We own or lease these principal operating facilities in addition to other administrative market offices and medical centers. We no longer operate most of these medical centers but, rather, lease or sublease them to their provider operators. The following table lists the location of properties we owned or leased, including our principal operating facilities, at December 31, 2007:
(b) Includes the acquired operations of CHA Service Company from May 1, 2006.
(e) Includes expenses of $30.8 million pretax ($18.8 million after tax, or $0.12 per diluted common share) for the writedown of building and equipment and software abandonment expenses. These expenses were partially offset by a gain of $15.2 million pretax ($10.1 million after tax, or $0.06 per diluted common share) for the sale of a venture capital investment. The net impact of these items reduced pretax income by $15.6 million ($8.7 million after tax, or $0.05 per diluted common share).
The results of each segment are measured by income before income taxes. We allocate all selling, general and administrative expenses, investment and other revenue, interest expense, and goodwill, but no other assets or liabilities, to our segments. Members served by our two segments often utilize the same medical provider networks, enabling us to obtain more favorable contract terms with providers. Our segments also share indirect overhead costs and assets. As a result, the profitability of each segment is interdependent.
In addition, we are diversifying our Commercial segment revenues through expanded and new specialty product offerings with the acquisitions of CompBenefits Corporation and KMG America Corporation in the fourth quarter of 2007, each discussed further below. These acquisitions significantly increased our dental membership and added new product offerings including vision and other supplemental health and life benefit plans primarily sold on a voluntary basis. The supplemental health plans cover, for example, some of the costs associated with cancer and critical illness. Along with our 2005 acquisition of Corphealth, Inc., a behavioral health care management company, these specialty acquisitions are anticipated to enhance our Commercial segment margins and our ability to appeal to more customers.
diluted common share, for the year ended December 31, 2007. In addition, a gain in the first quarter of 2006 of $51.7 million pretax, or $0.19 per diluted common share, from the sale of a venture capital investment also impacted year over year comparisons.
Cash flows from operations decreased $462.4 million to $1,224.3 million for the year ended December 31, 2007 compared to $1,686.7 million for the year ended December 31, 2006. Our operating cash flows were unfavorably impacted by the Part D provisions of our Medicare contracts, primarily the 2007 payment of the $725.5 million risk corridor payable to CMS associated with the 2006 contract year, partially offset by improvement in operating earnings.
In September 2007, we received approval from CMS to resume marketing of individual Medicare PFFS plans. This announcement ended the June 15, 2007 voluntary suspension agreed to in conjunction with other industry participants.
In October 2007, we were awarded the Department of Veterans Affairs first specialty network demonstration project, known as Project HERO (Healthcare Effectiveness through Resource Optimization), to support healthcare delivery to veterans.
On December 20, 2005, our Commercial segment acquired Corphealth, Inc., a behavioral health care management company, for cash consideration of approximately $54.0 million. This acquisition allowed Humana to integrate coverage of medical and behavior health benefits.
On February 16, 2005, we acquired CarePlus Health Plans of Florida, or CarePlus, as well as its affiliated 10 medical centers and pharmacy company for approximately $444.9 million in cash, adding approximately 50,400 Medicare Advantage members in Miami-Dade, Broward and Palm Beach counties. This acquisition enhanced our Medicare market position in South Florida.
Certain of these transactions are more fully described in Note 3 to the consolidated financial statements included in Item 8.-Financial Statements and Supplementary Data.
In December 2007, the Financial Accounting Standards Board, or FASB, issued FASB Statement No. 141 (Revised 2007), Business Combination, or SFAS 141R. SFAS 141R will significantly change the accounting for business combinations. Under SFAS 141R, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. SFAS 141R will change the accounting treatment for certain specific items including expensing transaction and restructuring costs and adjusting earnings in periods subsequent to the acquisition for changes in deferred tax asset valuation allowances and income tax uncertainties as well as changes in the fair value of acquired contingent liabilities. SFAS 141R also includes a substantial number of new disclosure requirements. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after January 1, 2009 with early adoption prohibited. Accordingly, we are required to record and disclose business combinations following existing GAAP until January 1, 2009. We currently are evaluating the provisions of SFAS 141R.
In December 2007, the FASB issued FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements-An Amendment of ARB No. 5, or SFAS 160. SFAS 160 establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, SFAS 160 requires the recognition of a noncontrolling interest (minority interest) as equity and separate from the parent’s equity. The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning January 1, 2009. Like SFAS 141R discussed above, earlier adoption is prohibited. We currently are evaluating the provisions of SFAS 160.
(a) Represents total benefit expense as a percentage of premium revenue. Also known as the benefits ratio.
These tables of financial data should be reviewed in connection with the discussion on the following pages.
Premium revenues increased $3.7 billion, or 17.9%, to $24.4 billion for 2007, compared to $20.7 billion for 2006 primarily due to higher premium revenues in the Government segment. Premium revenues reflect changes in membership and increases in average per member premiums. Items impacting average per member premiums include changes in premium rates as well as changes in the geographic mix of membership, the mix of product offerings, the mix of benefit plans selected by our membership, the impact of the risk corridor provisions, and changes in health status factors or risk adjustment provisions.
