(b) Includes the acquired operations of CarePlus Health Plans of Florida from February 16, 2005, and the acquired operations of Corphealth, Inc. from December 20, 2005. Also includes expenses of $71.9 million ($44.8 million after tax, or $0.27 per diluted common share) for a class action litigation settlement, as well as expenses of $27.0 million ($16.9 million after tax, or $0.10 per diluted common share) related to Hurricane Katrina. These expenses were partially offset by the realization of a tax gain contingency of $22.8 million, or $0.14 per diluted share.
(c) Includes the acquired operations of Ochsner Health Plan from April 1, 2004.
(e) Includes expenses of $85.6 million pretax ($58.2 million after tax, or $0.35 per diluted common share) for severance and facility costs related to reducing our administrative cost structure with the elimination of three customer service centers and an enterprise-wide workforce reduction, reserves for liabilities related to a previous acquisition and the impairment in the fair value of certain private debt and equity investments.
The results of each segment are measured by income before income taxes. We allocate all selling, general and administrative expenses, investment and other income, 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 overhead costs and assets. As a result, the profitability of each segment is interdependent. We believe our customer, membership, revenue and pretax income diversification across segments and products allows us to increase our chances of success.
Our industry relies on two key statistics to measure performance. MER, which is computed by taking total medical expenses as a percentage of premium revenues, represents a statistic used to measure underwriting profitability. The SG&A expense ratio, which is computed by taking total selling, general and administrative expenses as a percentage of premium revenues and administrative services fees, represents a statistic used to measure administrative spending efficiency.
Our strategy and commitment to the expanded Medicare programs, including new product choices and pharmacy benefits for seniors, led to substantial growth during 2006. Medicare Advantage membership increased to 1,002,600 members at December 31, 2006, up 79.7% from 557,800 members at December 31, 2005, primarily due to sales of our PFFS product. Our new Medicare stand-alone PDP products added 3,536,600 members during 2006. Medicare premium revenues more than doubled to $11.5 billion during 2006 primarily as a result of this membership growth.
Commercial segment medical membership increased 113,000 members, or 3.6% from December 31, 2005 to 3,283,800 at December 31, 2006 as a result of the May 1, 2006 CHA acquisition which added 88,400 members and higher ASO, individual and consumer-choice membership, partially offset by a decline in our fully insured group membership. ASO membership at December 31, 2006 was up 31% from December 31, 2005. Individual membership increased 15% and consumer-choice membership increased 13% during 2006. These three areas, together with our small group business, now represent more than 84% of our Commercial medical membership.
Certain of our operations, primarily the Louisiana market, were negatively affected by the impact of Hurricane Katrina in August 2005. Expenses related to Hurricane Katrina primarily stemmed from our efforts, in cooperation with Departments of Insurance in the affected states, to help our members by offering participating-provider benefits at non-participating providers’ rates, paying claims for members who were unable at the time to meet their premium obligations and similar measures. In connection with Hurricane Katrina, we recorded pretax medical and administrative expenses of $27.0 million ($16.9 million after taxes, or $0.10 per diluted common share) during the third and fourth quarters of 2005. Of the $27.0 million, $5.9 million was included in the Government segment results and the remaining $21.1 million was included in the Commercial segment results.
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 allows Humana to integrate coverage of medical and behavior health benefits.
These transactions are more fully described in Note 3 to the consolidated financial statements included in Item 8.-Financial Statements and Supplementary Data.
(c) Represents total selling, general, and administrative expenses as a percentage of premium revenues and administrative services fees. Also known as the SG&A expense ratio.
Medical membership was as follows at December 31, 2006 and 2005:
Commercial segment premium revenues decreased 5.3% to $6.1 billion for 2006 compared to $6.5 billion for 2005. Lower premium revenues primarily resulted from a reduction of fully insured membership. Our fully insured membership decreased 12.3%, or 245,600 members, to 1,754,200 at December 31, 2006 compared to 1,999,800 at December 31, 2005 primarily as a result of continued attrition within the fully insured group accounts, partially offset by membership gains from the CHA acquisition, and membership increases in the individual and consumer-choice product lines. Attrition in the fully insured group accounts results from a competitive pricing environment. Average per member premiums for our fully insured group medical members increased approximately 5.7% from 2005 to 2006. The average per member premium increase reflects a shift in the mix in our fully insured group membership from large groups to individuals and small groups as large groups continue to move to an administrative services only offering. Average per member premiums are lower for individuals and small groups than large groups.
The consolidated MER for 2006 was 84.0%, an 80 basis point increase from 83.2% for 2005. Higher medical expenses from Hurricane Katrina increased the 2005 MER 20 basis points. An improvement in the Commercial segment MER was more than offset by a higher Government segment MER impacted by the new Medicare stand-alone PDP offerings.
