Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-Q

 


 

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

For the quarterly period ended March 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 or other jurisdiction

of incorporation or organization)

 

(I.R.S. Employer

Identification Number)

500 West Main Street

Louisville, Kentucky 40202

(Address of principal executive offices, including zip code)

(502) 580-1000

(Registrant’s telephone number, including area code)

 


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, and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

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

Large accelerated filer  x    Accelerated filer  ¨    Non-accelerated filer  ¨

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date.

 

Class of Common Stock

 

Outstanding at

March 31, 2007

$0.16 2/3 par value

  168,036,992 shares

 



Table of Contents

Humana Inc.

FORM 10-Q

MARCH 31, 2007

I NDEX

 

     Page
Part I: Financial Information   

Item 1.

   Financial Statements   
   Condensed Consolidated Balance Sheets at March 31, 2007 and December 31, 2006    3
   Condensed Consolidated Statements of Income for the three months ended March 31, 2007 and 2006    4
   Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2007 and 2006    5
   Notes to Condensed Consolidated Financial Statements    6

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    13

Item 3.

   Quantitative and Qualitative Disclosures about Market Risk    23

Item 4.

   Controls and Procedures    23

Part II: Other Information

  

Item 1.

   Legal Proceedings    24

Item 1A.

   Risk Factors    24

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds    25

Item 3.

   Defaults Upon Senior Securities    25

Item 4.

   Submission of Matters to a Vote of Security Holders    25

Item 5.

   Other Information    25

Item 6.

   Exhibits    25
   Signatures and Certifications    26

 

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Humana Inc.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

     March 31,
2007
    December 31,
2006
 
     (in thousands, except share amounts)  
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 3,694,059     $ 1,740,304  

Investment securities

     3,154,920       3,192,273  

Receivables, less allowance for doubtful accounts of $52,313 in 2007 and $45,589 in 2006:

    

Premiums

     826,314       667,657  

Administrative services fees

     10,806       13,284  

Securities lending collateral

     1,049,195       627,990  

Other

     1,135,298       1,091,465  
                

Total current assets

     9,870,592       7,332,973  
                

Property and equipment, net

     571,405       545,004  

Other assets:

    

Long-term investment securities

     380,138       414,877  

Goodwill

     1,331,418       1,310,631  

Other

     552,572       524,011  
                

Total other assets

     2,264,128       2,249,519  
                

Total assets

   $ 12,706,125     $ 10,127,496  
                
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Current liabilities:

    

Medical and other expenses payable

   $ 2,886,214     $ 2,488,261  

Trade accounts payable and accrued expenses

     1,977,465       1,626,658  

Book overdraft

     284,572       293,605  

Securities lending payable

     1,049,195       627,990  

Unearned revenues

     1,330,325       155,298  
                

Total current liabilities

     7,527,771       5,191,812  

Long-term debt

     1,329,334       1,269,100  

Other long-term liabilities

     689,493       612,698  
                

Total liabilities

     9,546,598       7,073,610  
                

Commitments and contingencies

    

Stockholders’ equity:

    

Preferred stock, $1 par; 10,000,000 shares authorized; none issued

     —         —    

Common stock, $0.16 2/3 par; 300,000,000 shares authorized; 184,476,052 shares issued at March 31, 2007 and 182,947,691 shares issued at December 31, 2006

     30,746       30,491  

Capital in excess of par value

     1,393,582       1,357,077  

Retained earnings

     1,980,339       1,909,098  

Accumulated other comprehensive loss

     (8,378 )     (13,205 )

Treasury stock, at cost, 16,439,060 shares at March 31, 2007 and 16,314,151 shares at December 31, 2006

     (236,762 )     (229,575 )
                

Total stockholders’ equity

     3,159,527       3,053,886  
                

Total liabilities and stockholders’ equity

   $ 12,706,125     $ 10,127,496  
                

See accompanying notes to condensed consolidated financial statements.

 

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Humana Inc.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

 

    

For the three months ended

March 31,

     2007    2006
     (in thousands, except per share results)

Revenues:

     

Premiums

   $ 6,004,563    $ 4,521,486

Administrative services fees

     95,864      78,678

Investment income

     73,527      98,902

Other revenue

     30,859      5,299
             

Total revenues

     6,204,813      4,704,365
             

Operating expenses:

     

Medical

     5,214,000      3,783,926

Selling, general and administrative

     820,610      740,886

Depreciation and amortization

     40,064      34,906
             

Total operating expenses

     6,074,674      4,559,718
             

Income from operations

     130,139      144,647

Interest expense

     17,918      13,439
             

Income before income taxes

     112,221      131,208

Provision for income taxes

     40,980      47,493
             

Net income

   $ 71,241    $ 83,715
             

Basic earnings per common share

   $ 0.43    $ 0.51
             

Diluted earnings per common share

   $ 0.42    $ 0.50
             

See accompanying notes to condensed consolidated financial statements.

 

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Humana Inc.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

    

For the three months ended

March 31,

 
     2007     2006  
     (in thousands)  

Cash flows from operating activities

    

Net income

   $ 71,241     $ 83,715  

Adjustments to reconcile net income to net cash provided by operating activities:

    

Gain on sale of investment securities, net

     (1,672 )     (56,914 )

Stock-based compensation

     9,802       6,580  

Depreciation and amortization

     40,064       34,906  

Benefit for deferred income taxes

     (6,111 )     (3,705 )

Changes in operating assets and liabilities, net of effect of businesses acquired:

    

Receivables

     (156,179 )     (46,061 )

Other assets

     (18,945 )     (185,250 )

Medical and other expenses payable

     397,953       259,807  

Other liabilities

     58,652       114,752  

Unearned revenues

     1,175,027       800,189  

Other, net

     4,649       (46 )
                

Net cash provided by operating activities

     1,574,481       1,007,973  
                

Cash flows from investing activities

    

Acquisitions, net of cash acquired

     (26,781 )     (113 )

Purchases of property and equipment

     (70,744 )     (45,261 )

Proceeds from sales of property and equipment

     4,070       2,138  

Purchases of investment securities

     (965,051 )     (1,663,658 )

Maturities of investment securities

     557,485       910,108  

Proceeds from sales of investment securities

     481,911       559,830  

Change in securities lending collateral

     (421,205 )     (202,712 )
                

Net cash used in investing activities

     (440,315 )     (439,668 )
                

Cash flows from financing activities

    

Receipts from CMS contract deposits

     843,637       494,194  

Withdrawals from CMS contract deposits

     (515,705 )     (273,444 )

Borrowings under credit agreement

     310,000       100,000  

Repayments under credit agreement

     (250,000 )     —    

Change in securities lending payable

     421,205       202,712  

Common stock repurchases

     (7,187 )     (105 )

Change in book overdraft

     (9,033 )     (4,418 )

Tax benefit from stock-based compensation

     9,128       8,404  

Proceeds from stock option exercises and other

     17,544       15,741  
                

Net cash provided by financing activities

     819,589       543,084  
                

Increase in cash and cash equivalents

     1,953,755       1,111,389  

Cash and cash equivalents at beginning of period

     1,740,304       732,016  
                

Cash and cash equivalents at end of period

   $ 3,694,059     $ 1,843,405  
                

Supplemental cash flow disclosures:

    

Interest payments

   $ 17,330     $ 14,551  

Income tax payments, net

   $ 5,654     $ 2,404  

See accompanying notes to condensed consolidated financial statements.