Government segment premium revenues increased $3.6 billion, or 24.8%, to $18.2 billion for 2007 compared to $14.6 billion for 2006 primarily attributable to higher average Medicare membership from the expanded participation in various Medicare products. Average membership is calculated by summing the ending membership for each month in a period and dividing the result by the number of months in a period. Average Medicare Advantage membership increased 26.4% for 2007 compared to 2006. Sales of our PFFS products drove the majority of the 140,400 increase in ending Medicare Advantage members since December 31, 2006. Average Medicare stand-alone PDP membership increased 19.5% for 2007 compared to 2006.
Commercial segment premium revenues increased $81.8 million, or 1.3%, to $6.2 billion for 2007 primarily due to our specialty product offerings, including dental, vision, and other supplemental health and life products,
Investment income totaled $314.2 million for 2007, an increase of $22.3 million from $291.9 million for 2006 primarily due to higher average investment balances in 2007 partially offset by a decrease in realized gains related to the sale of venture capital investments in 2006. Investment income for 2006 included a $51.7 million realized gain related to the sale of a venture capital investment in the first quarter.
Consolidated benefit expense was $20.3 billion for 2007, an increase of $2.9 billion, or 16.7%, from $17.4 billion for 2006. The increase primarily was driven by the increase in the average number of Medicare members and an increase in average per member claims costs primarily from the effects of health care inflation.
The consolidated benefits ratio for 2007 was 83.0%, a 100 basis point decrease from 84.0% for 2006. The decrease primarily was attributable to improvements in the benefits ratio for both the Commercial and Government segments.
The Government segment’s benefits ratio for 2007 was 83.8%, a 120 basis point decrease from 2006 of 85.0%. The decrease in the benefits ratio resulted from the combination of the extended enrollment period in 2006, improvement in the stand-alone PDP Complete plan, changes in estimates associated with our 2006 Medicare Part D reconciliation with CMS as well as the settlement of some TRICARE contractual provisions
The consolidated SG&A expense ratio for 2007 was 13.9%, decreasing 40 basis points from 14.3% for 2006. The SG&A expense ratio decrease resulted from improving administrative cost efficiency and productivity gains associated with servicing our members offset by our expanding mail order pharmacy business as well as differences in the composition of our medical membership portfolio for 2007 versus 2006. The consolidated SG&A expense ratio is expected to be in the range of 13.5% to 14.0% for 2008.
SG&A expenses in the Government segment increased $312.0 million, or 18.0%, during 2007 compared to 2006. The Government segment SG&A expense ratio decreased 60 basis points from 11.8% for 2006 to 11.2% for 2007. The decrease primarily resulted from efficiency and productivity gains associated with servicing higher average Medicare membership.
The Commercial segment SG&A expenses increased $143.0 million, or 11.1%, during 2007 compared to 2006. The Commercial segment SG&A expense ratio increased 150 basis points from 20.0% for 2006 to 21.5% for 2007. This increase primarily resulted from the continued shift in the mix of membership towards ASO, an increase in the percentage of individual and small group members comprising our fully-insured membership, and
Year over year comparisons have been impacted by litigation and Hurricane Katrina expenses in 2005 that did not recur in 2006, as more fully discussed in the following sections.
Consolidated benefit expense was $17.4 billion for 2006, an increase of $5.7 billion, or 48.7%, from $11.7 billion for 2005. The increase was primarily driven by the increase in the number of members, particularly higher cost Medicare members, and an increase in average per member claims costs primarily from the effects of health care inflation.
The Government segment’s benefit expenses increased $6.2 billion, or 98.1%, during 2006 compared to 2005. The increase was primarily due to an increase in the number of Medicare members, including those enrolled in our stand-alone PDPs.
The Commercial segment’s benefit expenses decreased $382.3 million, or 7.1%, from 2005 to 2006. This decrease primarily results from the decrease in fully-insured group membership partially offset by the increase in average per member claims costs. The increase in average per member claims costs for fully-insured group members was approximately 6% for 2006.
The benefits ratio for the Commercial segment of 81.7% in 2006 decreased 160 basis points from the 2005 benefits ratio of 83.3%. Higher benefit expenses from Hurricane Katrina increased the 2005 benefits ratio 30 basis points. The decrease in the benefits ratio primarily reflects improving medical cost utilization trends and an increase in the percentage of individual and small group members comprising our total fully-insured block. Individual and smaller group accounts generally carry a lower benefits ratio than larger group accounts.
Consolidated SG&A expenses increased $825.9 million, or 37.6%, during 2006 compared to 2005. The increase primarily resulted from an increase in the number of employees and increased sales and marketing costs due to the Medicare expansion offset by prior year litigation expenses which did not recur in 2006. The number of employees increased by 3,600 to 22,300 from 18,700 at December 31, 2005, primarily in the customer service and marketing functions associated with the growth in the Medicare business.
for 2005. Expenses related to the litigation settlement increased the SG&A expense ratio 60 basis points for 2005. After considering the effect of the litigation, the increase primarily resulted from an increase in the percentage of small group members comprising our total fully-insured membership as well as the continued shift in the mix of membership towards ASO. At December 31, 2005, 37% of our Commercial segment medical membership related to ASO business compared to 47% at December 31, 2006. Small group accounts bear a higher SG&A ratio than larger group accounts and ASO business bears a significantly higher SG&A ratio than fully-insured business.
