Annual Reports

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  • 10-K (Feb 17, 2017)
  • 10-K (Feb 18, 2016)
  • 10-K (Feb 18, 2015)
  • 10-K (Feb 19, 2014)
  • 10-K (Jan 30, 2014)

 
Quarterly Reports

 
8-K

 
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Humana 10-K 2008
Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2007

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission file number 1-5975

 

 

HUMANA INC.

(Exact name of registrant as specified in its charter)

 

Delaware   61-0647538
(State of incorporation)   (I.R.S. Employer Identification Number)
500 West Main Street  
Louisville, Kentucky   40202
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (502) 580-1000

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of exchange on which registered

Common stock, $0.16 2/3 par value   New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:

None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  þ    No  ¨

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  þ

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ    Accelerated filer ¨    Non-accelerated filer ¨    Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ¨    No þ

The aggregate market value of voting stock held by non-affiliates of the Registrant as of June 30, 2007 was $10,250,115,899 calculated using the average price on such date of $61.41.

The number of shares outstanding of the Registrant’s Common Stock as of January 31, 2008 was 170,173,405.

DOCUMENTS INCORPORATED BY REFERENCE

Parts I, II and III incorporate herein by reference portions of the Registrant’s Proxy Statement to be filed pursuant to Regulation 14A covering the Annual Meeting of Stockholders scheduled to be held April 24, 2008.

 

 

 


Table of Contents

HUMANA INC.

INDEX TO ANNUAL REPORT ON FORM 10-K

For the Year Ended December 31, 2007

 

            Page
   Part I   

Item 1.

   Business    3

Item 1A.

   Risk Factors    16

Item 1B.

   Unresolved Staff Comments    26

Item 2.

   Properties    27

Item 3.

   Legal Proceedings    27

Item 4.

   Submission of Matters to a Vote of Security Holders    27
   Part II   

Item 5.

   Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    28

Item 6.

   Selected Financial Data    30

Item 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    31

Item 7A.

   Quantitative and Qualitative Disclosures about Market Risk    61

Item 8.

   Financial Statements and Supplementary Data    62

Item 9.

   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    97

Item 9A.

   Controls and Procedures    97

Item 9B.

   Other Information    98
   Part III   

Item 10.

   Directors, Executive Officers and Corporate Governance    99

Item 11.

   Executive Compensation    101

Item 12.

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    101

Item 13.

   Certain Relationships and Related Transactions, and Director Independence    102

Item 14.

   Principal Accounting Fees and Services    102
   Part IV   

Item 15.

   Exhibits, Financial Statement Schedules    103
   Signatures and Certifications    113


Table of Contents

PART I

 

ITEM 1. BUSINESS

General

Headquartered in Louisville, Kentucky, Humana Inc., referred to throughout this document as “we,” “us,” “our,” the “Company” or “Humana,” is one of the nation’s largest publicly traded health and supplemental benefits companies, based on our 2007 revenues of $25.3 billion. 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. As of December 31, 2007, we had approximately 11.5 million members in our medical benefit plans, as well as approximately 6.8 million members in our specialty products. During 2007, 71% of our premiums and administrative services fees were derived from contracts with the federal government, including 17% related to our contracts in Florida with the Centers for Medicare and Medicaid Services, or CMS, and 12% related to our military services contracts. Under our CMS contracts in Florida, we provide health insurance coverage to approximately 507,700 members as of December 31, 2007.

We were organized as a Delaware corporation in 1964. Our principal executive offices are located at 500 West Main Street, Louisville, Kentucky 40202, the telephone number at that address is (502) 580-1000, and our website address is www.humana.com.

This Annual Report on Form 10-K contains both historical and forward-looking information. See Item 1A.—Risk Factors for a description of a number of factors that could adversely affect our results or business.

Business Segments

We manage our business with two segments: Government and Commercial. 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. We identified our segments in accordance with the aggregation provisions of Statement of Financial Accounting Standards (SFAS) No. 131, Disclosures About Segments of an Enterprise and Related Information, or SFAS 131, which aggregates products with similar economic characteristics. These characteristics include the nature of customer groups as well as pricing, benefits, and underwriting requirements. These segment groupings are consistent with information used by our Chief Executive Officer.

The results of each segment are measured by income before income taxes. We allocate all selling, general and administrative expenses, investment and other revenue, interest expense, and goodwill, but no other assets or liabilities, to our segments. Members served by our two segments often utilize the same medical provider networks, enabling us to obtain more favorable contract terms with providers. Our segments also share indirect overhead costs and assets. As a result, the profitability of each segment is interdependent.

 

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Our Products

As more fully described in the products discussion that follows, we provide health insurance benefits under health maintenance organization, or HMO, Private Fee-For-Service, or PFFS, and preferred provider organization, or PPO, plans. In addition, we provide other benefits with our specialty products including dental, vision, and other supplementary benefits. The following table presents our segment membership at December 31, 2007, and premiums and administrative services only, or ASO, fees by product for the year ended December 31, 2007:

 

    Medical
Membership
  Specialty
Membership
  Premiums   ASO Fees   Total
Premiums and
ASO Fees
  Percent of
Total
Premiums
and ASO
Fees
 
    (dollars in thousands)  

Government:

 

Medicare Advantage:

           

HMO

  453,100   —     $ 5,378,804   $ —     $ 5,378,804   21.7 %

PFFS

  615,800   —       5,146,955     —       5,146,955   20.7 %

PPO

  74,100   —       647,658     —       647,658   2.6 %
                               

Total Medicare Advantage

  1,143,000   —       11,173,417     —       11,173,417   45.0 %
                               

Medicare stand-alone PDP

  3,442,000   —       3,668,425     —       3,668,425   14.8 %
                               

Total Medicare

  4,585,000   —       14,841,842     —       14,841,842   59.8 %
                               

Medicaid insured

  384,400   —       555,594     —       555,594   2.3 %

Medicaid ASO

  180,600   —       —       8,556     8,556   —   %
                               

Total Medicaid

  565,000   —       555,594     8,556     564,150   2.3 %
                               

Military services insured

  1,719,100   —       2,839,790     —       2,839,790   11.4 %

Military services ASO

  1,146,800   —       —       65,103     65,103   0.3 %
                               

Total military services

  2,865,900   —       2,839,790     65,103     2,904,893   11.7 %
                               

Total Government

  8,015,900   —       18,237,226     73,659     18,310,885   73.8 %
                               

Commercial:

           

Fully-insured:

           

PPO

  1,215,800   —       3,664,019     —       3,664,019   14.7 %

HMO

  592,800   —       1,998,981     —       1,998,981   8.1 %
                               

Total fully-insured

  1,808,600   —       5,663,000     —       5,663,000   22.8 %

ASO

  1,643,000   —       —       307,823     307,823   1.2 %

Specialty

  —     6,783,800     534,121     10,033     544,154   2.2 %
                               

Total Commercial

  3,451,600   6,783,800     6,197,121     317,856     6,514,977   26.2 %
                               

Total

  11,467,500   6,783,800   $ 24,434,347   $ 391,515   $ 24,825,862   100.0 %
                               

Our Products Marketed to Government Segment Members and Beneficiaries

Medicare

We have participated in the Medicare program for private health plans for over 20 years. Since recent significant changes were made to the Medicare program for health plans like those offered by us, we have expanded from a regional to a national presence, now offering at least one type of Medicare plan in all 50 states. The resulting growing membership base provides us with greater leverage to expand our network of PPO and HMO providers. We employ strategies including health assessments and programs such as Personal Nurse®, a case management and disease management program, and a fitness program for seniors to guide Medicare beneficiaries in making cost-effective decisions with respect to their health care, including cost savings that occur from making positive behavior changes that result in living healthier.

 

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Medicare is a federal program that provides persons age 65 and over and some disabled persons under the age of 65 certain hospital and medical insurance benefits. Hospitalization benefits are provided under Part A, without the payment of any premium, for up to 90 days per incident of illness plus a lifetime reserve aggregating 60 days. Eligible beneficiaries are required to pay an annually adjusted premium to the federal government to be eligible for physician care and other services under Part B. Beneficiaries eligible for Part A and Part B coverage under traditional Medicare are still required to pay out-of-pocket deductibles and coinsurance. Prescription drug benefits are provided under Part D. CMS, an agency of the United States Department of Health and Human Services, administers the Medicare program.

Medicare Advantage Products

We contract with CMS under the Medicare Advantage program to provide a comprehensive array of health insurance benefits including wellness programs to Medicare eligible persons under HMO, PPO, and PFFS plans in exchange for contractual payments received from CMS, usually a fixed payment per member per month. We refer to beneficiaries enrolled in these plans collectively as Medicare Advantage, or MA-PD, members. With each of these products, the beneficiary receives benefits in excess of traditional Medicare, typically including reduced cost sharing, enhanced prescription drug benefits, care coordination, data mining techniques to help identify member needs, complex case management, tools to guide members in their health care decisions, disease management programs, wellness and prevention programs, and a reduced monthly Part B premium. Since 2006, Medicare beneficiaries have had more health plan options, including a prescription drug benefit option and greater access to a PPO offering with the roll-out of Regional PPO plans. Prior to 2006, PPO plans were offered on a local basis only. Most Medicare Advantage plans must offer the prescription drug benefit under Part D as part of the basic plan, subject to cost sharing and other limitations. Accordingly, all of the provisions of the Medicare Part D program described in connection with our stand-alone prescription drug plans in the following section also are applicable to our Medicare Advantage plans. Medicare Advantage plans may charge beneficiaries monthly premiums and other copayments for Medicare-covered services or for certain extra benefits.

Our Medicare HMO and PPO plans, which cover Medicare-eligible individuals residing in certain counties, may eliminate or reduce coinsurance or the level of deductibles on many other medical services while seeking care from participating in-network providers or in emergency situations. Except in emergency situations, HMO plans provide no out-of-network benefits. PPO plans carry an out-of network benefit that is subject to higher member cost-sharing. In many cases, these beneficiaries also may be required to pay a monthly premium to the HMO or PPO plan in addition to the monthly Part B premium they are required to pay the Medicare program.

Our Medicare PFFS plans have no preferred network. Individuals in these plans pay us a monthly premium to receive typical Medicare Advantage benefits along with the freedom to choose any health care provider that accepts individuals at reimbursement rates equivalent to traditional Medicare payment rates.

CMS uses monthly rates per person for each county to determine the fixed monthly payments per member to pay to health benefit plans. These rates are adjusted under CMS’s risk adjustment model which uses health status indicators, or risk scores, to improve the accuracy of payment. The risk adjustment model, which CMS implemented pursuant to the Balanced Budget Act of 1997 (BBA) and the Benefits and Improvement Protection Act of 2000 (BIPA), uses principal hospital inpatient diagnoses as well as diagnosis data from ambulatory treatment settings (hospital outpatient department and physician visits). CMS transitioned to this risk-based reimbursement model while the old reimbursement model based on demographic data including gender, age, and disability status was phased out. In 2006, the portion of risk adjusted payment was increased to 75% from 50% in 2005. The phase-in of risk adjusted payment increased to 100% in 2007. Under the risk adjustment methodology, all health benefit organizations must capture, collect, and submit the necessary diagnosis code information to CMS within prescribed deadlines.

Commensurate with phase-in of the risk-adjustment methodology, payments to Medicare Advantage plans were increased by a “budget neutrality” factor. The budget neutrality factor was implemented to prevent overall

 

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health plan payments from being reduced during the transition from the previous reimbursement model, based upon average original Medicare fee-for-service spending, to the risk-adjustment payment model. The payment adjustments for budget neutrality were first developed in 2002 and first used with the 2003 payments.

The budget neutrality adjustment began phasing out in 2007 and will be fully eliminated by 2011. This does not mean, however, that the aggregate per-member payments to Medicare plans will be reduced. As plans enroll less healthy beneficiaries, the need for the budget neutrality adjustment declines as the underlying risk adjusted Medicare rates paid to plans increase to account for their enrollees’ greater healthcare needs. As a result of changes in the CMS payment processes, including the phasing in of the risk adjustment methodology and the phasing out of the budget neutrality adjustment described previously, our CMS payments per member may change materially, either favorably or unfavorably.

At December 31, 2007, we provided health insurance coverage under CMS contracts to approximately 1,143,000 MA-PD members for which we received premium revenues of approximately $11.2 billion, or 45.0% of our total premiums and ASO fees for the year ended December 31, 2007. Under our Medicare Advantage contracts with CMS in Florida, we provided health insurance coverage to approximately 325,000 members. These contracts accounted for premium revenues of approximately $4.2 billion, which represented approximately 37.5% of our Medicare Advantage premium revenues, or 16.8% of our total premiums and ASO fees for the year ended December 31, 2007.

Our HMO, PFFS, and PPO products covered under Medicare Advantage contracts with CMS 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 Advantage business have been renewed for 2008.

Medicare Stand-Alone Prescription Drug Products

On January 1, 2006, we began offering stand-alone prescription drug plans, or PDPs, under Medicare Part D. Generally, Medicare-eligible individuals enroll in one of our three plan choices between November 15 and December 31 for coverage that begins January 1. The enrollment period was extended to May 31 during 2006 because it was the first year of the program. Our stand-alone PDP offerings consist of plans offering basic coverage with benefits mandated by Congress, as well as plans providing enhanced coverage with varying degrees of out-of-pocket costs for premiums, deductibles and co-insurance. Our revenues from CMS and the beneficiary are determined from our bids submitted annually to CMS. These revenues also reflect the health status of the beneficiary and risk sharing provisions as more fully described beginning on page 56. Our stand-alone PDP contracts with CMS 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 stand-alone PDP business have been renewed for 2008.