 

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Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Unaudited

 

(1) Basis of Presentation

The accompanying condensed consolidated financial statements are presented in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the disclosures normally required by accounting principles generally accepted in the United States of America, or those normally made in an Annual Report on Form 10-K. For further information, the reader of this Form 10-Q should refer to our Form 10-K for the year ended December 31, 2006, that was filed with the Securities and Exchange Commission, or the SEC, on February 23, 2007. References throughout this document to “we,” “us,” “our,” “Company,” and “Humana,” mean Humana Inc. and its subsidiaries.

The preparation of our condensed consolidated financial statements in accordance with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. The areas involving the most significant use of estimates are the estimation of medical expenses payable, the impact of risk sharing provisions related to our Medicare and TRICARE contracts, the valuation and related impairment recognition of investment securities, and the valuation and related impairment recognition of long-lived assets, including goodwill. These estimates are based on knowledge of current events and anticipated future events, and accordingly, actual results may ultimately differ materially from those estimates. Refer to “Significant Accounting Policies” in Humana’s 2006 Annual Report on Form 10-K for information on accounting policies that the Company considers in preparing its consolidated financial statements.

The financial information has been prepared in accordance with our customary accounting practices and has not been audited. In our opinion, the information presented reflects all adjustments necessary for a fair statement of interim results. All such adjustments are of a normal and recurring nature.

 

(2) Recently Issued Accounting Pronouncements

In February 2007, the Financial Accounting Standards Board, or 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 presentation and disclosure requirements. We are required to adopt SFAS 159 in the first quarter of 2008. We currently are evaluating the provisions of SFAS 159. We do not expect the adoption of SFAS 159 to have a material impact on our financial position or results of operations.

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 are required to adopt SFAS 157 in the first quarter of 2008. We currently are evaluating the provisions of SFAS 157. We do not expect the adoption of SFAS 157 to have a material impact on our financial position or results of operations.

 

(3) Acquisition

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 approximately $26.7 million.

 

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Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

 

(4) Medicare Part D

The condensed consolidated balance sheets include the following amounts associated with Medicare Part D as of March 31, 2007 and December 31, 2006. The risk corridor settlement includes amounts classified as long-term because settlement associated with the 2007 provision will exceed 12 months.

 

     March 31, 2007     December 31, 2006  
     Risk
Corridor
Settlement
    CMS
Subsidies
    Risk
Corridor
Settlement
    CMS
Subsidies
 
     (in thousands)  

Other current assets

   $ 16,463     $ 498,374     $ 18,365     $ 449,984  

Trade accounts payable and accrued expenses

     (756,069 )     (704,040 )     (757,084 )     (327,718 )
                                

Net current (liability) asset

     (739,606 )     (205,666 )     (738,719 )     122,266  
                                

Other long-term assets

     21,297       —         —         —    

Other long-term liabilities

     (68,699 )     —         —         —    
                                

Net long-term liability

     (47,402 )     —         —         —    
                                

Total net (liability) asset

   $ (787,008 )   $ (205,666 )   $ (738,719 )   $ 122,266  
                                

 

(5) Goodwill and Other Intangible Assets

Changes in the carrying amount of goodwill, by operating segment, for the three months ended March 31, 2007 were as follows:

 

     Commercial    Government    Total
     (in thousands)

Balance at December 31, 2006

   $ 782,501    $ 528,130    $ 1,310,631

DefenseWeb acquisition

     —        20,787      20,787
                    

Balance at March 31, 2007

   $ 782,501    $ 548,917    $ 1,331,418
                    

The following table presents details of our other intangible assets included in other long-term assets in the accompanying condensed consolidated balance sheets at March 31, 2007 and December 31, 2006:

 

    

Weighted

Average Life
at 3/31/07

   March 31, 2007    December 31, 2006
      Cost    Accumulated
Amortization
   Net    Cost    Accumulated
Amortization
   Net
     (in thousands)

Other intangible assets:

                    

Customer contracts

   10.1 yrs    $ 120,328    $ 40,498    $ 79,830    $ 114,944    $ 36,449    $ 78,495

Provider contracts

   14.5 yrs      11,500      2,214      9,286      11,500      2,012      9,488

Licenses and other

   16.7 yrs      11,602      4,234      7,368      11,602      3,929      7,673
                                            

Total other intangible assets

   10.9 yrs    $ 143,430    $ 46,946    $ 96,484    $ 138,046    $ 42,390    $ 95,656
                                            

 

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Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

Amortization expense for other intangible assets was approximately $4.6 million for the three months ended March 31, 2007 and $5.1 million for the three months ended March 31, 2006. The following table presents our estimate of amortization expense for the remaining nine months of 2007 and for each of the five next succeeding fiscal years:

 

     (in thousands)

For the nine month period ending December 31, 2007

   $ 12,838

For the years ending December 31,

  

2008

   $ 14,614

2009

   $ 10,635

2010

   $ 10,049

2011

   $ 9,978

2012

   $ 9,909

 

(6) Comprehensive Income

The following table presents details supporting the computation of comprehensive income for the three months ended March 31, 2007 and 2006:

 

    

For the three months ended

March 31,

 
     2007    2006  
     (in thousands)  

Net income

   $ 71,241    $ 83,715  

Net unrealized investment gain (loss), net of tax

     4,827      (53,240 )
               

Comprehensive income, net of tax

   $ 76,068    $ 30,475  
               

 

(7) Earnings Per Common Share Computation

Detail supporting the computation of basic and diluted earnings per common share for the three months ended March 31, 2007 and 2006:

 

     For the three months ended
March 31,
     2007    2006
     (in thousands, except per share
results)

Net income available for common stockholders

   $ 71,241    $ 83,715
             

Weighted average outstanding shares of common stock used to compute basic earnings per common share

     165,813      163,116

Dilutive effect of:

     

Employee stock options

     2,635      3,996

Restricted stock

     508      213
             

Shares used to compute diluted earnings per common share

     168,956      167,325
             

Basic earnings per common share

   $ 0.43    $ 0.51
             

Diluted earnings per common share

   $ 0.42    $ 0.50
             

Number of antidilutive stock options and restricted stock excluded from computation

     1,588      496

 

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Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

 

(8) Income Taxes

The Company and certain subsidiaries file income tax returns in the United States and certain foreign jurisdictions. During the first quarter of 2007, the Internal Revenue Service (IRS) completed its examination of our U.S. income tax returns for 2003 and 2004 resulting in immaterial adjustments. With few exceptions, which are immaterial in the aggregate, the Company is no longer subject to state, local and foreign tax examinations by tax authorities for years before 2003.

We adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, or FIN 48, on January 1, 2007. The liability for unrecognized tax benefits, including interest and penalties, at December 31, 2006 was $15.6 million, all of which would affect the effective tax rate if recognized. There were no changes in the liability for unrecognized tax benefits as a result of the implementation of FIN 48. There are no positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase or decrease within the next twelve months. We recognize penalties and interest accrued related to unrecognized tax benefits in tax expense. There were no material changes to the liability for unrecognized tax benefits or penalties and interest during the three months ended March 31, 2007.

 

(9) Guarantees and Contingencies

Government Contracts

Our Medicare business, which accounted for approximately 60% of our total premiums and ASO fees for the three months ended March 31, 2007, consisted of products covered under the Medicare Advantage and stand-alone PDP contracts with the federal government. These contracts are renewed generally for a one-year term each December 31 unless CMS notifies Humana of its decision not to renew by May 1 of the contract year, or Humana notifies CMS of its decision not to renew by the first Monday in June of the contract year.

Our TRICARE business, which accounted for approximately 12% of our total premiums and ASO fees for the three months ended March 31, 2007, primarily consisted of the 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. On April 27, 2007, the government announced that it has developed requirements and is now preparing a draft solicitation related to the contracts which would follow the current contracts. As required under the contract, the target underwritten health care cost and underwriting fee amounts for the fourth option period were negotiated. Any variance from the target health care cost is shared with the federal government. Accordingly, events and circumstances not contemplated in the negotiated target health care cost amount could have a material adverse effect on our business. These changes may include, for example, an increase or reduction in the number of persons enrolled or eligible to enroll due to the federal government’s decision to increase or decrease U.S. military deployments. In the event government reimbursements were to decline from projected amounts, our failure to reduce the health care costs associated with these programs could have a material adverse effect on our business.

Our Medicaid business, which accounted for approximately 2% of our total premiums and ASO fees for the three months ended March 31, 2007, consisted of contracts in Puerto Rico and Florida. Our Medicaid contracts with the Puerto Rico Health Insurance Administration accounted for approximately 2% of our total premium and ASO fees for the three months ended March 31, 2007. We currently are operating under the terms of our contracts that expired October 31, 2006. Due to several ongoing and unresolved issues with the program, the government of Puerto Rico has decided to delay the bid process for new contracts. We currently are working with the Puerto Rico Health Insurance Administration regarding terms and rates which is expected to result in an extension of the existing contracts through September 30, 2007. There is no assurance that the Puerto Rico Health Insurance Administration will request such an extension, and we are unable to predict the ultimate impact that any government policy or fiscal decisions might have on the continuation of our Medicaid contracts in Puerto Rico.

The loss of any of the contracts above or significant changes in these programs as a result of legislative action, including reductions in premium payments to us, or increases in member benefits without corresponding increases in premium payments to us, may have a material adverse effect on our financial position, results of operations, and cash flows.

 

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Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

Legal Proceedings

Our current and past business practices are subject to review by various state insurance and health care regulatory authorities and other state and federal regulatory authorities. These authorities regularly scrutinize the business practices of health insurance and benefits companies. These reviews focus on numerous facets of our business, including claims payment practices, competitive practices, commission payments, privacy issues, utilization management practices, and sales practices. Some of these reviews have historically resulted in fines imposed on us and some have required changes to some of our practices. We continue to be subject to these reviews, which could result in additional fines or other sanctions being imposed on us or additional changes in some of our practices.

We also are involved in various lawsuits that arise, for the most part, in the ordinary course of our business operations, including employment litigation, claims of medical malpractice, bad faith, nonacceptance or termination of providers, anticompetitive practices, improper rate setting, failure to disclose network discounts and various other provider arrangements, intellectual property matters, and challenges to subrogation practices. We also are subject to claims relating to performance of contractual obligations to providers, members, and others, including failure to properly pay claims, challenges to our implementation of the new Medicare prescription drug program and other litigation.

Personal injury claims and claims for extracontractual damages arising from medical benefit denials are covered by insurance from our wholly owned captive insurance subsidiary and excess carriers, except to the extent that claimants seek punitive damages, which may not be covered by insurance in certain states in which insurance coverage for punitive damages is not permitted. In addition, insurance coverage for all or certain forms of liability has become increasingly costly and may become unavailable or prohibitively expensive in the future.

The outcome of current suits or likelihood or outcome of future suits or governmental investigations cannot be accurately predicted with certainty, and therefore, such legal actions and government audits and investigations could have a material adverse effect on our financial position, results of operations, and cash flows.

 

(10) Segment Information

We manage our business with two segments: Government and Commercial. The Government segment consists of members enrolled in government-sponsored programs, and includes three lines of business: Medicare, TRICARE, and Medicaid. The Commercial segment consists of members enrolled in products marketed to employer groups and individuals, and includes two lines of business: medical (fully and self insured) and specialty. We identified our segments in accordance with the aggregation provisions of SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information, or SFAS 131, which is consistent with information used by our Chief Executive Officer in managing our business. The segment information aggregates products with similar economic characteristics. These characteristics include the nature of customer groups and pricing, benefits and underwriting requirements.

The accounting policies of each segment are the same and are described in Note 2 to the consolidated financial statements included in our Form 10-K for the year ended December 31, 2006. 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 some indirect overhead costs and assets. As a result, the profitability of each segment is interdependent.