The Government segment’s medical 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 MER for the Commercial segment of 81.7% in 2006 decreased 160 basis points from 2005 MER of 83.3%. Higher medical expenses from Hurricane Katrina increased the 2005 MER 30 basis points. The decrease in MER 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 MER than larger group accounts.
Depreciation and amortization for 2006 totaled $148.6 million compared to $128.9 million in 2005, an increase of $19.7 million, or 15.3%. The increase resulted primarily from capital expenditures related to the Medicare expansion.
Net income was $296.7 million, or $1.79 per diluted common share, in 2005 compared to $269.9 million, or $1.66 per diluted common share, in 2004. The increase in net income primarily resulted from improved profits in our Government segment, driven by gains in Medicare Advantage membership and improved pretax results in both our Medicare Advantage and TRICARE operations.
Premium revenues increased 10.3% to $14.0 billion for 2005, compared to $12.7 billion for 2004. Higher Government segment premium revenues were partially offset by a decrease in Commercial segment premium revenues.
Government segment premium revenues increased 31.8% to $7.5 billion for 2005, compared to $5.7 billion for 2004. This increase primarily was attributable to our Medicare Advantage operations and the effects of transitioning to the TRICARE South Region contract during 2004. Medicare Advantage membership was 557,800 at December 31, 2005, compared to 377,200 at December 31, 2004, an increase of 180,600 members, or 47.9%. This increase was due to expanded participation in various Medicare Advantage programs and geographic markets, as well as the CarePlus acquisition. The February 16, 2005 CarePlus acquisition added 50,400 members and $486.3 million in premium revenues in 2005. Average per member premiums for our Medicare Advantage business increased approximately 12% during 2005. This reflects a shift in our Medicare Advantage membership mix to higher reimbursement markets, due primarily to the South Florida CarePlus acquisition. TRICARE premium revenues increased 13.2% in 2005, reflecting the transition to the new South Region contract during 2004 which included a temporary loss of approximately 1 million members for 4 months in 2004. Medicaid membership declined by 20,700 members from December 31, 2004 to December 31, 2005
Commercial segment premium revenues decreased 7.3% to $6.5 billion for 2005, compared to $7.0 billion for 2004. Lower premium revenues primarily resulted from a reduction of fully insured membership partially offset by increases in average per member premiums. Our fully insured membership decreased 12.5%, or 286,700 members, to 1,999,800 at December 31, 2005 compared to 2,286,500 at December 31, 2004. The decrease is primarily due to the relinquishment of an 89,000-member unprofitable account on January 1, 2005 and continued attrition due to the ongoing competitive environment within the fully insured group accounts, partially offset by membership gains in the individual and consumer-choice product lines. Average per member premiums for our fully insured group medical members increased approximately 7.4% in 2005.
Investment income totaled $143.0 million in 2005, an increase of $10.2 million from $132.8 million in 2004. This increase primarily was attributable to higher interest rates and average invested balances offset by lower capital gains. Net realized capital gains of $18.3 million in 2005 decreased $9.9 million from $28.2 million in 2004. As of December 31, 2005, we had an unrealized gain of $52.3 million related to a venture capital investment which was realized in the first quarter of 2006.
Consolidated medical expenses increased $981.8 million or 9.2% during 2005. The increase was primarily driven by the increase in average per member claims costs primarily from the effects of health care inflation and incremental medical expenses related to the CarePlus acquisition.
The Government segment’s medical expenses increased $1.4 billion, or 30.0% during 2005 primarily due to the increase in average per member claims costs and the increase in the number of Medicare Advantage members, including those related to the CarePlus acquisition. The increase in average per member claims costs for Medicare Advantage approximated 8% to 10% during 2005.
The Government segment’s MER for 2005 was 83.1%, a 120 basis point decrease from the 2004 rate of 84.3%. Excluding a 10 basis point increase in the 2005 MER from Hurricane Katrina, the decrease was primarily
attributable to the increase in Medicare Advantage revenues as a percentage of total Government segment revenues and average per member Medicare Advantage premiums outpacing average per member Medicare Advantage claim costs.
Consolidated SG&A expenses increased $301.3 million or 15.9% during 2005 primarily resulting from an increase in the number of employees due to the Medicare expansion, the class action litigation settlement, and increased advertising and marketing costs also due to the Medicare expansion. These increases were partially offset by a decrease in administrative expenses associated with transitioning to the TRICARE South Region contract in 2004. During 2005, the number of employees increased 5,000 to 18,700 at December 31, 2005, primarily in the sales and customer service functions associated with the growth in the Medicare business, as well as approximately 1,200 employees added with the CarePlus acquisition.
