(a) Includes the acquired operations of DefenseWeb Technologies, Inc. from March 1, 2007, the acquired operations of CompBenefits Corporation from October 1, 2007, and the acquired operations of KMG America Corporation from November 30, 2007. Also includes the benefit of $68.9 million ($43.0 million after tax, or $0.25 per diluted share) related to our 2006 Medicare Part D reconciliation with CMS and the settlement of some TRICARE contractual provisions related to prior years.
(c) 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.
(d) Includes the acquired operations of Ochsner Health Plan from April 1, 2004.
Our industry relies on two key statistics to measure performance. The benefits ratio, which is computed by taking total benefit expenses as a percentage of premium revenues, represents a statistic used to measure underwriting profitability. The selling, general, and administrative expense ratio, or SG&A expense ratio, which is computed by taking total selling, general and administrative expenses as a percentage of premium revenues, administrative services fees and other revenues, 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, has led to significant growth. Medicare Advantage membership increased to 1,143,000 members at December 31, 2007, up 14.0% from 1,002,600 at December 31, 2006 and up 104.9% from 557,800 at December 31, 2005, primarily due to sales of Private Fee-For-Service, or PFFS, products. Average Medicare Advantage membership was 26.4% higher for the year ended December 31, 2007 compared to the year ended December 31, 2006, and average stand-alone PDP membership was 19.5% higher. Likewise, Medicare premium revenues have increased $3.3 billion, or 28.5%, to $14.8 billion for the year ended December 31, 2007 from $11.5 billion for the year ended December 31, 2006. We expect Medicare Advantage membership to continue to grow into 2008, adding between 200,000 and 250,000 members by December 31, 2008, with a shift in sales mix towards our PPO and HMO offerings.
Our quarterly Government segment earnings are particularly impacted by the Medicare Part D benefit design and changes in the composition of our membership. The Medicare Part D benefit design results in coverage that varies as a member’s cumulative out-of-pocket costs pass through successive stages of a member’s plan period which begins January 1 for renewals. These plan designs generally result in us sharing a greater portion of the responsibility for total pharmacy costs in the early stages and less in the latter stages. As a result the Government segment’s benefits ratio generally improves as the year progresses. In addition, the number of low-income senior members as well as year over year changes in the mix of membership in our stand-alone PDP products, Standard, Enhanced, and Complete, affect the quarterly benefits ratio pattern. We expect the combination of these items will result in a greater proportion of earnings for 2008 to be earned in the first half versus the second half when compared to the quarterly earnings pattern in 2007.
Earnings increased 69% to $4.91 per diluted common share in 2007 from $2.90 per diluted common share in 2006, primarily due to increased premium revenue from higher average Medicare membership.
Year over year comparisons were impacted by changes in estimates associated with our 2006 Medicare Part D reconciliation with CMS and the settlement of some TRICARE contractual provisions related to prior years which increased our Government segment’s results by $68.9 million pretax, or $0.25 per
Currently, we are anticipating a formal request for proposal, or RFP, for the TRICARE contracts.
Medical membership was as follows at December 31, 2007 and 2006:
as a result of the CompBenefits and KMG acquisitions. Increases in average fully-insured per member premiums were offset by a decrease in average fully-insured membership. Average fully-insured group membership decreased 6.9% for 2007 compared to 2006, primarily as a result of a large group account moving from fully-insured to ASO on July 1, 2006, partially offset by membership gains in strategic areas of commercial growth including Smart plans and other consumer offerings, individual, and small group product lines. Average per member premiums for our fully-insured group medical members increased approximately 5.2% from 2006 to 2007.
For the Government segment, administrative services fees increased $24.2 million, or 49.0%, to $73.7 million for 2007 as a result of the DefenseWeb acquisition and the award of a new Puerto Rico ASO contract during the fourth quarter of 2006.
The Commercial segment’s benefit expense decreased $6.2 million, or 0.1%, from 2006 to 2007. This decrease primarily results from the decrease in fully-insured group membership partially offset by the increase in average per member claims costs due to medical expense inflation.
The benefits ratio for the Commercial segment of 80.5% for 2007 decreased 120 basis points from the 2006 benefits ratio of 81.7%. The decrease in the benefits ratio primarily reflects an increase in the percentage of individual and small group members comprising our total fully-insured block, the CompBenefits and KMG acquisitions which added dental, vision, and other supplemental health and life members, and improving medical cost utilization. Individual and smaller group as well as specialty, primarily dental and vision, accounts generally carry a lower benefits ratio and a higher SG&A expense ratio compared to larger group accounts due to higher distribution costs. See related SG&A expense ratio discussion in the following section.