Interest expense was $63.1 million for 2006, compared to $39.3 million for 2005, an increase of $23.8 million. This increase primarily resulted from higher average outstanding debt and higher interest rates.
Our effective tax rate for 2006 of 36.0% increased 9.7% compared to the 26.3% effective tax rate for 2005. The higher effective tax rate for 2006 is primarily due to the resolution of a contingent tax gain of $22.8 million in the first quarter of 2005 in connection with the expiration of the statute of limitations on an uncertain tax position related to the 2000 tax year which did not recur in 2006. See Note 9 to the consolidated financial statements included in Item 8.-Financial Statements and Supplementary Data for a complete reconciliation of the federal statutory rate to the effective tax rate.
Our primary sources of cash include receipts of premiums, ASO fees, investment income, as well as proceeds from the sale or maturity of our investment securities and from borrowings. Our primary uses of cash include disbursements for claims payments, SG&A expenses, interest expense, taxes, purchases of investment securities, acquisitions, capital expenditures, and payments on borrowings. Because premiums generally are collected in advance of claim payments by a period of up to several months in many instances, our business normally should produce positive cash flows during periods of increasing enrollment. Conversely, cash flows would be negatively impacted during periods of decreasing enrollment. We have experienced improving operating cash flows associated with growth in Medicare enrollment. The use of operating cash flows may be limited by regulatory requirements which require, among other items, that our regulated subsidiaries maintain minimum levels of capital.
The decrease in operating cash flows for 2007 resulted from timing of cash flows associated with our Medicare Part D offerings, offset by Medicare enrollment growth and improved earnings. During 2007, we paid $725.5 million to CMS under the risk corridor terms of our 2006 contracts with CMS. Similarly, the provision for net amounts payable under the risk corridor terms of our 2007 contracts with CMS, which will be paid in 2008, was $102.6 million.
The increase in operating cash flows for 2006 compared to 2005 resulted from Medicare enrollment growth, improved earnings, and the timing of cash flows associated with our Medicare Part D offerings which were new beginning January 1, 2006. Our 2006 Part D results related to both stand-alone PDP and MA-PD offerings reflected provisions for net amounts payable to CMS under the risk corridor terms of our contracts with CMS. This risk corridor amount, which was paid in 2007 as discussed above, reflects favorable experience on allowable risk corridor costs during the second half of 2006 compared to the expectations set out in our original annual bid for 2006 contracts with CMS. The favorable experience was associated with the Medicare Part D portion of our MA-PD offerings as well as our Standard and Enhanced stand-alone plans.
The decline in Commercial and other receivables from 2005 to 2006 resulted from the change in the mix of members from fully-insured to ASO.
The $22.7 million increase in the allowance for doubtful accounts from 2006 to 2007 resulted from the growth of the Medicare business.
The detail of benefits payable was as follows at December 31, 2007, 2006 and 2005:
(2) Military services benefits payable primarily results from the timing of the cost of providing health care services to beneficiaries and the related reimbursement by the federal government as more fully described in Note 2 to the consolidated financial statements included in Item 8.-Financial Statements and Supplementary Data. A corresponding receivable is included in the base receivable in the previous receivables table.
(4) Other benefits payable includes capitation and pharmacy payables. The balance due to our pharmacy benefit administrator fluctuates due to bi-weekly payments and the month-end cutoff.
During 2006, we issued $500 million of 6.45% senior notes due June 1, 2016. Our net proceeds, reduced for the discount and cost of the offering were $494.3 million. We used the proceeds from the offering for the repayment of the outstanding balance under our credit agreement, which at the time of the issuance was $200 million, and the repayment of our $300 million 7.25% senior notes which matured on August 1, 2006.
Receipts from CMS associated with Medicare Part D claim subsidies were $185.1 million less than the corresponding claim payments during 2007 and $122.3 million less than the corresponding claim payments during 2006. See Note 2 to the consolidated financial statements included in Item 8.-Financial Statements and Supplementary Data for further description.
The remainder of financing activities in 2007, 2006, and 2005 resulted primarily from the change in the securities lending payable, proceeds from stock option exercises, the tax benefit from stock compensation, and the change in the book overdraft. The increase in securities lending in 2007 and 2006 coincides with higher average balances of investments to lend and a change in lending terms during 2006. In connection with employee stock plans, we acquired common shares totaling 406,377 in 2007, 467,767 in 2006, and 68,296 in 2005 for an aggregate cost of $27.4 million in 2007, $26.2 million in 2006, and $2.4 million in 2005. On February 21, 2008, the Board of Directors authorized the use of up to $150 million for the repurchase of our common shares exclusive of shares repurchased in connection with employee stock plans.
The credit agreement contains customary restrictive and financial covenants as well as customary events of default, including financial covenants regarding the maintenance of a minimum level of net worth and a maximum leverage ratio. The terms of the credit agreement also include standard provisions related to conditions of borrowing, including a customary material adverse effect clause which could limit our ability to borrow additional funds. We have not experienced a material adverse effect, and we know of no circumstances or events which would be reasonably likely to result in a material adverse effect. At this time, we do not believe the material adverse effect clause poses a material funding risk to us.