 

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Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

Our segment results were as follows for the three months ended March 31, 2007 and 2006:

 

     Government Segment
     For the three months ended March 31,
     2007    2006
     (in thousands)

Revenues:

     

Premiums:

     

Medicare Advantage

   $ 2,742,711    $ 1,720,843

Medicare stand-alone PDP

     906,426      515,157
             

Total Medicare

     3,649,137      2,236,000

TRICARE

     727,215      600,754

Medicaid

     129,325      129,467
             

Total premiums

     4,505,677      2,966,221

Administrative services fees

     16,390      11,191

Investment income

     43,238      12,271

Other revenue

     384      527
             

Total revenues

     4,565,689      2,990,210
             

Operating expenses:

     

Medical

     4,023,408      2,537,874

Selling, general and administrative

     489,962      409,784

Depreciation and amortization

     23,921      19,306
             

Total operating expenses

     4,537,291      2,966,964
             

Income from operations

     28,398      23,246

Interest expense

     10,533      1,674
             

Income before income taxes

   $ 17,865    $ 21,572
             

 

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Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

 

     Commercial Segment
     For the three months ended March 31,
     2007    2006
     (in thousands)

Revenues:

     

Premiums:

     

Fully-insured

     

PPO

   $ 927,506    $ 905,881

HMO

     463,299      548,051
             

Total fully-insured

     1,390,805      1,453,932

Specialty

     108,081      101,333
             

Total premiums

     1,498,886      1,555,265

Administrative services fees

     79,474      67,487

Investment income

     30,289      86,631

Other revenue

     30,475      4,772
             

Total revenues

     1,639,124      1,714,155
             

Operating expenses:

     

Medical

     1,190,592      1,246,052

Selling, general and administrative

     330,648      331,102

Depreciation and amortization

     16,143      15,600
             

Total operating expenses

     1,537,383      1,592,754
             

Income from operations

     101,741      121,401

Interest expense

     7,385      11,765
             

Income before income taxes

   $ 94,356    $ 109,636
             

 

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Humana Inc.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The condensed 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 SEC, 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 our Form 10-K for the year ended December 31, 2006 that was filed with the SEC on February 23, 2007. In making these statements, we are not undertaking to address or update these factors in future filings or communications regarding our business or results. 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 benefits companies, based on our 2006 revenues of $21.4 billion. We offer a diversified portfolio of health insurance products and related services through traditional and consumer-choice plans for government-sponsored programs, employer groups, and individuals. As of March 31, 2007, we had approximately 11.3 million members in our medical benefit programs, as well as approximately 1.9 million members in our specialty products programs.

We manage our business with two segments: Government and Commercial. The Government segment consists of members enrolled in government-sponsored programs, and includes three lines of business: Medicare, TRICARE, and Medicaid. The Commercial segment consists of members enrolled in products marketed to employer groups and individuals, and includes two lines of business: medical (fully and self insured) and specialty. We identified our segments in accordance with the aggregation provisions of SFAS 131, which is consistent with information used by our Chief Executive Officer in managing our business. The segment information aggregates products with similar economic characteristics. These characteristics include the nature of customer groups and pricing, benefits and underwriting requirements.

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 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 medical and administrative costs. Medical costs are subject to a high rate of inflation due to many forces, including new higher priced technologies and medical procedures, increasing capacity and supply of medical services, 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 medical expense ratio, or MER, which is computed by taking total medical 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 and administrative services fees, represents a statistic used to measure administrative spending efficiency.

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 1,113,400 members at March 31, 2007, up 11.1% from 1,002,600 members at December 31, 2006, and 50.2% from

 

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741,200 at March 31, 2006, primarily due to sales of Private Fee-For-Service, or PFFS, products. Our Medicare stand-alone prescription drug plan, or PDP, products increased to 3,473,700 members during the first quarter of 2007, compared to 1,959,000 members at March 31, 2006. Likewise, Medicare premium revenues have increased 63.2% to $3.6 billion for the first quarter of 2007 from $2.2 billion in the first quarter of 2006.

Our Government segment earnings are particularly impacted during the first quarter by higher medical expenses associated with the Medicare Part D benefit structure and increased marketing expenses associated with a selling season which ended March 31, 2007. 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, we expect a higher earnings contribution from our Government segment for the remaining quarters of 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 decreased by 1,900 members from March 31, 2006 to 3,257,500 at March 31, 2007 as a result of a decline in the fully-insured group product membership partially offset by enrollment gains in the individual and consumer-choice products. MER declined to 79.4% during the first quarter of 2007 compared to 80.1% in the first quarter of 2006. ASO membership at March 31, 2007 was up 9.6% from March 31, 2006. Individual membership increased 17.8% and fully-insured consumer-choice membership increased 25.5% since March 31, 2006. These three areas, together with our small group business, now represent more than 80% of our Commercial medical membership.

Other Highlights

 

   

Quarter over quarter comparisons were impacted by a gain in the prior year quarter of $51.7 million pretax, or $0.19 per diluted common share, from the sale of a venture capital investment.

 

   

Sales during the final two weeks of the open enrollment season for Medicare Advantage increased Medicare Advantage membership for April 2007 to approximately 1,137,000.

 

   

The Medicare premium receipt for April 2007 of $1.13 billion was received in March 2007 because the payment date of April 1 fell on a weekend.

 

   

Cash flows from operations increased $566.5 million to $1,574.5 million in the first quarter of 2007 compared to $1,008.0 million in the first quarter of 2006. Operating cash flows included the late March Medicare premium receipt for April of $1,129.8 million and $774.7 million in the first quarter of 2007 and 2006, respectively.

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 March 1, 2007, our Government segment acquired DefenseWeb Technologies, Inc., a company responsible for delivering customized software solutions for the Department of Defense, for cash consideration of approximately $26.7 million. This transaction will not have a material impact on our results of operations or cash flows from operations for 2007.

Recently Issued Accounting Pronouncements

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 presentation and disclosure requirements. We are required to adopt SFAS 159 in the first quarter of 2008. We currently are evaluating the provisions of SFAS 159. We do not expect the adoption of SFAS 159 to have a material impact on our financial position or results of operations.

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 are required to adopt SFAS 157 in the first quarter of 2008. We currently are evaluating the provisions of SFAS 157. We do not expect the adoption of SFAS 157 to have a material impact on our financial position or results of operations.

 

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Comparison of Results of Operations for 2007 and 2006

The following discussion primarily deals with our results of operations for the three months ended March 31, 2007, or the 2007 quarter, and the three months ended March 31, 2006, or the 2006 quarter.