Consolidated SG&A expenses increased $455.0 million, or 15.1%, during 2007 compared to 2006. The increase primarily resulted from an increase in the number of employees due to the Medicare expansion, expenses associated with RightSourceSM, our mail order pharmacy, and higher Medicare marketing expenses associated with higher sales goals for 2008 compared to 2007. The number of employees increased by 2,700 to 25,000 at December 31, 2007 from 22,300 at December 31, 2006, or 12.1%.
administrative costs associated with increased business for our mail order pharmacy. For 2007, 46.8% of our Commercial segment average medical membership was related to ASO business compared to 44.5% for 2006. Likewise, at December 31, 2007, 29.3% of our Commercial segment average medical membership was related to individual and small group accounts compared to 27.7% at December 31, 2006. Fee based ASO business carries a higher SG&A expense ratio than fully-insured business since there is no benefit expense or offsetting premium revenue. Additionally, individual and smaller group accounts carry a higher SG&A expense ratio due to higher distribution costs compared to larger group accounts.
Our effective tax rate for 2007 of 35.3% compared to the effective tax rate of 36.0% for 2006. The decrease is primarily due to a lower state tax rate. The lower state tax rate results from a shift in the geographic mix of revenues to states with lower tax rates. 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. We expect the 2008 effective tax rate to be in the range of 35.5% to 36.0%.
On October 17, 2005, we reached an agreement with representatives of more than 700,000 physicians to settle a nationwide class action suit. In connection with the settlement and other related litigation costs, we recorded pretax administrative expenses of $71.9 million ($44.8 million after taxes, or $0.27 per diluted common share) in the third quarter of 2005. Of the $71.9 million, $33.4 million was included in the Government segment results and the remaining $38.5 million was included in the Commercial segment results. These amounts were paid in 2006.
Government segment premium revenues increased $7.1 billion, or 93.6% to $14.6 billion for 2006, compared to $7.5 billion for 2005. This increase primarily was attributable to the expanded participation in various Medicare products and geographic markets. Sales of our PFFS products drove the majority of the 79.7%
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 as well as Smart plans and other consumer 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.
Our administrative services fees for 2006 were $341.2 million, an increase of $81.8 million, or 31.5%, from $259.4 million for 2005. The increase was due to increases in our Commercial segment administrative services fees.
For the Commercial segment, administrative services fees increased $82.4 million, or 39.4%, from $209.4 million for 2005 to $291.8 million for 2006. This increase resulted from increased membership. ASO membership of 1,171,000 members at December 31, 2005 increased 30.6% to 1,529,600 at December 31, 2006. Average per member fees increased approximately 19% in 2006. ASO fees from our Commercial segment represent 86% of total ASO fees.
The consolidated benefits ratio for 2006 was 84.0%, an 80 basis point increase from 83.2% for 2005. Higher benefit expenses from Hurricane Katrina increased the 2005 benefits ratio 20 basis points. An improvement in the Commercial segment benefits ratio was more than offset by a higher Government segment benefits ratio impacted by the new Medicare stand-alone PDP offerings.
The Government segment’s benefits ratio for 2006 was 85.0%, a 190 basis point increase from 2005 of 83.1%. The increase was primarily attributable to the introduction of the stand-alone PDPs in January 2006 with a benefits ratio of 92.5% for 2006. The stand-alone PDP benefits ratio was negatively impacted by a benefits ratio in our Complete plan of 115.9% for 2006, one of three stand-alone PDP offerings representing approximately 12% of our stand-alone PDP members.
The consolidated SG&A expense ratio for 2006 was 14.3%, decreasing 110 basis points from 15.4% for 2005. Expenses related to the litigation settlement increased the SG&A expense ratio 50 basis points for 2005. After considering the effects of the litigation settlement, the remaining decrease resulted from growth in revenues from higher average medical membership outpacing the related increase in administrative spending on a consolidated basis during 2006.
The Commercial segment SG&A expenses increased $59.0 million, or 4.8%, during 2006 compared to 2005. The Commercial segment SG&A expense ratio of 20.0% for 2006 increased 150 basis points from 18.5%
Cash and cash equivalents increased to $2,040.5 million at December 31, 2007 from $1,740.3 million at December 31, 2006. The change in cash and cash equivalents for the years ended December 31, 2007, 2006 and 2005 is summarized as follows:
The detail of total net receivables was as follows at December 31, 2007, 2006 and 2005:
Military services base receivables consist of estimated claims owed from the federal government for health care services provided to beneficiaries and underwriting fees. The claim reimbursement component of military services base receivables is generally collected over a three to four month period. The timing of claim reimbursements resulted in the decrease in base receivables from 2006 to 2007 as well as from 2005 to 2006. The $28.0 million decrease in military services change order receivables from 2005 to 2006 resulted from the collection of receivables in 2006 related to an equitable adjustment to the contract price negotiated in late 2005 for services not originally specified in the contract.