Adverse changes in our credit rating may increase the rate of interest we pay and may impact the amount of credit available to us in the future. Our investment-grade credit rating at December 31, 2007 was Baa3 according to Moody’s Investors Services, Inc., or Moody’s, and BBB, according to Standard & Poor’s Ratings Services, or S&P. A downgrade to Ba2 or lower by Moody’s and BB or lower by S&P would give the counterparties of three of our interest rate swap agreements with a $300 million notional amount, the right, but not the obligation, to cancel the interest rate swap agreement. If cancelled, we would pay or receive an amount based on the fair market value of the
swap agreement. Assuming these swap agreements had been cancelled on December 31, 2007, we would have received $18.3 million, net, and future net interest payments would increase assuming LIBOR does not change. Other than the swap agreements, adverse changes in our credit ratings do not create, increase, or accelerate any liabilities.
(1) Interest includes the estimated contractual interest payments under our debt agreements net of the effect of the associated swap agreements assuming no change in the LIBOR rate as of December 31, 2007.
(2) We lease facilities, computer hardware, and other equipment under long-term operating leases that are noncancelable and expire on various dates through 2018. We sublease facilities or partial facilities to third party tenants for space not used in our operations which partially mitigates our operating lease commitments. An operating lease, accounted for under the provisions of SFAS No. 13, Accounting for Leases, is a type of off-balance sheet arrangement. Assuming we acquired the asset, rather than leased such asset, we would have recognized a liability for the financing of these assets. See also Note 14 to the consolidated financial statements included in Item 8.-Financial Statements and Supplementary Data.
No related party transactions had a material effect on our financial position, results of operations, or cash flows. Certain related party transactions not having a material effect are discussed in our Proxy Statement for the meeting to be held April 24, 2008-see “Certain Transactions with Management and Others.”
generally for a one-year term each December 31 unless CMS notifies Humana of its decision not to renew by August 1 of the year in which the contract would end, or Humana notifies CMS of its decision not to renew by the first Monday in June of the year in which the contract would end. All material contracts between Humana and CMS relating to our Medicare business have been renewed for 2008.
Our military business, which accounted for approximately 12% of our total premiums and ASO fees for the year ended December 31, 2007, primarily consisted of the TRICARE South Region contract. The 5-year South Region contract, which expires March 31, 2009, is subject to annual renewals on April 1 of each year at the government’s option. Effective April 1, 2007, the South Region contract was extended into the fourth option period, which runs from April 1, 2007 to March 31, 2008. We have received a notice from the government of its intent to renew the fifth option period which runs from April 1, 2008 to March 31, 2009. The Department of Defense has the option to extend the current contract for up to six months under existing terms. Congressional authority has also been granted to extend the contract in one year increments for a maximum of two additional years. In the second quarter of 2007, a draft solicitation related to the new TRICARE contracts, currently scheduled to begin April 1, 2009, was issued for industry comment. Currently, we are anticipating a formal request for proposal, or RFP, for the TRICARE contracts. As required under the contract, the target underwritten health care cost and underwriting fee amounts for the fourth option period were negotiated. Any variance from the target health care cost is shared with the federal government. Accordingly, events and circumstances not contemplated in the negotiated target health care cost amount could have a material adverse effect on our business. These changes may include, for example, an increase or reduction in the number of persons enrolled or eligible to enroll due to the federal government’s decision to increase or decrease U.S. military deployments. In the event government reimbursements were to decline from projected amounts, our failure to reduce the health care costs associated with these programs could have a material adverse effect on our business.
The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements and accompanying notes, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements and accompanying notes requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We continuously evaluate our estimates and those critical accounting policies related primarily to benefit expenses and revenue recognition as well as accounting for impairments related to our investment securities, goodwill, and long-lived assets. These estimates are based on knowledge of current events and anticipated future events, and accordingly, actual results ultimately may differ from those estimates. We believe the following critical accounting policies involve the most significant judgments and estimates used in the preparation of our consolidated financial statements.
The completion and claims per member per month trend factors are the most significant factors impacting the IBNR estimate. The portion of IBNR estimated using completion factors for claims incurred prior to the most recent three months is less variable than the portion of IBNR estimated using trend factors. The following table illustrates the sensitivity of these factors assuming moderate adverse experience and the estimated potential impact on our operating results caused by reasonably likely changes in these factors based on December 31, 2007 data:
As summarized in the previous table, claim reserve balances at December 31, 2006 ultimately settled during 2007 for $242.9 million less than the amounts originally estimated. During 2006, claim reserve balances at December 31, 2005 ultimately settled for $179.0 million less than the amounts originally estimated. The $63.9 million change in the amounts incurred related to prior years for 2007 as compared to 2006 primarily relates to favorable development experienced in our Medicare operations. As previously described, our key assumptions consist of trend factors and completion factors using an assumption of moderately adverse conditions. In our Medicare operations, both our trend factor and completion factor assumptions at December 31, 2006 ultimately developed favorable versus our original estimate primarily due to changes in estimates associated with our 2006 Medicare Part D reconciliation and the growth in our Medicare business. First year Medicare Part D enrollment and eligibility issues in 2006 led to actual claim settlements with other health plans and states during 2007 for amounts less than originally estimated. Similar adjustments in the future are not expected to be as significant due to the program’s operational improvement in 2007.
