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.

Activity in our professional liability and workers’ compensation self-insurance reserves as of and for the periods ended June 30, 2012 and 2011 is as follows (in thousands):



	For the Three Months Ended June 30, 2012									For the Six Months Ended June 30, 2012
	Professional Liability			Workers’ Compensation			Total			Professional Liability			Workers’ Compensation			Total
Gross balance, beginning of period	$	118,626		$	87,542		$	206,168		$	120,856		$	87,241		$	208,097
Less: anticipated insurance recoveries	(2,390		)	(21,930		)	(24,320		)	(2,390		)	(21,930		)	(24,320		)
Net balance, beginning of period	$	116,236		$	65,612		$	181,848		$	118,466		$	65,311		$	183,777

Current year provision, continuing operations	7,500			5,690			13,190			15,635			12,872			28,507
Current year provision, discontinued operations	567			526			1,093			1,034			851			1,885
Claims paid, continuing operations	(6,695		)	(4,077		)	(10,772		)	(13,114		)	(8,903		)	(22,017		)
Claims paid, discontinued operations	(914		)	(615		)	(1,529		)	(4,183		)	(985		)	(5,168		)
Amounts paid for administrative services and other	(576		)	(1,462		)	(2,038		)	(1,720		)	(3,472		)	(5,192		)

Net balance, end of period	$	116,118		$	65,674		$	181,792		$	116,118		$	65,674		$	181,792
Plus: anticipated insurance recoveries	2,388			22,268			24,656			2,388			22,268			24,656
Gross balance, end of period	$	118,506		$	87,942		$	206,448		$	118,506		$	87,942		$	206,448



	For the Three Months Ended June 30, 2011									For the Six Months Ended June 30, 2011
	Professional Liability			Workers’ Compensation			Total			Professional Liability			Workers’ Compensation			Total
Gross balance, beginning of period	$	110,742		$	97,775		$	208,517		$	113,971		$	96,585		$	210,556
Less: anticipated insurance recoveries	(2,100		)	(28,100		)	(30,200		)	(2,100		)	(28,100		)	(30,200		)
Net balance, beginning of period	$	108,642		$	69,675		$	178,317		$	111,871		$	68,485		$	180,356

Current year provision, continuing operations	8,375			6,166			14,541			15,348			13,750			29,098
Current year provision, discontinued operations	482			408			890			949			792			1,741
Claims paid, continuing operations	(8,277		)	(4,049		)	(12,326		)	(17,792		)	(8,716		)	(26,508		)
Claims paid, discontinued operations	(1,380		)	(497		)	(1,877		)	(1,726		)	(863		)	(2,589		)
Amounts paid for administrative services and other	(800		)	(1,667		)	(2,467		)	(1,608		)	(3,412		)	(5,020		)

Net balance, end of period	$	107,042		$	70,036		$	177,078		$	107,042		$	70,036		$	177,078
Plus: anticipated insurance recoveries	2,273			26,150			28,423			2,273			26,150			28,423
Gross balance, end of period	$	109,315		$	96,186		$	205,501		$	109,315		$	96,186		$	205,501

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.

A summary of the assets and liabilities related to insurance risks at June 30, 2012 and December 31, 2011 is as indicated below (in thousands):



	June 30, 2012							December 31, 2011
	Professional Liability		Workers’ Compensation		Total		\| \|	Professional Liability		Workers’ Compensation		Total
Assets:							\|
Restricted cash (1)							\|
Current	$	5,458	$	8,523	$	13,981	\|	$	6,254	$	9,332	$	15,586
Non-current	—		—		—		\|	—		—		—
	$	5,458	$	8,523	$	13,981	\|	$	6,254	$	9,332	$	15,586
							\|
Anticipated insurance recoveries (2)							\|
Current	$	483	$	2,820	$	3,303	\|	$	524	$	2,730	$	3,254
Non-current	1,905		19,448		21,353		\|	1,866		19,200		21,066
	$	2,388	$	22,268	$	24,656	\|	$	2,390	$	21,930	$	24,320
Total Assets	$	7,846	$	30,791	$	38,637	\|	$	8,644	$	31,262	$	39,906

Liabilities:							\|
Self-insurance liabilities (3)(4)							\|
Current	$	29,946	$	21,454	$	51,400	\|	$	28,758	$	22,074	$	50,832
Non-current	88,560		66,488		155,048		\|	92,099		65,168		157,267
Total Liabilities	$	118,506	$	87,942	$	206,448	\|	$	120,857	$	87,242	$	208,099


(1)	Total restricted cash includes cash collateral deposits and other cash held by third parties. Total restricted cash above excludes $703 and $473 at June 30, 2012 and December 31, 2011, 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 June 30, 2012 and December 31, 2011 consolidated balance sheets.


(3)	Total self-insurance liabilities above exclude $6,228 and $6,978 at June 30, 2012 and December 31, 2011, 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 $57,538 as of June 30, 2012 and $55,335 as of December 31, 2011.

(b) Litigation

Between June 27, 2012 and July 16, 2012, we, the members of our board of directors, Genesis and Merger Sub have been named as defendants in a purported class action lawsuit filed in the Court of Chancery of the State of Delaware in connection with the transactions contemplated by the Merger Agreement with Genesis and in four additional separate lawsuits that were filed in the Superior Court of the State of California, County of Orange. The suits allege, among other things, that our directors breached their fiduciary duties to our stockholders in entering into the Merger Agreement pursuant to an unfair process, and that we, Genesis and Merger Sub aided and abetted the alleged breaches of fiduciary duties. In addition, the Delaware complaint alleges that the preliminary proxy statement filed by us on July 12, 2012 omits or misrepresents material information. The suits seek, among other things, to enjoin consummation of the merger. At this stage, it is not possible to predict the outcome of the proceedings and their impact on us. We believe the allegations made in the complaints are without merit and intend to vigorously defend these actions.

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. In certain states in which we have operations, insurance coverage for the risk of punitive damages arising from general and professional liability litigation may not be available due to state law public policy prohibitions. There can be no assurance that we will not be liable for punitive damages awarded in litigation arising in states for which punitive damage insurance coverage is not available.

We operate in an industry that is 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 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 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. Our appeal is currently pending with the Kentucky Court of Appeals. We believe our reserves are adequate for this matter.

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.

(d) Genesis Termination Fee

The Merger Agreement contains customary representations and warranties and pre-closing covenants. It contains termination provisions for each of us and Genesis, and provides that in certain specified circumstances, we must pay Genesis a termination fee equal to $6.9 million and up to $1.0 million of reasonable, out of pocket expenses incurred by Genesis in connection with the Merger Agreement.