The consolidated SG&A expense ratio for 2005 was 15.4%, increasing 80 basis points from 14.6% for 2004. Expenses related to the class action litigation settlement increased the SG&A expense ratio 50 basis points for 2005. After considering the effect of litigation expenses, the SG&A expense ratio increase primarily resulted from a commercial membership mix shift and increased spending associated with the Medicare expansion.
SG&A expenses in the Government segment increased $248.1 million, or 34.7% during 2005 due to the CarePlus acquisition, increased spending associated with the Medicare expansion, and the class action litigation settlement. These increases were partially offset by a decrease in TRICARE expenses from the transition to the South Region contract in 2004. The Government segment SG&A expense ratio increased 40 basis points from 12.3% for 2004 to 12.7% for 2005. Expenses related to the class action litigation settlement increased the SG&A expense ratio 50 basis points for 2005.
Interest expense was $39.3 million for 2005, compared to $23.2 million for 2004, an increase of $16.1 million. This increase primarily resulted from higher interest rates and higher average outstanding debt.
Our primary sources of cash include receipts of premiums, ASO fees, CMS settlements, 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, CMS settlements, interest expense, taxes, purchases of investment securities, capital expenditures, acquisitions, 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 should normally produce positive cash flows during a period of increasing enrollment. Conversely, cash flows would be negatively impacted during a period of shrinking enrollment. We have recently been experiencing 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.
Cash and cash equivalents increased to $1,740.3 million at December 31, 2006 from $732.0 million at December 31, 2005. The change in cash and cash equivalents for the years ended December 31, 2006, 2005 and 2004 is summarized as follows:
The increase in operating cash flows for 2006 resulted from Medicare enrollment growth, improved earnings, and the timing of cash flows associated with our new Medicare Part D offerings. Our Part D results related to both stand-alone PDP and MA-PD offerings reflect provisions for net amounts payable to CMS of $738.7 million under the risk corridor terms of our contracts with CMS. This risk corridor amount, which is expected to be paid mid-2007, 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 detail of total net receivables was as follows at December 31, 2006, 2005 and 2004:
The increase in TRICARE base receivables from 2004 to 2005 was primarily due to the transition to the reimbursement model under the South Region contract beginning on August 1, 2004 and higher claims inventories at our third party claims processing vendor. The transition to the South region contract had the effect of increasing the TRICARE base receivable and a corresponding increase in TRICARE claims payable.
The detail of medical and other expenses payable was as follows at December 31, 2006, 2005 and 2004:
(3) Reported claims in process represents the estimated valuation of processed claims that are in the post claim adjudication process, which consists of administrative functions such as audit and check batching and handling.
We reinvested a portion of our operating cash flows over the last several years in investment securities, primarily short-duration fixed income securities, totaling $862.1 million in 2006, $233.3 million in 2005, and $407.3 million in 2004. Our ongoing capital expenditures primarily relate to our technology initiatives and administrative facilities necessary for activities such as claims processing, billing and collections, medical utilization review, and customer service. Total capital expenditures, excluding acquisitions, were $193.2 million
Subsidies from CMS associated with Medicare Part D claims for which we do not assume risk were $122.3 million less than the claim payments, as described in Note 2 to the consolidated financial statements included in Item 8.-Financial Statements and Supplementary Data.
In May 2006, we issued $500 million of 6.45% senior notes due June 1, 2016 as discussed previously. We paid $300 million when our 7.25% senior notes matured on August 1, 2006. Our senior notes and related swap agreements are more fully discussed in Note 10 to the consolidated financial statements included in Item 8.-Financial Statements and Supplementary Data.
On July 14, 2006, we replaced our existing 5-year $600 million unsecured revolving credit agreement with a 5-year $1.0 billion unsecured revolving credit agreement. We entered into the credit agreement for general corporate purposes. Under the credit agreement, at our option, we can borrow on either a competitive advance
basis or a revolving credit basis. The revolving credit portion bears interest at either a fixed rate or floating rate based on LIBOR plus a spread. The spread, which varies depending on our credit ratings, ranges from 27 to 80 basis points. We also pay an annual facility fee regardless of utilization. This facility fee, currently 10 basis points, may fluctuate between 8 and 20 basis points, depending upon our credit ratings. In addition, a utilization fee of 10 basis points is payable for any day in which borrowings under the facility exceed 50% of the total $1 billion commitment. The competitive advance portion of any borrowings will bear interest at market rates prevailing at the time of borrowing on either a fixed rate or a floating rate basis, at our option.
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, 2006 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,
We are contractually obligated to make payments for years subsequent to December 31, 2006 as follows:
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, 2006, we are not involved in any SPE transactions.