During 2006, claim reserve balances at December 31, 2005 ultimately settled during 2006 for $179.0 million less than the amounts originally estimated. During 2005, claim reserve balances at December 31, 2004 ultimately settled for $72.9 million less than the amounts originally estimated. This $106.1 million change in the amounts incurred related to prior years for 2006 as compared to 2005 primarily was attributable to both our Medicare and commercial lines of business. In each of these lines of business, both our trend factor and completion factor assumptions at December 31, 2005 ultimately developed favorable versus our original estimate primarily due to (1) the utilization of hospital and physician services during the latter half of 2005 ultimately being lower than estimated, (2) the impact of hurricanes in Florida and Louisiana in the second half of 2005 on both utilization of services and claims processing, (3) significant growth in our Medicare PFFS product, (4) reductions in receipt cycle times driven by an increase in electronic claims submissions, and (5) an increase in claim overpayment recovery levels versus our historical overpayment recovery rate.
Reinsurance and low-income cost subsidies represent reimbursements from CMS in connection with the Medicare Part D program for which we assume no risk. Reinsurance subsidies represent reimbursements for CMS’s portion of prescription drug costs which exceed the member’s out-of-pocket threshold, or the catastrophic coverage level. Low-income cost subsidies represent reimbursements from CMS for all or a portion of the deductible, the coinsurance and co-payment amounts above the out-of-pocket threshold for low-income beneficiaries. Monthly prospective payments from CMS for reinsurance and low-income cost subsidies are based on assumptions submitted with our annual bid. A reconciliation and related settlement of CMS’s prospective subsidies against actual prescription drug costs we paid is made after the end of the year. We account for these subsidies as a deposit in our consolidated balance sheets and as a financing activity in our consolidated statements of cash flows. We do not recognize premium revenues or benefit expense for these subsidies. Receipt and payment activity is accumulated at the contract level and recorded in our consolidated balance sheets in other current assets or trade accounts payable and accrued expenses depending on the contract balance at the end of the reporting period. Gross financing receipts were $2,866.2 million and gross financing withdrawals were $3,051.2 million during 2007. CMS subsidy activity recorded to the consolidated balance sheets at December 31, 2007 was $580.4 million to other current assets and $273.0 million to trade accounts payable and accrued expenses.
In order to allow plans offering enhanced benefits the maximum flexibility in designing alternative prescription drug coverage, CMS provided a demonstration payment option in lieu of the reinsurance subsidy for plans offering enhanced coverage, or coverage beyond CMS’s defined standard benefits. The demonstration payment option is an arrangement in which CMS pays a capitation amount to a plan for assuming the
CMS has transitioned to the risk adjustment model while the old demographic model was phased out. The demographic model based the monthly premiums paid to health plans on factors such as age, sex and disability status. The monthly premium amount for each member is separately determined under both the risk adjustment and demographic model. These separate payment amounts are then blended according to the transition schedule. CMS transitioned to the risk adjustment model for Medicare Advantage plans as follows: 30% in 2004, 50% in 2005, 75% in 2006, and 100% in 2007. The stand-alone PDP payment methodology is based 100% on the risk adjustment model. As a result of this process and the phasing in of the risk adjustment model, as well as budget neutrality as described in Item 1.-Business on page 5, our CMS monthly premium payments per member may change materially, either favorably or unfavorably.
The TRICARE contract contains provisions whereby the federal government bears a substantial portion of the risk associated with financing the cost of health benefits. Annually, we negotiate a target health care cost
amount, or target cost, with the federal government and determine an underwriting fee. Any variance from the target cost is shared. We earn more revenue or incur additional costs based on the variance in actual health care costs versus the negotiated target cost. We receive 20% for any cost underrun, subject to a ceiling that limits the underwriting profit to 10% of the target cost. We pay 20% for any cost overrun, subject to a floor that limits the underwriting loss to negative 4% of the target cost. A final settlement occurs 12 to 18 months after the end of each contract year to which it applies. We defer the recognition of any revenues for favorable contingent underwriting fee adjustments related to cost underruns until the amount is determinable and the collectibility is reasonably assured. We estimate and recognize unfavorable contingent underwriting fee adjustments related to cost overruns currently in operations as an increase in benefit expenses. We continually review these benefit expense estimates of future payments to the government for cost overruns and make necessary adjustments to our reserves.
Duration is indicative of the relationship between changes in market value and changes in interest rates, providing a general indication of the sensitivity of the fair values of our debt securities to changes in interest rates. However, actual market values may differ significantly from estimates based on duration. The average duration of our debt securities was approximately 3.9 years at December 31, 2007. Given that short term interest rates were higher than long term rates during most of 2007, cash was invested in cash equivalents instead of longer duration investment securities. Including cash equivalents, the average duration was approximately 2.6 years. Based on the duration including cash equivalents, a 1% increase in interest rates would generally decrease the fair value of our securities by approximately $172 million.
Our investment securities, which consist primarily of debt securities, have been categorized as available for sale and, as a result, are stated at fair value. Fair value of actively traded debt and equity securities are based on quoted market prices. Fair value of inactively traded debt securities are based on quoted market prices of identical or similar securities or based on observable inputs like interest rates. Fair value of privately held debt securities, including venture capital investments are estimated using a variety of valuation methodologies where an observable quoted market does not exist. Such methodologies include reviewing the value ascribed to the most recent financing, comparing the security with securities of publicly traded companies in a similar line of business, and reviewing the underlying financial performance including estimating discounted cash flows. Investment securities available for current operations are classified as current assets. Unrealized holding gains and losses, net of applicable deferred taxes, are included as a component of stockholders’ equity and comprehensive income until realized from a sale or other than temporary impairment.