Medicaid Product

Medicaid is a federal program that is state-operated to facilitate the delivery of health care services primarily to low-income residents. Each electing state develops, through a state specific regulatory agency, a Medicaid managed care initiative that must be approved by CMS. CMS requires that Medicaid managed care plans meet federal standards and cost no more than the amount that would have been spent on a comparable fee-for-service basis. States currently either use a formal proposal process in which they review many bidders before selecting one or award individual contracts to qualified bidders who apply for entry to the program. In either case, the contractual relationship with a state generally is for a one-year period. Under these contracts, we receive a fixed monthly payment from a government agency for which we are required to provide health

 

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insurance coverage to enrolled members. Due to the increased emphasis on state health care reform and budgetary constraints, more states are utilizing a managed care product in their Medicaid programs.

Our Medicaid business, which accounted for approximately 2.3% of our total premiums and ASO fees for the year ended December 31, 2007, consisted of contracts in Puerto Rico and Florida, with the vast majority in Puerto Rico.

Military Services

Under our TRICARE South Region contract with the Department of Defense, we provide health insurance coverage to the dependents of active duty military personnel and to retired military personnel and their dependents. Currently, three health benefit options are available to TRICARE beneficiaries. In addition to a traditional indemnity option, participants may enroll in a HMO-like plan with a point-of-service option or take advantage of reduced copayments by using a network of preferred providers, similar to a PPO.

We have participated in the TRICARE program since 1996 under contracts with the United States Department of Defense. Our current TRICARE South Region contract, which we were awarded in 2003, covers approximately 2.9 million eligible beneficiaries as of December 31, 2007 in Florida, Georgia, South Carolina, Mississippi, Alabama, Tennessee, Louisiana, Arkansas, Texas and Oklahoma. The South Region is one of the three regions in the United States as defined by the Department of Defense. Of these eligible beneficiaries, 1.1 million were TRICARE ASO members representing active duty beneficiaries, seniors over the age of 65 and beneficiaries in Puerto Rico for which the Department of Defense retains all of the risk of financing the cost of their health benefit. We have subcontracted with third parties to provide selected administration and specialty services under the contract. The TRICARE South Region contract is for a five-year period subject to annual renewals at the federal government’s option, with the fifth option period scheduled to begin April 1, 2008 and run through March 31, 2009. The Department of Defense has the option to extend the current contract for up to six months under existing terms. Congressional authority has also been granted to extend the contract in one year increments for a maximum of two additional years. In the second quarter of 2007, a draft solicitation related to the new TRICARE contracts, currently scheduled to begin April 1, 2009, was issued for industry comment. Currently, we are anticipating a formal request for proposal, or RFP, for the TRICARE contracts.

The TRICARE South Region contract contains provisions that require us to negotiate a target health care cost amount annually with the federal government. Any variance from the target health care cost is shared with the federal government. Accordingly, events and circumstances not contemplated in the negotiated target health care cost amount could have a material adverse effect on our business. These changes may include, for example, an increase or reduction in the number of persons enrolled or eligible to enroll due to the federal government’s decision to increase or decrease U.S. military deployments.

For the year ended December 31, 2007, TRICARE premium revenues were approximately $2.8 billion, or 11.4% of our total premiums and ASO fees, and TRICARE ASO fees totaled $65.1 million, or 0.3% of our total premiums and ASO fees.

In October 2007, we were awarded the Department of Veterans Affairs first specialty network demonstration project, known as Project HERO (Healthcare Effectiveness through Resource Optimization), to support healthcare delivery to veterans. The contract is comprised of one base period and four one-year option periods subject to annual renewals at the federal government’s option, with services beginning January 1, 2008.

International and Green Ribbon Health Operations

We established our subsidiary Humana Europe in the United Kingdom to provide commissioning support to Primary Care Trusts, or PCTs, in England. Under the contracts we are awarded, we will work in partnership with local PCTs, health care providers, and patients to strengthen health-service delivery and to implement strategies at a local level to help the National Health Service enhance patient experience, improve clinical outcomes, and reduce costs. We are in the start-up phase in anticipation of rendering services under contracts.

 

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We participate in a Medicare Health Support pilot program through Green Ribbon Health, or GRH, a joint-venture company with Pfizer Health Solutions Inc. GRH is designed to support Medicare beneficiaries living with diabetes and/or congestive heart failure in Central Florida. GRH uses disease management initiatives including evidence-based clinical guidelines, personal self-directed change strategies, and personal nurses to help participants navigate the health system. Revenues under the contract with CMS, which expires October 31, 2008 unless terminated earlier, are subject to refund unless a savings target is met. To date, all revenues have been deferred until reliable estimates are determinable.

Our Products Marketed to Commercial Segment Employers and Members

Smart Plans and Other Consumer Products

Over the last several years, we have developed and offered various commercial products designed to provide options and choices to employers that are annually facing substantial premium increases driven by double-digit medical cost inflation. These Smart plans, discussed more fully below, and other consumer offerings, which can be offered on either a fully-insured or ASO basis, provided coverage to approximately 564,700 members at December 31, 2007, representing approximately 16.4% of our total commercial medical membership as detailed below.

 

     Smart Plans and
Other Consumer
Membership
   Other Commercial
Membership
   Commercial
Medical
Membership

Fully-insured

   327,900    1,480,700    1,808,600

ASO

   236,800    1,406,200    1,643,000
              

Total Commercial medical

   564,700    2,886,900    3,451,600
              

These products are often offered to employer groups as “bundles”, where the subscribers are offered various HMO and PPO options, with various employer contribution strategies as determined by the employer.

Paramount to our product strategy, we have developed a group of innovative consumer products, styled as “Smart” products, that we believe will be a long-term solution for employers. We believe this new generation of products provides more (1) choices for the individual consumer, (2) transparency of provider costs, and (3) benefit designs that engage consumers in the costs and effectiveness of health care choices. Innovative tools and technology are available to assist consumers with these decisions, including the trade-offs between higher premiums and point-of-service costs at the time consumers choose their plans, and to suggest ways in which the consumers can maximize their individual benefits at the point they use their plans. We believe that when consumers can make informed choices about the cost and effectiveness of their health care, a sustainable long term solution for employers can be realized. Smart products, which accounted for approximately 55% of enrollment in all of our consumer-choice plans as of December 31, 2007, are only sold to employers who use Humana as their sole health insurance carrier.

Some employers have selected other types of consumer-choice products, such as, (1) a product with a high deductible, (2) a catastrophic coverage plan, or (3) ones that offer a spending account option in conjunction with more traditional medical coverage or as a stand alone plan. Unlike our Smart products, these products, while valuable in helping employers deal with near-term cost increases by shifting costs to employees, are not considered by us to be long-term comprehensive solutions to the employers’ cost dilemma, although we view them as an important interim step.

HMO

Our commercial HMO products provide prepaid health insurance coverage to our members through a network of independent primary care physicians, specialty physicians, and other health care providers who

 

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contract with the HMO to furnish such services. Primary care physicians generally include internists, family practitioners, and pediatricians. Generally, the member’s primary care physician must approve access to certain specialty physicians and other health care providers. These other health care providers include, among others, hospitals, nursing homes, home health agencies, pharmacies, mental health and substance abuse centers, diagnostic centers, optometrists, outpatient surgery centers, dentists, urgent care centers, and durable medical equipment suppliers. Because the primary care physician generally must approve access to many of these other health care providers, the HMO product is considered the most restrictive form of a health benefit plan.

An HMO member, typically through the member’s employer, pays a monthly fee, which generally covers, together with some copayments, health care services received from, or approved by, the member’s primary care physician. We participate in the Federal Employee Health Benefits Program, or FEHBP, primarily with our HMO offering in certain markets. FEHBP is the government’s health insurance program for Federal employees, retirees, former employees, family members, and spouses. For the year ended December 31, 2007, commercial HMO premium revenues totaled approximately $2.0 billion, or 8.1% of our total premiums and ASO fees.

PPO

Our commercial PPO products, which are marketed primarily to employer groups and individuals, include some types of wellness and utilization management programs. However, they typically include more cost-sharing with the member, through copayments and annual deductibles. PPOs also are similar to traditional health insurance because they provide a member with more freedom to choose a physician or other health care provider. In a PPO, the member is encouraged, through financial incentives, to use participating health care providers, which have contracted with the PPO to provide services at favorable rates. In the event a member chooses not to use a participating health care provider, the member may be required to pay a greater portion of the provider’s fees.

As part of our PPO products, we offer HumanaOne, a major medical product marketed directly to individuals. We offer this product in select markets where we can generally underwrite risk and utilize our existing networks and distribution channels. This individual product includes provisions mandated by law to guarantee renewal of coverage for as long as the individual chooses.

For the year ended December 31, 2007, employer and individual commercial PPO premium revenues totaled approximately $3.7 billion, or 14.7% of our total premiums and ASO fees.

ASO

In addition to fully-insured Smart plans and other consumer offerings, HMO and PPO products, we also offer ASO products to employers who self-insure their employee health plans. We receive fees to provide administrative services which generally include the processing of claims, offering access to our provider networks and clinical programs, and responding to customer service inquiries from members of self-funded employers. These products may include all of the same benefit and product design characteristics of our fully-insured PPO, HMO or Smart plans and other consumer products described previously. Under ASO contracts, self-funded employers retain the risk of financing substantially all of the cost of health benefits. However, most ASO customers purchase stop loss insurance coverage from us to cover catastrophic claims or to limit aggregate annual costs. For the year ended December 31, 2007, commercial ASO fees totaled $307.8 million, or 1.2% of our total premiums and ASO fees.

Specialty

We also offer various specialty products including dental, vision, and other supplemental products. During 2007, we made investments which significantly expanded our specialty product offerings with the acquisitions of CompBenefits Corporation and KMG America Corporation. These acquisitions significantly increased our dental

 

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membership and added new product offerings including vision and other supplemental health and life benefit plans primarily sold on a voluntary basis. The supplemental health plans cover, for example, some of the costs associated with cancer and critical illness. At December 31, 2007, we had approximately 6.8 million specialty members, including 3.6 million dental members and 2.3 million vision members. For the year ended December 31, 2007, specialty product premiums and ASO fees were approximately $544.2 million, or 2.2% of our total premiums and ASO fees.

Membership

The following table summarizes our total medical membership at December 31, 2007, by market and product:

 

    Government   Commercial          
    Medicare
Advantage
  Medicare
Stand-alone
PDP
  Medicaid   Military
services
  PPO   HMO   ASO   Total   Percent
of Total
 
    (in thousands)  

Florida

  325.0   182.7   39.6   —     125.2   162.6   89.5   924.6   8.1 %

Texas

  64.7   257.0   —     —     253.3   106.8   174.5   856.3   7.5 %

Kentucky

  42.3   71.6   —     —     157.7   34.6   494.7   800.9   7.0 %

Illinois

  47.7   93.4   —     —     123.5   58.4   129.2   452.2   3.9 %

Puerto Rico

  19.0   0.2   344.8   —     40.1   17.9   22.5   444.5   3.9 %

Wisconsin

  45.2   60.6   —     —     71.1   57.0   207.8   441.7   3.8 %

Ohio

  40.5   118.9   —     —     59.1   57.5   163.3   439.3   3.8 %

Missouri/Kansas

  54.1   181.8   —     —     46.3   15.4   5.2   302.8   2.6 %

Louisiana

  54.3   60.7   —     —     38.2   22.0   124.3   299.5   2.6 %

California

  2.6   246.7   —     —     1.4   —     —     250.7   2.2 %

Indiana

  22.7   110.8   —     —     47.1   0.9   54.4   235.9   2.1 %

Georgia

  32.4   87.6   —     —     18.8   39.8   16.4   195.0   1.7 %

Tennessee

  18.2   99.6   —     —     40.7   —     30.9   189.4   1.6 %

North Carolina

  57.6   120.5   —     —     4.8   —     —     182.9   1.6 %

Arizona

  28.7   48.2   —     —     43.9   19.4   31.0   171.2   1.5 %

Michigan

  20.8   101.6   —     —     44.8   —     3.2   170.4   1.5 %

New York

  1.6   153.8   —     —     —     —     —     155.4   1.3 %

Virginia

  44.8   95.5   —     —     1.2   —     —     141.5   1.2 %

Pennsylvania

  14.9   119.1   —     —     3.2   —     —     137.2   1.2 %

Mississippi

  9.6   84.1   —     —     15.1   —     2.3   111.1   1.0 %

Colorado

  13.5   38.7   —     —     57.9   0.5   —     110.6   1.0 %

Minnesota

  33.8   71.3   —     —     —     —     0.2   105.3   0.9 %

Puerto Rico ASO

  —     —     180.6   —     —     —     —     180.6   1.6 %

Military services

  —     —     —     1,719.1   —     —     —     1,719.1   15.0 %

Military services ASO

  —     —     —     1,146.8   —     —     —     1,146.8   10.0 %

Others

  149.0   1,037.6   —     —     22.4   —     93.6   1,302.6   11.4 %
                                     

Totals

  1,143.0   3,442.0   565.0   2,865.9   1,215.8   592.8   1,643.0   11,467.5   100.0 %
                                     

Provider Arrangements

We provide our members with access to health care services through our networks of health care providers with whom we have contracted, including hospitals and other independent facilities such as outpatient surgery centers, primary care physicians, specialist physicians, dentists and providers of ancillary health care services and facilities. These ancillary services and facilities include ambulance services, medical equipment services, home health agencies, mental health providers, rehabilitation facilities, nursing homes, optical services, and pharmacies. Our membership base and the ability to influence where our members seek care generally enable us to obtain contractual discounts with providers.

 

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We use a variety of techniques to provide access to effective and efficient use of health care services for our members. These techniques include the coordination of care for our members, product and benefit designs, hospital inpatient management systems and enrolling members into various disease management programs. The focal point for health care services in many of our HMO networks is the primary care physician who, under contract with us, provides services to our members, and may control utilization of appropriate services, by directing or approving hospitalization and referrals to specialists and other providers. Some physicians may have arrangements under which they can earn bonuses when certain target goals relating to the provision of quality patient care are met. Our hospitalist programs use specially-trained physicians to effectively manage the entire range of an HMO member’s medical care during a hospital admission and to effectively coordinate the member’s discharge and post-discharge care. We have available a variety of disease management programs related to specific medical conditions such as congestive heart failure, coronary artery disease, prenatal and premature infant care, asthma related illness, end stage renal disease, diabetes, cancer, and certain other conditions.