Our operating lease of an airplane, which expires January 1, 2010, provides for a residual value payment of no more than $4.8 million at the end of the lease term. At the end of the term, we have the right to exercise a purchase option for $8.9 million or the airplane can be sold to a third party. The residual value payment will be reduced by the net sales proceeds in excess of $4.2 million from the sale of the airplane to a third party.
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 26, 2007-see “Certain Transactions with Management and Others.”
Our Medicare business, which accounted for approximately 55% of our total premiums and ASO fees for the year ended December 31, 2006, primarily consisted of products covered under the Medicare Advantage and stand-alone PDP contracts with the federal government. These contracts are renewed generally for a one-year term each December 31 unless CMS notifies Humana of its decision not to renew by May 1 of the contract year, or Humana notifies CMS of its decision not to renew by the first Monday in June of the contract year. All material contracts between Humana and CMS relating to our Medicare business have been renewed for 2007.
Our TRICARE business, which accounted for approximately 12% of our total premiums and ASO fees for the year ended December 31, 2006, primarily consisted of the South Region contract. The 5-year South Region contract is subject to annual renewals on April 1 of each year at the government’s option. Effective April 1, 2006, the South Region contract was extended into the third option period, which runs from April 1, 2006 to March 31, 2007. We have received a notice from the government of its intent to renew the fourth option period. The 5-year South Region contract expires March 31, 2009. As required under the contract, the target underwritten health care cost and underwriting fee amounts for the third 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.
Our Medicaid business, which accounted for approximately 3% of our total premiums and ASO fees for the year ended December 31, 2006, consisted of contracts in Puerto Rico and Florida. Our Medicaid contracts with the Puerto Rico Health Insurance Administration accounted for approximately 2% of our total premium and ASO fees for the year ended December 31, 2006. We currently are operating under the terms of our contracts that expired October 31, 2006. Due to several ongoing and unresolved issues with the program, the government of Puerto Rico has decided to delay the bid process for new contracts. We currently are working with the Puerto Rico Health Insurance Administration regarding terms and rates which is expected to result in an extension of the existing contracts through September 30, 2007. There is no assurance that the Puerto Rico Health Insurance Administration will request such an extension, and we are unable to predict the ultimate impact that any government policy or fiscal decisions might have on the continuation of our Medicaid contracts in Puerto Rico.
The following table provides a historical perspective regarding the accrual and payment of our medical and other expense payable. Components of the total incurred claims for each year include amounts accrued for current year estimated medical expense as well as adjustments to prior year estimated accruals.
As summarized in the previous table, claim reserve balances at December 31, 2005 ultimately settled during 2006 for $275.5 million less than the amounts originally estimated. During 2005, claim reserve balances at December 31, 2004 ultimately settled for $114.2 million less than the amounts originally estimated. This $161.3 million change in the amounts incurred related to prior years for 2006 as compared to 2005 consisted of $106.2 million attributable to our Medicare and commercial lines of business, as well as $55.1 million attributable to our TRICARE line of business. Amounts attributable to our TRICARE line of business are discussed separately due to the additional variability and risk sharing provisions with the Department of Defense and subcontractors. As previously described, our key assumptions consist of trend factors and completion factors using an assumption of moderately adverse conditions. In our Medicare and commercial operations, 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. In our TRICARE line of business, both our trend factor and completion factor assumptions ultimately developed favorable versus our original estimate primarily due to the utilization of hospital and physician services during the latter half of 2005 ultimately being lower than estimated, changes in claim payment patterns resulting from fluctuations in claim inventory levels, and an increase in claim overpayment recovery levels versus our historical overpayment recovery rate.
We generally establish one-year contracts with commercial employer groups, subject to cancellation by the employer group on 30-day written notice. Our Medicare contracts with the federal government renew annually while our Medicaid and TRICARE contracts with state and federal governments, respectively, are generally multi-year contracts subject to annual renewal provisions.
Premium revenues and ASO fees are estimated by multiplying the membership covered under the various contracts by the contractual rates. In addition, we adjust revenues for estimated changes in an employer’s enrollment and individuals that ultimately may fail to pay. Enrollment changes not yet reported by an employer group, an individual, or the government, also known as retroactive membership adjustments, are estimated based on available data and historical trends. We monitor the collectibility of specific accounts, the aging of receivables, as well as prevailing and anticipated economic conditions, and reflect any required adjustments in the current period’s revenue.
We bill and collect premium and ASO fee remittances from employer groups, the federal and state governments, and individual members monthly. Premium and ASO fee receivables are presented net of allowances for estimated uncollectible accounts and retroactive membership adjustments. Premiums and ASO fees received prior to the period members are entitled to receive services are recorded as unearned revenues.
related to these risk corridor provisions based upon pharmacy claims experience to date as if the annual contract were to terminate at the end of the reporting period. Accordingly, this estimate provides no consideration to future pharmacy claims experience. We record a receivable or payable at the contract level and classify the amount as current or long-term in the consolidated balance sheets based on the expected settlement.
