We own our principal executive office, which is located in the Humana Building, 500 West Main Street, Louisville, Kentucky 40202. In addition, as of December 31, 2003, we own buildings in Louisville, Kentucky, and Green Bay, Wisconsin, and lease facilities in Cincinnati, Ohio and Puerto Rico, all of which are used for customer service, enrollment, and claims processing. During 2003, we completed the consolidation of the San Antonio, Texas, Jacksonville, Florida, and Madison, Wisconsin customer service center operations into the remaining four locations. Some of these former service center buildings have been sold or are in the process of being sold. Our Louisville and Green Bay facilities also house other corporate functions.
(c) As described in Note 2 to our consolidated financial statements included herein, we adopted Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets, as of January 1, 2002. We ceased amortizing goodwill upon adopting Statement 142 on January 1, 2002. Note 5 identifies goodwill amortized in 2001 and the estimated impact on our reported net income and earnings per common share had amortization been excluded from 2001 results.
(d) Includes expenses of $584.8 million pretax ($499.3 million after tax, or $2.97 per diluted share) primarily related to goodwill impairment, losses on non-core asset sales, professional liability reserve strengthening, premium deficiency and medical reserve strengthening.
Our strategy to increase Commercial segment profitability focuses on providing solutions for employers to the rising cost of health care through the use of innovative and consumer-choice product designs which are supported by service excellence and industry-leading electronic capabilities, including education, tools and technologies provided primarily through the Internet. To that end, we have developed an innovative suite of products styled as “Smart” products. We believe that these Smart products offer the best solution for many employers to the problem of fast rising health care costs for their employees. Although enrollment in our Smart products is a relatively modest 130,000 members at December 31, 2003, we believe that substantial growth in these products, which may be competitively priced to produce higher margins, is the key for our continuing improvement in the Commercial segment. January 2004 sales were approximately 70,000 in our Smart products.
increasing underwriting margins versus achieving enrollment growth. With respect to market conditions, there is the impact of economies of scale on administrative overhead. As a result of the decline in popularity of tightly managed HMOs and intensive utilization review procedures, medical costs become increasingly comparable among the larger competitors, with product design and consumer involvement then becoming the more important drivers of medical services consumption. As a result, administrative expense efficiency is becoming a primary driver of commercial margin sustainability. In line with that philosophy, we continue to reduce our administrative expense structure, realize administrative expense savings through technology tools, and look at acquisition opportunities that align with our geographic presence and Commercial strategy.
In our Government segment, there were two significant developments in 2003. First, in August 2003, our subsidiary, Humana Military Healthcare Services, or HMHS, was awarded the Department of Defense’s TRICARE contract to support healthcare delivery to active duty and retired service members and their families in the South Region beginning in 2004. The South Region is one of the three regions in the United States as defined by the Department of Defense’s new contract alignment. Under the terms of the award, HMHS will be the Managed Care Support Contractor serving approximately 2.8 million TRICARE beneficiaries in Tennessee, South Carolina, Georgia, Alabama, Mississippi, Florida, Arkansas, Louisiana, Oklahoma and Texas. Most importantly, procurement of the South Region contract positions us to continue our TRICARE operating margins consistent with the levels we have enjoyed since beginning the TRICARE program in July 1996.
In December 2003, we reached a definitive agreement to purchase Ochsner Health Plan from Ochsner Clinic Foundation having approximately 152,000 Commercial medical members, primarily in fully insured large group accounts, and approximately 36,000 members in the Medicare+Choice program. This transaction, which is subject to state regulatory approval, is expected to close in the second quarter of 2004.
Estimating IBNR is complex, involves a significant amount of judgment and represents a material portion of our medical and other expenses payable. Accordingly, it represents a critical accounting estimate. Changes in this estimate can materially affect, either favorably or unfavorably, our results from operations and overall financial position. For example, a 100 basis point, or 1 percent, change in the estimate of our medical and other expenses payable at December 31, 2003, which represents approximately 40% of total liabilities, would require an adjustment of approximately $13 million in a future period in which a revision in the estimate became known.
Most medical 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”, which causes less than 2% of our medical and other expenses payable as of the end of any given period to be outstanding for more than 12 months. As such, we expect that substantially all of the 2003 estimate of medical and other expenses payable will be known and paid during 2004.
expected to be higher than the otherwise estimated value of such claims at the time of the estimate. Therefore, in many situations, the claim amounts ultimately settled will be less than the estimate that satisfies the actuarial standards of practice.
Our TRICARE contracts contain risk-sharing provisions with the Department of Defense and with subcontractors, which effectively limit profits and losses when actual claim experience varies from the medical claim amounts included in our annual bids. Additionally, other factors impacting medical claims expenses such as changes in the number of eligible beneficiaries and changes in the level of usage of military treatment facilities result in equitable revenue adjustments through the change order and bid price adjustment process. As a result of the above contract provisions, the impact of changes in estimates for prior year TRICARE medical claims payable on our results of operations is reduced substantially, whether positive or negative.
As summarized in the previous table, claim reserve balances at December 31, 2000 ultimately settled during 2001 for $23.4 million less than the amounts originally estimated, representing 0.3% of medical claim expenses recorded in 2000. During 2002, claim reserve balances at December 31, 2001 ultimately settled for $12.3 million more than the amounts originally estimated, representing 0.1% of medical claim expenses recorded in 2001. This $35.7 million increase in the amounts incurred related to prior years was substantially all attributable to our TRICARE operations and resulted primarily from enhanced benefits enacted for TRICARE beneficiaries as a result of Congressional legislation, the impact of which was not fully determinable at December 31, 2001. As these additional medical expenses were recognized during 2002, we also recognized and received commensurate revenues from the Department of Defense as a result of change orders and bid price adjustments, or BPAs.