We typically contract with hospitals on either (1) a per diem rate, which is an all-inclusive rate per day, (2) a case rate or diagnosis-related groups (DRG), which is an all-inclusive rate per admission, or (3) a discounted charge for inpatient hospital services. Outpatient hospital services generally are contracted at a flat rate by type of service, ambulatory payment classifications, or APCs, or at a discounted charge. APCs are similar to flat rates except multiple services and procedures may be aggregated into one fixed payment. These contracts are often multi-year agreements, with rates that are adjusted for inflation annually based on the consumer price index or other nationally recognized inflation indexes. Outpatient surgery centers and other ancillary providers typically are contracted at flat rates per service provided or are reimbursed based upon a nationally recognized fee schedule such as the Medicare allowable fee schedule.

Our contracts with physicians typically are renewed automatically each year, unless either party gives written notice, generally ranging from 90 to 120 days, to the other party of their intent to terminate the arrangement. Most of the physicians in our PPO networks and some of our physicians in our HMO networks are reimbursed based upon a fixed fee schedule, which typically provides for reimbursement based upon a percentage of the standard Medicare allowable fee schedule.

Capitation

For 2.3% of our December 31, 2007 medical membership, we contract with hospitals and physicians to accept financial risk for a defined set of HMO membership. In transferring this risk, we prepay these providers a monthly fixed-fee per member, known as a capitation (per capita) payment, to coordinate substantially all of the medical care for their capitated HMO membership, including some health benefit administrative functions and claims processing. For these capitated HMO arrangements, we generally agree to reimbursement rates that target a benefits ratio ranging from 82% to 89%. The benefits ratio measures underwriting profitability and is computed by taking total benefit expenses as a percentage of premium revenues. Providers participating in hospital-based capitated HMO arrangements generally receive a monthly payment for all of the services within their system for their HMO membership. Providers participating in physician-based capitated HMO arrangements generally have subcontracted directly with hospitals and specialist physicians, and are responsible for reimbursing such hospitals and physicians for services rendered to their HMO membership.

For another 4.7% of our December 31, 2007 medical membership, we contract with physicians under risk-sharing arrangements whereby physicians have assumed some level of risk for all or a portion of the medical costs of their HMO membership. Although these arrangements do include physician capitation payments for services rendered, we share hospital and other benefit expenses and process substantially all of the claims under these arrangements.

Physicians under capitation arrangements typically have stop loss coverage so that a physician’s financial risk for any single member is limited to a maximum amount on an annual basis. We monitor the financial performance and solvency of our capitated providers. However, we remain financially responsible for health care services to our members in the event our providers fail to provide such services.

 

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Medical membership under these various arrangements was as follows at December 31, 2007 and 2006:

 

    Government Segment     Commercial Segment        
    Medicare
Advantage
    Medicare
stand-alone
PDP
    Military
services
    Military
Services
ASO
    Medicaid     Total
Segment
    Fully-
Insured
    ASO     Total
Segment
    Total
Medical
 

Medical Membership:

 

December 31, 2007

                   

Capitated HMO hospital system based

  27,000     —       —       —       —       27,000     24,500     —       24,500     51,500  

Capitated HMO physician group based

  23,000     —       —       —       150,500     173,500     25,800     —       25,800     199,300  

Risk-sharing

  275,200     —       —       —       230,800     506,000     26,000     —       26,000     532,000  

Other

  817,800     3,442,000     1,719,100     1,146,800     183,700     7,309,400     1,732,300     1,643,000     3,375,300     10,684,700  
                                                           

Total

  1,143,000     3,442,000     1,719,100     1,146,800     565,000     8,015,900     1,808,600     1,643,000     3,451,600     11,467,500  
                                                           

December 31, 2006

                   

Capitated HMO hospital system based

  29,800     —       —       —       —       29,800     33,600     —       33,600     63,400  

Capitated HMO physician group based

  23,900     —       —       —       148,300     172,200     29,900     —       29,900     202,100  

Risk-sharing

  279,300     —       —       —       239,700     519,000     25,900     —       25,900     544,900  

Other

  669,600     3,536,600     1,716,400     1,163,600     181,100     7,267,300     1,664,800     1,529,600     3,194,400     10,461,700  
                                                           

Total

  1,002,600     3,536,600     1,716,400     1,163,600     569,100     7,988,300     1,754,200     1,529,600     3,283,800     11,272,100  
                                                           

Medical Membership Distribution:

 

December 31, 2007

                   

Capitated HMO hospital system based

  2.4 %   —       —       —       —       0.3 %   1.4 %   —       0.7 %   0.5 %

Capitated HMO physician group based

  2.0 %   —       —       —       26.6 %   2.2 %   1.4 %   —       0.8 %   1.8 %

Risk-sharing

  24.1 %   —       —       —       40.9 %   6.3 %   1.4 %   —       0.8 %   4.7 %

All other membership

  71.5 %   100.0 %   100.0 %   100.0 %   32.5 %   91.2 %   95.8 %   100.0 %   97.7 %   93.0 %
                                                           

Total

  100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %
                                                           

December 31, 2006

                   

Capitated HMO hospital system based

  3.0 %   —       —       —       —       0.4 %   1.9 %   —       1.0 %   0.6 %

Capitated HMO physician group based

  2.4 %   —       —       —       26.1 %   2.2 %   1.7 %   —       0.9 %   1.8 %

Risk-sharing

  27.9 %   —       —       —       42.1 %   6.4 %   1.5 %   —       0.8 %   4.8 %

All other membership

  66.7 %   100.0 %   100.0 %   100.0 %   31.8 %   91.0 %   94.9 %   100.0 %   97.3 %   92.8 %
                                                           

Total

  100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %
                                                           

Capitation expense as a percentage of total benefit expense was as follows for the years ended December 31, 2007, 2006, and 2005:

 

     2007     2006     2005  
     (dollars in thousands)  

Benefit Expenses:

               

Capitated HMO expense

   $ 366,075    1.8 %   $ 382,584    2.2 %   $ 456,123    3.9 %

Other benefit expense

     19,904,456    98.2 %     17,038,620    97.8 %     11,195,347    96.1 %
                                       

Consolidated benefit expense

   $ 20,270,531    100.0 %   $ 17,421,204    100.0 %   $ 11,651,470    100.0 %
                                       

 

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Accreditation Assessment

Our accreditation assessment program consists of several internal programs, including those that credential providers and those designed to meet the audit standards of federal and state agencies, as well as external accreditation standards. We also offer quality and outcome measurement and improvement programs such as the Health Plan Employer Data Information Sets, or HEDIS, which is used by employers, government purchasers and the National Committee for Quality Assurance, or NCQA, to evaluate HMOs based on various criteria, including effectiveness of care and member satisfaction.

Physicians participating in our HMO networks must satisfy specific criteria, including licensing, patient access, office standards, after-hours coverage, and other factors. Most participating hospitals also meet accreditation criteria established by CMS and/or the Joint Commission on Accreditation of Healthcare Organizations, or JCAHO.

Recredentialing of participating providers occurs every two to three years, depending on applicable state laws. Recredentialing of participating physicians includes verification of their medical licenses; review of their malpractice liability claims histories; review of their board certifications, if applicable; and review of applicable quality information. Committees, composed of a peer group of physicians, review the applications of physicians being considered for credentialing and recredentialing.

We request accreditation for certain of our HMO plans from NCQA and the American Accreditation Healthcare Commission, also known as the Utilization Review Accreditation Commission, or URAC. URAC performs reviews for utilization management standards and for health plan and health network standards in quality management, credentialing, rights and responsibilities, and network management. Accreditation or external review by an approved organization is mandatory in the states of Florida and Kansas for licensure as an HMO. Accreditation specific to the utilization review process also is required in the state of Georgia for licensure as an HMO or PPO. Certain commercial businesses, like those impacted by a third-party labor agreement or those where a request is made by the employer, may require or prefer accredited health plans.

NCQA performs reviews of standards for quality improvement, credentialing, utilization management, and member rights and responsibilities. We have achieved and maintained NCQA accreditation in all of our commercial HMO markets except Puerto Rico and in select PPO markets.

Sales and Marketing

We use various methods to market our Medicare, Medicaid, and commercial products, including television, radio, the Internet, telemarketing, and direct mailings.

At December 31, 2007, we employed approximately 1,800 sales representatives, who are each paid a salary and per member commission to market our Medicare and Medicaid products in the United States and Puerto Rico. We employed approximately 600 telemarketing representatives who assisted in the marketing of Medicare and Medicaid products by making appointments for sales representatives with prospective members. We also market our Medicare products via a strategic alliance with Wal-Mart Stores, Inc., or Wal-Mart. This alliance includes stationing Humana representatives in certain Wal-Mart stores, SAM’S CLUB locations, and Neighborhood Markets across the country providing an opportunity to enroll Medicare eligible individuals in person. In addition, we market our Medicare products through licensed independent brokers and agents including strategic alliances with State Farm® and USAA. We generally pay brokers a commission based on premiums, including bonuses based on sales volume.

Individuals become members of our commercial HMOs and PPOs through their employers or other groups which typically offer employees or members a selection of health insurance products, pay for all or part of the

 

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premiums, and make payroll deductions for any premiums payable by the employees. We attempt to become an employer’s or group’s exclusive source of health insurance benefits by offering a variety of HMO, PPO, and specialty products that provide cost-effective quality health care coverage consistent with the needs and expectations of their employees or members. We also offer commercial health insurance and specialty products directly to individuals.

At December 31, 2007, we used licensed independent brokers and agents and approximately 700 licensed employees to sell our commercial products. Many of our employer group customers are represented by insurance brokers and consultants who assist these groups in the design and purchase of health care products. We generally pay brokers a commission based on premiums, with commissions varying by market and premium volume. In addition to a commission based directly on premium volume for sales to particular customers, we also have programs that pay brokers and agents based on other metrics. These include commission bonuses based on sales that attain certain levels or involve particular products. We also pay additional commissions based on aggregate volumes of sales involving multiple customers.

Risk Management

Through the use of internally developed underwriting criteria, we determine the risk we are willing to assume and the amount of premium to charge for our commercial products. In most instances, employer and other groups must meet our underwriting standards in order to qualify to contract with us for coverage. Small group laws in some states have imposed regulations which provide for guaranteed issue of certain health insurance products and prescribe certain limitations on the variation in rates charged based upon assessment of health conditions.

Underwriting techniques are not employed in connection with our Medicare, military services, or Medicaid products because government regulations require us to accept all eligible applicants regardless of their health or prior medical history.

Competition

The health benefits industry is highly competitive. Our competitors vary by local market and include other managed care companies, national insurance companies, and other HMOs and PPOs, including HMOs and PPOs owned by Blue Cross/Blue Shield plans. Many of our competitors have larger memberships and/or greater financial resources than our health plans in the markets in which we compete. Our ability to sell our products and to retain customers may be influenced by such factors as those described on page 17 in Item 1A.—Risk Factors.

Government Regulation

Federal regulation

Government regulation of health care products and services is a changing area of law that varies from jurisdiction to jurisdiction. Regulatory agencies generally have broad discretion to issue regulations and interpret and enforce laws and rules. The passing of the Medicare Modernization Act of 2003, or MMA, represents the most sweeping changes to Medicare since the BBA in 1997. Changes in applicable laws and regulations are continually being considered, and the interpretation of existing laws and rules also may change periodically. These regulatory revisions could affect our operations and financial results. Also, it may become increasingly difficult to control medical costs if federal and state bodies continue to consider and enact significant and sometimes onerous managed care laws and regulations.

State and local regulation

We are also subject to substantial regulation by the states in which we do business. We regularly are audited and subject to various enforcement actions by state departments of insurance. These departments enforce laws

 

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relating to all aspects of our operations, including benefit offerings, marketing, claim payments, subsidiary capital requirements, and premium rate setting, especially with regard to our small group business. Although any of the pending government actions could result in assessment of damages, civil or criminal fines or penalties, and other sanctions against us, including exclusion from participation in government programs, we do not believe the results of any of these actions, individually or in the aggregate, will have a material adverse effect on our financial position, results of operations, or cash flows.

Pending federal and state legislation

Diverse legislative and regulatory initiatives continue at both the federal and state levels to affect aspects of the nation’s health care system.

Our management works proactively to ensure compliance with all governmental laws and regulations affecting our business. We are unable to predict how existing federal or state laws and regulations may be changed or interpreted, what additional laws or regulations affecting our businesses may be enacted or proposed, when and which of the proposed laws will be adopted or what effect any such new laws and regulations will have on our financial position, results of operations or cash flows.

For a complete description of all of the current activities in the federal and state legislative areas, see Item 1A.—Risk Factors on page 22.

Other

Captive Insurance Company

We bear general business risks associated with operating our Company such as professional and general liability, employee workers’ compensation, and officer and director errors and omissions risks. Professional and general liability risks may include, for example, medical malpractice claims and disputes with members regarding benefit coverage. We retain certain of these risks through our wholly-owned, captive insurance subsidiary. We reduce exposure to these risks by insuring levels of coverage for losses in excess of our retained limits with a number of third-party insurance companies. We remain liable in the event these insurance companies are unable to pay their portion of the losses. In an effort to minimize credit risk, we insure our risks with a number of insurance companies having a long history of strong financial ratings.

Centralized Management Services

We provide centralized management services to each of our health plans and both of our business segments from our headquarters and service centers. These services include management information systems, product development and administration, finance, human resources, accounting, law, public relations, marketing, insurance, purchasing, risk management, internal audit, actuarial, underwriting, claims processing, and customer service.

Employees

As of December 31, 2007, we had approximately 25,000 employees, including 28 employees covered by collective bargaining agreements. We believe we have good relations with our employees and have not experienced any work stoppages.