The estimate of the settlement associated with risk corridor provisions, which is not expected to be applied against the rigors of a final settlement with CMS until mid-2007, requires us to consider factors that may not be certain. These factors include some first year implementation issues such as member eligibility differences with CMS, as well as interpretations of CMS operational guidance. Our estimate of the settlement associated with the Medicare Part D risk corridor provisions was a net liability of $738.7 million at December 31, 2006.
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 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 medical expenses. We continually review these medical expense estimates of future payments to the government for cost overruns and make necessary adjustments to our reserves.
The TRICARE contract contains provisions to negotiate change orders. Change orders occur when we perform services or incur costs under the directive of the federal government that were not originally specified in our contract. Under federal regulations we may be entitled to an equitable adjustment to the contract price in these situations. Change orders may be negotiated and settled at any time throughout the year. We record revenue applicable to change orders when services are performed and these amounts are determinable and the collectibility is reasonably assured.
Investment securities totaled $3,607.2 million, or 36% of total assets at December 31, 2006. Debt securities totaled $3,598.3 million, or 99% of this investment portfolio. More than 97% of our debt securities were of investment-grade quality, with an average credit rating of AA+ by S&P at December 31, 2006. Most of the debt securities that are below investment grade are rated at the higher end (BB or better) of the non-investment grade spectrum. Our investment policy limits investments in a single issuer and requires diversification among various asset types.
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 at December 31, 2006, included the following:
Unrealized losses at December 31, 2006 resulted from 425 positions out of a total of 758 positions held. Approximately 30% of the carrying value of our consolidated 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
Our strategy, long-range business plan, and annual planning process support our goodwill impairment tests. These tests are based primarily on an evaluation of future discounted cash flows under several scenarios. Outcomes from the discounted cash flow analysis were compared to other market approach valuation methodologies for reasonableness. We used a range of discount rates that correspond to a market-based weighted-average cost of capital. Key assumptions, including changes in membership, premium yields, medical cost trends and certain government contract extensions, are consistent with those utilized in our long-range business plan and annual planning process. If these assumptions differ from actual, the estimates underlying our goodwill impairment tests could be adversely affected. Goodwill impairment tests completed in each of the last three years did not result in an impairment loss.
Headquartered in Louisville, Kentucky, Humana Inc. is one of the nation’s largest publicly traded health benefits companies, based on our 2006 revenues of $21.4 billion. References throughout this document to “we,” “us,” “our,” “Company,” and “Humana,” mean Humana Inc. and its subsidiaries. We offer coordinated health insurance coverage and related services through a variety of traditional and consumer-choice plans for government-sponsored programs, employer groups, and individuals. We derived approximately 67% of our premiums and administrative services fees from contracts with the federal government in 2006. Under our federal government contracts with the Centers for Medicare and Medicaid Services, or CMS, we provide health and pharmacy insurance coverage for Medicare members in Florida, accounting for approximately 17% of our total premiums and administrative services fees in 2006. CMS is the federal government’s agency responsible for administering the Medicare program. Under a federal government contract with the Department of Defense, we provide health insurance coverage to TRICARE members, accounting for approximately 12% of our total premiums and administrative services fees in 2006.
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 medical expenses 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.
For the purpose of determining gross realized gains and losses, which are included as a component of investment income in the consolidated statements of income, the cost of investment securities sold is based upon specific identification. 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.
We participate in a securities lending program to maximize investment income. We loan certain investment securities for short periods of time in exchange for collateral initially equal to at least 102% of the fair value of the investment securities on loan. The fair value of the loaned investment securities is monitored on a daily basis, with additional collateral obtained or refunded as the fair value of the loaned investment securities fluctuates. The collateral, which may be in the form of cash or U.S. Government securities, is deposited by the borrower with an independent lending agent. Any cash collateral is invested by the lending agent according to our investment guidelines, primarily in cash equivalents or other liquid investments. Cash collateral is recorded on our consolidated balance sheets, along with a liability to reflect our obligation to return the collateral. Collateral received in the form of securities is not recorded in our consolidated balance sheets because we do not have the right to sell, pledge or otherwise reinvest securities collateral. Loaned securities continue to be carried as investment securities on the consolidated balance sheets. Revenue, net of related expense, is recorded as investment income.
We generally establish one-year commercial membership contracts with employer groups, subject to cancellation by the employer group on 30-day written notice. Our TRICARE contract with the federal government and our contracts with various state Medicaid programs generally are multi-year contracts subject to annual renewal provisions. Our Medicare contracts with CMS renew annually.