The following table presents certain financial data for our two segments:

 

     For the three months ended March 31,     Change  
     2007     2006     Dollars     Percentage  
     (in thousands, except ratios)        

Premium revenues:

        

Medicare Advantage

   $ 2,742,711     $ 1,720,843     $ 1,021,868     59.4 %

Medicare stand-alone PDP

     906,426       515,157       391,269     76.0 %
                              

Total Medicare

     3,649,137       2,236,000       1,413,137     63.2 %

TRICARE

     727,215       600,754       126,461     21.1 %

Medicaid

     129,325       129,467       (142 )   (0.1 )%
                              

Total Government

     4,505,677       2,966,221       1,539,456     51.9 %
                              

Fully-insured

     1,390,805       1,453,932       (63,127 )   (4.3 )%

Specialty

     108,081       101,333       6,748     6.7 %
                              

Total Commercial

     1,498,886       1,555,265       (56,379 )   (3.6 )%
                              

Total

   $ 6,004,563     $ 4,521,486     $ 1,483,077     32.8 %
                              

Administrative services fees:

        

Government

   $ 16,390     $ 11,191     $ 5,199     46.5 %

Commercial

     79,474       67,487       11,987     17.8 %
                              

Total

   $ 95,864     $ 78,678     $ 17,186     21.8 %
                              

Income before income taxes:

        

Government

   $ 17,865     $ 21,572     $ (3,707 )   (17.2 )%

Commercial

     94,356       109,636       (15,280 )   (13.9 )%
                              

Total

   $ 112,221     $ 131,208     $ (18,987 )   (14.5 )%
                              

Medical expense ratios (a):

        

Government

     89.3 %     85.6 %     3.7 %

Commercial

     79.4 %     80.1 %     (0.7 )%
                        

Total

     86.8 %     83.7 %     3.1 %
                        

SG&A expense ratios (b):

        

Government

     10.8 %     13.8 %     (3.0 )%

Commercial

     20.9 %     20.4 %     0.5 %
                        

Total

     13.5 %     16.1 %     (2.6 )%
                        

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

 

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Ending medical membership was as follows at March 31, 2007 and 2006:

 

     March 31,    Change  
     2007    2006    Members     Percentage  

Government segment medical members:

          

Medicare Advantage

   1,113,400    741,200    372,200     50.2 %

Medicare stand-alone PDP

   3,473,700    1,959,000    1,514,700     77.3 %
                      

Total Medicare

   4,587,100    2,700,200    1,886,900     69.9 %
                      

TRICARE

   1,712,900    1,724,700    (11,800 )   (0.7 )%

TRICARE ASO

   1,165,500    1,149,300    16,200     1.4 %
                      

Total TRICARE

   2,878,400    2,874,000    4,400     0.2 %
                      

Medicaid

   384,000    427,000    (43,000 )   (10.1 )%

Medicaid ASO

   175,400    —      175,400     100.0 %
                      

Total Medicaid

   559,400    427,000    132,400     31.0 %
                      

Total Government

   8,024,900    6,001,200    2,023,700     33.7 %
                      

Commercial segment medical members:

          

Fully-insured

   1,728,100    1,864,200    (136,100 )   (7.3 )%

ASO

   1,529,400    1,395,200    134,200     9.6 %
                      

Total Commercial

   3,257,500    3,259,400    (1,900 )   (0.1 )%
                      

Total medical membership

   11,282,400    9,260,600    2,021,800     21.8 %
                      

These tables of financial data should be reviewed in connection with the discussion that follows.

Summary

Net income was $71.2 million, or $0.42 per diluted common share, in the 2007 quarter compared to $83.7 million, or $0.50 per diluted common share, in the 2006 quarter. The 2006 quarter’s net income included $32.2 million, or $0.19 per diluted common share, from the sale of a venture capital investment. Excluding the venture capital gain, the increase in quarterly earnings resulted primarily from the higher operating earnings in our Commercial segment.

Premium Revenues and Medical Membership

Premium revenues increased 32.8% to $6.0 billion for the 2007 quarter, compared to $4.5 billion for the 2006 quarter. Higher Government segment premium revenues were partially offset by a decrease in Commercial segment premium revenues. 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.

Government segment premium revenues increased 51.9% to $4.5 billion for the 2007 quarter, compared to $3.0 billion for the 2006 quarter. This increase primarily was attributable to higher Medicare Advantage membership from the expanded participation in various Medicare products and geographic markets. Sales of our PFFS products drove the majority of the 50.2% increase in Medicare Advantage members since March 31, 2006. Additionally, our Medicare stand-alone PDP products added 1,514,700 members since March 31, 2006 and $391.3 million in premium revenues compared to the 2006 quarter. Average per member premiums for our Medicare Advantage business increased approximately 0.2% from the 2006 quarter to the 2007 quarter reflecting the shift in membership mix to a higher percentage of lower premium PFFS products. Medicaid membership increased by 132,400 members from March 31, 2006 to March 31, 2007 primarily due to the award of a new Puerto Rico regional ASO contract during the fourth quarter of 2006. The increase has been partially offset by eligible Puerto Rico Medicaid members choosing to move into the Medicare Advantage program.

Commercial segment premium revenues decreased 3.6% to $1.5 billion for the 2007 quarter. Lower premium revenues primarily resulted from a reduction of fully-insured membership partially offset by increases in average per member premiums. Our fully-insured membership decreased 7.3%, or 136,100 members, to 1,728,100 at March 31, 2007 compared to 1,864,200 at March 31, 2006 primarily due to continued attrition due to the ongoing competitive environment within the fully-insured group accounts, partially offset by membership gains in the individual and consumer-choice product lines. Average per member premiums for our fully-insured group medical members increased approximately 5% from the 2006 quarter to the 2007 quarter.

 

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Administrative Services Fees

Our administrative services fees for the 2007 quarter were $95.9 million, an increase of $17.2 million, or 21.8%, from $78.7 million for the 2006 quarter primarily due to increases in our Commercial segment administrative services fees.

For the Commercial segment, administrative services fees increased $12.0 million, or 17.8%, from $67.5 million for the 2006 quarter to $79.5 million for the 2007 quarter. This increase resulted from increased membership and higher average per member fees. ASO membership of 1,395,200 members at March 31, 2006 increased 9.6% to 1,529,400 at March 31, 2007. Average per member fees increased approximately 9.7% from the 2006 quarter to the 2007 quarter.

Investment Income

Investment income totaled $73.5 million for the 2007 quarter, a decrease of $25.4 million from $98.9 million for the 2006 quarter. The 2006 quarter amount included a $51.7 million gain realized related to the sale of a venture capital investment. Excluding the venture capital gain, investment income increased primarily due to higher average invested balances.

Other Revenue

Other revenue totaled $30.9 million for the 2007 quarter, an increase of $25.6 million from $5.3 million for 2006 quarter. The increase is primarily attributable to increased revenue from growth related to RightSource SM , our mail order pharmacy.

Medical Expense

Consolidated medical expenses increased $1.4 billion, or 37.8%, during the 2007 quarter compared to the 2006 quarter. The increase was primarily driven by the increase in the number of Medicare members and an increase in average per member claims costs primarily from the effects of health care inflation.

The consolidated MER for the 2007 quarter was 86.8%, which was 310 basis points higher than the 2006 quarter. The MER increase was due to a higher Government segment MER.

The Government segment’s medical expenses increased $1.5 billion, or 58.5% during the 2007 quarter compared to the 2006 quarter primarily due to an increase in the number of Medicare members.

The Government segment’s MER for the 2007 quarter was 89.3%, a 370 basis point increase from the 2006 quarter rate of 85.6%. The MER for the 2007 quarter included the combined effect of a seasonal pattern of higher medical expenses during the first quarter associated Part D benefits together with approximately twice the average stand-alone PDP membership for the 2007 quarter versus the 2006 quarter. The Part D benefit designs result in us sharing a greater portion of the responsibility for total pharmacy costs in the early stages of a member’s plan period and less in the later stages, resulting in a declining MER 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 Part D benefits. Following the reset of the benefit on January 1, 2007, we expect the total Medicare MER will decrease each quarter of 2007.

The Commercial segment’s medical expenses decreased $55.5 million, or 4.5% from the 2006 quarter to the 2007 quarter. 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 consistent with the increase in average per member premiums for the 2007 quarter and is expected to be in the range of 4.5% to 5.5% for the full year 2007.

The MER for the Commercial segment of 79.4% in the 2007 quarter decreased 70 basis points from the 2006 quarter MER of 80.1%. The decrease in MER for the 2007 quarter primarily reflects improving medical cost utilization trends and, to a lesser extent, an increase in the percentage of individual and small group members comprising our total fully-insured block. Individual and smaller group accounts generally carry a lower MER than larger group accounts.

SG&A Expense

Consolidated selling, general, and administrative (SG&A) expenses increased $79.7 million or 10.8% during the 2007 quarter compared to the 2006 quarter primarily resulting from an increase in the number of employees and an increase in sales and marketing costs due to the Medicare expansion, as well as expenses associated with RightSource SM , our mail order pharmacy.

The consolidated SG&A expense ratio for the 2007 quarter was 13.5%, decreasing 260 basis points from 16.1% for the 2006 quarter. The SG&A expense ratio decrease resulted from growth in revenues from higher average medical membership outpacing the related increase in administrative spending. The consolidated SG&A expense ratio is expected to be in the range of 13% to 14% for the full year 2007.

 

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Our Government and Commercial segments bear direct and indirect overhead SG&A expenses. We allocate 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 $80.2 million, or 19.6% during the 2007 quarter compared to the 2006 quarter. The Government segment SG&A expense ratio decreased 300 basis points from 13.8% for the 2006 quarter to 10.8% for the 2007 quarter. These changes resulted from growth in revenues from higher average Medicare Advantage membership outpacing the related increase in administrative spending.

The Commercial segment SG&A expenses decreased $0.5 million, or 0.1% during the first quarter of 2007 compared to the same period in 2006. The Commercial segment SG&A expense ratio increased 50 basis points from 20.4% for the 2006 quarter to 20.9% for the 2007 quarter. This increase primarily resulted from the continued shift in the mix of membership towards ASO and an increase in the percentage of individual and small group members comprising our fully-insured membership. This increase was partially offset by the benefit of the Commercial segment bearing a smaller share of overhead expenses due to the Government segment’s growth in revenues. At March 31, 2007, 47.0% of our Commercial segment membership was related to ASO business compared to 42.8% at March 31, 2006. Likewise, 29.0% of our Commercial segment membership was related to individual and small group accounts compared to 27.1% at March 31, 2006. ASO business carries a significantly higher SG&A ratio than fully-insured business, and individual and small group accounts bear a higher SG&A ratio as compared to larger accounts.

Depreciation and Amortization

Depreciation and amortization for the 2007 quarter totaled $40.1 million compared to $34.9 million for the 2006 quarter, an increase of $5.2 million, or 14.9%. The increase resulted primarily from capital expenditures related to the Medicare expansion.

Interest Expense

Interest expense was $17.9 million for the 2007 quarter, compared to $13.4 million for the 2006 quarter, an increase of $4.5 million. This increase primarily resulted from higher average outstanding debt.

Income Taxes

Our effective tax rate during the first quarter of 2007 of 36.5% increased 0.3% compared to the 36.2% effective tax rate in the 2006 quarter.

 

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Membership

The following table presents our medical and specialty membership at March 31, 2007, and at the end of each quarter in 2006:

 

     2007    2006
     March 31    Dec. 31    Sept. 30    June 30    March 31

Medical Membership:

              

Government segment:

              

Medicare Advantage

   1,113,400    1,002,600    993,000    959,800    741,200

Medicare stand-alone PDP

   3,473,700    3,536,600    3,521,000    3,458,800    1,959,000
                        

Total Medicare

   4,587,100    4,539,200    4,514,000    4,418,600    2,700,200
                        

TRICARE

   1,712,900    1,716,400    1,721,300    1,732,600    1,724,700

TRICARE ASO

   1,165,500    1,163,600    1,141,400    1,141,900    1,149,300
                        

Total TRICARE

   2,878,400    2,880,000    2,862,700    2,874,500    2,874,000
                        

Medicaid

   384,000    390,700    412,600    418,500    427,000

Medicaid ASO

   175,400    178,400    —      —      —  
                        

Total Medicaid

   559,400    569,100    412,600    418,500    427,000
                        

Total Government

   8,024,900    7,988,300    7,789,300    7,711,600    6,001,200
                        

Commercial segment:

              

Fully-insured

   1,728,100    1,754,200    1,779,900    1,893,100    1,864,200

ASO

   1,529,400    1,529,600    1,512,000    1,420,800    1,395,200
                        

Total Commercial

   3,257,500    3,283,800    3,291,900    3,313,900    3,259,400
                        

Total medical members

   11,282,400    11,272,100    11,081,200    11,025,500    9,260,600
                        

Specialty Membership:

              

Commercial segment

   1,935,200    1,902,800    1,899,700    1,894,900    1,882,300
                        

Liquidity

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

Cash and cash equivalents increased to $3,694.1 million at March 31, 2007 from $1,740.3 million at December 31, 2006. The increase in cash and cash equivalents primarily was due to the early receipt of the April Medicare premium remittance and an increase in operating cash flows. The early receipt of the April Medicare premium remittance also resulted in an increase to unearned revenue in our condensed consolidated balance sheet at March 31, 2007. The change in cash and cash equivalents for the three months ended March 31, 2007 and 2006 is summarized as follows:

 

     2007     2006  
     (in thousands)  

Net cash provided by operating activities

   $ 1,574,481     $ 1,007,973  

Net cash used in investing activities

     (440,315 )     (439,668 )

Net cash provided by financing activities

     819,589       543,084  
                

Increase in cash and cash equivalents

   $ 1,953,755     $ 1,111,389  
                

 

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Cash Flow from Operating Activities

Our operating cash flows for the 2007 and 2006 quarters were significantly impacted by the timing of the Medicare premium remittance which is payable to us on the first day of each month. Generally, when the first day of a month falls on a weekend or holiday, with the exception of January 1 (New Year’s Day), we receive this payment at the end of the previous month. As such, Medicare receipts for April 2007 of $1,129.8 million and April 2006 of $774.7 million were received in the first quarter of 2007 and 2006 (late March in each case) because April 1 fell on a weekend in both 2007 and 2006.

In addition to the impact from the timing of the Medicare premium receipts, operating cash flows improved due to Medicare enrollment growth and improved earnings after adjusting for the venture capital gain in the 2006 quarter. Our Medicare Part D results related to both stand-alone PDP and Medicare Advantage offerings reflect provisions for net amounts payable to CMS of $739.6 million for the 2006 contract year and $47.4 million for the 2007 contract year under the risk corridor terms of our contracts with CMS. The risk corridor amounts generally are expected to be settled with CMS in the subsequent year during the third or fourth quarter. For example, the $739.6 million risk corridor payable amount associated with the 2006 contract year is expected to be settled during the fourth quarter of 2007.

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

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

 

    

March 31,

2007

   

December 31,

2006

    Change  
     (in thousands)  

TRICARE:

      

Base receivable

   $ 500,156     $ 452,509     $ 47,647  

Change orders

     6,786       4,247       2,539  
                        

TRICARE subtotal

     506,942       456,756       50,186  

Medicare

     237,316       143,875       93,441  

Commercial and other

     145,175       125,899       19,276  

Allowance for doubtful accounts

     (52,313 )     (45,589 )     (6,724 )
                        

Total net receivables

   $ 837,120     $ 680,941     $ 156,179  
                        

TRICARE base receivables consist of estimated amounts owed from the federal government for claims incurred including claims incurred but not reported, or IBNR, and underwriting fees. The claim reimbursement component of TRICARE base receivables is generally collected over a three to four month period. The $47.6 million increase in base receivables primarily resulted from an increase in the estimated amount owed from the federal government for claims incurred and is consistent with the increase in TRICARE claims payable reported in the next section.

The $93.4 million increase in Medicare receivables as of March 31, 2007 as compared to December 31, 2006 primarily resulted from an increase in receivables associated with CMS’s risk adjustment model.

The detail of medical and other expenses payable was as follows at March 31, 2007 and December 31, 2006:

 

    

March 31,

2007

  

December 31,

2006

   Change
     (in thousands)

IBNR (1)

   $ 1,839,101    $ 1,678,052    $ 161,049

TRICARE claims payable (2)

     470,334      430,674      39,660

Reported claims in process (3)

     124,688      98,033      26,655

Other medical expenses payable (4)

     452,091      281,502      170,589
                    

Total medical and other expenses payable

   $ 2,886,214    $ 2,488,261    $ 397,953
                    

(1) IBNR represents an estimate of medical expenses payable for claims incurred but not reported (IBNR) at the balance sheet date. The level of IBNR is primarily impacted by membership levels, medical claim trends and the receipt cycle time, which represents the length of time between when a claim is initially incurred and when the claim form is received (i.e. a shorter time span results in a lower IBNR).

 

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(2) TRICARE claims payable includes all claim activity associated with TRICARE, including IBNR and payables for sharing risk with the federal government for cost overruns.
(3) Reported claims in process represents the estimated valuation of processed claims that are in the post claim adjudication process, which consists of administrative functions such as audit and check batching and handling.
(4) Other medical expenses payable includes capitation and pharmacy payables. The balance due to our pharmacy benefit administrator fluctuates due to bi-weekly payments and the month-end cutoff.

Medical and other expenses payable primarily increased during the 2007 quarter due to growth in Medicare membership, the timing of pharmacy payables, and to a lesser extent medical claims inflation.

Cash Flow from Investing Activities

We reinvested a portion of our operating cash flows in investment securities, primarily short-duration fixed income securities, totaling $74.3 million in the 2007 quarter. Our ongoing capital expenditures primarily relate to our information technology initiatives and administrative facilities necessary for activities such as claims processing, billing and collections, medical utilization review, and customer service. Total capital expenditures, excluding acquisitions, were $70.7 million in the 2007 quarter compared to $45.3 million in the same period in 2006. The increased spending in the 2007 quarter primarily resulted from the purchase of three medical centers for approximately $20.4 million in South Florida that were previously leased. During the 2007 quarter, we paid $26.7 million to acquire DefenseWeb, net of $1.6 million of cash acquired, and $1.7 million to settle the purchase price contingencies associated with prior year acquisitions. Excluding acquisitions, we expect our total capital expenditures in 2007 to approximate $200 million.

Cash Flow from Financing Activities

Net borrowings under our credit agreement increased $60.0 million in the 2007 quarter and $100.0 million in the 2006 quarter primarily related to funding additional capital into certain subsidiaries in conjunction with the growth in Medicare revenues.

Receipts from CMS associated with Medicare Part D subsidized claims for which we do not assume risk were $327.9 million and $220.8 million more than claim payments during the 2007 and 2006 quarters, respectively.

The remainder of the cash provided by financing activities in the 2007 and 2006 quarters resulted primarily from the change in the securities lending payable, proceeds from stock option exercises, the tax benefit from stock compensation, and the change in book overdraft.

Senior Notes

We previously issued in the public debt capital markets, $300 million aggregate principal amount of 6.30% senior unsecured notes that mature on August 1, 2018 and $500 million aggregate principal amount of 6.45% senior unsecured notes that mature on June 1, 2016. We have entered into interest rate swap agreements to exchange the fixed interest rate under these senior notes for a variable interest rate based on LIBOR.

Credit Agreement

Our 5-year $1.0 billion unsecured revolving credit agreement expires in July 2011. Under the credit agreement, at our option, we can borrow on either a competitive advance basis or a revolving credit basis. The revolving credit portion bears interest at either a fixed rate or floating rate based on LIBOR plus a spread. The spread, which varies depending on our credit ratings, ranges from 27 to 80 basis points. We also pay an annual facility fee regardless of utilization. This facility fee, currently 10 basis points, may fluctuate between 8 and 20 basis points, depending upon our credit ratings. In addition, a utilization fee of 10 basis points is payable for any day in which borrowings under the facility exceed 50% of the total $1 billion commitment. The competitive advance portion of any borrowings will bear interest at market rates prevailing at the time of borrowing on either a fixed rate or a floating rate basis, at our option.

The credit agreement contains customary restrictive and financial covenants as well as customary events of default, including financial covenants regarding the maintenance of a minimum level of net worth and a maximum leverage ratio. The terms of the credit agreement also include standard provisions related to conditions of borrowing, including a customary material adverse effect clause which could limit our ability to borrow additional funds. We have not experienced a material adverse effect and we know of no circumstances or events which would be reasonably likely to result in a material adverse effect. At this time, we do not believe the material adverse effect clause poses a material funding risk to us.

At March 31, 2007, we had $510.0 million of borrowings under the credit agreement outstanding at an interest rate of 5.7%. In addition, we have outstanding letters of credit of $4.0 million secured under the credit agreement.

 

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No amounts have ever been drawn on these letters of credit. As of March 31, 2007, we had $486.0 million of remaining borrowing capacity under the credit agreement. We have other customary, arm’s-length relationships, including financial advisory and banking, with some parties to the credit agreement.

Other Long-Term Borrowings

Other long-term borrowings of $2.9 million at March 31, 2007 represent financing for the renovation of a building, bear interest at 2% per annum, are collateralized by the building, and are payable in various installments through 2014.

Shelf Registration

We filed a universal shelf registration statement with the SEC which allows us to sell our debt or equity securities, from time to time, with the amount, price and terms to be determined at the time of the sale. The net proceeds from any future sales of our securities under the universal shelf registration may be used for our operations and for other general corporate purposes, including repayment or refinancing of borrowings, working capital, capital expenditures, investments, acquisitions, or the repurchase of our outstanding securities.

Liquidity Requirements

We believe our cash balances, investment securities, operating cash flows, access to debt and equity markets and borrowing capacity, taken together, provide adequate resources to fund ongoing operating and regulatory requirements, to fund future expansion opportunities and capital expenditures in the foreseeable future, and to refinance debt as it matures.

Regulatory Requirements

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.

As of March 31, 2007, we maintained aggregate statutory capital and surplus of $2,353.5 million in our state regulated subsidiaries. Each of these subsidiaries was in compliance with applicable statutory requirements which aggregated to $1,625.9 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 2007, capital requirements will increase. We expect to fund these increased requirements with capital contributions from Humana Inc., our parent company, in the range of $325 million to $425 million for the full year 2007.

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 March 31, 2007, each of our subsidiaries would be in substantial compliance and we would have $647.9 million of aggregate capital and surplus above any of the levels that require corrective action under RBC, or individual state requirements.

 

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Item 3. Quantitative and Qualitative Disclosure about Market Risk

No material changes have occurred in our exposures to market risk since the date of our Annual Report on Form 10-K for the fiscal year ended December 31, 2006.

 

Item 4. Controls and Procedures

Under the supervision and with the participation of our Chief Executive Officer, or CEO, our Chief Financial Officer, or CFO, and our Principal Accounting Officer, we carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures for the quarter ended March 31, 2007.

Based on our evaluation, our CEO, CFO and Principal Accounting Officer concluded that our disclosure controls and procedures are effective, at a reasonable assurance level, in timely alerting them to material information required to be included in our periodic SEC reports.

There have been no significant changes in the Company’s internal control over financial reporting that occurred during the Company’s last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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Part II. Other Information

 

Item 1:   Legal Proceedings
  For a description of the litigation and legal proceedings pending against us, see “Legal Proceedings” in Note 9 to the condensed consolidated financial statements beginning on page 10 of this Form 10-Q.
Item 1A.   Risk Factors
  The Risk Factors included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006 as filed with the SEC on February 23, 2007 have not materially changed. Some of the risks which may be relevant to us could include:

 

   

if the premiums we charge are insufficient to cover the cost of health care services delivered to our members, or if our medical expense trends are higher than the level contemplated in our premiums, our profitability could decline;

 

   

if we do not design and price our products properly and competitively, our membership and profitability could decline;

 

   

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

 

   

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;

 

   

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

 

   

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;

 

   

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;

 

   

any failure to manage administrative costs could hamper profitability;

 

   

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

 

   

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

 

   

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

 

   

our ability to obtain funds from our subsidiaries is restricted;

 

   

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

 

   

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

This list of important factors is not intended to be exhaustive. A further list and description of some of these risks and uncertainties can be found in our reports filed with the SEC from time to time, including our annual reports on Form 10-K and quarterly reports on Form 10-Q. Any or all forward-looking statements we make may turn out to be wrong. You should not place undue reliance on forward-looking statements, which speak only as of the date they are made. Except to the extent otherwise required by federal securities laws, we do not undertake to publicly update or revise any forward-looking statements.

 

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Item 2: Unregistered Sales of Equity Securities and Use of Proceeds

None.

 

Item 3: Defaults Upon Senior Securities

None.

 

Item 4: Submission of Matters to a Vote of Security Holders

 

  (a) The regular annual meeting of the stockholders of Humana Inc. was held in Louisville, Kentucky on April 26, 2007, for the purpose of voting on the proposals described in clause (c) below.

 

  (b) Proxies for the meeting were solicited pursuant to Section 14(a) of the Securities Exchange Act of 1934 and there was no solicitation in opposition to management’s nominees for directors. All of management’s nominees for directors were elected as set forth in clause (c) below.

 

  (c) Two proposals were submitted to a vote of security holders as follows:

 

  (1) The stockholders approved the election of the following persons as directors of the Company:

 

Name

   For    Against    Abstain

David A. Jones, Jr.

   147,483,329    2,728,144    888,934

Frank A. D’Amelio

   148,304,972    1,823,575    971,858

W. Roy Dunbar

   149,772,220    354,301    973,885

Kurt J. Hilzinger

   149,002,692    1,126,696    971,018

Michael B. McCallister

   147,569,571    2,674,945    855,889

James J. O’Brien

   149,780,254    370,173    949,979

W. Ann Reynolds, Ph.D.

   142,481,368    7,524,650    1,094,387

James O. Robbins

   149,738,806    403,611    957,988

(2)    The stockholders approved the appointment of PricewaterhouseCoopers LLC as the Company’s independent registered public accounting firm for the year ended December 31, 2007. This proposal received votes as follows:

     For    Against    Abstain
   147,299,019    2,880,344    921,042

 

Item 5: Other Information

None.

 

Item 6: Exhibits

 

12

   Computation of ratio of earnings to fixed charges.

31.1

   CEO certification pursuant to Section 302 of Sarbanes–Oxley Act of 2002.

31.2

   CFO certification pursuant to Section 302 of Sarbanes–Oxley Act of 2002.

32

   CEO and CFO certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

       

HUMANA INC.

(Registrant)

Date:   May 3, 2007   By:  

/S/ STEVEN E. MCCULLEY

      Steven E. McCulley
      Vice President and Controller
      (Principal Accounting Officer)
Date:   May 3, 2007   By:  

/S/ ARTHUR P. HIPWELL

      Arthur P. Hipwell
      Senior Vice President

 

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