Despite significant growth in Medicare, Medicare receivables declined $6.5 million from 2006 to 2007 due to the net collection of receivables associated with the CMS risk adjustment model. Likewise, the $77.3 million increase in Medicare receivables from 2005 to 2006 resulted from an increase in receivables associated with the CMS risk adjustment model.
(1) IBNR represents an estimate of benefits payable for claims incurred but not reported (IBNR) at the balance sheet date. The level of IBNR is primarily impacted by membership levels, medical claim trends and the receipt cycle time, which represents the length of time between when a claim is initially incurred and when the claim form is received (i.e. a shorter time span results in a lower IBNR).
Benefits payable increased during 2007 and 2006 primarily due to growth in Medicare membership and to a lesser extent medical claims inflation.
We reinvested a portion of our operating cash flows over the last several years in investment securities, primarily short-duration fixed income securities, totaling $430.1 million in 2007, $862.1 million in 2006, and $233.3 million in 2005. Our ongoing capital expenditures primarily relate to our information 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 $239.2 million in 2007, $193.2 million in 2006, and $165.8 million in 2005. The increased spending in 2007 primarily resulted from the
purchase of three medical centers which were previously leased in South Florida in the first quarter of 2007 for approximately $20.4 million. The increased spending in 2006 and 2005 primarily resulted from our Medicare expansion initiatives. Excluding acquisitions, we expect total capital expenditures in 2008 of approximately $275 million.
During 2007, we paid $369.1 million to acquire CompBenefits, $156.3 million to acquire KMG, and $27.0 million to acquire DefenseWeb. These amounts include $58.9 million of cash acquired.
During 2006, we paid $65.8 million to acquire CHA Health, including $43.5 million of cash acquired, and we paid $5.8 million to settle the purchase price contingencies associated with prior year acquisitions. During 2005, net of cash acquired, we paid $444.9 million to acquire CarePlus, and $54.0 million to acquire Corphealth. These amounts include $96.1 million of cash acquired.
During 2007, our net borrowings of $350 million under our credit agreements related to the financing of the CompBenefits and KMG acquisitions. During 2006, our borrowings of $550 million and repayments of $300 million under our credit agreements related to the timing of our senior notes issuance and repayment, and funding of additional capital into certain subsidiaries during 2006 in conjunction with growth in Medicare revenues. During 2005, we borrowed $494 million under our credit agreement related to the financing of the CarePlus acquisition, a portion of which was repaid in 2005.
We previously issued in the public debt capital markets, $300 million aggregate principal amount of 6.30% senior unsecured notes that mature on August 1, 2018 and $500 million aggregate principal amount of 6.45% senior unsecured notes that mature on June 1, 2016. We have entered into interest rate swap agreements to exchange the fixed interest rate under these senior notes for a variable interest rate based on LIBOR. 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.
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 each 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.
At December 31, 2007, we had $800 million of borrowings under the credit agreement outstanding at an interest rate, which varies with LIBOR, of 5.30%. In addition, we have outstanding letters of credit of $2.0 million secured under the credit agreement. No amounts have ever been drawn on these letters of credit. As of December 31, 2007, we had $198.0 million of remaining borrowing capacity under the credit agreement. We have other customary, arms-length relationships, including financial advisory and banking, with some parties to the credit agreement.
Other long-term borrowings of $38.6 million at December 31, 2007 represent junior subordinated debt assumed in the KMG acquisition of $36.1 million and financing for the renovation of a building of $2.5 million. The junior subordinated debt, which is due in 2037, may be called by us in 2012 and bears a fixed annual interest rate of 8.02% payable quarterly until 2012, and then payable at a floating rate based on LIBOR plus 310 basis points. The debt associated with the building renovation bears interest at 2.00%, is collateralized by the building, and is payable in various installments through 2014.
We believe our cash balances, investment securities, operating cash flows, access to debt and equity markets, and borrowing capacity, taken together, provide adequate resources to fund ongoing operating and regulatory requirements, to fund future expansion opportunities and capital expenditures in the foreseeable future, and to refinance debt as it matures.
In addition, we operate as a holding company in a highly regulated industry. Our parent company is dependent upon dividends and administrative expense reimbursements from our subsidiaries, most of which are subject to regulatory restrictions. Cash, cash equivalents and short-term investments at the parent company increased $111.3 million to $535.7 million at December 31, 2007 compared to $424.4 million at December 31, 2006 reflecting dividends received net of funding of additional capital into certain subsidiaries during 2007 in conjunction with growth in Medicare revenues. See Schedule I to this Form 10-K beginning on page 107 for our parent company only financial information.