We generally establish one-year contracts with commercial employer groups, subject to cancellation by the employer group’s 30-day written notice. Our contracts with federal or state governments are generally multi-year contracts subject to annual renewal provisions with the exception of our Medicare+Choice contracts with the federal government which renew annually. Our commercial contracts establish rates on a per member basis for each month of coverage. Except for TRICARE contracts discussed in the following section, our government contracts also establish monthly rates per member but may have additional amounts due to us based on items such as age, working status, or specific health issues of the member.
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 customers 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 based on 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 Medicare+Choice 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.
Under our TRICARE contracts, we retain the financial risk of contractual discounts in the provider networks, same-store utilization of services, and administrative overhead. However, the federal government retains the financial risk associated with changes in usage levels at military treatment facilities, or MTFs, changes in the number of persons eligible for TRICARE benefits, and medical unit cost inflation. BPAs are utilized to retroactively adjust premium revenues for the impact of the items for which the federal government retains risk. We work closely with the federal government to obtain and review eligibility and MTF workload data, and to quantify and negotiate amounts recoverable or payable under our contractual BPA requirements. We record revenues applicable to BPAs when these amounts are determinable and the collectibility is reasonably assured. Because final settlement of BPAs occurs only at specified intervals, typically in excess of 6 months after the end of a contract year for our largest regions, cumulative amounts receivable or payable under BPAs may be outstanding in excess of a year. Amounts receivable or payable within a year are classified as premiums receivable or trade accounts payable and accrued expenses, respectively, in our consolidated balance sheets. Amounts receivable or payable for longer than one year are classified as other long-term assets or other long-term liabilities, respectively. The increase in activity and deployments surrounding military conflicts in the Middle East has significantly impacted BPA activity in recent years.
TRICARE change orders occur when we perform services or incur costs under the directive of the federal government that were not originally specified in our contracts. Under federal regulations we are entitled to an equitable adjustment to the contract price, which results in additional premium revenues. Examples of items that have necessitated substantial change orders in recent years include congressionally legislated increases in the level of benefits for TRICARE beneficiaries and the administration of new government programs such as TRICARE for Life and TRICARE Senior Pharmacy. Like BPAs, we record revenue applicable to change orders when these amounts are determinable and the collectibility is reasonably assured. Unlike BPAs, where settlement only occurs at specified intervals, change orders may be negotiated and settled at any time throughout the year.
Our investment securities are categorized as available for sale and, as a result, are stated at fair value. Fair value of publicly traded debt and equity securities are based on quoted market prices. Non-traded debt securities are priced independently by a third party vendor. Fair value of venture capital debt securities that are privately
Our strategy, long-range business plan, and annual planning process supports our goodwill impairment tests. These tests are based primarily on an evaluation of future discounted cash flows under several scenarios. We used a range of discount rates that correspond to our 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.
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 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, 2003, we are not involved in any SPE transactions. The adoption of FIN 46 or FIN 46-R is not expected to have a material impact on our financial position, results of operations or cash flows.
Administrative services fees for 2003 were $271.7 million, an increase of $27.3 million from $244.4 million for 2002. For the Commercial segment, administrative services fees increased $19.6 million, or 19.0%, to $122.8 million. This increase corresponds to the higher level of ASO membership at December 31, 2003, which was 712,400 members, compared to 652,200 members at December 31, 2002 and also reflects an increase in the average fees received per member. Administrative services fees for the Government segment increased $7.6 million when comparing 2003 to 2002. This increase resulted from contractual adjustments related to TRICARE for Life, a program for seniors in which we provide medical benefit administrative services.
The Commercial and Government segments’ SG&A expense ratios likewise were impacted by the same items described previously. Operational efficiencies gained from completing the consolidation of the service centers and workforce reductions, as well as increases in premiums in excess of inflationary trends on administrative expenses, are expected to decrease the Commercial segment’s SG&A expense ratio to a range of 15.5% to 16.5% and the Government segment’s SG&A expense ratio to a range of 11.0% to 12.0% in 2004.
Certain financial data for our two segments was as follows for the years ended December 31, 2002 and 2001:
Premium revenues increased 10.0%, to $10.9 billion, for 2002 compared to $9.9 billion for 2001. Higher premium revenues resulted primarily from significant increases in fully insured commercial per member premiums and an increase in TRICARE premiums. Items impacting per member premiums include changes in premium and government reimbursement rates, as well as changes in geographic mix of membership, the mix of product offerings, and the mix of benefit plans selected by our membership.
Government segment premium revenues increased 8.5%, to $5.1 billion, for 2002 compared to $4.7 billion for 2001. This increase was primarily attributable to our TRICARE business, partially offset by a reduction in our Medicare+Choice membership.
TRICARE premium revenues were $2.0 billion, an increase of $660 million or 49.2% compared to 2001. $334 million of the increase in TRICARE premium revenues is attributable to the acquisition of TRICARE Regions 2 and 5 on May 31, 2001, with the remainder of the increase attributable to the annual increase in our contractually determined base revenues and increases in premium revenues recorded as a result of bid price adjustments, or BPAs, and change orders.