 

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ITEM 1A. RISK FACTORS

This document includes both historical and forward-looking statements. The forward-looking statements are made within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. We intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and we are including this statement for purposes of complying with these safe harbor provisions. We have based these forward-looking statements on our current expectations and projections about future events, trends and uncertainties. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions, including, among other things, the information discussed below. In making these statements, we are not undertaking to address or update each factor in future filings or communications regarding our business or results. Our business is highly complicated, regulated and competitive with many different factors affecting results.

If the premiums we charge are insufficient to cover the cost of health care services delivered to our members, or if our estimates of benefits payable or future policy benefits payable based upon our estimates of future benefit claims are inadequate, our profitability could decline.

We use a significant portion of our revenues to pay the costs of health care services delivered to our members. These costs include claims payments, capitation payments, and various other costs incurred to provide health insurance coverage to our members. These costs also include estimates of future payments to hospitals and others for medical care provided to our members. Generally, premiums in the health care business are fixed for one-year periods. Accordingly, costs we incur in excess of our benefit cost projections generally are not recovered in the contract year through higher premiums. We estimate the costs of our future benefit claims and other expenses using actuarial methods and assumptions based upon claim payment patterns, medical inflation, historical developments, including claim inventory levels and claim receipt patterns, and other relevant factors. We also record benefits payable for future payments. We continually review estimates of future payments relating to benefit claims costs for services incurred in the current and prior periods and make necessary adjustments to our reserves. However, many factors may and often do cause actual health care costs to exceed what was estimated and used to set our premiums. These factors may include:

 

   

increased use of medical facilities and services, including prescription drugs;

 

   

increased cost of such services;

 

   

our membership mix;

 

   

variances in actual versus estimated levels of cost associated with new products, benefits or lines of business, product changes or benefit level changes;

 

   

membership in markets lacking adequate provider networks;

 

   

changes in the demographic characteristics of an account or market;

 

   

termination of capitation arrangements resulting in the transfer of membership to fee-for-service arrangements;

 

   

changes or reductions of our utilization management functions such as preauthorization of services, concurrent review or requirements for physician referrals;

 

   

possible changes in our pharmacy rebate program with drug manufacturers;

 

   

catastrophes, including acts of terrorism, public health epidemics, or severe weather (e.g. hurricanes, earthquakes, etc.);

 

   

the introduction of new or costly treatments, including new technologies;

 

   

medical cost inflation; and

 

   

government mandated benefits or other regulatory changes.

 

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Failure to adequately price our products or estimate sufficient benefits payable or future policy benefits payable may result in a material adverse effect on our financial position, results of operations and cash flows.

If we do not design and price our products properly and competitively, our membership and profitability could decline.

We are in a highly competitive industry. Some of our competitors are more established in the health care industry in terms of a larger market share and have 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 Medicare program as well as in Smart plans and other consumer health plans, such as high deductible health plans with HSAs. We believe that barriers to entry in many markets are not substantial, so the addition of new competitors can occur relatively easily, and customers enjoy significant flexibility in moving between competitors. 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 intense competitive pressure to contain premium prices. Factors such as business consolidations, strategic alliances, legislative reform and marketing practices create pressure to contain premium price increases, despite being faced with increasing medical costs.

Premium increases, introduction of new product designs, and our relationship with our providers in various markets, among other issues, could also affect our membership levels. Other actions that could affect membership levels include our possible exit from or entrance into Medicare or Commercial markets, or the termination of a large contract, including our TRICARE contract.

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, if membership 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.

If we fail to effectively implement our operational and strategic initiatives, including our Medicare initiatives, our business could be materially adversely affected.

Our future performance depends in large part upon our management team’s ability to execute our strategy to position the Company for the future. This strategy includes opportunities created by the MMA. The MMA offers new opportunities in our Medicare programs, including our HMO, PPO, and PFFS Medicare Advantage products, as well as our stand-alone PDP products. We have made substantial additional investments in the Medicare program to enhance our ability to participate in these expanded programs. Over the last few years we have increased the size of our Medicare geographic reach since the enactment of the MMA through expanded Medicare product offerings. We are offering both the stand-alone Medicare Prescription Drug Coverage and Medicare Advantage Health Plan with Prescription Drug Coverage in addition to our other product offerings. We have been approved to offer the Medicare prescription drug plan in 50 states as well as Puerto Rico and the District of Columbia.

The growth of our Medicare business is an important part of our business strategy. Any failure to achieve this growth may have a material adverse effect on our financial position, results of operations or cash flows. In addition, the expansion of our Medicare business in relation to our other businesses may intensify the risks to us inherent in the Medicare business, which are described elsewhere in this document. These expansion efforts may result in less diversification of our revenue stream.

Additionally, our strategy includes the growth of our Commercial segment business, with emphasis on our ASO and individual products, introduction of new products and benefit designs, including our Smart plans and other consumer offerings such as HSAs, and our specialty products, as well as the adoption of new technologies and the integration of acquired businesses and contracts.

 

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There can be no assurance that we will be able to successfully implement our operational and strategic initiatives that are intended to position us for future growth or that the products we design will be accepted or adopted in the time periods assumed. Failure to implement this strategy may result in a material adverse effect on our financial position, results of operations and cash flows.

If we fail to properly maintain the integrity of our data, to strategically implement new information systems, or to protect our proprietary rights to our systems, our business 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 information systems. We have been taking steps to reduce the number of systems we operate, have upgraded and expanded our information systems capabilities, and are gradually migrating existing business to fewer systems. Our information systems require an ongoing commitment of significant resources to maintain, protect and enhance existing systems and develop new systems to keep pace with continuing changes in information processing technology, evolving industry and regulatory standards, and changing customer preferences. If the information we rely upon to run our businesses was found to be inaccurate or unreliable or if we fail to maintain effectively our information systems and data integrity, we could have operational disruptions, have problems in determining medical cost estimates and establishing appropriate pricing, have customer and physician and other health care provider disputes, have regulatory or other legal problems, have increases in operating expenses, lose existing customers, have difficulty in attracting new customers, or suffer other adverse consequences.

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. A change in service providers could result in a decline in service quality and effectiveness or less favorable contract terms which could adversely affect our operating results.

We rely on our agreements with customers, confidentiality agreements with employees, and our trade secrets and copyrights to protect our proprietary rights. These legal protections and precautions may not prevent misappropriation of our proprietary information. In addition, substantial litigation regarding intellectual property rights exists in the software industry. We expect software products to be increasingly subject to third-party infringement claims as the number of products and competitors in this area grows.

Our business plans also include becoming a quality e-business organization by enhancing interactions with customers, brokers, agents, and other stakeholders through web-enabling technology. Our strategy includes sales and distribution of health benefit products through the Internet, and implementation of advanced self-service capabilities, for internal and external stakeholders.

There can be no assurance that our process of improving existing systems, developing new systems to support our expanding operations, integrating new systems, protecting our proprietary information, and improving service levels will not be delayed or that additional systems issues will not arise in the future. Failure to adequately protect and maintain the integrity of our information systems and data may result in a material adverse effect on our financial positions, results of operations and cash flows.

 

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We are involved in various legal actions, which, if resolved unfavorably to us, could result in substantial monetary damages.

We are a party to a variety of legal actions that affect our business, including employment and employment discrimination-related suits, employee benefit claims, breach of contract actions, and tort claims.

In addition, because of the nature of the health care business, we are subject to a variety of legal actions relating to our business operations, including the design, management and offering of products and services. These include and could include in the future:

 

   

claims relating to the methodologies for calculating premiums;

 

   

claims relating to the denial of health care benefit payments;

 

   

claims relating to the denial or rescission of insurance coverage;

 

   

challenges to the use of some software products used in administering claims;

 

   

claims relating to our administration of our Medicare Part D offerings;

 

   

medical malpractice actions based on our medical necessity decisions or brought against us on the theory that we are liable for our providers’ alleged malpractice;

 

   

allegations of anti-competitive and unfair business activities;

 

   

provider disputes over compensation and termination of provider contracts;

 

   

disputes related to ASO business, including actions alleging claim administration errors;

 

   

claims related to the failure to disclose some business practices;

 

   

claims relating to customer audits and contract performance; and

 

   

claims relating to dispensing of drugs associated with our in-house mail order pharmacy.

In some cases, substantial non-economic or punitive damages as well as treble damages under the federal False Claims Act, Racketeer Influenced and Corrupt Organizations Act and other statutes may be sought. While we currently have insurance coverage for some of these potential liabilities, other potential liabilities may not be covered by insurance, insurers may dispute coverage or the amount of our insurance may not be enough to cover the damages awarded. Additionally, the cost of business insurance coverage has increased significantly. As a result, we have increased the amount of risk that we self-insure, particularly with respect to matters incidental to our business. In addition, some types of damages, like punitive damages, may not be covered by insurance. In some jurisdictions, coverage of punitive damages is prohibited. Insurance coverage for all or some forms of liability may become unavailable or prohibitively expensive in the future.

See “Legal Proceedings” in Note 14 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data. We cannot predict the outcome of these suits with certainty.

As a government contractor, we are exposed to additional risks that could adversely affect our business or our willingness to participate in government health care programs.

A significant portion of our revenues relates to federal and state government health care coverage programs, including the Medicare, Military, and Medicaid programs. Our Government segment accounted for approximately 74% of our total premiums and ASO fees for the year ended December 31, 2007 and we expect the Government segment to account for a greater percentage of our total premiums and ASO fees in 2008. These programs involve various risks, including:

 

   

at December 31, 2007, under our contracts with CMS we provided health insurance coverage to approximately 507,700 Medicare members in Florida. These contracts accounted for approximately

 

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17% of our total premiums and ASO fees for the year ended December 31, 2007. The loss of these and other CMS contracts or significant changes in the Medicare program 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;

 

   

at December 31, 2007, our military services business, which accounted for approximately 12% of our total premiums and ASO fees for the year ended December 31, 2007, primarily consisted of the TRICARE South Region contract. The 5-year South Region contract, which expires March 31, 2009, is subject to annual renewals on April 1 of each year at the government’s option. Effective April 1, 2007, the South Region contract was extended into the fourth option period, which runs from April 1, 2007 to March 31, 2008 and covers 2.9 million beneficiaries. We have received a notice from the government of its intent to renew the fifth option period which runs from April 1, 2008 to March 31, 2009. The Department of Defense has the option to extend the current contract for up to six months under existing terms. Congressional authority has also been granted to extend the contract in one year increments for a maximum of two additional years. In the second quarter of 2007, a draft solicitation related to the new TRICARE contracts, currently scheduled to begin April 1, 2009, was issued for industry comment. Currently, we are anticipating a formal request for proposal, or RFP, for the TRICARE contracts. If we were not awarded a new TRICARE contract, it would have a material adverse effect on our business, results of operation and financial condition. As required under the contract, the target underwritten health care cost and underwriting fee amounts for the fourth option period were negotiated. Any variance from the target health care cost is shared with the federal government. Accordingly, events and circumstances not contemplated in the negotiated target health care cost amount could have a material adverse effect on our business. These changes may include, for example, an increase or reduction in the number of persons enrolled or eligible to enroll due to the federal government’s decision to increase or decrease U.S. military deployments. In the event government reimbursements were to decline from projected amounts, our failure to reduce the health care costs associated with these programs could have a material adverse effect on our business;

 

   

at December 31, 2007, under our contracts with the Puerto Rico Health Insurance Administration, we provided health insurance coverage to approximately 525,400 Medicaid members in Puerto Rico. These contracts accounted for approximately 2% of our total premiums and ASO fees for the year ended December 31, 2007. These contracts for the East and Southeast regions of Puerto Rico are effective from November 1, 2006 through June 30, 2008. In 2007, we also entered into an ASO contract with the Puerto Rico Health Administration for the Metro North Region which is effective from November 1, 2006 through October 31, 2009. The loss of these contracts or significant changes in the Puerto Rico Medicaid program 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;

 

   

the possibility of temporary or permanent suspension from participating in government health care programs, including Medicare and Medicaid, if we are convicted of fraud or other criminal conduct in the performance of a health care program or if there is an adverse decision against us under the federal False Claims Act;

 

   

CMS has implemented a risk adjustment model which apportions premiums paid to Medicare health plans according to health severity. A risk adjustment model pays more for enrollees with predictably higher costs. Under the risk adjustment methodology, all Medicare health plans must collect, capture and submit the necessary diagnosis code information from inpatient and ambulatory treatment settings to CMS within prescribed deadlines. The CMS risk adjustment model uses this diagnosis data to calculate the risk adjusted premium payment to Medicare health plans. CMS has transitioned to the risk adjustment model for Medicare Advantage plans. In 2006, the portion of risk adjusted payment was increased to 75% from 50% in 2005. The phase-in of risk adjusted payment was increased to 100% in 2007;

 

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commensurate with phase-in of the risk-adjustment methodology, payments to Medicare Advantage plans have been increased by a “budget neutrality” factor. The budget neutrality factor was implemented to prevent overall health plan payments from being reduced during the transition to the risk-adjustment payment model. The payment adjustments for budget neutrality were first developed in 2002 and began to be used with the 2003 payments. The budget neutrality adjustment began phasing out in 2007 and will be fully eliminated by 2011. This does not mean, however, that the aggregate per-member payments to Medicare plans will be reduced. As plans enroll less healthy beneficiaries, the need for the budget neutrality adjustment declines as the underlying risk adjusted Medicare rates paid to plans increase to account for their enrollees’ greater healthcare needs. As a result of the CMS payment methodology described previously, the amount and timing of our CMS monthly premium payments per member may change materially, either favorably or unfavorably;

 

   

Our CMS contracts which cover members’ prescription drugs under the Part D provisions of the MMA contain provisions for 1) risk sharing and 2) reimbursements of prescription drug costs for which we are not at risk.