Most states rely on risk-based capital requirements, or RBC, to define their required levels of equity discussed above. RBC is a model developed by the National Association of Insurance Commissioners to monitor an entity’s solvency. This calculation indicates recommended minimum levels of required capital and surplus and signals regulatory measures should actual surplus fall below these recommended levels. If RBC were adopted by the remaining states and Puerto Rico at December 31, 2007, we would have $966.3 million of aggregate capital and surplus above any of the levels that require corrective action under RBC, or individual state requirements based on the most recent statutory financial statements as of December 31, 2007.
We are contractually obligated to make payments for years subsequent to December 31, 2007 as follows:
(4) Excludes future policy benefits payable ceded to third parties through a 100% coinsurance agreement as more fully described in Note 16 to the consolidated financial statements included in Item 8.-Financial Statements and Supplementary Data. The reinsurance carrier, not us, is responsible for cash flows associated with the reinsured contract. Our reinsured reserves are supported by reinsurance recoverables included in other long-term assets. Our potential liability is limited to the credit exposure which exists should the reinsurer be unable to meet its obligations assumed under these reinsurance arrangements. We evaluate the financial condition of these reinsurers on a regular basis.
Our Medicare business, which accounted for approximately 60% of our total premiums and ASO fees for the year ended December 31, 2007, primarily consisted of products covered under the Medicare Advantage and Medicare Part D Prescription Drug Plan contracts with the federal government. These contracts are renewed
Military services benefits payable primarily consists of our estimate of incurred healthcare services provided to beneficiaries which are in turn reimbursed 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. This amount is generally offset by a corresponding receivable due from the federal government, as more fully-described on page 45.
Estimating IBNR is complex and involves a significant amount of judgment. Changes in this estimate can materially affect, either favorably or unfavorably, our results of operations and overall financial position. Accordingly, it represents a critical accounting estimate. Most benefit claims are paid within a few months of the member receiving service from a physician or other health care provider. As a result, these liabilities generally are described as having a “short-tail”. As such, we expect that substantially all of the December 31, 2007 estimate of benefits payable will be known and paid during 2008.
We develop our estimate for IBNR using actuarial methodologies and assumptions, primarily based upon historical claim experience. Depending on the period for which incurred claims are estimated, we apply a different method in determining our estimate. For periods prior to the most recent three months, the key assumption used in estimating our IBNR is that the completion factor pattern remains consistent over a rolling 12-month period after adjusting for known changes in claim inventory levels and known changes in claim payment processes. Completion factors result from the calculation of the percentage of claims incurred during a given period that have historically been adjudicated as of the reporting period. For the most recent three months, the incurred claims are estimated primarily from a trend analysis based upon per member per month claims trends developed from our historical experience in the preceding months, adjusted for known changes in estimates of recent hospital and drug utilization data, provider contracting changes, changes in benefit levels, changes in member cost sharing, product mix, and weekday seasonality.
consistently reliable result. Conversely, for the most recent three months of incurred claims, the volume of claims processed historically is not at a level sufficient to produce a reliable result, which therefore requires us to examine historical trend patterns as the primary method of evaluation. Changes in claim processes, including receipt cycle times, claim inventory levels, recoveries of overpayments, outsourcing, system conversions, and processing disruptions due to weather or other events affect views regarding the reasonable choice of completion factors. The receipt cycle time measures the average length of time between when a medical claim was initially incurred and when the claim form was received. Increased electronic claim submissions from providers have decreased the receipt cycle time over the last few years. For example, the average receipt cycle time has decreased from 16.5 days in 2005 to 15.6 days in 2007 which represents a 5.5% reduction in cycle time over the three year period.
(a) Reflects estimated potential changes in benefits payable caused by changes in completion factors for incurred months prior to the most recent three months.
Future policy benefits payable of $980.7 million and $320.6 million at December 31, 2007 and 2006, respectively, represent liabilities for long-duration insurance policies including life insurance, annuities and health policies sold to individuals for which some of the premium received in the earlier years is intended to pay anticipated benefits to be incurred in future years. These reserves are recognized on a net level premium method based on interest, mortality, morbidity, withdrawal and maintenance expense assumptions from published actuarial tables, modified based upon actual experience. Changes in estimates of these reserves are recognized as an adjustment to benefit expenses in the period the changes occur. Future policy benefits payable of $239.7 million at December 31, 2007 and $242.7 million at December 31, 2006 are subject to 100% coinsurance agreements as more fully described in Note 16 to the consolidated financial statements included in Item 8.-Financial Statements and Supplementary Data, and as such are offset by a related reinsurance recoverable included in other long-term assets. Long-duration insurance policies associated with the KMG acquisition increased the balance in future policy benefits payable at December 31, 2007 compared to December 31, 2006.
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.
On January 1, 2006, we began covering prescription drug benefits in accordance with Medicare Part D under multiple contracts with CMS. The payments we receive monthly from CMS and members, which are determined from our annual bid, represent amounts for providing prescription drug insurance coverage. We recognize premium revenues for providing this insurance coverage ratably over the term of our annual contract. Our CMS payment is subject to risk sharing through the Medicare Part D risk corridor provisions. In addition, we receive and disburse amounts for portions of prescription drug costs for which we are not at risk, as described more fully below.
The estimate of the settlement associated with risk corridor provisions requires us to consider factors that may not be certain, including, among others, member eligibility differences with CMS. In 2007, we paid $725.5 million related to our reconciliation with CMS regarding the 2006 Medicare Part D risk corridor provisions compared to our estimate of $738.7 million at December 31, 2006. 2006 marked the first year of providing for the risk corridor estimate and required us to consider factors which were not certain, including certain first year implementation issues. The net liability associated with the 2007 risk corridor estimate, which will be settled in 2008, was $102.6 million at December 31, 2007.
government’s portion of prescription drug costs in the catastrophic layer of coverage. The capitation amount represents a fixed monthly amount per member to provide prescription drug coverage in the catastrophic layer. We chose the demonstration payment option for all of our enhanced benefit plans. This capitation amount, derived from our annual bid submissions, 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.
Settlement of the reinsurance and low-income cost subsidies as well as the risk corridor payment is based on a reconciliation made approximately 6 months after the close of each calendar year. This reconciliation process requires us to submit claims data necessary for CMS to administer the program.
CMS has implemented a risk adjustment model which apportions premiums paid to all health plans according to health severity. The CMS risk adjustment model pays more for members with predictably higher costs, as more fully described in Item 1.-Business on page 5. Under this risk adjustment methodology, diagnosis data from inpatient and ambulatory treatment settings are used to calculate the risk adjusted premium payment to us. We collect, capture, and submit the necessary and available diagnosis data to CMS within prescribed deadlines. We estimate risk adjustment revenues based upon the diagnosis data submitted to CMS and ultimately accepted by CMS. We do not have access to diagnosis data with respect to our stand-alone PDP members.
In 2007, military services revenues represented 12% of total premiums and administrative services fees. Military services revenue primarily is derived from our TRICARE South Region contract with the Department of Defense and in addition, beginning January 1, 2008, from our contract with the Department of Veterans Affairs. Revenues associated with our contract with the Department of Veterans Affairs are recognized in the period services are performed. The single TRICARE contract for the South Region includes multiple revenue generating activities and as such was evaluated under Emerging Issues Task Force (EITF) Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. We allocate the consideration to the various components based on the relative fair values 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.
Investment securities totaled $4,650.4 million, or 36% of total assets at December 31, 2007. Debt securities totaled $4,639.1 million, or nearly 100% of this investment portfolio. More than 98% of our debt securities were of investment-grade quality, with an average credit rating of AA+ by S&P at December 31, 2007. 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. We have minimal exposure to sub-prime mortgages as we acceded to approximately $8 million of sub-prime and second-lien mortgages with our acquisition of KMG in the fourth quarter of 2007. However, by the end of January 2008, we had reduced that amount to approximately $4 million of sub-prime mortgages, each of which have maintained at least an AA+ rating after subsequent reviews by the rating agencies. There are no collateralized debt obligations or structured investment vehicles in our investment portfolio. Our investment policy limits investments in a single issuer and requires diversification among various asset types.
The Government segment consists of beneficiaries of government benefit programs, and includes three lines of business: Medicare, Military, and Medicaid. The Commercial segment consists of members enrolled in our medical and specialty products marketed to employer groups and individuals. Goodwill is assigned to the reporting unit that is expected to benefit from a specific acquisition.
Long-lived assets consist of property and equipment and other finite-lived intangible assets. These assets are depreciated or amortized over their estimated useful life, and are subject to impairment reviews. We periodically review long-lived assets whenever adverse events or changes in circumstances indicate the carrying value of the asset may not be recoverable. In assessing recoverability, we must make assumptions regarding estimated future cash flows and other factors to determine if an impairment loss may exist, and, if so, estimate fair value. We also must estimate and make assumptions regarding the useful life we assign to our long-lived assets. If these estimates or their related assumptions change in the future, we may be required to record impairment losses or change the useful life, including accelerating depreciation or amortization for these assets. There were no impairment losses in the last three years. See Note 6 to the consolidated financial statements included in Item 8.-Financial Statements and Supplementary Data.
Headquartered in Louisville, Kentucky, Humana Inc. is one of the nation’s largest publicly traded health and supplemental benefits companies, based on our 2007 revenues of $25.3 billion. References throughout this document to “we,” “us,” “our,” “Company,” and “Humana,” mean Humana Inc. and its subsidiaries. We are a full-service benefits solutions company, offering a wide array of health and supplemental benefit plans for employer groups, government benefit programs, and individuals. We derived approximately 71% of our premiums and administrative services fees from contracts with the federal government in 2007. Under our federal government contracts with the Centers for Medicare and Medicaid Services, or CMS, we provide health insurance coverage for Medicare members in Florida, accounting for approximately 17% of our total premiums and administrative services fees in 2007. 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 2007.
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. Investment securities available for our long-term insurance product and professional liability funding requirements, as well as restricted statutory deposits and venture capital investments, are classified as long-term 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.
On January 1, 2006, we began covering prescription drug benefits in accordance with Medicare Part D under multiple contracts with CMS. The payments we receive monthly from CMS and members, which are determined from our annual bid, represent amounts for providing prescription drug insurance coverage. We recognize premium revenues for providing this insurance coverage ratably over the term of our annual contract. Our CMS payment is subject to risk sharing through the Medicare Part D risk corridor provisions. In addition, receipts for reinsurance and low-income cost subsidies represent reimbursements of prescription drug costs for which we are not at risk.
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.
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 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 Government segment consists of beneficiaries of government benefit programs, and
includes three lines of business: Medicare, Military, and Medicaid. The Commercial segment consists of members enrolled in our medical and specialty products marketed to employer groups and individuals. Goodwill is assigned to the reporting unit that is expected to benefit from a specific acquisition.
Other intangible assets primarily relate to acquired customer 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 customer contracts because the asset tends to dissipate at a more rapid rate in earlier periods. Other than customer 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.
Future policy benefits payable include liabilities for long-duration insurance policies including life insurance, annuities and health policies sold to individuals for which some of the premium received in the earlier years is intended to pay anticipated benefits to be incurred in future years. These reserves are recognized on a net level premium method based on interest, mortality, morbidity, withdrawal and maintenance expense assumptions from published actuarial tables, modified based upon actual experience. Changes in estimates of these reserves are recognized as an adjustment to benefit expenses in the period the changes occur.
We recognize stock-based compensation expense, as determined on the date of grant at fair value, straight-line over the period during which an employee is required to provide service in exchange for the award (usually the vesting period). We estimate expected forfeitures and recognize compensation expense only for those awards which are expected to vest. We estimate the grant-date fair value of stock awards using the Black-Scholes option-pricing model. In addition, we report certain tax effects of stock-based compensation as a financing activity rather than an operating activity in the consolidated statement of cash flows. Additional detail regarding our stock-based compensation plans is included in Note 11.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, or SFAS 159. SFAS 159 allows us an option to report selected financial assets and liabilities at fair value and establishes related presentation and disclosure requirements. We were required to make an election regarding this fair value option in the first quarter of 2008, and we did not elect to adopt this fair value option under SFAS 159.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements, or SFAS 157. SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 does not require new fair value measurements. We adopted SFAS 157 on January 1, 2008. The adoption of SFAS 157 did not have a material impact on our financial position or results of operations. We are evaluating the disclosure provisions of SFAS 157 required in connection with the filing of our first quarter 2008 Form 10-Q.
On November 30, 2007, our Commercial segment acquired KMG America Corporation, or KMG, for cash consideration of $156.3 million including direct transaction costs, plus the assumption of $36.1 million of long-term debt. KMG provides long-duration insurance benefits including supplemental health and life benefit plans. On October 1, 2007, our Commercial segment acquired CompBenefits Corporation, or CompBenefits, for cash consideration of $369.1 million including direct transaction costs. CompBenefits provides dental and vision insurance benefits. These acquisitions, which were financed through a combination of cash and borrowings under our credit agreement, expand our commercial product offerings allowing for significant cross-selling opportunities with our medical insurance products.
Investment securities classified as current assets were as follows at December 31, 2007 and 2006:
Long-term investment securities with a fair value of $116.6 million at December 31, 2007 and $99.1 million at December 31, 2006 were on deposit at financial institutions in certain states pursuant to the respective states’ insurance regulations.
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 and 2006:
The contractual maturities of debt securities available for sale at December 31, 2007, 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.
Gross realized investment losses were $8.9 million in 2007, $13.6 million in 2006, and $3.5 million in 2005.
As discussed in Note 2, on January 1, 2006, we began covering prescription drug benefits in accordance with Medicare Part D under multiple contracts with CMS. In 2007, we paid $725.5 million related to our reconciliation with CMS regarding the 2006 Medicare Part D risk corridor provisions. The consolidated balance sheets include the following amounts associated with Medicare Part D as of December 31, 2007 and 2006:
Property and equipment was comprised of the following at December 31, 2007 and 2006:
Depreciation expense was $162.4 million in 2007, $128.6 million in 2006, and $105.1 million in 2005.
Other intangible assets primarily relate to acquired customer contracts and are included with other long-term assets in the consolidated balance sheets. Amortization expense for other intangible assets was approximately $22.4 million in 2007, $20.0 million in 2006 and $23.8 million in 2005. The following table presents our estimate of amortization expense for each of the five next succeeding fiscal years:
The following table presents details of our other intangible assets included in other long-term assets in the accompanying consolidated balance sheets at December 31, 2007 and 2006:
Military services benefits payable of $341.4 million and $430.7 million at December 31, 2007 and 2006, respectively, primarily consisted of our estimate of incurred healthcare services provided to beneficiaries which
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. The favorable development experienced in our Medicare and commercial operations primarily was 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.
The provision for income taxes consisted of the following for the years ended December 31, 2007, 2006 and 2005:
The provision for income taxes was different from the amount computed using the federal statutory rate for the years ended December 31, 2007, 2006 and 2005 due to the following:
The $27.4 million reduction in 2005 tax expense primarily related to the recognition of a $22.8 million contingent tax benefit and associated $3.1 million reversal of accrued interest resulting from the resolution of an uncertain tax position associated with the 2000 tax year during the first quarter of 2005 in connection with the expiration of the statute of limitations.
Deferred income tax balances reflect the impact of temporary differences between the tax bases of assets or liabilities and their reported amounts in our consolidated financial statements, and are stated at enacted tax rates expected to be in effect when the reported amounts are actually recovered or settled. Principal components of our net deferred tax balances at December 31, 2007 and 2006 were as follows:
At December 31, 2007, we had approximately $107.8 million of net operating losses to carryforward related to prior acquisitions. These net operating loss carryforwards, if not used to offset future taxable income, will expire from 2008 through 2022. Based on our historical record of producing taxable income and profitability, we have concluded that future operating income will be sufficient to give rise to tax expense to recover all deferred tax assets.
We previously issued in the public debt capital markets, $300 million aggregate principal amount of 6.30% senior unsecured notes that mature on August 1, 2018 and $500 million aggregate principal amount of 6.45% senior unsecured notes that mature on June 1, 2016. We have entered into interest rate swap agreements to exchange the fixed interest rate under these senior notes for a variable interest rate based on LIBOR.
The interest rate swap agreements, which have the same critical terms as our senior notes, are designated as fair value hedges. Changes in the fair value of the senior notes and the swap agreements due to changing interest rates are assumed to offset each other completely, resulting in no impact to earnings from hedge ineffectiveness. Our swap agreements are recognized in our consolidated balance sheets at fair value with an equal and offsetting adjustment to the carrying value of our senior notes. The fair value of our interest rate swap agreements are estimated based on quoted market prices of comparable agreements, and reflect the amounts we would receive (or pay) to terminate the agreements at the reporting date.
Our 5-year $1.0 billion unsecured revolving credit agreement expires in July 2011. Under the credit agreement, at our option, we can borrow on either a revolving credit basis or a competitive advance 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 each 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. 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.
We have a universal shelf registration statement filed with the SEC which 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 $69.7 million in 2007, $56.0 million in 2006, and $42.9 million in 2005, 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 $75.31, 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, 2007. Through December 31, 2006, the Company match was invested in
We have plans under which options to purchase our common stock and restricted stock awards have been granted to executive officers, directors, key employees and consultants. The terms and vesting schedules for stock-based awards vary by type of grant. Generally, the awards vest upon time-based conditions. Upon exercise, 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, 2007, 2006, and 2005:
Beginning April 2006, the stock plans provide that one restricted share is equivalent to 1.7 stock options. At December 31, 2007, there were 15,774,996 shares reserved for stock award plans, including 9,994,245 shares of common stock available for future grants assuming all stock options or 5,878,968 shares available for future grants assuming all restricted shares.
The volatility used to value employee stock options is based on historical volatility. We calculate historical volatility using a simple average calculation methodology based on daily price intervals as measured over the expected term of the option. We have consistently applied this methodology since our adoption of the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation, or SFAS 123. The decrease in the historical volatility used to value our employee stock options is due to changes in the stock price pattern over the past several years.
Activity for our option plans was as follows for the year ended December 31, 2007:
(1) Computed based upon the amount by which the fair market value of our common stock at December 31, 2007 of $75.47 per share exceeded the weighted average exercise price.
The total intrinsic value of stock options exercised during 2007 was $133.9 million, compared with $133.7 million during 2006 and $57.8 million during 2005. Cash received from stock option exercises for the years ended December 31, 2007, 2006, and 2005 totaled $62.7 million, $49.2 million, and $36.4 million, respectively.
The weighted average grant date fair value of our restricted stock awards was $63.59, $54.36, and $32.81 for the years ended December 31, 2007, 2006, and 2005, respectively. Activity for our restricted stock awards was as follows for the year ended December 31, 2007:
Detail supporting the computation of basic and diluted earnings per common share was as follows for the years ended December 31, 2007, 2006 and 2005:
Restricted stock and stock options to purchase 1,017,381 shares in 2007, 854,379 shares in 2006, and 826,587 shares in 2005 were anti-dilutive and, therefore, were not included in the computations of diluted earnings per common share.
In connection with employee stock plans, we acquired 406,377 of our common shares at an aggregate cost of $27.4 million during 2007, and 467,767 of our common shares at an aggregate cost of $26.2 million during 2006.
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. Rent with scheduled escalation terms are accounted for on a straight-line basis over the lease term. Rent expense and sublease rental income, which are recorded net as an administrative expense, for all operating leases were as follows for the years ended December 31, 2007, 2006 and 2005:
Future annual minimum payments due subsequent to December 31, 2007 under all of our noncancelable operating leases with initial terms in excess of one year are as follows:
Our Medicare business, which accounted for approximately 60% of our total premiums and ASO fees for the year ended December 31, 2007, primarily consisted of products covered under the Medicare Advantage and Medicare Part D Prescription Drug Plan 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 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.
The loss of any of the contracts above or significant changes in these programs as a result of legislative action, including reductions in premium payments to us, or increases in member benefits without corresponding increases in premium payments to us, may have a material adverse effect on our financial position, results of operations, and cash flows.
On February 13, 2008, New York Attorney General Andrew Cuomo announced he had issued subpoenas to 16 health plans in conjunction with a lawsuit his office is filing against UnitedHealth Group and its subsidiary, Ingenix, as part of an industry-wide investigation into certain provider-payment practices. We received a subpoena in connection with this matter and intend to cooperate fully with the investigation. The matters covered by the subpoena do not involve our Medicare operations in New York or any other state. Our operations in New York consist primarily of Medicare business.
We also are involved in various lawsuits that arise, for the most part, in the ordinary course of our business operations, including employment litigation, claims of medical malpractice, bad faith, nonacceptance or termination of providers, anticompetitive practices, improper rate setting, failure to disclose network discounts and various other provider arrangements, intellectual property matters, and challenges to subrogation practices.
We also are subject to claims relating to performance of contractual obligations to providers, members, and others, including failure to properly pay claims, challenges to our implementation of the new Medicare prescription drug program and other litigation.
The outcome of current suits or likelihood or outcome of future suits or governmental investigations cannot be accurately predicted with certainty. Although it is not reasonably possible to estimate whether a loss will occur as a result of these legal matters, or if a loss should occur, the amount of such loss, we do not believe that any legal matters to which we are a party are likely to have a material adverse effect on our financial position, results of operations, and cash flows. However, there can be no assurance that any pending legal matters or any legal matters that may arise in the future would not have a material adverse effect on our financial position, results of operations, and cash flows.
Certain blocks of insurance assumed in acquisitions, primarily life, long-term care and annuities in run-off status, are subject to reinsurance where some or all of the underwriting risk related to these policies has been ceded to a third party. In addition, a large portion of our reinsurance takes the form of 100% coinsurance agreements where, in addition to all of the underwriting risk, all administrative responsibilities, including premium collections and claim payment, have also been ceded to a third party. We acquired these policies and related reinsurance agreements with the purchase of stock of companies in which the policies were originally written. We acquired these companies for business reasons unrelated to these particular policies, including the companies’ other products and licenses necessary to fulfill strategic plans.
Reinsurance recoverables represent the portion of future policy benefits payable that are covered by reinsurance. Amounts recoverable from reinsurers are estimated in a manner consistent with the methods used to determine future policy benefits payable as detailed in Note 2. Reinsurance recoverables, included in other long-term assets, were $341.6 million at December 31, 2007 and $242.7 million at December 31, 2006. The percentage of these reinsurance recoverables resulting from 100% coinsurance agreements was 70% at
We evaluate the financial condition of these reinsurers on a regular basis. These reinsurers are well-known and well-established, as evidenced by the strong financial ratings at December 31, 2007 presented below:
The all other category represents approximately 20 reinsurers with individual balances less than $25.0 million. Two of these reinsurers have placed $31.0 million in trusts equivalent to the amount recoverable from the reinsurer.
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, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 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. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying 2007 Annual Report to Stockholders. Our responsibility is to express opinions on these financial statements, financial statement schedules and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included 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. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A summary of our quarterly unaudited results of operations for the years ended December 31, 2007 and 2006 follows: