDITED)

 
As of and for the
                                   
Three Months Ended
                                   
September 30, 2010
                                   
         
Rehabilitation
   
Medical
                   
   
Inpatient
   
Therapy
   
Staffing
         
Intersegment
       
   
Services
   
Services
   
Services
   
Corporate
   
Eliminations
   
Consolidated
 
                                     
Revenues from external customers
$
421,573
 
$
30,343
 
$
21,481
 
$
14
 
$
-
 
$
473,411
 
                                     
Intersegment revenues
 
-
   
21,397
   
724
   
-
   
(22,121
)
 
-
 
                                     
Total net revenues
 
421,573
   
51,740
   
22,205
   
14
   
(22,121
)
 
473,411
 
                                     
Operating salaries and benefits
 
209,375
   
42,860
   
16,266
   
-
   
-
   
268,501
 
                                     
Self-insurance for workers’
                                   
compensation and general and
                                   
professional liability insurance
 
13,712
   
435
   
323
   
61
   
-
   
14,531
 
                                     
Other operating costs
 
114,253
   
1,952
   
3,249
   
-
   
(22,121
)
 
97,333
 
                                     
General and administrative expenses(1)
 
10,778
   
1,939
   
627
   
18,892
   
-
   
 32,236
 
                                     
Provision for losses on
                                   
accounts receivable
 
4,639
   
297
   
162
   
-
   
-
   
5,098
 
                                     
Segment operating income (loss)
$
68,816
 
$
4,257
 
$
1,578
 
$
(18,939
)
$
-
 
$
55,712
 
                                     
Center rent expense
 
18,629
   
123
   
202
   
-
   
-
   
18,954
 
                                     
Depreciation and amortization
 
11,536
   
173
   
181
   
749
   
-
   
12,639
 
                                     
Interest, net
 
2,483
   
-
   
-
   
8,044
   
-
   
10,527
 
                                     
Net segment income (loss)
$
36,168
 
$
3,961
 
$
1,195
 
$
(27,732
)
$
-
 
$
13,592
 
                                     
Identifiable segment assets
$
1,174,539
 
$
15,047
 
$
20,631
 
$
329,881
 
$
20,867
 
$
1,560,965
 
                                     
Goodwill
$
332,140
 
$
75
 
$