The premiums from CMS are subject to risk corridor provisions which compare costs targeted in our annual bids to actual prescription drug costs, limited to actual costs that would have been incurred under the standard coverage as defined by CMS. Variances exceeding certain thresholds may result in CMS making additional payments to us or require us to refund to CMS a portion of the premiums we received. We estimate and recognize an adjustment to premium revenues related to the risk corridor payment settlement based upon pharmacy claims experience. The estimate of the settlement associated with these risk corridor provisions requires us to consider factors that may not be certain including member eligibility differences with CMS. Beginning in 2008, the risk corridor thresholds increase which means we will bear more risk. Our estimate of the settlement associated with the Medicare Part D risk corridor provisions was a net liability of $102.6 million at December 31, 2007.

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 claims 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 settlement of CMS’s prospective subsidies against actual prescription drug costs we paid is made after the end of the year.

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. Our claims data may not pass CMS’s claims edit processes due to various reasons, including but not limited to, discrepancies in eligibility or classification of low-income members. To the extent our data does not pass CMS’s claim edit processes, we may bear the risk for all or a portion of the claim which otherwise may have been subject to the risk corridor provision or reimbursement as a low-income or reinsurance claim. In addition, in the event the settlement represents an amount CMS owes us, there is a negative impact on our cash flows and financial condition as a result of financing CMS’s share of the risk. The opposite is true in the event the settlement represents an amount we owe CMS;

 

   

future changes to these government programs which may affect our ability or willingness to participate in these programs;

 

   

higher comparative medical costs;

 

   

government regulatory and reporting requirements; and

 

   

higher marketing and advertising costs per member as a result of marketing to individuals as opposed to groups.

 

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Our industry is currently subject to substantial government regulation, which, along with possible increased governmental regulation or legislative reform, increases our costs of doing business and could adversely affect our profitability.

The health care industry in general, and health insurance, particularly HMOs and PPOs are subject to substantial federal and state government regulation.

Our licensed subsidiaries are subject to regulation under state insurance holding company and Puerto Rico regulations. These regulations generally require, among other things, prior approval and/or notice of new products, rates, benefit changes, and certain material transactions, including dividend payments, purchases or sales of assets, intercompany agreements, and the filing of various financial and operational reports.

Certain of our subsidiaries operate in states that regulate the payment of dividends, loans, or other cash transfers to Humana Inc., our parent company, and require minimum levels of equity as well as limit investments to approved securities. The amount of dividends that may be paid to Humana Inc. by these subsidiaries, without prior approval by state regulatory authorities, is limited based on the entity’s level of statutory income and statutory capital and surplus. In most states, prior notification is provided before paying a dividend even if approval is not required.

Based on the most recent statutory financial statements as of December 31, 2007, we maintained aggregate statutory capital and surplus of $2,905.2 million in our state regulated subsidiaries. This compares to applicable statutory requirements which aggregated $1,810.5 million. Although the minimum required levels of equity are largely based on premium volume, product mix, and the quality of assets held, minimum requirements can vary significantly at the state level. Given our anticipated continued premium growth in 2008, capital requirements will increase. We expect to fund these increased requirements with capital contributions from Humana Inc., our parent company, of approximately $200 million in 2008.

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.

The use of individually identifiable health data by our business is regulated at federal and state levels. These laws and rules are changed frequently by legislation or administrative interpretation. Various state laws address the use and maintenance of individually identifiable health data. Most are derived from the privacy provisions in the federal Gramm-Leach-Bliley Act and HIPAA. HIPAA includes administrative provisions directed at simplifying electronic data interchange through standardizing transactions, establishing uniform health care provider, payer, and employer identifiers and seeking protections for confidentiality and security of patient data. The 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.

These regulations set standards for the security of electronic health information. Violations of these rules could subject us to significant criminal and civil penalties, including significant monetary penalties. Compliance with HIPAA regulations requires significant systems enhancements, training and administrative effort. HIPAA could also expose us to additional liability for violations by our business associates. A business associate is a person or entity, other than a member of the work force, who on behalf of a covered entity performs or assists in the performance of a function or activity involving the use or disclosure of individually identifiable health information, or provides legal, accounting, consulting, data aggregation, management, administrative, accreditation, or financial services.

 

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Laws in each of the states (including Puerto Rico) in which we operate our HMOs, PPOs and other health insurance-related services regulate our operations, including the scope of benefits, rate formulas, delivery systems, utilization review procedures, quality assurance, complaint systems, enrollment requirements, claim payments, marketing, and advertising. The HMO, PPO, and other health insurance-related products we offer are sold under licenses issued by the applicable insurance regulators. Our licensed subsidiaries are also subject to regulation under state insurance holding company and Puerto Rico regulations.

We are also subject to various governmental audits and investigations. Under state laws, our HMOs and health insurance companies are audited by state departments of insurance for financial and contractual compliance. Our HMOs are audited for compliance with health services by state departments of health. Audits and investigations are also conducted by state attorneys general, CMS, the Office of the Inspector General of Health and Human Services, the Office of Personnel Management, the Department of Justice, the Department of Labor, and the Defense Contract Audit Agency. Several departments of insurance are currently investigating the practices of insurance brokers, particularly in the Medicare marketing area. All of these activities could result in the loss of licensure or the right to participate in various programs, or the imposition of fines, penalties and other civil and criminal sanctions. In addition, disclosure of any adverse investigation or audit results or sanctions could negatively affect our industry or our reputation in various markets and make it more difficult for us to sell our products and services.

Other areas subject to substantial regulation include:

 

   

licensing requirements;

 

   

approval of policy language and benefits;

 

   

mandated benefits and processes;

 

   

approval of entry, withdrawal or re-entry into a state or market;

 

   

premium rates; and

 

   

periodic examinations by state and federal agencies.

Two areas of legislation that can impact the company are experiencing an increase in activity. These are Medicare funding under MMA and proposals to expand health insurance coverage. MMA funding and associated program structure is an area of substantial legislative attention that may be influenced by federal budget considerations and Medicare spending trends. The federal and state efforts to expand access to health coverage may offer opportunities to serve individuals who are not currently in the health insurance market through public program expansions, coverage connectors or premium assistance programs. Some access proposals also include increased regulation of our commercial business, particularly small group and individual, through a combination of benefit mandates, underwriting restrictions, rating limitations and assessments.

State and federal governmental authorities are continually considering changes to laws and regulations applicable to us and are currently considering regulations relating to:

 

   

health insurance access and affordability;

 

   

regulation of broker licensing, particularly in the Medicare marketing area;

 

   

e-connectivity;

 

   

universal health coverage;

 

   

disclosure of provider fee schedules and other data about payments to providers, sometimes called transparency;

 

   

disclosure of provider quality information; and

 

   

formation of regional/national association health plans for small employers.

 

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All of these proposals could apply to us and could result in new regulations that increase the cost of our operations.

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 change will not have a material adverse effect on our business. Delays in obtaining or failure to obtain or maintain required approvals could adversely affect entry into new markets, our revenues or the number of our members, increase our costs or adversely affect our ability to bring new products to market as forecasted.

We are also subject to potential changes in the political environment that can affect public policy and can adversely affect the markets for our products.

While it is not possible to predict when and whether fundamental policy changes would occur, these could include policy changes on the local, state, and federal level that could fundamentally change the dynamics of our industry, such as a larger role of the government in the health care arena. Changes in public policy could materially affect our profitability and cash flow, our ability to retain or grow our business, and our financial position.

Any failure to manage administrative costs could hamper profitability.

The level of our administrative expenses impacts our profitability. While we proactively attempt to effectively manage such expenses, increases in staff-related expenses, investment in new products, including our opportunities in the Medicare programs, greater emphasis on small group and individual health insurance products, acquisitions, and implementation of regulatory requirements, among others, may occur from time to time.

There can be no assurance that we will be able to successfully contain our administrative expenses in line with our membership and this may result in a material adverse effect on our financial position, results of operations and cash flows.

Any failure by us to manage acquisitions, and other significant transactions successfully could harm our financial results, business and prospects.

As part of our business strategy, we frequently engage in discussions with third parties regarding possible investments, acquisitions, strategic alliances, joint ventures, and outsourcing transactions and often enter into agreements relating to such transactions in order to further our business objectives. In order to pursue this strategy successfully, we must identify suitable candidates for and successfully complete transactions, some of which may be large and complex, and manage post-closing issues such as the integration of acquired companies or employees. Integration and other risks can be more pronounced for larger and more complicated transactions, or if multiple transactions are pursued simultaneously. In 2007, we acquired KMG America Corporation, CompBenefits Corporation, and DefenseWeb Technologies, Inc. The failure to successfully integrate each and all of these entities may adversely impact our revenues and results of operations. If we fail to identify and complete successfully transactions that further our strategic objectives, we may be required to expend resources to develop products and technology internally. We may also be at a competitive disadvantage or we may be adversely affected by negative market perceptions, any of which may have a material adverse effect on our results of operations, financial position or cash flows.

If we fail to develop and maintain satisfactory relationships with the providers of care to our members, our business could be adversely affected.

We contract with physicians, hospitals and other providers to deliver health care to our members. Our products encourage or require our customers to use these contracted providers. These providers may share medical cost risk with us or have financial incentives to deliver quality medical services in a cost-effective manner.

 

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In any particular market, providers could refuse to contract with us, demand to contract with us, demand higher payments, or take other actions that could result in higher health care costs for us, less desirable products for customers and members or difficulty meeting regulatory or accreditation requirements. In some markets, some providers, particularly hospitals, physician specialty groups, physician/hospital organizations or multi-specialty physician groups, may have significant market positions and negotiating power. In addition, physician or practice management companies, which aggregate physician practices for administrative efficiency and marketing leverage, may compete directly with us. If these providers refuse to contract with us, use their market position to negotiate favorable contracts or place us at a competitive disadvantage, our ability to market products or to be profitable in those areas could be adversely affected.

In some situations, we have contracts with individual or groups of primary care physicians for an actuarially determined, fixed, per-member-per-month fee under which physicians are paid an amount to provide all required medical services to our members. This type of contract is referred to as a “capitation” contract. The inability of providers to properly manage costs under these capitation arrangements can result in the financial instability of these providers and the termination of their relationship with us. In addition, payment or other disputes between a primary care provider and specialists with whom the primary care provider contracts can result in a disruption in the provision of services to our members or a reduction in the services available to our members. The financial instability or failure of a primary care provider to pay other providers for services rendered could lead those other providers to demand payment from us even though we have made our regular fixed payments to the primary provider. There can be no assurance that providers with whom we contract will properly manage the costs of services, maintain financial solvency or avoid disputes with other providers. Any of these events could have an adverse effect on the provision of services to our members and our operations.

Our recently implemented mail order pharmacy business subjects us to additional regulations in addition to those we face with our core health benefits businesses.

We have opened a mail order pharmacy business that subjects us to extensive federal, state and local regulation. We are also subject to risks inherent in the packaging and distribution of pharmaceuticals and other health care products, and the application of state laws related to the operation of internet and mail-services pharmacies. The failure to adhere to these laws and regulations could expose our pharmacy subsidiary to civil and criminal penalties.

Our ability to obtain funds from our subsidiaries is restricted.

Because we operate as a holding company, we are dependent upon dividends and administrative expense reimbursements from our subsidiaries to fund the obligations of Humana Inc., our parent company. These subsidiaries generally are regulated by states’ Departments of Insurance. We are also required by law to maintain specific prescribed minimum amounts of capital in these subsidiaries. The levels of capitalization required depend primarily upon the volume of premium generated. A significant increase in premium volume will require additional capitalization from our parent company. In most states, we are required to seek prior approval by these state regulatory authorities before we transfer money or pay dividends from these subsidiaries that exceed specified amounts, or, in some states, any amount. In addition, we normally notify the state Departments of Insurance prior to making payments that do not require approval. In the event that we are unable to provide sufficient capital to fund the obligations of Humana Inc., our operations or financial position may be adversely affected.

Downgrades in our debt ratings, should they occur, may adversely affect our business, financial condition and results of operations.

Claims paying ability, financial strength, and debt ratings by recognized rating organizations are an increasingly important factor in establishing the competitive position of insurance companies. Ratings information is broadly disseminated and generally used throughout the industry. We believe our claims paying

 

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ability and financial strength ratings are an important factor in marketing our products to certain of our customers. Our debt ratings impact both the cost and availability of future borrowings. Each of the rating agencies reviews its ratings periodically and there can be no assurance that current ratings will be maintained in the future. Our ratings reflect each rating agency’s opinion of our financial strength, operating performance, and ability to meet our debt obligations or obligations to policyholders, but are not evaluations directed toward the protection of investors in our common stock and should not be relied upon as such. Downgrades in our ratings, should they occur, may adversely affect our business, financial condition and results of operations.

Changes in economic conditions could adversely affect our business and results of operations.

Recent events, including fallout from problems in the U.S. credit markets, indicate a potential near-term recession in the U.S. economy. The state of the U.S. economy could adversely affect our employer group renewal prospects and our ability to collect or increase premiums. The state of the U.S. economy could also adversely affect the budget of individual states and of the federal government. That could result in attempts to reduce payments in our federal and state government health care coverage programs, including the Medicare, military services, and Medicaid programs, and could result in an increase in taxes and assessments on our activities. Although we could attempt to mitigate or cover our exposure from such increased costs through, among other things, increases in premiums, there can be no assurance that we will be able to mitigate or cover all of such costs which could adversely affect our financial position, results of operations, and cash flows.

Increased litigation and negative publicity could increase our cost of doing business.

The health benefits industry continues to receive significant negative publicity reflecting the public perception of the industry. This publicity and perception have been accompanied by increased litigation, including some large jury awards, legislative activity, regulation and governmental review of industry practices. These factors may adversely affect our ability to market our products or services, may require us to change our products or services, may increase the regulatory burdens under which we operate and may require us to pay large judgments or fines. Any combination of these factors could further increase our cost of doing business and adversely affect our financial position, results of operations, and cash flows.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

 

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ITEM 2. PROPERTIES

Our principal executive office is located in the Humana Building, 500 West Main Street, Louisville, Kentucky 40202. In addition to this property, our other principal operating facilities are located in Louisville, Kentucky, Green Bay, Wisconsin, Tampa Bay, Florida, Cincinnati, Ohio and San Juan, Puerto Rico, all of which are used for customer service, enrollment, and claims processing. Our Louisville and Green Bay facilities also house other corporate functions.