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 claims 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.
For plans where we provide enhanced benefits and selected the alternative demonstration payment option in lieu of the reinsurance subsidy, we receive a monthly per member capitation amount from CMS determined from our annual bid submissions. The capitation amount we receive from CMS for assuming the government’s portion of prescription drug costs in the catastrophic layer of coverage is recorded as premium revenue. The variance between the capitation amount and actual drug costs in the catastrophic layer is subject to risk sharing as part of the risk corridor settlement.
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 service 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 amount is determinable and the collectibility is reasonably assured. We estimate and recognize contingent medical expense for unfavorable variances currently in our results of operations. We continually review the contingent medical expense estimates of future payments to the government for cost overruns and make necessary adjustments to our reserves.
ASO fees are recognized as income in the period services are performed. ASO fees cover the processing of claims, offering access to our provider networks and clinical programs, and responding to customer service inquiries from members of self-funded groups. Under ASO contracts, self-funded employers retain the risk of financing substantially all of the cost of health benefits. However, most ASO customers purchase stop loss insurance coverage from us to cover catastrophic claims or to limit aggregate annual costs. Accordingly, we have recorded premiums and medical expenses related to these stop loss arrangements.
Other revenues primarily relate to an in-house mail order pharmacy operation. These revenues are recognized in connection with the shipment of the prescriptions.
Policy acquisition costs are those costs that vary with and primarily are related to the acquisition of new and renewal business. Such costs include broker commissions, costs of policy issuance and underwriting, and other costs we incur to acquire new business or renew existing business. We expense policy acquisition costs related to our employer-group prepaid health services policies as incurred in accordance with the Health Care Organization Audit and Accounting Guide. These short-duration employer-group prepaid health services policies typically have a one-year term and may be cancelled upon 30 days notice by the employer group.
Goodwill represents the unamortized excess of cost over the fair value of the net tangible and other intangible assets acquired. SFAS No. 142, Goodwill and Other Intangible Assets, or SFAS 142, requires that we not amortize goodwill to earnings, but instead 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 one level below our Commercial and Government segments. The Commercial segment’s two reporting units consist of medical (fully and self insured) and
specialty. The Government segment’s three reporting units consist of Medicare, TRICARE and Medicaid. Goodwill is assigned to the reporting unit that is expected to benefit from a specific acquisition.
SFAS 142 requires a two-step process to review goodwill for impairment. The first step is a screen for potential impairment, and the second step measures the amount of impairment, if any. Impairment tests are performed, at a minimum, in the fourth quarter of each year supported by our long-range business plan and annual planning process. Impairment tests completed for 2006, 2005 and 2004 did not result in an impairment loss.
Other intangible assets primarily relate to acquired subscriber and provider contracts and are included with other long-term assets in the consolidated balance sheets. Other intangible assets are amortized over the useful life, based upon the pattern of future cash flows attributable to the asset. This sometimes results in an accelerated method of amortization for subscriber contracts because the asset tends to dissipate at a more rapid rate in earlier periods. Other than subscriber contracts, other intangible assets generally are amortized using the straight-line method. We review other finite-lived intangible assets for impairment under our long-lived asset policy.
We reassess the profitability of our contracts for providing health insurance coverage to our members when current operating results or forecasts indicate probable future losses. We establish a premium deficiency liability in current operations to the extent that the sum of expected future medical costs, claim adjustment expenses, and maintenance costs exceeds related future premiums under contract without consideration of investment income. For purposes of premium deficiencies, contracts are grouped in a manner consistent with our method of acquiring, servicing, and measuring the profitability of such contracts. Losses recognized as a premium deficiency result in a beneficial effect in subsequent periods as operating losses under these contracts are charged to the liability previously established. There were no premium deficiency liabilities recorded at December 31, 2006 and 2005. Because the majority of our member contracts renew annually, we do not anticipate recording a premium deficiency liability, except when unanticipated adverse events or changes in circumstances indicate otherwise.
For our health and life policies sold to individuals and accounted for as long-duration insurance products under the provisions of SFAS 60, medical and other expenses payable include liabilities for future policy benefits for which some of the premium received in the earlier years is intended to pay anticipated benefits to be incurred in future years.
We recognize an asset or liability for the deferred tax consequences of temporary differences between the tax bases of assets or liabilities and their reported amounts in the consolidated financial statements. These temporary differences will result in taxable or deductible amounts in future years when the reported amounts of the assets or liabilities are recovered or settled. We also recognize the future tax benefits such as net operating and capital loss carryforwards as deferred tax assets. A valuation allowance is provided against these deferred tax assets if it is more likely than not that some portion or all of the deferred tax assets will not be realized. Future years’ tax expense may be increased or decreased by adjustments to the valuation allowance or to the estimated accrual for income taxes.
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
On May 1, 2006, our Commercial segment acquired CHA Service Company, or CHA Health, a health plan serving employer groups in Kentucky, for cash consideration of $67.5 million, including a $1.7 million contingent purchase price settlement paid in January 2007. This acquisition strengthens our position in the Kentucky market. The fair value of net tangible assets acquired of $20.0 million primarily consisted of cash and cash equivalents. The purchase price exceeded the estimated fair value of the net tangible assets acquired by approximately $47.5 million. We allocated this excess purchase price to other intangible assets of $12.2 million and associated deferred tax liabilities of $4.6 million, and non-deductible goodwill of $39.9 million. The other intangible assets, which primarily consist of customer contracts, have a weighted average useful life of 6.8 years. We used an independent third party valuation specialist firm to assist us in evaluating the fair value of assets acquired.
On February 16, 2005, our Government segment acquired CarePlus Health Plans of Florida, or CarePlus, as well as its affiliated 10 medical centers and pharmacy company, for cash consideration of $444.9 million.
Investment securities classified as current assets were as follows at December 31, 2006 and 2005:
Long-term investment securities with a fair value of $99.1 million at December 31, 2006 and $93.5 million at December 31, 2005 were on deposit at financial institutions in certain states pursuant to the respective states’ insurance regulations.
The contractual maturities of debt securities available for sale at December 31, 2006, regardless of their balance sheet classification, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Depreciation expense was $128.6 million in 2006, $105.1 million in 2005, and $107.3 million in 2004. Depreciation expense in 2004 included the impact of accelerating depreciation related to abandoned software more fully described below.
After finalizing plans during the third quarter of 2004 to abandon some enrollment software by December 31, 2004, we reduced the estimated useful life of the software effective July 1, 2004. Accordingly, we
accelerated the depreciation of the remaining software balance. The change in the useful life increased depreciation expense during 2004 by approximately $9.3 million ($5.7 million after tax), all of which was allocated to the Commercial segment.
Changes in the carrying amount of goodwill, by operating segment, for the year ended December 31, 2006 were as follows:
The following table presents details of our other intangible assets included in other non-current assets in the accompanying consolidated balance sheets at December 31, 2006 and 2005:
Activity in medical and other expenses payable was as follows for the years ended December 31, 2006, 2005 and 2004:
During 2004, claim reserve balances at December 31, 2003 ultimately settled during 2004 for $93.5 million less than the amounts originally estimated. The $20.7 million change in the amounts incurred related to prior years for 2005 as compared to 2004 consisted of $16.3 million attributable to our TRICARE line of business and $4.4 million attributable to our Medicare and commercial lines of business. In each of these lines of business, the favorable development primarily was due to the utilization of hospital and physician services during the latter half of 2004 ultimately being lower than originally estimated.
Certain of our Medicare Advantage and Medicaid members are also under risk-sharing arrangements with providers. Accordingly, the impact of changes in estimates for prior year medical claims payable on our results of operations that are attributable to our Medicare and Medicaid lines of business may also be significantly reduced, whether positive or negative.
The provision for income taxes consisted of the following for the years ended December 31, 2006, 2005 and 2004:
Long-term debt outstanding was as follows at December 31, 2006 and 2005:
In May 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 $300 million of 7.25% senior notes which matured on August 1, 2006.
At December 31, 2006, the fair value of all our swap agreements was in our favor by $18.1 million and included in other long-term assets. Likewise, the carrying values of all of our senior notes have been increased $18.1 million to reflect their fair values. The counterparties to our swap agreements are major financial institutions with which we also have other financial relationships.
In June 2003, we recorded a deferred gain and received proceeds of $31.6 million in exchange for new swap agreements related to our 7.25% senior notes. The corresponding deferred swap gain of $31.6 million was being amortized to reduce interest expense over the remaining term of the 7.25% senior notes which matured August 1, 2006. Amortization of the deferred swap gain reduced interest expense by $6.1 million in 2006, $10.2 million in 2005, and $9.8 million in 2004.
On March 31, 2006, we filed a universal shelf registration statement with the SEC. We are considered a “well known seasoned issuer” under the Securities Offering Reform Act that became effective in December 2005. The universal shelf registration allows us to sell our debt or equity securities, from time to time, with the amount, price and terms to be determined at the time of the sale. The net proceeds from any future sales of our securities under the universal shelf registration may be used for our operations and for other general corporate purposes, including repayment or refinancing of borrowings, working capital, capital expenditures, investments, acquisitions, or the repurchase of our outstanding securities.
We have defined contribution retirement and savings plans covering eligible employees. Our contribution to these plans is based on various percentages of compensation, and in some instances, on the amount of our employees’ contributions to the plans. The cost of these plans amounted to approximately $56.0 million in 2006, $42.9 million in 2005, and $37.6 million in 2004, all of which was funded currently to the extent it was deductible for federal income tax purposes. Based on the year end closing stock price of $55.31, approximately 26% of the retirement and savings plan’s assets were invested in our common stock representing 3% of the shares outstanding as of December 31, 2006. Through December 31, 2006, the Company match was invested in 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 match in cash is invested in the same way as a participant’s contributions to the plan as directed by the participant.
We provide severance and related employee benefits based upon our existing employee benefit plans and policies. Severance benefits are generally determined based on years of service and salary. We accrue severance benefits when payment is probable and reasonably estimable in accordance with SFAS No. 112, Employers’ Accounting for Postemployment Benefits. The cost of this benefit amounted to approximately $2.7 million in 2006, $0.7 million in 2005 and $15.5 million in 2004. Severance is paid bi-weekly resulting in payments in periods subsequent to termination. We continually review estimates of future payments for probable severance benefits and make necessary adjustments to our liability for severance benefits.
stock-based compensation awards are settled with authorized but unissued company stock. The compensation expense that has been charged against income for these plans was as follows for the years ended December 31, 2006, 2005, and 2004:
A greater proportion of the awards granted to employees, excluding executive officers, during 2006 were restricted stock awards as opposed to stock options when compared to grants made in prior years.
Beginning April 2006, the stock plans provide that one restricted share is equivalent to 1.7 stock options. At December 31, 2006, there were 19,559,951 shares reserved for stock award plans, including 12,190,484 shares of common stock available for future grants assuming all stock options or 7,170,873 shares available for future grants assuming all restricted shares.
The weighted average fair value of each option granted during 2006, 2005, and 2004 is provided below. The fair value was estimated on the date of grant using the Black-Scholes pricing model with the weighted average assumptions indicated below:
We base the risk-free interest rate on a traded zero-coupon U.S. Treasury bond with a term substantially equal to the option’s expected term.
Activity for our option plans was as follows for the year ended December 31, 2006:
(1) Computed based upon the amount by which the fair market value of our common stock at December 29, 2006 of $55.38 per share exceeded the weighted average exercise price.
(2) We began estimating forfeitures under SFAS 123R upon adoption on January 1, 2006.
The total intrinsic value of stock options exercised during 2006 was $133.7 million, compared with $57.8 million during 2005 and $18.9 million during 2004. Cash received from stock option exercises for the years ended December 31, 2006, 2005, and 2004 totaled $49.2 million, $36.4 million, and $30.0 million, respectively.
Total compensation expense related to nonvested options not yet recognized was $19.3 million at December 31, 2006. We expect to recognize this compensation expense over a weighted average period of approximately 1.7 years.
Restricted stock awards are granted with a fair value equal to the market price of our common stock on the date of grant. Compensation expense is recorded straight-line over the vesting period, generally three years from the date of grant.
Future annual minimum payments due subsequent to December 31, 2006 under all of our noncancelable operating leases with initial terms in excess of one year are as follows:
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 67% for 2006, 51% for 2005 and 43% for 2004.
A reinsurance agreement between two entities transfers the underwriting risk of policyholder liabilities to a reinsurer; while the primary insurer retains the contractual relationship with the ultimate insured. As such, these reinsurance agreements do not completely relieve us of our potential liability to the ultimate insured. However, given the transfer of underwriting risk, our potential liability is limited to the credit exposure which exists should the reinsurer be unable to meet its obligations assumed under these reinsurance agreements.
Given that all policies are 100% reinsured by third parties, the following amounts pertaining to the reinsurance agreements had no effect on our results of operations. Premiums ceded were $15.7 million in 2006, $21.7 million in 2005, and $30.0 million in 2004. Liabilities, included in other long-term liabilities, and related reinsurance recoverables, included in other long-term assets, in the accompanying consolidated balance sheets under these coinsurance agreements were $242.7 million at December 31, 2006 and $253.4 million at December 31, 2005.
We have completed integrated audits of Humana Inc.’s consolidated financial statements and of its internal control over financial reporting as of December 31, 2006, in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of stockholders’ equity and of cash flows present fairly, in all material respects, the financial position of Humana Inc. and its subsidiaries at December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15 (2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 2 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, in accordance with the modified retrospective method effective January 1, 2006.
(a) Includes the operations of CHA Health since May 1, 2006, the date of its acquisition.
(d) We adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, or SFAS 123R, on January 1, 2006. We have adjusted prior period amounts to reflect the effect of expensing stock awards under the modified retrospective application method of SFAS 123R.