Increasing premium revenues recorded in connection with BPAs resulted from an increase in the number of eligible TRICARE beneficiaries and a decrease in the use of military treatment facilities, or MTFs, by TRICARE beneficiaries. The number of TRICARE beneficiaries increased in 2002 as a result of the events of September 11, 2001, the subsequent build-up of military personnel to support military operations in Afghanistan, and the continuing build-up of military personnel surrounding other international tensions. A decline in the usage of MTFs occurred for some periods after September 11, 2001 when certain MTFs were restricted by the Department of Defense resulting in a greater use of our provider network by retired military personnel and the dependents of both active duty and retired military personnel. Increasing premium revenues recorded in connection with change orders primarily resulted from expanded benefits for TRICARE beneficiaries as mandated by Congress which includes, among other items, a reduction of the beneficiary out-of-pocket maximum cost and the elimination of certain copayments.
Collectively, all of these actions resulted in higher medical expenses during 2002. Since these actions were not originally specified in our contracts, we were entitled to equitable revenue adjustments via the change order and BPA process. We recognized revenues related to these adjustments when the settlement amount became determinable and the collectibility was reasonably assured.
Investment and other income totaled $86.4 million in 2002, a decrease of $32.4 million from $118.8 million in 2001. Net realized losses of $10.1 million in 2002 compared to net realized gains of $13.9 million in 2001. Net realized losses in 2002 included impairment losses of $27.2 million primarily related to privately held venture capital investment securities after an evaluation indicated that a decline in fair value below the cost basis was other than temporary. Lower interest rates also decreased investment income $10.9 million in 2002 compared to 2001. The average yield on investment securities was 4.6% in 2002, declining from 5.1% in 2001.
The medical expense ratio for 2002 was 83.6%, increasing 30 basis points from 83.3% in 2001.
The SG&A expense ratio for 2002 was 15.9%, increasing 60 basis points from 15.3% for 2001. This increase primarily resulted from an increase in severance and related employee benefit expenses of $36.0 million, long-lived asset impairments of $2.4 million, and the establishment of reserves for a contingent contractual provider dispute and other items associated with our 1997 acquisition of Physician Corporation of America, or PCA of $30.1 million.
Depreciation and amortization was $120.7 million in 2002, a decrease of $40.8 million, or 25.3%, from $161.5 million in 2001. As discussed in Note 2 to the consolidated financial statements, we ceased amortizing goodwill on January 1, 2002 in accordance with adopting a new accounting standard. This decreased goodwill amortization by $55 million. On a comparable basis, depreciation and amortization was $106.5 million in 2001, excluding goodwill amortization expense. The $14.2 million increase in 2002 compared to 2001, as adjusted, resulted from capital expenditures primarily related to our technology initiatives and a full year of amortization of other intangible assets related to the acquisition of TRICARE Regions 2 and 5 on May 31, 2001.
Our effective tax rate in 2002 of 32% decreased 4% compared to the 36% effective tax rate in 2001. The lower effective tax rate in 2002 primarily resulted from the cessation of non-deductible goodwill amortization on January 1, 2002, partially offset by higher state income taxes and a lower proportion of tax-exempt investment income to pretax income. In addition, during 2002, the Internal Revenue Service completed their audit of all open years prior to 2000, which resulted in a favorable adjustment to the estimated accrual for income taxes of approximately $32.6 million. This was offset by an increase of approximately $24.5 million in the capital loss valuation allowance after we reevaluated probable capital gain realization in the allowable carryforward period based upon our capital gain experience beginning in 2000 and consideration of alternative tax planning strategies. See Note 7 to the consolidated financial statements for a complete reconciliation to the federal statutory rate.
During 2003, our operating cash flows were not substantially impacted by a change in the timing of premium and ASO fee collections or medical claim payments, as both amounts generally increased with inflation and membership growth. However, during 2002, our operating cash flows were negatively impacted by slower cash collections of premium and ASO fee receivables when TRICARE receivables increased by $174 million as detailed in the following table:
(3) Processed claim inventories represent 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.
(4) The balance due to our pharmacy benefit administrator fluctuates due to bi-weekly payments and the month-end cutoff and other medical expenses payable.
During 2003, we reinvested a portion of our operating cash flows in investment securities, primarily short-duration fixed income securities, totaling $283.1 million. During 2003, 2002 and 2001, we also made capital expenditures as discussed below.
During 2003, we converted our short-term commercial paper debt to long-term borrowings and repurchased common shares as discussed below. The cash used in financing activities in 2002 resulted primarily from common share repurchases while the use of cash in 2001 resulted from reductions in borrowings.
in 2002, and $115.5 million in 2001. Excluding acquisitions, we expect our total capital expenditures in 2004 to be approximately $100 million, most of which will be used for our technology initiatives and improvement of administrative facilities.
Short-term and long-term debt outstanding was as follows at December 31, 2003 and 2002:
on quoted market prices of comparable agreements, and reflect the amounts we would receive (or pay) to terminate the agreements at the reporting date.
In June 2003, we recorded a deferred gain and received proceeds of $31.6 million in exchange for new swap agreements discussed above related to our 7.25% senior notes. The corresponding deferred swap gain of $31.6 million is being amortized to reduce interest expense over the remaining term of the 7.25% senior notes. The carrying value of our 7.25% senior notes has been increased $26.2 million by the remaining deferred swap gain balance at December 31, 2003.
At December 31, 2003, the $12.8 million fair value of our swap agreements is included in other long-term assets. Likewise, the carrying value of our senior notes has been increased $12.8 million to reflect its fair value. The counterparties to our swap agreements are major financial institutions with which we also have other financial relationships.