We own or lease these principal operating facilities in addition to other administrative market offices and medical centers. We no longer operate most of these medical centers but, rather, lease or sublease them to their provider operators. The following table lists the location of properties we owned or leased, including our principal operating facilities, at December 31, 2007:

 

     Medical Centers    Administrative
Offices
    
     Owned    Leased    Owned    Leased    Total

Florida

   5    46    6    70    127

Texas

   —      —      2    35    37

Kentucky

   —      —      10    13    23

Ohio

   —      —      —      17    17

Puerto Rico

   —      —      —      17    17

Georgia

   —      —      —      16    16

Louisiana

   —      —      —      13    13

South Carolina

   —      —      6    5    11

Illinois

   1    1    —      7    9

Wisconsin

   —      —      1    8    9

Others

   —      —      —      115    115
                        

Total

   6    47    25    316    394
                        

 

ITEM 3. LEGAL PROCEEDINGS

We are party to a variety of legal actions in the ordinary course of business, including employment matters, breach of contract actions, and tort claims. See “Legal Proceedings” in Note 14 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data. We cannot predict the outcome of these suits with certainty.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

Not applicable.

 

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PART II

 

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

a) Market Information

Our common stock trades on the New York Stock Exchange under the symbol HUM. The following table shows the range of high and low closing sales prices as reported on the New York Stock Exchange Composite Price for each quarter in the years ended December 31, 2007 and 2006:

 

     High    Low

Year Ended December 31, 2007

     

First quarter

   $ 63.45    $ 52.25

Second quarter

   $ 65.81    $ 59.05

Third quarter

   $ 71.13    $ 58.39

Fourth quarter

   $ 78.46    $ 70.20

Year Ended December 31, 2006

     

First quarter

   $ 57.67    $ 48.91

Second quarter

   $ 53.76    $ 41.60

Third quarter

   $ 67.94    $ 51.54

Fourth quarter

   $ 67.97    $ 51.60

 

b) Holders of our Capital Stock

As of January 31, 2008, there were approximately 5,200 holders of record of our common stock and approximately 89,000 beneficial holders of our common stock.

 

c) Dividends

Since February 1993, we have not declared or paid any cash dividends on our common stock. We do not presently intend to pay dividends, and we currently plan to retain our earnings for future operations and growth of our businesses.

 

d) Equity Compensation Plan

The information required by this part of Item 5 is incorporated herein by reference from our Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on April 24, 2008 appearing under the caption “Equity Compensation Plan Information” of such Proxy Statement.

 

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e) Stock Performance

The following graph compares the performance of the our common stock to the Standard & Poor’s Composite 500 Index (“S&P 500”) and the Morgan Stanley Health Care Payer Index (“Peer Group”) for the five years ended December 31, 2007. The graph assumes an investment of $100 in each of our common stock, the S&P 500, and the Peer Group on December 31, 2002.

LOGO

 

     12/31/02    12/31/03    12/31/04    12/31/05    12/31/06    12/31/07

HUM

   $ 100    $ 229    $ 297    $ 543    $ 553    $ 753

S&P 500

   $ 100    $ 126    $ 138    $ 142    $ 161    $ 167

Peer Group

   $ 100    $ 169    $ 246    $ 338    $ 360    $ 419

 

f) Issuer Purchases of Equity Securities

On February 21, 2008, the Board of Directors authorized the use of up to $150 million for the repurchase of our common shares exclusive of shares repurchased in connection with employee stock plans. The shares may be purchased from time to time at prevailing prices in the open market, by block purchases, or in privately-negotiated transactions.

There were no common shares acquired by the Company in open market transactions in 2007. During 2007, we acquired 406,377 shares of our common stock in connection with employee stock plans at an aggregate cost of $27.4 million, or an average of $67.45 per share.

 

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ITEM 6. SELECTED FINANCIAL DATA

 

     2007 (a)     2006 (b)     2005 (c)     2004 (d)      2003 (e)  
     (in thousands, except per common share results, membership and ratios)  

Summary of Operations:

           

Revenues:

           

Premiums

   $ 24,434,347     $ 20,729,182     $ 14,001,591     $ 12,689,432      $ 11,825,283  

Administrative services fees

     391,515       341,211       259,437       272,796        271,676  

Investment income

     314,239       291,880       142,976       132,838        122,041  

Other revenue

     149,888       54,264       14,123       9,259        7,311  
                                         

Total revenues

     25,289,989       21,416,537       14,418,127       13,104,325        12,226,311  
                                         

Operating expenses:

           

Benefits

     20,270,531       17,421,204       11,651,470       10,669,647        9,879,421  

Selling, general and administrative

     3,476,468       3,021,509       2,195,604       1,894,336        1,866,531  

Depreciation and amortization

     184,812       148,598       128,858       117,792        126,779  
                                         

Total operating expenses

     23,931,811       20,591,311       13,975,932       12,681,775        11,872,731  
                                         

Income from operations

     1,358,178       825,226       442,195       422,550        353,580  

Interest expense

     68,878       63,141       39,315       23,172        17,367  
                                         

Income before income taxes

     1,289,300       762,085       402,880       399,378        336,213  

Provision for income taxes

     455,616       274,662       106,150       129,431        112,474  
                                         

Net income

   $ 833,684     $ 487,423     $ 296,730     $ 269,947      $ 223,739  
                                         

Basic earnings per common share

   $ 5.00     $ 2.97     $ 1.83     $ 1.68      $ 1.41  
                                         

Diluted earnings per common share

   $ 4.91     $ 2.90     $ 1.79     $ 1.66      $ 1.38  
                                         

Financial Position:

           

Cash and investments

   $ 6,690,820     $ 5,347,454     $ 3,477,955     $ 3,074,189      $ 2,927,213  

Total assets

     12,879,074       10,098,486       6,846,851       5,645,523        5,375,449  

Benefits payable

     2,696,833       2,410,407       1,849,142       1,389,845        1,260,546  

Debt

     1,687,823       1,269,100       815,044       636,696        642,638  

Stockholders’ equity

     4,028,937       3,053,886       2,508,874       2,124,248        1,868,972  

Key Financial Indicators:

           

Benefits ratio

     83.0 %     84.0 %     83.2 %     84.1 %      83.5 %

SG&A expense ratio

     13.9 %     14.3 %     15.4 %     14.6 %      15.4 %

Medical Membership by Segment:

           

Government:

           

Medicare Advantage

     1,143,000       1,002,600       557,800       377,200        328,600  

Medicare stand-alone PDP

     3,442,000       3,536,600       —         —          —    
                                         

Total Medicare

     4,585,000       4,539,200       557,800       377,200        328,600  
                                         

Military services insured

     1,719,100       1,716,400       1,750,900       1,789,400        1,849,700  

Military services ASO

     1,146,800       1,163,600       1,138,200       1,082,400        1,057,200  
                                         

Total military services

     2,865,900       2,880,000       2,889,100       2,871,800        2,906,900  
                                         

Medicaid insured

     384,400       390,700       457,900       478,600        468,900  

Medicaid ASO

     180,600       178,400       —         —          —    
                                         

Total Medicaid

     565,000       569,100       457,900       478,600        468,900  
                                         

Total Government

     8,015,900       7,988,300       3,904,800       3,727,600        3,704,400  
                                         

Commercial:

           

Fully-insured

     1,808,600       1,754,200       1,999,800       2,286,500        2,352,800  

ASO

     1,643,000       1,529,600       1,171,000       1,018,600        712,400  
                                         

Total Commercial

     3,451,600       3,283,800       3,170,800       3,305,100        3,065,200  
                                         

Total medical membership

     11,467,500       11,272,100       7,075,600       7,032,700        6,769,600  
                                         

Specialty Membership:

           

Dental

     3,639,800       1,452,000       1,456,500       1,246,700        1,147,400  

Vision

     2,272,800       —         —         —          —    

Other supplemental benefits

     871,200       450,800       445,600       461,500        520,700  
                                         

Total specialty membership

     6,783,800       1,902,800       1,902,100       1,708,200        1,668,100  
                                         

 

(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.
(b) Includes the acquired operations of CHA Service Company from May 1, 2006.
(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.
(e) Includes expenses of $30.8 million pretax ($18.8 million after tax, or $0.12 per diluted common share) for the writedown of building and equipment and software abandonment expenses. These expenses were partially offset by a gain of $15.2 million pretax ($10.1 million after tax, or $0.06 per diluted common share) for the sale of a venture capital investment. The net impact of these items reduced pretax income by $15.6 million ($8.7 million after tax, or $0.05 per diluted common share).

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The consolidated financial statements of Humana Inc. in this document present the Company’s financial position, results of operations and cash flows, and should be read in conjunction with the following discussion and analysis. References to “we,” “us,” “our,” “Company,” and “Humana” mean Humana Inc. and its subsidiaries. This discussion includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. When used in filings with the Securities and Exchange Commission, in our press releases, investor presentations, and in oral statements made by or with the approval of one of our executive officers, the words or phrases like “expects,” “anticipates,” “intends,” “likely will result,” “estimates,” “projects” or variations of such words and similar expressions are intended to identify such forward–looking statements. These forward–looking statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions, including, among other things, information set forth in Item 1A.—Risk Factors. In making these statements, we are not undertaking to address or update these factors in future filings or communications regarding our business or results except as required by law. In light of these risks, uncertainties and assumptions, the forward–looking events discussed in this document might not occur. There may also be other risks that we are unable to predict at this time. Any of these risks and uncertainties may cause actual results to differ materially from the results discussed in the forward–looking statements.

Overview

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. 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. As of December 31, 2007, we had approximately 11.5 million members in our medical benefit plans, as well as approximately 6.8 million members in our specialty products.

We manage our business with two segments: Government and Commercial. 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. We identified our segments in accordance with the aggregation provisions of SFAS 131, which aggregates products with similar economic characteristics. These characteristics include the nature of customer groups as well as pricing, benefits, and underwriting requirements. These segment groupings are consistent with information used by our Chief Executive Officer.

The results of each segment are measured by income before income taxes. We allocate all selling, general and administrative expenses, investment and other revenue, interest expense, and goodwill, but no other assets or liabilities, to our segments. Members served by our two segments often utilize the same medical provider networks, enabling us to obtain more favorable contract terms with providers. Our segments also share indirect overhead costs and assets. As a result, the profitability of each segment is interdependent.

Our results are impacted by many factors, but most notably are influenced by our ability to establish and maintain a competitive and efficient cost structure and to accurately and consistently establish competitive premium, ASO fee, and plan benefit levels that are commensurate with our benefit and administrative costs. Benefit costs are subject to a high rate of inflation due to many forces, including new higher priced technologies and medical procedures, new prescription drugs and therapies, an aging population, lifestyle challenges including obesity and smoking, the tort liability system, and government regulation.

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.

 

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Government Segment

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.

Commercial Segment

We continue to increase the diversification of our Commercial segment membership base and continue to exercise pricing discipline relative to our fully-insured accounts. Commercial segment medical membership increased by 167,800 members from December 31, 2006 to 3,451,600 at December 31, 2007 primarily as a result of the acquisition of KMG America Corporation, discussed more fully below, which added approximately 95,900 members, primarily ASO. The remaining increase primarily was due to enrollment gains in strategic areas of commercial growth including Smart plans and other consumer offerings, individual, small group, and ASO products, partially offset by a decline in the fully-insured larger group product membership. Membership changes from exercising pricing discipline and sales focused on strategic growth areas resulted in a decline in the benefits ratio to 80.5% for the year ended December 31, 2007 compared to 81.7% for the year ended December 31, 2006.

In addition, we are diversifying our Commercial segment revenues through expanded and new specialty product offerings with the acquisitions of CompBenefits Corporation and KMG America Corporation in the fourth quarter of 2007, each discussed further below. These acquisitions significantly increased our dental membership and added new product offerings including vision and other supplemental health and life benefit plans primarily sold on a voluntary basis. The supplemental health plans cover, for example, some of the costs associated with cancer and critical illness. Along with our 2005 acquisition of Corphealth, Inc., a behavioral health care management company, these specialty acquisitions are anticipated to enhance our Commercial segment margins and our ability to appeal to more customers.

Other Highlights

 

   

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

 

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diluted common share, for the year ended December 31, 2007. In addition, a gain in the first quarter of 2006 of $51.7 million pretax, or $0.19 per diluted common share, from the sale of a venture capital investment also impacted year over year comparisons.

 

   

Cash flows from operations decreased $462.4 million to $1,224.3 million for the year ended December 31, 2007 compared to $1,686.7 million for the year ended December 31, 2006. Our operating cash flows were unfavorably impacted by the Part D provisions of our Medicare contracts, primarily the 2007 payment of the $725.5 million risk corridor payable to CMS associated with the 2006 contract year, partially offset by improvement in operating earnings.

 

   

In September 2007, we received approval from CMS to resume marketing of individual Medicare PFFS plans. This announcement ended the June 15, 2007 voluntary suspension agreed to in conjunction with other industry participants.

 

   

In October 2007, we were awarded the Department of Veterans Affairs first specialty network demonstration project, known as Project HERO (Healthcare Effectiveness through Resource Optimization), to support healthcare delivery to veterans.

 

   

Currently, we are anticipating a formal request for proposal, or RFP, for the TRICARE contracts.

We intend for the discussion of our financial condition and results of operations that follows to assist in the understanding of our financial statements and related changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain critical accounting principles and estimates impact our financial statements.

Recent Acquisitions

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.

On March 1, 2007, our Government segment acquired DefenseWeb Technologies, Inc., or DefenseWeb, a company responsible for delivering customized software solutions for the Department of Defense, for cash consideration of $27.0 million.