Gross unrealized losses and fair value aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position were as follows at December 31, 2007.
We regularly evaluate our investment securities for impairment. We consider factors affecting the issuer, factors affecting the industry the issuer operates within, and general debt and equity market trends. We consider the length of time an investment’s fair value has been below carrying value, the severity of the decline, the near term prospects for recovery to cost, and our intent and ability to hold the investment until maturity or market recovery is realized. If and when a determination is made that a decline in fair value below the cost basis is other than temporary, the related investment is written down to its estimated fair value through a charge to earnings. The risks inherent in assessing the impairment of an investment include the risk that market factors may differ from our expectations; facts and circumstances factored into our assessment may change with the passage of time; or we may decide to subsequently sell the investment. The determination of whether a decline in the value of an investment is other than temporary requires us to exercise significant diligence and judgment. The discovery of new information and the passage of time can significantly change these judgments. The status of the general economic environment and significant changes in the national securities markets influence the determination of fair value and the assessment of investment impairment.
Unrealized losses at December 31, 2007 resulted from 472 positions out of a total of 1,165 positions held. Approximately 14% of the carrying value of our investment securities have been in an unrealized loss position greater than one year. Of these investment securities in an unrealized loss position longer than a year, approximately 99% of the carrying value are within 5% of recovering fair value up to cost. The unrealized losses at December 31, 2007 primarily were caused by increases in interest rates. All issuers of securities trading at an unrealized loss remain current on all contractual payments and we believe it is probable that we will be able to collect all amounts due according to the contractual terms of the debt securities. After taking into account these and other factors, including the severity of the decline and our ability and intent to hold these securities until recovery or maturity, we determined the unrealized losses on these investment securities were temporary and, as such, no impairment was required.
SFAS No. 142, Goodwill and Other Intangible Assets, or SFAS 142, requires that we test at least annually for impairment at a level of reporting referred to as the reporting unit and more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. A reporting unit is our operating segments or one level below the operating segments which comprise our reportable Commercial and Government segments.
The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. The areas involving the most significant use of estimates are the estimation of benefits payable, the impact of risk sharing provisions related to our Medicare and TRICARE contracts, the valuation and related impairment recognition of investment securities, and the valuation and related impairment recognition of long-lived assets, including goodwill. These estimates are based on knowledge of current events and anticipated future events, and accordingly, actual results may ultimately differ materially from those estimates.
We bill and collect premium and administrative fee remittances from employer groups and members in our Medicare and individual products monthly. We receive monthly premiums and administrative fees from the federal government and various states according to government specified reimbursement rates and various contractual terms. Changes in revenues from CMS for our Medicare products resulting from the periodic changes in risk adjustment scores for our membership are recognized when the amounts become determinable and the collectibility is reasonably assured.
Military services revenue primarily is derived from our TRICARE South Region contract with the Department of Defense. We account for the TRICARE South Region contract under EITF Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, and as such allocate the consideration to the various components of the contract based on the relative fair value of the components. TRICARE revenues consist generally of (1) an insurance premium for assuming underwriting risk for the cost of civilian health care services delivered to eligible beneficiaries; (2) health care services provided to beneficiaries which are in turn reimbursed by the federal government; and (3) administrative services fees related to claim processing, customer service, enrollment, disease management and other services. We recognize the insurance premium as revenue ratably over the period coverage is provided. Health care services reimbursements are recognized as revenue in the period health services are provided. Administrative services fees are recognized as revenue in the period services are performed. Our TRICARE South Region contract contains provisions to share the risk associated with financing the cost of health benefits with the federal government. We earn more revenue or incur additional costs based on the variance of actual health care costs versus a negotiated target cost. We defer the recognition of any contingent revenues for favorable variances until the end of the contract period when the amount is determinable and the collectibility is reasonably assured. We estimate and recognize contingent benefit expense for unfavorable variances currently in our results of operations. We continually review the contingent benefit expense estimates of future payments to the government for cost overruns and make necessary adjustments to our reserves.
Other revenues primarily relate to RightSource SM, our mail order pharmacy. These revenues are recognized in connection with the shipment of the prescriptions.
Benefit expenses include claim payments, capitation payments, pharmacy costs net of rebates, allocations of certain centralized expenses and various other costs incurred to provide health insurance coverage to members, as well as estimates of future payments to hospitals and others for medical care and other supplemental benefits provided prior to the balance sheet date. Capitation payments represent monthly contractual fees disbursed to primary care physicians and other providers who are responsible for providing medical care to members. Pharmacy costs represent payments for members’ prescription drug benefits, net of rebates from drug manufacturers. Receivables for such pharmacy rebates are included in other current assets in the consolidated balance sheets. Other supplemental benefits include dental, vision, and other voluntary benefits.
We use interest rate swap agreements to manage our exposure to interest rate risk. The differential between fixed and variable rates to be paid or received is accrued and recognized over the life of the agreements as adjustments to interest expense in the consolidated statements of income. Our interest rate swap agreements convert the fixed interest rates on our senior notes to a variable rate and are accounted for as fair value hedges. Our interest rate swap agreements are more fully described in Note 10.
We compute basic earnings per common share on the basis of the weighted average number of unrestricted common shares outstanding. Diluted earnings per common share is computed on the basis of the weighted average number of unrestricted common shares outstanding plus the dilutive effect of outstanding employee stock options and restricted shares using the treasury stock method.
The balance sheet reflects the reclassification of future policy benefits payable to conform to the current year presentation.
The purchase price was allocated to the fair value of KMG’s and CompBenefits’ assets acquired and liabilities assumed. The excess of the purchase price over the fair value of net assets acquired resulted in $335.8 million of non-deductible goodwill for the Commercial segment.
The preliminary fair values of KMG’s and CompBenefits’ assets acquired and liabilities assumed at the date of the acquisition are summarized as follows:
The other intangible assets, which primarily consist of customer and provider contracts, have a weighted average useful life of 19.6 years for KMG and 11.5 years for CompBenefits. The long-durational nature of KMG’s customer contracts contributes to a longer useful life and corresponding higher fair value. The purchase price allocations are preliminary, subject to completion of valuation analyses including, for example, refining assumptions used to calculate the fair value of other intangible assets and future policy benefits payable.
On March 1, 2007, our Government segment acquired DefenseWeb Technologies, Inc., or DefenseWeb, a company responsible for delivering customized software solutions for the Department of Defense, for cash consideration of $27.0 million.
The results of operations and financial condition of KMG, CompBenefits, DefenseWeb and CHA Health have been included in our consolidated statements of income and consolidated balance sheets from the respective acquisition dates. The proforma financial information assuming these acquisitions had occurred as of the beginning of each respective period was not material to our results of operations.
Investment securities classified as long-term assets were as follows at December 31, 2007 and 2006:
Gross realized investment gains were $20.6 million in 2007, $82.0 million in 2006, and $21.8 million in 2005. Gross realized gains included gains from the sale of venture capital investments of $16.0 million in 2007, $76.2 million in 2006, and $5.7 million in 2005.
We participate in a securities lending program where we loan certain investment securities for short periods of time in exchange for collateral, consisting of cash or U.S. Government securities, initially equal to at least 102% of the fair value of the investment securities on loan. As of December 31, 2007, investment securities with a fair value of $1,336.1 million were on loan. Net investment income earned on securities lending transactions was $6.6 million in 2007, $1.1 million in 2006, and $0.2 million in 2005.
Changes in the carrying amount of goodwill, by operating segment, for the year ended December 31, 2007 were as follows:
Activity in benefits payable, excluding military services, was as follows for the years ended December 31, 2007, 2006 and 2005:
As summarized in the previous table, claim reserve balances at December 31, 2006 ultimately settled during 2007 for $242.9 million less than the amounts originally estimated. During 2006, claim reserve balances at December 31, 2005 ultimately settled for $179.0 million less than the amounts originally estimated. The $63.9 million change in the amounts incurred related to prior years for 2007 as compared to 2006 primarily relates to favorable development experienced in our Medicare operations. This favorable development primarily was due to changes in estimates associated with our 2006 Medicare Part D reconciliation and the growth in our Medicare business. First year Medicare Part D enrollment and eligibility issues in 2006 led to actual claim settlements with other health plans and states during 2007 for amounts less than originally estimated. Similar adjustments in the future are not expected to be as significant due to the program’s operational improvement in 2007.
Changes in the capital loss valuation allowance in 2005 resulted from our regular evaluation of probable capital gain realization in the allowable carryforward period given our recent and historical capital gain experience and the consideration of alternative tax planning strategies. The capital loss carryforward expired on December 31, 2005. As such, the remaining unused deferred tax asset and associated allowance were written off.
We adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, on January 1, 2007. The liability for unrecognized tax benefits was $14.6 million at December 31, 2007 and 2006, all of which would affect the effective tax rate if recognized. There were no changes in the liability during the twelve months ended December 31, 2007, and there are no positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase or decrease within the next twelve months. We recognize interest accrued related to unrecognized tax benefits and penalties in tax expense.
Long-term debt outstanding was as follows at December 31, 2007 and 2006:
In order to hedge the risk of changes in the fair value of all our senior notes attributable to fluctuations in interest rates, we entered into interest rate swap agreements. Interest rate swap agreements, which are considered derivatives, are contracts that exchange interest payments on a specified principal amount, or notional amount, for a specified period. Our interest rate swap agreements, which have a notional amount of $800 million, exchange the fixed interest rate under all our senior notes for a variable interest rate based on LIBOR. At December 31, 2007, the weighted average effective interest rate for all of our senior notes was 5.9%.
At December 31, 2007, the fair value of all our swap agreements was in our favor by $51.1 million and included in other long-term assets. Likewise, the carrying values of all of our senior notes have been increased $51.1 million to reflect their fair values. The counterparties to our swap agreements are major financial institutions with which we also have other financial relationships.
the Humana common stock fund. However, a participant could reinvest any funds, including the Company match in the Humana common stock fund, in any other plan investment option at any time. Beginning January 1, 2007, the Company’s cash match is invested pursuant to the participant’s contribution direction.
Since 2006, a greater proportion of the awards granted to employees, excluding executive officers, were restricted stock awards as opposed to stock options when compared to grants made in prior years.
The tax benefit recognized in our consolidated financial statements is based on the amount of compensation expense recorded for book purposes. The actual tax benefit realized in our tax return is based on the intrinsic value, or the excess of the market value over the exercise or purchase price, of stock options exercised and restricted stock awards vested during the period. The actual tax benefit realized for the deductions taken on our tax returns from option exercises and restricted stock vesting totaled $48.0 million in 2007, $47.8 million in 2006, and $22.3 million in 2005. There was no capitalized stock-based compensation expense.
Stock options are granted with an exercise price equal to the average market value of the underlying common stock on the date of grant. Our stock plans, as approved by the Board of Directors and stockholders, define average market value as the average of the highest and lowest stock prices reported by the New York Stock Exchange on a given date. Exercise provisions vary, but most options vest in whole or in part 1 to 3 years after grant and expire 7 to 10 years after grant. Upon grant, stock options are assigned a fair value based on the Black-Scholes valuation model. Compensation expense is recognized on a straight-line basis over the total requisite service period, generally the total vesting period, for the entire award.
The fair value of shares vested during the years ended December 31, 2007, 2006, and 2005 was $3.4 million, $2.3 million, and $0.6 million, respectively. Total compensation expense related to nonvested restricted stock awards not yet recognized was $44.7 million at December 31, 2007. We expect to recognize this compensation expense over a weighted average period of approximately 1.4 years. There are no other contractual terms covering restricted stock awards once vested.
Based on the most recent statutory financial statements as of December 31, 2007, we maintained aggregate statutory capital and surplus of $2,905.2 million in our state regulated subsidiaries. This compares to applicable
statutory requirements which aggregated $1,810.5 million. Although the minimum required levels of equity are largely based on premium volume, product mix, and the quality of assets held, minimum requirements can vary significantly at the state level.
significant terms, including: fixed or minimum levels of service to be purchased; fixed, minimum or variable price provisions; and the appropriate timing of the transaction. We have purchase obligation commitments of $57.8 million in 2008, $42.0 million in 2009, $32.2 million in 2010, $22.9 million in 2011 and $25.2 million thereafter. Purchase obligations exclude agreements that are cancelable without penalty.
As part of our ongoing business, we do not participate or knowingly seek to participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities (SPEs), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2007, we are not involved in any SPE transactions.
Our military business, which accounted for approximately 12% of our total premiums and ASO fees for the year ended December 31, 2007, primarily consisted of the TRICARE South Region contract. The 5-year South Region contract, which expires March 31, 2009, is subject to annual renewals on April 1 of each year at the government’s option. Effective April 1, 2007, the South Region contract was extended into the fourth option period, which runs from April 1, 2007 to March 31, 2008. We have received a notice from the government of its intent to renew the fifth option period which runs from April 1, 2008 to March 31, 2009. The Department of Defense has the option to extend the current contract for up to six months under existing terms. Congressional authority has also been granted to extend the contract in one year increments for a maximum of two additional years. In the second quarter of 2007, a draft solicitation related to the new TRICARE contracts, currently scheduled to begin April 1, 2009, was issued for industry comment. Currently, we are anticipating a formal
request for proposal, or RFP, for the TRICARE contracts. As required under the contract, the target underwritten health care cost and underwriting fee amounts for the fourth option period were negotiated. Any variance from the target health care cost is shared with the federal government. Accordingly, events and circumstances not contemplated in the negotiated target health care cost amount could have a material adverse effect on our business. These changes may include, for example, an increase or reduction in the number of persons enrolled or eligible to enroll due to the federal government’s decision to increase or decrease U.S. military deployments. In the event government reimbursements were to decline from projected amounts, our failure to reduce the health care costs associated with these programs could have a material adverse effect on our business.
In October 2007, we were awarded the Department of Veterans Affairs first specialty network demonstration project, known as Project HERO (Healthcare Effectiveness through Resource Optimization), to support healthcare delivery to veterans. The contract is comprised of one base period and four one-year option periods subject to annual renewals at the federal government’s option, with services beginning January 1, 2008.
Our Medicaid business, which accounted for approximately 2% of our total premiums and ASO fees for the year ended December 31, 2007, consisted of contracts in Puerto Rico and Florida, with the vast majority in Puerto Rico. Our Medicaid contracts with the Puerto Rico Health Insurance Administration for the East and Southeast regions of Puerto Rico are effective from November 1, 2006 through June 30, 2008. In 2007, we also entered into an ASO contract with the Puerto Rico Health Administration for the Metro North Region which is effective from November 1, 2006 through October 31, 2009.
The accounting policies of each segment are the same and are described in Note 2. The results of each segment are measured by income before income taxes. We allocate all selling, general and administrative expenses, investment and other revenue, interest expense, and goodwill, but no other assets or liabilities, to our segments. Members served by our two segments often utilize the same medical provider networks, enabling us to obtain more favorable contract terms with providers. Our segments also share indirect overhead costs and assets. As a result, the profitability of each segment is interdependent.
Our segment results were as follows for the years ended December 31, 2007, 2006, and 2005:
Premium and administrative services revenues derived from our contracts with the federal government, as a percentage of our total premium and ASO revenues, were approximately 71% for 2007, 67% for 2006 and 51% for 2005.
December 31, 2007 and 100% at December 31, 2006. The decrease primarily was related to the November 30, 2007 KMG acquisition. Premiums ceded were $13.4 million in 2007, $15.7 million in 2006 and $21.7 million in 2005.