There were no balances outstanding under either agreement at December 31, 2003 or 2002. Under these agreements, at our option, we can borrow on either a competitive advance basis or a revolving credit basis. The revolving credit portion of both agreements 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 80 to 125 basis points for our 4-year agreement, and 85 to 137.5 basis points for our 364-day agreement. We also pay an annual facility fee regardless of utilization. This facility fee, currently 25 basis points, may fluctuate between 15 and 50 basis points, depending upon our credit ratings. The competitive advance portion of any borrowings under either credit agreement 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.
These credit agreements, and the agreement relating to the conduit commercial paper program described below, contain customary restrictive and financial covenants as well as customary events of default, including financial covenants regarding the maintenance of net worth, minimum interest coverage, and maximum leverage ratios. At December 31, 2003, we were in compliance with all applicable financial covenant requirements. The terms of each of these credit agreements also include standard provisions related to conditions of borrowing, including a customary material adverse effect clause which could limit our ability to borrow. We have not experienced a material adverse effect and we know of no circumstances or events which would be reasonably likely to result in a material adverse effect. We do not believe the material adverse effect clause poses a material funding risk to Humana in the future.
We maintain indirect access to the commercial paper market through our conduit commercial paper financing program. Under this program, a third party issues commercial paper and loans the proceeds of those issuances to us so that the interest and principal payments on the loans match those on the underlying commercial
paper. The $265 million, 364-day revolving credit agreement supports the conduit commercial paper financing program of up to $265 million.
Other borrowings of $4.9 million at December 31, 2003 and $5.5 million at December 31, 2002 represent financing for the renovation of a building, bear interest at 2% per annum, are collateralized by the building, and are payable in various installments through 2014.
We are contractually obligated to make payments for years subsequent to December 31, 2003 as follows:
(1) Debt payments could be accelerated upon violation of debt covenants. We believe the likelihood of a debt covenant violation is remote.
(3) Purchase and other obligations include agreements to purchase services, primarily information technology related services, or to make improvements to real estate that are enforceable and legally binding on us and that specify all significant terms, including: fixed or minimum levels of service to be purchased; fixed, minimum or variable price provisions; and the appropriate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty.
Our 5-year and 7-year airplane operating leases provide for a residual value payment of no more than $9.2 million at the end of the lease terms, which expire December 29, 2004 for the 5-year lease and January 1, 2010 for the 7-year lease. We have the right to exercise a purchase option with respect to the leased airplanes or the airplanes can be sold to a third party. If we decide not to exercise our purchase option at the end of the lease, we must pay the lessor a maximum amount of $4.4 million related to the 5-year lease and $4.8 million related to the 7-year lease. The amount will be reduced by the net sales proceeds of the airplanes to a third party. After considering the current fair value of the airplanes, we recorded a $1.5 million provision during 2003 for the exposure from the residual value guarantee. During 2003, we terminated two 5-year airplane leases early. The impact of these transactions was not material.
Our investment-grade credit rating at December 31, 2003 was Baa3 according to Moody’s Investors Services, Inc., or Moody’s, and BBB, according to Standard & Poor’s Corporation, 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, 2003, we would have received $8.7 million. Other than the swap agreements, adverse changes in our credit ratings will not create, increase, or accelerate any liabilities. Adverse changes in our credit rating will increase the rate of interest we pay and may impact the amount of credit available to us in the future.
No related party transactions had a material effect on our financial position, results of operations, or cash flows. Certain immaterial related party transactions are discussed in our Proxy Statement for the meeting to be held April 22, 2004-see “Certain Transactions with Management and Others.”
We evaluated the impact on our investment income and debt expense resulting from a hypothetical change in interest rates of 100, 200 and 300 basis points over the next twelve-month period, as reflected in the following table. The modeling technique used to calculate the pro forma net change in pretax earnings considered the cash flows related to fixed income investments and debt, which are subject to interest rate changes during a prospective twelve-month period. This evaluation measures parallel shifts in interest rates and may not account for certain unpredictable events that may effect interest income, including, among others, unexpected changes of cash flow into and out of the portfolio, shifts in the asset mix between tax and tax-exempt securities, and spread changes specific to various investment categories. In the past ten years, changes in 3 month LIBOR rates during the year have exceeded 300 basis points twice, have not changed between 200 and 300 basis points, have changed between 100 and 200 basis points once and have changed by less than 100 basis points seven times. LIBOR was 1.15% at December 31, 2003. Our model assumed the maximum possible reduction in LIBOR could not exceed 115 basis points.
Our MedicareAdvantage contracts with the federal government are renewed for a one-year term each December 31 unless notice of termination is received at least 90 days prior thereto. In December 2003, the Medicare Prescription Drug, Improvement, and Modernization Act, or DIMA, was signed into law. DIMA includes provisions that require the 2004 stabilization funding to be directed toward increased reimbursement for providers, increased benefits or access for members, or decreased member premiums. We believe DIMA will open new opportunities for us. However, we do not believe that the benefit to our 2004 financial position, results of operations, or cash flows will be material.
Our current TRICARE contract with the Department of Defense will be in effect until April 30, 2004 for Regions 2 and 5 and until June 30, 2004 for Regions 3 and 4. Each of the contracts is subject to a one-year renewal at the Government’s option. We believe these contracts will continue until the TRICARE transition described below.
Pursuant to the Department of Defense’s bid process, each of the three awards was subject to protests by unsuccessful bidders of prime contracts, however, none of the protests were successful.
Under the Department of Defense’s current schedule for implementation of the new TRICARE contracts, Regions 2 and 5 will transition to the new North Region for the start of healthcare delivery on July 1, 2004. Regions 3 and 4 will become part of the new South Region for the start of healthcare delivery on August 1, 2004 and Region 6 will become part of our new South Region for the start of healthcare delivery on November 1, 2004. If this schedule is realized, our TRICARE membership is expected to temporarily decline to 1.5 million in July 2004, and is expected to increase to 2.8 million in November 2004. This will also result in a decline in revenues during this period.
Part 1. We cannot predict the outcome of these suits with certainty, and we are incurring expenses in defense of these matters. In addition, recent court decisions and legislative activity may increase our exposure for any of these types of claims. Therefore, these legal actions could have a material adverse effect on our financial position, results of operations and cash flows.
• increased use of medical facilities and services, including prescription drugs;
• termination of capitation arrangements resulting in the transfer of membership to fee-for-service arrangements;
Failure to adequately price our products or estimate sufficient medical claim reserves may result in a material adverse effect on our financial position, results of operations and cash flows.
We are in a highly competitive industry. Many of our competitors are more established in the health care industry and have a larger market share and greater financial resources than we do in some markets. In addition, other companies may enter our markets in the future, including emerging competitors in the MedicareAdvantage program, in e-commerce insurance or benefit programs and in consumer-directed health plans. Contracts for the sale of commercial products are generally bid upon or renewed annually. While health plans compete on the basis of many factors, including service and the quality and depth of provider networks, we expect that price will continue to be a significant basis of competition. In addition to the challenge of controlling health care costs, we face competitive pressure to contain premium prices.
Premium increases, introduction of new product designs, and our relationship with our providers in various markets, among other issues, could affect our membership levels. Other actions that could affect membership levels include the possible exit of or entrance to MedicareAdvantage or Commercial markets. If we do not compete effectively in our markets, if we set rates too high or too low in highly competitive markets to keep or increase our market share, if membership does not increase as we expect, or if it declines, or if we lose accounts with favorable medical cost experience while retaining or increasing membership in accounts with unfavorable medical cost experience, our business and results of operations could be materially adversely affected.
Our business depends significantly on effective information systems and the integrity and timeliness of the data we use to run our business. Our business strategy involves providing members and providers with easy to use products that leverage our information to meet their needs. Our ability to adequately price our products and services, provide effective and efficient service to our customers, and to timely and accurately report our financial results depends significantly on the integrity of the data in our information systems. As a result of our past and on-going acquisition activities, we have acquired additional systems. We have been taking steps to
We depend on independent third parties for significant portions of our systems-related support, equipment, facilities, and certain data, including data center operations, data network, voice communication services and pharmacy data processing. This dependence makes our operations vulnerable to such third parties’ failure to perform adequately under the contract, due to internal or external factors. Due to continued consolidation in the industry, there are a limited number of service organizations with the size, scale and capabilities to effectively provide certain of these services, especially with regard to pharmacy benefits processing and management. However, we believe that other organizations could provide similar services on comparable terms. A change in service providers, however, could result in a decline in service quality and effectiveness or less favorable contract terms which could adversely affect our operating results.
• disputes related to self-funded business, including actions alleging claim administration errors;
A description of material legal actions in which we are currently involved is included under “Legal Proceedings” of Item 3 in Part I. We cannot predict the outcome of these suits with certainty, and we are incurring expenses in the defense of these matters. In addition, recent court decisions, including some that erode protections under the Employee Retirement Income Security Act, or ERISA, and legislative activity may increase our exposure for any of these types of claims. Therefore, these legal actions could have a material adverse effect on our financial position, results of operations and cash flows.
A significant portion of our revenues relates to federal, state and local government health care coverage programs, including the TRICARE, Medicare+Choice, and Medicaid programs. These programs involve various risks, including:
• the possibility that we will not be able to extend or renew any of the contracts relating to these programs. These contracts also are generally subject to frequent change, including changes that may reduce the number of persons enrolled or eligible to enroll, reduce the revenue we receive or increase
• in the event government reimbursement 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. Changes to these government programs in the future may also affect our ability or willingness to participate in these programs. Other than as described herein, the loss of our current or future TRICARE contracts, would have a material adverse effect on our financial position, results of operations and cash flows;
• higher marketing and advertising costs per member as a result of marketing to individuals as opposed to groups; and
• approval of entry, withdrawal or re-entry into a state or market;
State regulations require our licensed, operating subsidiaries to maintain minimum net worth requirements and restrict some investment activities. Additionally, those regulations restrict the ability of our subsidiaries to make dividend payments, loans, loan repayments or other payments to us.
• rules tightening time periods in which claims must be paid;
• disclosure of provider fee schedules and other data impacting payments to providers;
• health plan liability to members who fail to receive appropriate care;
There can be no assurance that we will be able to continue to obtain or maintain required governmental approvals or licenses or that legislative or regulatory changes will not have a material adverse effect on our business. Delays in obtaining or failure to obtain or maintain required approvals could adversely affect our revenue or the number of our members, increase costs or adversely affect our ability to bring new products to market as forecasted.
Additionally, under the new HIPAA privacy rules, which became effective on April 14, 2003, we must now comply with a variety of requirements concerning the use and disclosure of individuals’ protected health information, establish rigorous internal procedures to protect health information and enter into business associate contracts with those companies to whom protected health information is disclosed. Regulations issued in February 2003 set standards for the security of electronic health information requiring compliance by April 21, 2005. Violations of these rules will subject us to significant penalties. Compliance with HIPAA regulations requires significant systems enhancements, training and administrative effort. The final rules do not provide for complete federal preemption of state laws, but rather preempt all inconsistent state laws unless the state law is more stringent. HIPAA could also expose us to additional liability for violations by our business associates.
Increased litigation and negative publicity could increase our cost of doing business.
In December 2003, we reached a definitive agreement to purchase a Louisiana health plan from Ochsner Clinic Foundation. This transaction, which is subject to state regulatory approval, is expected to close in the second quarter of 2004.
We generally establish one-year commercial membership contracts with employer groups, subject to cancellation by a 30 day written notice. Our TRICARE contracts with the federal government and our contracts with various state Medicaid programs generally are multi-year contracts subject to annual renewal provisions. Our Medicare+Choice contracts with the federal government renew annually. We bill and collect premium and administrative fee remittances from employer groups and some individual Medicare+Choice members monthly. We receive monthly premiums and administrative fees from the federal government and various states according to government specified reimbursement rates and various contractual terms.
Premium revenues are recognized as income in the period members are entitled to receive services, and are net of estimated uncollectible amounts and retroactive membership adjustments. Retroactive membership adjustments result from enrollment changes not yet processed, or not yet reported by an employer group or the government. We routinely monitor the collectibility of specific accounts, the aging of receivables, historical retroactivity trends, as well as prevailing and anticipated economic conditions, and reflect any required adjustments in current operations. Revenues also may include change orders and bid price adjustments attributable to our TRICARE contracts. Change orders represent equitable adjustments for services not originally specified in the contracts. Bid price adjustments, or BPAs, represent adjustments defined in our contracts subject to negotiations with the federal government. Revenues for these adjustments are recognized when a settlement amount becomes determinable and the collectibility is reasonably assured.
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. Our short-duration employer-group prepaid health services policies typically have a one-year term and may be cancelled upon 30 days notice.
Property and equipment is recorded at cost. Gains and losses on sales or disposals of property and equipment are included in administrative expense. Certain costs related to the development or purchase of internal-use software are capitalized in accordance with AICPA Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. Depreciation is computed using the straight-line method over estimated useful lives ranging from 3 to 10 years for equipment, 3 to 7 years for computer software, and 20 to 40 years for buildings.
We ceased amortizing goodwill upon adopting Statement 142 on January 1, 2002. Statement 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 2002 and 2003 did not result in an impairment loss.
represent monthly contractual fees disbursed to primary care physicians and other providers who are responsible for providing medical care to members. We estimate the costs of our future medical claims and other medical expense payments using actuarial methods and assumptions based upon claim payment patterns, medical cost inflation, historical developments such as claim inventory levels and claim receipt patterns, and other relevant factors, and record medical claims reserves for future payments. We continually review estimates of future payments relating to medical claims costs for services incurred in the current and prior periods and make necessary adjustments to our reserves.
Under our cash management system, checks issued but not yet presented to banks frequently result in overdraft balances for accounting purposes and are classified as a current liability in the consolidated balance sheets.
We have stock-based employee compensation plans, which are described more fully in Note 10. We account for our stock option plans under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations, or APB No. 25. No employee compensation cost is reflected in net income related to fixed-based stock option awards because these options had an exercise price equal to the market value of the underlying common stock on the date of grant. Generally, if a fixed-based stock option award is subsequently modified, compensation expense, if any, is recorded for the amount that the market price of Humana common stock exceeds the option’s exercise price on the date the option is modified. Compensation expense is recorded for restricted stock grants over their vesting periods based on fair value, which is equal to the market price of Humana common stock on the date of the grant. The effect on net income and earnings per share if we had applied the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, to our fixed-based stock option awards was as follows for the years ended December 31, 2003, 2002 and 2001.
Investment securities classified as long-term assets were as follows at December 31, 2003 and 2002:
Unrealized losses at December 31, 2003 resulted from 96 positions. Less than 3% of the carrying value of our consolidated investment securities have been in an unrealized loss position greater than one year. The unrealized losses at December 31, 2003 generally can be attributed to changes in interest rates. All securities trading at an unrealized loss remain current on all contractual payments and we believe it is probable that we will be able to collect all amounts due according to the contractual terms of the debt securities. After taking into account these and other factors, including our ability and intent to hold these securities until recovery or maturity, we determined the unrealized losses on these investment securities were temporary.
The contractual maturities of debt securities available for sale at December 31, 2003, 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 gains were $52.8 million in 2003, $24.7 million in 2002, and $25.1 million in 2001. Gross realized gains in 2003 included a gain of $15.2 million related to the sale of one venture capital investment in the second quarter of 2003.
Property and equipment was comprised of the following at December 31, 2003 and 2002:
Our impairment review during the fourth quarter of 2002 indicated that estimated undiscounted cash flows expected to result from the remaining use of the San Antonio, Texas customer service center long-lived assets, primarily buildings, were insufficient to recover their carrying value. Accordingly, we reduced the carrying value of these long-lived assets to their estimated fair value resulting in non-cash impairment expenses of $2.4 million ($1.5 million after tax) during the fourth quarter of 2002.
no longer supporting the carrying value of the center’s long-lived assets. Accordingly, we reduced the carrying value of these long-lived assets to their estimated fair value resulting in non-cash impairment expenses of approximately $17.2 million ($10.5 million after tax) during the first quarter of 2003.
Based upon our decision to sell some of the buildings previously used in our Jacksonville and San Antonio customer service operations, we classified them as held for sale and ceased depreciating these buildings effective July 1, 2003. The estimated costs to sell the building were not material to the estimated fair value. The impact of ceasing depreciation of the buildings was not material to our results of operations.
After finalizing plans during the first quarter of 2003 to abandon software used in our operations by March 2003, we reduced the estimated useful life of the software effective January 1, 2003. Accordingly, we accelerated the depreciation of the remaining software balance of approximately $13.5 million ($8.3 million after tax) during the first quarter of 2003.
The allocation of the non-cash pretax expenses related to the writedown and accelerated depreciation of certain long-lived assets to our Commercial and Government segments was as follows for the years ended December 31, 2003 and 2002:
We ceased amortizing goodwill upon adopting Statement 142 on January 1, 2002 as described in Note 2. The following table adjusts net income and basic and diluted earnings per common share to reflect the non-amortization of goodwill assuming the non-amortization provisions of Statement 142 were adopted as of January 1, 2001 for the years ended December 31, 2003, 2002 and 2001:
Activity in medical and other expenses payable was as follows for the years ended December 31, 2003, 2002 and 2001:
As summarized in the previous table, claim reserve balances at December 31, 2000 ultimately settled during 2001 for $23.4 million less than the amounts originally estimated, representing 0.3% of medical claim expenses incurred in 2000. During 2002, claim reserve balances at December 31, 2001 ultimately settled for $12.3 million more than the amounts originally estimated, representing 0.1% of medical claim expenses incurred in 2001. This $35.7 million increase in the amounts incurred related to prior years was substantially all attributable to our TRICARE operations and resulted primarily from enhanced benefits enacted for TRICARE beneficiaries as a result of Congressional legislation, the impact of which was not fully determinable at December 31, 2001. As these additional medical expenses were recognized during 2002, we also recognized and received commensurate revenues from the Department of Defense as a result of change orders.
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, 2003 and 2002 are as follows:
At December 31, 2003, we had approximately $79.4 million of capital losses to carryforward, primarily related to the sale of our workers’ compensation business in 2000. These capital loss carryforwards, if unused to offset future capital gains, will expire in 2005. A valuation allowance has been established for a portion of these deferred tax assets.
In order to term-out our short-term debt and take advantage of historically low interest rates, we issued $300 million 6.30% senior notes due August 1, 2018 on August 5, 2003. Our net proceeds, reduced for the cost of the offering, were approximately $295.8 million. The net proceeds were used for general corporate purposes, including the funding of our short term cash needs.
In June 2003, we recorded a deferred gain and received proceeds of $31.6 million in exchange for new swap agreements discussed above related to our 7.25% senior notes. The corresponding deferred swap gain of $31.6 million is being amortized to reduce interest expense over the remaining term of the 7.25% senior notes.
The carrying value of our 7.25% senior notes has been increased $26.2 million by the remaining deferred swap gain balance at December 31, 2003.
There were no balances outstanding under either agreement at December 31, 2003 or 2002. Under these agreements, at our option, we can borrow on either a competitive advance basis or a revolving credit basis. The revolving credit portion of both agreements bear 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 80 to 125 basis points for our 4-year agreement, and 85 to 137.5 basis points for our 364-day agreement. We also pay an annual facility fee regardless of utilization. This facility fee, currently 25 basis points, may fluctuate between 15 and 50 basis points, depending upon our credit ratings. The competitive advance portion of any borrowings under either credit agreement 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.
Activity in the reserve for professional liability risks was as follows for the years ended December 31, 2003, 2002 and 2001:
malpractice exposures. Since January 1, 2002, we have reduced the amount of coverage purchased from third party insurance carriers, causing an increase in the provision for professional liability risks and a decrease in the estimated recoverables from insurance. The total cost associated with our professional liabilities, including the cost of purchasing insurance coverage from a number of third party insurance companies not included in the table above, totaled $52.5 million in 2003, $33.6 million in 2002 and $31.4 million in 2001.
Amounts classified as current and non-current and their respective location in the consolidated balance sheets were as follows at December 31, 2003 and 2002:
We have plans under which restricted stock awards and options to purchase our common stock have been granted to officers, directors, key employees and consultants.
Activity for our restricted stock awards was as follows for the years ended December 31, 2003, 2002 and 2001:
Restricted stock awards generally vest three years from the date of grant. Unearned compensation under the restricted stock award plans is amortized over the vesting periods. Compensation expense recognized related to our restricted stock award plans was $5.8 million in 2003, $9.0 million in 2002, and $9.5 million in 2001. The decrease in compensation expense in 2003 was due to the August 7, 2003 vesting of 3.9 million shares of restricted stock.
A summary of our stock options outstanding and exercisable was as follows at December 31, 2003:
The weighted average fair value of each option granted during 2003, 2002 and 2001 is provided below. The fair value was estimated on the date of grant using the Black-Scholes pricing model with the following weighted average assumptions for the years ended December 31, 2003, 2002 and 2001:
Detail supporting the computation of basic and diluted earnings per common share was as follows for the years ended December 31, 2003, 2002 and 2001:
As of December 31, 2003, we maintained aggregate statutory capital and surplus of $1,086.5 million in our state regulated health insurance subsidiaries. Each of these subsidiaries was in compliance with applicable statutory requirements which aggregated $640.4 million. Although the minimum required levels of equity are largely based on premium volume, product mix, and the quality of assets held, minimum requirements can vary significantly at the state level. Certain states rely on risk-based capital requirements, or RBC, to define the required levels of equity. 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 all states at December 31, 2003, each of our subsidiaries would be in compliance and we would have $381.9 million of aggregate capital and surplus above any of the levels that require corrective action under RBC.
We lease facilities, computer hardware, and other equipment under long-term operating leases that are noncancelable and expire on various dates through 2017. We sublease facilities or partial facilities to third party tenants for space not used in our operations. Rent expense and sublease rental income for all operating leases was as follows for the years ended December 31, 2003, 2002, and 2001:
behalf of us, or for losses arising from certain events as defined within the particular contract, which may include, for example, litigation or claims relating to past performance. Such indemnification obligations may not be subject to maximum loss clauses. Historically, payments made related to these indemnifications have been immaterial.
On August 21, 2003, the Department of Defense notified us that we were awarded the contract for the South Region, one of three newly-created regions under the government’s revised TRICARE Program. The current TRICARE Regions 3 and 4 will become part of the new South Region along with Region 6, which is currently administered by another contractor. The current Regions 2 and 5 will become part of the North Region, which was awarded to another contractor.
Under the Department of Defense’s current schedule for implementation of the new TRICARE contracts, Regions 2 and 5 will transition to the new North Region for the start of healthcare delivery on July 1, 2004. Regions 3 and 4 will become part of the new South Region for the start of healthcare delivery on August 1, 2004 and Region 6 will become part of our new South Region for the start of healthcare delivery on November 1, 2004.
We currently have Medicaid contracts with the Puerto Rico Health Insurance Administration through June 30, 2005, subject to each party agreeing upon annual rates. In July 2003, we signed amendments to the Puerto Rico Medicaid contracts regarding a premium rate increase for the annual period ending June 30, 2004. Our other Medicaid contracts are in Florida and Illinois, and are annual contracts. As of December 31, 2003, Puerto Rico accounted for approximately 84% of our total Medicaid membership.
In late 1997, three purported class action complaints were filed in the United States District Court for the Southern District of Florida by former stockholders of Physician Corporation of America, or PCA, against PCA and certain of its former directors and officers. We acquired PCA by a merger that became effective on September 8, 1997. The three actions were consolidated into a single action entitled In re Physician Corporation of America Securities Litigation. The consolidated complaint alleged that PCA and the individual defendants knowingly or recklessly made false and misleading statements in press releases and public filings with respect to the financial and regulatory difficulties of PCA’s workers’ compensation business. The Court certified a class on May 20, 2003. On August 25, 2003, the parties entered into an agreement to settle the case for the amount of $10.2 million. On November 26, 2003, the settlement received final approval by the Court. A provision for the settlement was previously made in our financial statements during the fourth quarter of 2002. The Company had pursued insurance coverage for this matter from two insurers and has settled the matter with one of the insurers who will pursue coverage against the other insurer.
Personal injury claims and claims for extracontractual damages arising from medical benefit denials are covered by insurance from our wholly owned captive insurance subsidiary and excess carriers, except to the extent that claimants seek punitive damages, which may not be covered by insurance in certain states in which insurance coverage for punitive damages is not permitted. In addition, insurance coverage for all or certain forms of liability has become increasingly costly and may become unavailable or prohibitively expensive in the future. On January 1, 2002 and again on January 1, 2003, we reduced the amount of coverage purchased from third party insurance carriers and increased the amount of risk we retain due to substantially higher insurance rates.
We do not believe that any pending or threatened legal actions against us or any pending or threatened audits or investigations by state or federal regulatory agencies will have a material adverse effect on our financial position, results of operations, or cash flows. However, the likelihood or outcome of current or future suits, like the purported class action lawsuits described above, or governmental investigations, cannot be accurately predicted with certainty. In addition, the potential for increased liability for medical negligence arising from claims adjudication, along with the increased litigation that has accompanied the negative publicity and public perception of our industry, adds to this uncertainty. Therefore, such legal actions and government audits and investigations could have a material adverse effect on our financial position, results of operations, and cash flows.
Our segment results were as follows for the years ended December 31, 2003, 2002, and 2001:
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 42% for 2003 and 44% for 2002 and 2001.
Certain old blocks of run-off insurance assumed in acquisitions, primarily life insurance and annuities, are subject to 100% coinsurance agreements where the entire risk and all administrative functions, including premium collections and claim payments, related to these policies has been ceded to a third-party. Coinsurance is a form of reinsurance. We acquired these policies and the related reinsurance agreements with the purchase of the stock of the companies in which the policies were originally written. We acquired these companies for business reasons unrelated to these policies, including the companies’ licenses necessary to fulfill strategic plans.
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 $45.3 million in 2003, $59.3 million in 2002, and $70.8 million in 2001. 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 $272.1 million at December 31, 2003 and $279.9 million at December 31, 2002.
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, 2003 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 consolidated financial position of Humana Inc. and its subsidiaries at December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) on page 99 presents 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 schedule are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit 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 ceased amortizing goodwill effective January 1, 2002.
A summary of our quarterly unaudited results of operations for the years ended December 31, 2003 and 2002 follows:
(a) Includes expenses of $30.8 million pretax ($18.8 million after tax, or $0.12 per diluted share) for the writedown of building and equipment and software abandonment expenses due to the elimination of three customer service centers. See Note 4 for the impact on the individual expense categories.