On May 1, 2006, our Commercial segment acquired CHA Service Company, or CHA Health, a health plan serving employer groups in Kentucky, for cash consideration of $67.5 million.

On December 20, 2005, our Commercial segment acquired Corphealth, Inc., a behavioral health care management company, for cash consideration of approximately $54.0 million. This acquisition allowed Humana to integrate coverage of medical and behavior health benefits.

On February 16, 2005, we acquired CarePlus Health Plans of Florida, or CarePlus, as well as its affiliated 10 medical centers and pharmacy company for approximately $444.9 million in cash, adding approximately 50,400 Medicare Advantage members in Miami-Dade, Broward and Palm Beach counties. This acquisition enhanced our Medicare market position in South Florida.

Certain of these transactions are more fully described in Note 3 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data.

 

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Recently Issued Accounting Pronouncements

In December 2007, the Financial Accounting Standards Board, or FASB, issued FASB Statement No. 141 (Revised 2007), Business Combination, or SFAS 141R. SFAS 141R will significantly change the accounting for business combinations. Under SFAS 141R, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. SFAS 141R will change the accounting treatment for certain specific items including expensing transaction and restructuring costs and adjusting earnings in periods subsequent to the acquisition for changes in deferred tax asset valuation allowances and income tax uncertainties as well as changes in the fair value of acquired contingent liabilities. SFAS 141R also includes a substantial number of new disclosure requirements. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after January 1, 2009 with early adoption prohibited. Accordingly, we are required to record and disclose business combinations following existing GAAP until January 1, 2009. We currently are evaluating the provisions of SFAS 141R.

In December 2007, the FASB issued FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements—An Amendment of ARB No. 5, or SFAS 160. SFAS 160 establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, SFAS 160 requires the recognition of a noncontrolling interest (minority interest) as equity and separate from the parent’s equity. The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning January 1, 2009. Like SFAS 141R discussed above, earlier adoption is prohibited. We currently are evaluating the provisions of SFAS 160.

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.

 

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Comparison of Results of Operations for 2007 and 2006

Certain financial data for our two segments was as follows for the years ended December 31, 2007 and 2006:

 

           Change  
     2007     2006     Dollars     Percentage  
     (dollars in thousands)        

Premium revenues:

        

Medicare Advantage

   $ 11,173,417     $ 8,499,064     $ 2,674,353     31.5 %

Medicare stand-alone PDP

     3,668,425       3,050,304       618,121     20.3 %
                              

Total Medicare

     14,841,842       11,549,368       3,292,474     28.5 %

Military services

     2,839,790       2,543,930       295,860     11.6 %

Medicaid

     555,594       520,520       35,074     6.7 %
                              

Total Government

     18,237,226       14,613,818       3,623,408     24.8 %
                              

Fully-insured

     5,663,000       5,704,378       (41,378 )   (0.7 )%

Specialty

     534,121       410,986       123,135     30.0 %
                              

Total Commercial

     6,197,121       6,115,364       81,757     1.3 %
                              

Total

   $ 24,434,347     $ 20,729,182     $ 3,705,165     17.9 %
                              

Administrative services fees:

        

Government

   $ 73,659     $ 49,442     $ 24,217     49.0 %

Commercial

     317,856       291,769       26,087     8.9 %
                              

Total

   $ 391,515     $ 341,211     $ 50,304     14.7 %
                              

Income before income taxes:

        

Government

   $ 1,027,531     $ 513,845     $ 513,686     100.0 %

Commercial

     261,769       248,240       13,529     5.4 %
                              

Total

   $ 1,289,300     $ 762,085     $ 527,215     69.2 %
                              

Benefits ratios(a):

        

Government

     83.8 %     85.0 %     (1.2 )%

Commercial

     80.5 %     81.7 %     (1.2 )%
                        

Total

     83.0 %     84.0 %     (1.0 )%
                        

SG&A expense ratios(b):

        

Government

     11.2 %     11.8 %     (0.6 )%

Commercial

     21.5 %     20.0 %     1.5 %
                        

Total

     13.9 %     14.3 %     (0.4 )%
                        

 

(a) Represents total benefit expense as a percentage of premium revenue. Also known as the benefits ratio.
(b) Represents total selling, general, and administrative expenses as a percentage of premium revenues, administrative services fees, and other revenues. Also known as the SG&A expense ratio.

 

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Medical membership was as follows at December 31, 2007 and 2006:

 

               Change  
     2007    2006    Members     Percentage  

Government segment medical members:

          

Medicare Advantage

   1,143,000    1,002,600    140,400     14.0 %

Medicare stand-alone PDP

   3,442,000    3,536,600    (94,600 )   (2.7 )%
                      

Total Medicare

   4,585,000    4,539,200    45,800     1.0 %
                      

Military services

   1,719,100    1,716,400    2,700     0.2 %

Military services ASO

   1,146,800    1,163,600    (16,800 )   (1.4 )%
                      

Total military services

   2,865,900    2,880,000    (14,100 )   (0.5 )%
                      

Medicaid

   384,400    390,700    (6,300 )   (1.6 )%

Medicaid ASO

   180,600    178,400    2,200     1.2 %
                      

Total Medicaid

   565,000    569,100    (4,100 )   (0.7 )%
                      

Total Government

   8,015,900    7,988,300    27,600     0.3 %
                      

Commercial segment medical members:

          

Fully-insured

   1,808,600    1,754,200    54,400     3.1 %

ASO

   1,643,000    1,529,600    113,400     7.4 %
                      

Total Commercial

   3,451,600    3,283,800    167,800     5.1 %
                      

Total medical membership

   11,467,500    11,272,100    195,400     1.7 %
                      

These tables of financial data should be reviewed in connection with the discussion on the following pages.

Summary

Net income was $833.7 million, or $4.91 per diluted common share, in 2007 compared to $487.4 million, or $2.90 per diluted common share, in 2006. The year-over-year increase in earnings primarily resulted from higher operating earnings in our Government segment largely due to increased premium revenue from higher average Medicare membership.

Premium Revenues and Medical Membership

Premium revenues increased $3.7 billion, or 17.9%, to $24.4 billion for 2007, compared to $20.7 billion for 2006 primarily due to higher premium revenues in the Government segment. Premium revenues reflect changes in membership and increases in average per member premiums. Items impacting average per member premiums include changes in premium rates as well as changes in the geographic mix of membership, the mix of product offerings, the mix of benefit plans selected by our membership, the impact of the risk corridor provisions, and changes in health status factors or risk adjustment provisions.

Government segment premium revenues increased $3.6 billion, or 24.8%, to $18.2 billion for 2007 compared to $14.6 billion for 2006 primarily attributable to higher average Medicare membership from the expanded participation in various Medicare products. Average membership is calculated by summing the ending membership for each month in a period and dividing the result by the number of months in a period. Average Medicare Advantage membership increased 26.4% for 2007 compared to 2006. Sales of our PFFS products drove the majority of the 140,400 increase in ending Medicare Advantage members since December 31, 2006. Average Medicare stand-alone PDP membership increased 19.5% for 2007 compared to 2006.

Commercial segment premium revenues increased $81.8 million, or 1.3%, to $6.2 billion for 2007 primarily due to our specialty product offerings, including dental, vision, and other supplemental health and life products,

 

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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.

Administrative Services Fees

Our administrative services fees were $391.5 million for 2007, an increase of $50.3 million, or 14.7%, from $341.2 million for 2006. The increase was due to increases in both our Government and Commercial segments.

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.

For the Commercial segment, administrative services fees increased $26.1 million, or 8.9%, from $291.8 million for 2006 to $317.9 million for 2007 primarily from higher average ASO membership, increasing 5.7% for 2007 compared to 2006.

Investment Income

Investment income totaled $314.2 million for 2007, an increase of $22.3 million from $291.9 million for 2006 primarily due to higher average investment balances in 2007 partially offset by a decrease in realized gains related to the sale of venture capital investments in 2006. Investment income for 2006 included a $51.7 million realized gain related to the sale of a venture capital investment in the first quarter.

Other Revenue

Other revenue totaled $149.9 million for 2007, an increase of $95.6 million from $54.3 million for 2006. The increase primarily was attributable to increased revenue from growth related to RightSourceSM, our mail order pharmacy.

Benefit Expenses

Consolidated benefit expense was $20.3 billion for 2007, an increase of $2.9 billion, or 16.7%, from $17.4 billion for 2006. The increase primarily was driven by the increase in the average number of Medicare members and an increase in average per member claims costs primarily from the effects of health care inflation.

The consolidated benefits ratio for 2007 was 83.0%, a 100 basis point decrease from 84.0% for 2006. The decrease primarily was attributable to improvements in the benefits ratio for both the Commercial and Government segments.

The Government segment’s benefit expenses increased $2.9 billion, or 23.0%, during 2007 compared to 2006 primarily due to an increase in the average number of Medicare members, including those enrolled in our PDPs, and to a lesser extent, an increase in average per member claims costs.

The Government segment’s benefits ratio for 2007 was 83.8%, a 120 basis point decrease from 2006 of 85.0%. The decrease in the benefits ratio resulted from the combination of the extended enrollment period in 2006, improvement in the stand-alone PDP Complete plan, changes in estimates associated with our 2006 Medicare Part D reconciliation with CMS as well as the settlement of some TRICARE contractual provisions

 

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related to prior years. Part D benefit designs result in us sharing a greater portion of the responsibilities for total pharmacy costs in the early stages of a member’s plan period and less in the later stages, resulting in a declining benefits ratio as the year progresses. The extended enrollment period in 2006, which ended June 30, 2006, skewed the standard pattern associated with the progression of members through the stages of Medicare Part D benefits. Regarding the Complete plan, benefit design changes improved the performance of that offering. Changes in estimates associated with our 2006 Medicare Part D reconciliation with CMS and the settlement of some TRICARE contractual provisions related to the prior years decreased the benefits ratio 40 basis points for 2007. These changes in estimates resulted from 1) the resolution of first year Medicare Part D implementation matters including enrollment discrepancies, of which similar adjustments in the future are not expected to be material due to the program’s operational improvement in 2007; and 2) the adjustment of certain TRICARE reserves as a result of the settlement of claims payment accuracy and risk share provisions for prior option periods.

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.

SG&A Expense

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%.

The consolidated SG&A expense ratio for 2007 was 13.9%, decreasing 40 basis points from 14.3% for 2006. The SG&A expense ratio decrease resulted from improving administrative cost efficiency and productivity gains associated with servicing our members offset by our expanding mail order pharmacy business as well as differences in the composition of our medical membership portfolio for 2007 versus 2006. The consolidated SG&A expense ratio is expected to be in the range of 13.5% to 14.0% for 2008.

Our Government and Commercial segments bear both direct and shared indirect overhead SG&A expenses. We allocate the indirect overhead expenses shared by the two segments primarily as a function of revenues. As a result, the profitability of each segment is interdependent.

SG&A expenses in the Government segment increased $312.0 million, or 18.0%, during 2007 compared to 2006. The Government segment SG&A expense ratio decreased 60 basis points from 11.8% for 2006 to 11.2% for 2007. The decrease primarily resulted from efficiency and productivity gains associated with servicing higher average Medicare membership.

The Commercial segment SG&A expenses increased $143.0 million, or 11.1%, during 2007 compared to 2006. The Commercial segment SG&A expense ratio increased 150 basis points from 20.0% for 2006 to 21.5% for 2007. This increase primarily resulted from the continued shift in the mix of membership towards ASO, an increase in the percentage of individual and small group members comprising our fully-insured membership, and

 

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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.

Depreciation and Amortization

Depreciation and amortization for 2007 totaled $184.8 million compared to $148.6 million for 2006, an increase of $36.2 million, or 24.4%. The increase primarily resulted from increased capital expenditures related to the Medicare expansion.

Interest Expense

Interest expense was $68.9 million for 2007, compared to $63.1 million for 2006, an increase of $5.8 million, primarily due to higher average outstanding debt partially offset by lower interest rates.

Income Taxes

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%.

Comparison of Results of Operations for 2006 and 2005

Year over year comparisons have been impacted by litigation and Hurricane Katrina expenses in 2005 that did not recur in 2006, as more fully discussed in the following sections.

2005 Settlement of Class Action Litigation

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.

2005 Hurricane Katrina

Certain of our operations, primarily the Louisiana market, were negatively affected by the impact of Hurricane Katrina in August 2005. Expenses related to Hurricane Katrina primarily stemmed from our efforts, in cooperation with Departments of Insurance in the affected states, to help our members by offering participating-provider benefits at non-participating providers’ rates, paying claims for members who were unable at the time to meet their premium obligations and similar measures. In connection with Hurricane Katrina, we recorded pretax medical and administrative expenses of $27.0 million ($16.9 million after taxes, or $0.10 per diluted common share) during the third and fourth quarters of 2005. Of the $27.0 million, $5.9 million was included in the Government segment results and the remaining $21.1 million was included in the Commercial segment results.

 

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Results of Operations

Certain financial data for our two segments was as follows for the years ended December 31, 2006 and 2005:

 

                 Change  
     2006     2005     Dollars     Percentage  
     (dollars in thousands)        

Premium revenues:

        

Medicare Advantage

   $ 8,499,064     $ 4,590,362     $ 3,908,702     85.2 %

Medicare stand-alone PDP

     3,050,304       —         3,050,304     100.0 %
                              

Total Medicare

     11,549,368       4,590,362       6,959,006     151.6 %

Military services

     2,543,930       2,407,653       136,277     5.7 %

Medicaid

     520,520       548,714       (28,194 )   (5.1 )%
                              

Total Government

     14,613,818       7,546,729       7,067,089     93.6 %
                              

Fully-insured

     5,704,378       6,068,115       (363,737 )   (6.0 )%

Specialty

     410,986       386,747       24,239     6.3 %
                              

Total Commercial

     6,115,364       6,454,862       (339,498 )   (5.3 )%
                              

Total

   $ 20,729,182     $ 14,001,591     $ 6,727,591     48.0 %
                              

Administrative services fees:

        

Government

   $ 49,442     $ 50,059     $ (617 )   (1.2 )%

Commercial

     291,769       209,378       82,391     39.4 %
                              

Total

   $ 341,211     $ 259,437     $ 81,774     31.5 %
                              

Income before income taxes:

        

Government

   $ 513,845     $ 316,676     $ 197,169     62.3 %

Commercial

     248,240       86,204       162,036     188.0 %
                              

Total

   $ 762,085     $ 402,880     $ 359,205     89.2 %
                              

Benefits ratios(a):

        

Government

     85.0 %     83.1 %     1.9 %

Commercial

     81.7 %     83.3 %     (1.6 )%
                        

Total

     84.0 %     83.2 %     0.8 %
                        

SG&A expense ratios(b):

        

Government

     11.8 %     12.7 %     (0.9 )%

Commercial

     20.0 %     18.5 %     1.5 %
                        

Total

     14.3 %     15.4 %     (1.1 )%
                        

 

(a) Represents total benefit expense as a percentage of premium revenue. Also known as the benefits ratio.
(b) Represents total selling, general, and administrative expenses as a percentage of premium revenues, administrative services fees, and other revenues. Also known as the SG&A expense ratio.

 

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Medical membership was as follows at December 31, 2006 and 2005:

 

               Change  
     2006    2005    Members     Percentage  

Government segment medical members:

          

Medicare Advantage

   1,002,600    557,800    444,800     79.7 %

Medicare stand-alone PDP

   3,536,600    —      3,536,600     100.0 %
                      

Total Medicare

   4,539,200    557,800    3,981,400     713.8 %
                      

Military services

   1,716,400    1,750,900    (34,500 )   (2.0 )%

Military services ASO

   1,163,600    1,138,200    25,400     2.2 %
                      

Total military services

   2,880,000    2,889,100    (9,100 )   (0.3 )%
                      

Medicaid

   390,700    457,900    (67,200 )   (14.7 )%

Medicaid ASO

   178,400    —      178,400     100.0 %
                      

Total Medicaid

   569,100    457,900    111,200     24.3 %
                      

Total Government

   7,988,300    3,904,800    4,083,500     104.6 %
                      

Commercial segment medical members:

          

Fully-insured

   1,754,200    1,999,800    (245,600 )   (12.3 )%

ASO

   1,529,600    1,171,000    358,600     30.6 %
                      

Total Commercial

   3,283,800    3,170,800    113,000     3.6 %
                      

Total medical membership

   11,272,100    7,075,600    4,196,500     59.3 %
                      

These tables of financial data should be reviewed in connection with the discussion on the following pages.

Summary

Net income was $487.4 million, or $2.90 per diluted common share, in 2006 compared to $296.7 million, or $1.79 per diluted common share, in 2005. Net income for 2005 included expenses resulting from the physician class action settlement ($44.8 million after taxes, or $0.27 per diluted common share) and costs associated with Hurricane Katrina ($16.9 million after taxes, or $0.10 per diluted common share) described previously. Net income for 2005 also included the beneficial effect of an effective tax rate of approximately 26.3% compared to 36.0% in 2006, primarily due to the resolution of a contingent gain ($22.8 million, or $0.14 per diluted common share) during the first quarter of 2005 in connection with the expiration of the statute of limitations on an uncertain tax position related to the 2000 tax year. After considering litigation and Hurricane Katrina expenses and the favorable tax gain contingency in 2005, the remaining year over year improvement in 2006 results from earnings increases in both the Government and Commercial segments.

Premium Revenues and Medical Membership

Premium revenues reflect changes in membership and increases in average per member premiums. Items impacting average per member premiums include changes in premium rates as well as changes in the geographic mix of membership, the mix of product offerings, and the mix of benefit plans selected by our membership. Premium revenues increased 48.0% to $20.7 billion for 2006, compared to $14.0 billion for 2005. Higher Government segment premium revenues were partially offset by a decrease in Commercial segment premium revenues. Premium revenues reflect higher enrollment in our Medicare Advantage plans and the addition of our stand-alone PDP business.

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%

 

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increase in Medicare Advantage members since December 31, 2005. At December 31, 2006, approximately 47% of the company’s Medicare Advantage members were in PFFS plans versus 22% at December 31, 2005. Additionally, our new Medicare stand-alone PDP products added 3,536,600 members and $3.1 billion in new premium revenues during 2006. Medicaid membership increased 111,200 members from December 31, 2005 due primarily to the award of a new Puerto Rico regional ASO contract in the fourth quarter of 2006 partially offset by eligible Puerto Rico Medicaid members choosing to move into the Medicare program.

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.

Administrative Services Fees

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.

Investment Income

Investment income totaled $291.9 million for 2006, an increase of $148.9 million from $143.0 million for 2005. The increase in investment income for 2006 primarily resulted from higher venture capital gains, and higher average invested balances and interest rates. Investment income for 2006 includes $75.7 million in net realized gains related to venture capital investments compared to $5.7 million in 2005.

Other Revenue

Other revenue totaled $54.3 million for 2006, an increase of $40.2 million from $14.1 million for 2005. The increase primarily was attributable to revenue from our new in-house mail order pharmacy operations in 2006.

Benefit Expenses

Consolidated benefit expense was $17.4 billion for 2006, an increase of $5.7 billion, or 48.7%, from $11.7 billion for 2005. The increase was primarily driven by the increase in the number of members, particularly higher cost Medicare members, and an increase in average per member claims costs primarily from the effects of health care inflation.

The 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.

 

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The Government segment’s benefit expenses increased $6.2 billion, or 98.1%, during 2006 compared to 2005. The increase was primarily due to an increase in the number of Medicare members, including those enrolled in our stand-alone PDPs.

The 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 Commercial segment’s benefit expenses decreased $382.3 million, or 7.1%, from 2005 to 2006. This decrease primarily results from the decrease in fully-insured group membership partially offset by the increase in average per member claims costs. The increase in average per member claims costs for fully-insured group members was approximately 6% for 2006.

The benefits ratio for the Commercial segment of 81.7% in 2006 decreased 160 basis points from the 2005 benefits ratio of 83.3%. Higher benefit expenses from Hurricane Katrina increased the 2005 benefits ratio 30 basis points. The decrease in the benefits ratio primarily reflects improving medical cost utilization trends and an increase in the percentage of individual and small group members comprising our total fully-insured block. Individual and smaller group accounts generally carry a lower benefits ratio than larger group accounts.

SG&A Expense

Consolidated SG&A expenses increased $825.9 million, or 37.6%, during 2006 compared to 2005. The increase primarily resulted from an increase in the number of employees and increased sales and marketing costs due to the Medicare expansion offset by prior year litigation expenses which did not recur in 2006. The number of employees increased by 3,600 to 22,300 from 18,700 at December 31, 2005, primarily in the customer service and marketing functions associated with the growth in the Medicare business.

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.

Our Government and Commercial segments bear both direct and shared indirect overhead SG&A expenses. We allocate the indirect overhead expenses shared by the two segments primarily as a function of revenues. As a result, the profitability of each segment is interdependent.

Government segment SG&A expenses of $1,730.2 million for 2006 increased $766.9 million, or 79.6%, from 2005. The increase primarily resulted from higher expenses associated with the infrastructure build out of our expanded Medicare offerings in the latter half of 2005 through the first half of 2006 as well as increased sales and marketing costs in 2006 also related to the Medicare expansion.

The Government segment SG&A expense ratio decreased 90 basis points from 12.7% for 2005 to 11.8% for 2006. Expenses related to the litigation settlement increased the SG&A expense ratio 50 basis points for 2005. After considering the effect of the litigation, the decrease from 2005 to 2006 resulted from average membership and related revenue associated with the Medicare expansion reaching the levels contemplated by the now complete build-out of infrastructure and support functions which began in the latter half of 2005, providing more leverage against administrative costs in 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%

 

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for 2005. Expenses related to the litigation settlement increased the SG&A expense ratio 60 basis points for 2005. After considering the effect of the litigation, the increase primarily resulted from an increase in the percentage of small group members comprising our total fully-insured membership as well as the continued shift in the mix of membership towards ASO. At December 31, 2005, 37% of our Commercial segment medical membership related to ASO business compared to 47% at December 31, 2006. Small group accounts bear a higher SG&A ratio than larger group accounts and ASO business bears a significantly higher SG&A ratio than fully-insured business.

Depreciation and Amortization

Depreciation and amortization for 2006 totaled $148.6 million compared to $128.9 million in 2005, an increase of $19.7 million, or 15.3%. The increase resulted primarily from capital expenditures related to the Medicare expansion.

Interest Expense

Interest expense was $63.1 million for 2006, compared to $39.3 million for 2005, an increase of $23.8 million. This increase primarily resulted from higher average outstanding debt and higher interest rates.

Income Taxes

Our effective tax rate for 2006 of 36.0% increased 9.7% compared to the 26.3% effective tax rate for 2005. The higher effective tax rate for 2006 is primarily due to the resolution of a contingent tax gain of $22.8 million in the first quarter of 2005 in connection with the expiration of the statute of limitations on an uncertain tax position related to the 2000 tax year which did not recur in 2006. See Note 9 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data for a complete reconciliation of the federal statutory rate to the effective tax rate.

Liquidity

Our primary sources of cash include receipts of premiums, ASO fees, investment income, as well as proceeds from the sale or maturity of our investment securities and from borrowings. Our primary uses of cash include disbursements for claims payments, SG&A expenses, interest expense, taxes, purchases of investment securities, acquisitions, capital expenditures, and payments on borrowings. Because premiums generally are collected in advance of claim payments by a period of up to several months in many instances, our business normally should produce positive cash flows during periods of increasing enrollment. Conversely, cash flows would be negatively impacted during periods of decreasing enrollment. We have experienced improving operating cash flows associated with growth in Medicare enrollment. The use of operating cash flows may be limited by regulatory requirements which require, among other items, that our regulated subsidiaries maintain minimum levels of capital.

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:

 

     2007     2006     2005  
     (in thousands)  

Net cash provided by operating activities

   $ 1,224,262     $ 1,686,712     $ 610,082  

Net cash used in investing activities

     (1,845,391 )     (1,654,066 )     (767,276 )

Net cash provided by financing activities

     921,278       975,642       309,131  
                        

Increase in cash and cash equivalents

   $ 300,149     $ 1,008,288     $ 151,937  
                        

 

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Cash Flow from Operating Activities

The decrease in operating cash flows for 2007 resulted from timing of cash flows associated with our Medicare Part D offerings, offset by Medicare enrollment growth and improved earnings. During 2007, we paid $725.5 million to CMS under the risk corridor terms of our 2006 contracts with CMS. Similarly, the provision for net amounts payable under the risk corridor terms of our 2007 contracts with CMS, which will be paid in 2008, was $102.6 million.

The increase in operating cash flows for 2006 compared to 2005 resulted from Medicare enrollment growth, improved earnings, and the timing of cash flows associated with our Medicare Part D offerings which were new beginning January 1, 2006. Our 2006 Part D results related to both stand-alone PDP and MA-PD offerings reflected provisions for net amounts payable to CMS under the risk corridor terms of our contracts with CMS. This risk corridor amount, which was paid in 2007 as discussed above, reflects favorable experience on allowable risk corridor costs during the second half of 2006 compared to the expectations set out in our original annual bid for 2006 contracts with CMS. The favorable experience was associated with the Medicare Part D portion of our MA-PD offerings as well as our Standard and Enhanced stand-alone plans.

Comparisons of our operating cash flows also are impacted by other changes in our working capital. The most significant drivers of changes in our working capital are typically the timing of receipts for premiums and ASO fees and payments of benefit expenses. We illustrate these changes with the following summaries of receivables and benefits payable.

The detail of total net receivables was as follows at December 31, 2007, 2006 and 2005:

 

                       Change  
     2007     2006     2005     2007     2006  
     (in thousands)  

Military services:

          

Base receivable

   $ 404,570     $ 452,509     $ 509,444     $ (47,939 )   $ (56,935 )

Change orders

     5,168       4,247       32,285       921       (28,038 )
                                        

Military services subtotal

     409,738       456,756       541,729       (47,018 )     (84,973 )

Medicare

     137,345       143,875       66,536       (6,530 )     77,339  

Commercial and other

     126,718       125,899       162,944       819       (37,045 )

Allowance for doubtful accounts

     (68,260 )     (45,589 )     (32,557 )     (22,671 )     (13,032 )
                                        

Total net receivables

   $ 605,541     $ 680,941     $ 738,652       (75,400 )     (57,711 )
                            

Reconciliation to cash flow statement:

          

Provision for doubtful accounts

           28,922       20,901  

Receivables from acquisition

           (14,267 )     (843 )
                      

Change in receivables per cash flow statement resulting in cash from operations

         $ (60,745 )   $ (37,653 )
                      

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.

 

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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.

The decline in Commercial and other receivables from 2005 to 2006 resulted from the change in the mix of members from fully-insured to ASO.

The $22.7 million increase in the allowance for doubtful accounts from 2006 to 2007 resulted from the growth of the Medicare business.

The detail of benefits payable was as follows at December 31, 2007, 2006 and 2005:

 

                Change  
    2007   2006   2005   2007     2006  
    (in thousands)  

IBNR(1)

  $ 1,712,599   $ 1,600,198   $ 1,013,949   $ 112,401     $ 586,249  

Military services benefits payable(2)

    341,372     430,674     514,426     (89,302 )     (83,752 )

Reported claims in process(3)

    91,938     98,033     67,065     (6,095 )     30,968  

Other benefits payable(4)

    550,924     281,502     253,702     269,422       27,800  
                                 

Total benefits payable

  $ 2,696,833   $ 2,410,407   $ 1,849,142     286,426       561,265  
                     

Reconciliation to cash flow statement: