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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 September 30, 2004

 

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 an accelerated filer (as defined in Rule 12b-2 of the Act).    Yes  x     No  ¨

 

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 October 31, 2004


$0.16 2/3 par value   159,407,737 shares

 



Table of Contents

Humana Inc.

FORM 10-Q

SEPTEMBER 30, 2004

 

INDEX

 

          Page

     Part I: Financial Information     

Item 1.

  

Financial Statements

    
    

Condensed Consolidated Balance Sheets at September 30, 2004 and December 31, 2003

   3
    

Condensed Consolidated Statements of Income for the three and nine months ended September 30, 2004 and 2003

   4
    

Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2003

   5
    

Notes to Condensed Consolidated Financial Statements

   6

Item 2.

  

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

   18

Item 3.

  

Quantitative and Qualitative Disclosures about Market Risk

   37

Item 4.

  

Controls and Procedures

   37
     Part II: Other Information     

Item 1.

  

Legal Proceedings

   38

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

   38

Item 6.

  

Exhibits

   38
    

Signatures and Certifications

   40

 

2


Table of Contents

Item 1. Financial Statements

 

Humana Inc.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

     September 30,
2004


   

December 31,

2003


 
     (in thousands, except share amounts)  

ASSETS

                

Current assets:

                

Cash and cash equivalents

   $ 375,090     $ 931,404  

Investment securities

     2,332,522       1,676,642  

Receivables, less allowance for doubtful accounts of $29,475 at September 30, 2004 and $40,400 at December 31, 2003:

                

Premiums

     405,067       452,404  

Administrative services fees

     19,803       13,583  

Other

     273,240       247,298  
    


 


Total current assets

     3,405,722       3,321,331  
    


 


Property and equipment, net

     390,735       416,472  

Other assets:

                

Long-term investment securities

     333,796       319,167  

Goodwill

     859,734       776,874  

Other

     421,623       459,479  
    


 


Total other assets

     1,615,153       1,555,520  
    


 


Total assets

   $ 5,411,610     $ 5,293,323  
    


 


LIABILITIES AND STOCKHOLDERS’ EQUITY

                

Current liabilities:

                

Medical and other expenses payable

   $ 1,436,135     $ 1,272,156  

Trade accounts payable and accrued expenses

     504,892       440,340  

Book overdraft

     116,106       219,054  

Unearned revenues

     132,659       333,071  
    


 


Total current liabilities

     2,189,792       2,264,621  

Long-term debt

     630,912       642,638  

Other long-term liabilities

     568,911       550,115  
    


 


Total liabilities

     3,389,615       3,457,374  
    


 


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; 175,062,193 shares issued at September 30, 2004 and 173,909,127 shares issued at December 31, 2003

     29,177       28,984  

Capital in excess of par value

     994,975       974,975  

Retained earnings

     1,182,697       949,811  

Accumulated other comprehensive income

     13,797       16,909  

Unearned stock compensation

     (203 )     (754 )

Treasury stock, at cost, 15,689,251 shares at September 30, 2004 and 12,018,281 shares at December 31, 2003

     (198,448 )     (133,976 )
    


 


Total stockholders’ equity

     2,021,995       1,835,949  
    


 


Total liabilities and stockholders’ equity

   $ 5,411,610     $ 5,293,323  
    


 


 

See accompanying notes to condensed consolidated financial statements.

 

3


Table of Contents

Humana Inc.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

 

     Three months ended
September 30,


   Nine months ended
September 30,


     2004

   2003

   2004

   2003

     (in thousands, except per share results)

Revenues:

                           

Premiums

   $ 3,083,554    $ 3,016,298    $ 9,566,447    $ 8,772,652

Administrative services fees

     59,837      66,984      219,420      199,788

Investment and other income

     32,882      28,483      108,833      100,999
    

  

  

  

Total revenues

     3,176,273      3,111,765      9,894,700      9,073,439
    

  

  

  

Operating expenses:

                           

Medical

     2,550,911      2,528,123      8,024,167      7,344,534

Selling, general and administrative

     460,171      458,381      1,416,695      1,371,196

Depreciation and amortization

     31,238      27,112      84,715      100,232
    

  

  

  

Total operating expenses

     3,042,320      3,013,616      9,525,577      8,815,962
    

  

  

  

Income from operations

     133,953      98,149      369,123      257,477

Interest expense

     6,480      4,737      16,524      12,473
    

  

  

  

Income before income taxes

     127,473      93,412      352,599      245,004

Provision for income taxes

     43,170      31,293      119,713      82,379
    

  

  

  

Net income

   $ 84,303    $ 62,119    $ 232,886    $ 162,625
    

  

  

  

Basic earnings per common share

   $ 0.53    $ 0.39    $ 1.45    $ 1.03
    

  

  

  

Diluted earnings per common share

   $ 0.52    $ 0.38    $ 1.43    $ 1.01
    

  

  

  

 

See accompanying notes to condensed consolidated financial statements.

 

4


Table of Contents

Humana Inc.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

     For the nine months ended
September 30,


 
     2004

    2003

 
     (in thousands)  

Cash flows from operating activities

                

Net income

   $ 232,886     $ 162,625  

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

                

Writedown of property and equipment

     —         17,233  

Depreciation and amortization

     84,715       100,232  

Provision for deferred income taxes

     27,545       30,213  

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

                

Receivables

     106,709       13,516  

Other assets

     (18,776 )     42,435  

Medical and other expenses payable

     92,916       154,435  

Other liabilities

     26,675       (151,363 )

Unearned revenues

     (204,426 )     (227,596 )

Other, net

     (19,920 )     (18,810 )
    


 


Net cash provided by operating activities

     328,324       122,920  
    


 


Cash flows from investing activities

                

Acquisition, net of cash and cash equivalents acquired

     (115,972 )     —    

Purchases of property and equipment

     (72,900 )     (64,980 )

Proceeds from sales of property and equipment

     28,972       2,483  

Purchases of investment securities

     (3,614,781 )     (3,659,394 )

Maturities of investment securities

     840,275       585,461  

Proceeds from sales of investment securities

     2,203,853       2,768,446  
    


 


Net cash used in investing activities

     (730,553 )     (367,984 )
    


 


Cash flows from financing activities

                

Net commercial paper conduit repayments

     —         (265,000 )

Proceeds from issuance of senior notes

     —         299,139  

Common stock repurchases

     (64,472 )     (44,147 )

Proceeds from swap exchange

     —         31,556  

Change in book overdraft

     (102,948 )     123,869  

Proceeds from stock option exercises and other

     13,335       14,127  
    


 


Net cash (used in) provided by financing activities

     (154,085 )     159,544  
    


 


Decrease in cash and cash equivalents

     (556,314 )     (85,520 )

Cash and cash equivalents at beginning of period

     931,404       721,357  
    


 


Cash and cash equivalents at end of period

   $ 375,090     $ 635,837  
    


 


Supplemental cash flow disclosures:

                

Interest payments

   $ 22,663     $ 11,324  

Income tax payments, net

   $ 44,922     $ 43,335  

 

See accompanying notes to condensed consolidated financial statements.

 

5


Table of Contents

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. References throughout this document to “we,” “us,” “our,” the “Company,” and “Humana,” mean Humana Inc. and all entities we own. For further information, the reader of this Form 10-Q should refer to our Form 10-K for the year ended December 31, 2003, that was filed with the Securities and Exchange Commission, or the SEC, on March 5, 2004.

 

The preparation of our condensed consolidated financial statements, in conformity 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 recognition of revenue related to our TRICARE contracts, the valuation and related impairment recognition of investment securities, and the valuation and related impairment recognition of long-lived assets, including goodwill. Although our estimates are based on knowledge of current events and anticipated future events, actual results may ultimately differ materially from those estimates. Refer to “Critical Accounting Policies and Estimates” in Humana’s 2003 Annual Report on Form 10-K for information on accounting policies that the Company considers critical 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) Significant Accounting Policies

 

Stock-Based Compensation

 

We have stock-based employee compensation plans, which are described more fully in Note 10 to the consolidated financial statements in Humana’s 2003 Annual Report on Form 10-K. We account for our stock option plans under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations, or APB No. 25. No employee compensation cost is reflected in net income related to fixed-based stock option awards because these options had an exercise price equal to the market value of the underlying common stock on the date of grant. Generally, if a fixed-based stock option award is subsequently modified, compensation expense, if any, is recorded for the amount that the market price of Humana common stock exceeds the option’s exercise price on the date the option is modified. Compensation expense is recorded for restricted stock grants over their vesting periods based on fair value, which is equal to the market price of Humana common stock on the date of the grant.

 

6


Table of Contents

Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

 

The effect on net income and earnings per share if we had applied the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, to our fixed-based stock option and restricted stock awards was as follows for the three and nine months ended September 30, 2004 and 2003.

 

     Three months ended
September 30,


    Nine months ended
September 30,


 
     2004

    2003

    2004

    2003

 
     (in thousands, except per share results)  

Net income, as reported

   $ 84,303     $ 62,119     $ 232,886     $ 162,625  

Add: Stock-based employee compensation expense included in reported net income, net of related tax

     591       644       1,463       3,448  

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax

     (3,664 )     (1,925 )     (9,926 )     (7,085 )
    


 


 


 


Adjusted net income

   $ 81,230     $ 60,838     $ 224,423     $ 158,988  
    


 


 


 


Earnings per share:

                                

Basic, as reported

   $ 0.53     $ 0.39     $ 1.45     $ 1.03  
    


 


 


 


Basic, pro forma

   $ 0.51     $ 0.38     $ 1.40     $ 1.00  
    


 


 


 


Diluted, as reported

   $ 0.52     $ 0.38     $ 1.43     $ 1.01  
    


 


 


 


Diluted, pro forma

   $ 0.50     $ 0.37     $ 1.38     $ 0.99  
    


 


 


 


 

New Accounting Standards

 

In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB 51, or FIN 46. The primary objectives of FIN 46 are to provide guidance on the identification of entities for which control is achieved through means other than through voting rights (variable interest entities, or VIEs) and how to determine when and which business enterprise should consolidate the VIE (the primary beneficiary). In December 2003, the FASB issued FIN 46-R, Consolidation of Variable Interest Entities — an interpretation of ARB 51 (revised December 2003), which amended certain provisions of FIN 46 and delayed implementation for entities that are not considered special purpose entities until the first quarter of 2004. The adoption of FIN 46 and FIN 46-R did not have a material impact on our financial position, results of operations, or cash flows.

 

7


Table of Contents

Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

 

(3) Acquisition

 

On April 1, 2004, we acquired Ochsner Health Plan, or Ochsner, from the Ochsner Clinic Foundation. Ochsner, a Louisiana health plan, added approximately 152,600 Commercial medical members, primarily in fully insured large group accounts, and approximately 33,100 members in the MedicareAdvantage program. This acquisition enabled us to enter a new market with significant market share which should facilitate new sales opportunities in this and surrounding markets, including Houston, Texas.

 

We paid $131.3 million in cash, including transaction costs. Our estimate of the fair value of the tangible assets(liabilities) as of the acquisition date is as follows:

 

     (in thousands)

 

Cash and cash equivalents

   $ 15,270  

Investment securities

     84,527  

Premiums receivable and other current assets

     20,616  

Property and equipment and other assets

     1,085  

Medical and other expenses payable

     (71,063 )

Other current liabilities

     (21,604 )

Other liabilities

     (3,183 )
    


Net tangible assets acquired

   $ 25,648  
    


 

The purchase price exceeded the estimated fair value of the net tangible assets acquired by approximately $105.7 million. We allocated the excess purchase price over the fair value of the net tangible assets acquired to other intangible assets, estimated at $22.8 million, and goodwill, estimated at $82.9 million. The other intangible assets, which consist primarily of subscriber and provider contracts, have a weighted-average useful life of approximately 13 years. The other intangible assets and goodwill are not deductible for income tax purposes. We used an independent third party valuation specialist firm to assist us in evaluating the fair value of assets acquired.

 

The purchase price is subject to adjustment in accordance with the terms and conditions of the purchase agreement. As early as the fourth quarter of 2004, the purchase price will be adjusted to reflect changes in net equity from the amount estimated as of the date the purchase agreement was signed in December 2003 until the transaction closed on April 1, 2004, giving effect for items such as higher cash balances from earnings and changes in Ochsner’s ultimate claims liability as of April 1, 2004 using claims paid data during a six month run-out period. The amount of this purchase price adjustment will be allocated to goodwill and is the final adjustment contemplated by the Ochsner acquisition agreement.

 

The results of operations and financial condition of Ochsner have been included in our condensed consolidated statements of income and condensed consolidated balance sheets since the acquisition date. The pro forma financial information presented below assumes that the acquisition of Ochsner had occurred as of the beginning of each respective period. The pro forma adjustments include the pro forma effect of amortization of other intangible assets arising from the purchase price allocation and interest expense related to the assumed financing of the cash purchase price and the associated income tax effects of the pro forma adjustments. The pro forma results have been prepared for comparative purposes only and do not purport to be indicative of the results of operations that would have occurred had the Ochsner acquisition been consummated at the beginning of the respective periods.

 

    

For the three
months ended
September 30,

2003


   For the nine months ended
September 30,


        2004

   2003

     (in thousands)

Revenues

   $ 3,287,972    $ 10,080,706    $ 9,598,593

Net income

   $ 64,167    $ 238,627    $ 167,815

Earnings per share:

                    

Basic

   $ 0.40    $ 1.48    $ 1.06

Diluted

   $ 0.39    $ 1.47    $ 1.04

 

8


Table of Contents

Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

 

(4) Long-lived Asset Impairment

 

A decision to close the Jacksonville, Florida customer service center prompted a review for the possible impairment of long-lived assets associated with this center. Under a transition plan, we continued to use the long-lived assets of the Jacksonville customer service center until mid-2003, the completion date for consolidating this customer service center. The long-lived assets of this customer service center were supported by the future cash flows expected to result from members serviced by that center. Cash flows from members serviced by the center represented the lowest level of independently identifiable cash flows. For example, cash flows from members located primarily in the state of Florida and serviced by the Jacksonville service center supported the Jacksonville center’s long-lived assets until those members’ service was transitioned elsewhere.

 

Our impairment review during the first quarter of 2003 indicated that estimated undiscounted cash flows expected to result from the remaining use of the Jacksonville, Florida customer service center long-lived assets, primarily a building, were insufficient to recover their carrying value. Accordingly, we reduced the carrying value of these long-lived assets to their estimated fair value resulting in non-cash impairment expenses of $17.2 million ($10.5 million after tax) during the first quarter of 2003.

 

We used an independent third party appraisal to assist us in evaluating the fair value of the building. The non-cash impairment expenses are included with selling, general and administrative expenses in the accompanying condensed consolidated statements of income.

 

Based upon our decision to sell the building previously used in our Jacksonville customer service operations, we classified it as held for sale and ceased depreciating the building effective July 1, 2003. The impact of ceasing depreciation of the building was not material to our results of operations. During the first quarter of 2004, we completed the sale of the Jacksonville building, recording proceeds of $14.8 million and a pretax loss of $0.2 million.

 

Accelerated Depreciation

 

After finalizing plans during the first quarter of 2003 to abandon software used in our operations by March 2003, we reduced the estimated useful life of the software effective January 1, 2003. Accordingly, we accelerated the depreciation of the remaining software balance of approximately $13.5 million ($8.3 million after tax) during the first quarter of 2003.

 

After finalizing plans during the third quarter of 2004 to abandon some enrollment software by December 31, 2004, we reduced the estimated useful life of the software effective July 1, 2004. Accordingly, we accelerated the depreciation of the remaining software balance. The change in the useful life increased depreciation expense during the third quarter of 2004 by approximately $4.0 million ($2.4 million after tax) and will increase depreciation expense for the full year 2004 by approximately $9.3 million ($5.7 million after tax).

 

The allocation of the non-cash pretax expenses related to the writedown and accelerated depreciation of certain long-lived assets to our Commercial and Government segments was as follows for the nine months ended September 30, 2004 and 2003:

 

     Nine months ended September 30, 2004

     Commercial

   Government

   Total

     (in thousands)

Line item affected:

                    

Depreciation and amortization

   $ 3,990    $ —      $ 3,990
    

  

  

Total pretax impact

   $ 3,990    $ —      $ 3,990
    

  

  

     Nine months ended September 30, 2003

     Commercial

   Government

   Total

     (in thousands)

Line item affected:

                    

Selling, general and administrative

   $ 4,325    $ 12,908    $ 17,233

Depreciation and amortization

     13,527      —        13,527
    

  

  

Total pretax impact

   $ 17,852    $ 12,908    $ 30,760
    

  

  

 

9


Table of Contents

Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

 

(5) Goodwill and Other Intangible Assets

 

Changes in the carrying amount of goodwill, by operating segment, for the nine months ended September 30, 2004 were as follows:

 

     Commercial

   Government

   Total

     (in thousands)

Balance at December 31, 2003

   $ 633,211    $ 143,663    $ 776,874

Ochsner acquisition

     49,716      33,144      82,860
    

  

  

Balance at September 30, 2004

   $ 682,927    $ 176,807    $ 859,734
    

  

  

 

Other intangible assets primarily relate to acquired subscriber, provider, and government contracts, and the cost of acquired licenses and are included with other long-term assets in the condensed consolidated balance sheets. Amortization expense for other intangible assets was approximately $8.1 million for the nine months ended September 30, 2004 and $9.2 million for the nine months ended September 30, 2003. The following table presents our estimate of amortization expense for the remaining three months of 2004, and for each of the five succeeding fiscal years:

 

     (in thousands)

For the three month period ending December 31, 2004

   $ 2,438

For the years ending December 31,:

      

2005

   $ 7,368

2006

   $ 2,092

2007

   $ 2,030

2008

   $ 1,905

2009

   $ 1,893

 

The following table presents details of our other intangible assets included in other non-current assets in the accompanying condensed consolidated balance sheets at September 30, 2004 and December 31, 2003:

 

     September 30, 2004

   December 31, 2003

     Cost

   Accumulated
Amortization


   Net

   Cost

   Accumulated
Amortization


   Net

     (in thousands)

Other intangible assets:

                                         

Subscriber contracts

   $ 97,256    $ 80,804    $ 16,452    $ 85,496    $ 75,194    $ 10,302

Provider contracts

     22,428      10,242      12,186      12,128      8,075      4,053

Government contracts

     —        —        —        11,820      11,820      —  

Licenses and other

     5,790      1,668      4,122      5,065      1,376      3,689
    

  

  

  

  

  

Total other intangible assets

   $ 125,474    $ 92,714    $ 32,760    $ 114,509    $ 96,465    $ 18,044
    

  

  

  

  

  

 

(6) Comprehensive Income

 

The following table presents details supporting the computation of comprehensive income for the three and nine months ended September 30, 2004 and 2003:

 

     Three months ended
September 30,


    Nine months ended
September 30,


 
     2004

   2003

    2004

    2003

 
     (in thousands)  

Net income

   $ 84,303    $ 62,119     $ 232,886     $ 162,625  

Net unrealized investment gains (losses), net of tax

     30,553      (9,753 )     (3,112 )     (2,369 )
    

  


 


 


Comprehensive income, net of tax

   $ 114,856    $ 52,366     $ 229,774     $ 160,256  
    

  


 


 


 

10


Table of Contents

Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

 

(7) Earnings Per Common Share

 

We compute basic earnings per common share on the basis of the weighted average number of unrestricted common shares outstanding. Diluted earnings per common share is computed on the basis of the weighted average number of unrestricted common shares outstanding plus the dilutive effect of outstanding employee stock options and restricted shares using the treasury stock method. There were no adjustments required to be made to net income for purposes of computing basic or diluted earnings per common share.

 

The following table presents details supporting the computation of basic and diluted earnings per common share for the three and nine months ended September 30, 2004 and 2003:

 

     Three months ended
September 30,


   Nine months ended
September 30,


     2004

   2003

   2004

   2003

     (in thousands, except per share results)

Net income available for common stockholders

   $ 84,303    $ 62,119    $ 232,886    $ 162,625
    

  

  

  

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

     159,308      159,454      160,697      158,202

Dilutive effect of:

                           

Stock options

     1,662      1,713      1,824      872

Restricted stock

     27      1,382      43      2,310
    

  

  

  

Shares used to compute diluted earnings per common share

     160,997      162,549      162,564      161,384
    

  

  

  

Basic earnings per common share

   $ 0.53    $ 0.39    $ 1.45    $ 1.03
    

  

  

  

Diluted earnings per common share

   $ 0.52    $ 0.38    $ 1.43    $ 1.01
    

  

  

  

Number of antidilutive stock options excluded from computation

     4,105      1,568      2,833      4,427

 

(8) Stock Repurchase Plan

 

In July 2003, the Board of Directors authorized the use of up to $100 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 or in privately negotiated transactions. For the nine months ended September 30, 2004, 3,636,000 common shares were acquired in open market transactions at an aggregate cost of $63.6 million, or an average of $17.49 per share. As of November 1, 2004, $36.4 million of the July 2003 authorization remains available for share repurchases until January 2005, the expiration date of the authorization. See also the chart in Part II, Item 2 on page 38.

 

(9) Long-term Debt

 

Long-term debt outstanding was as follows at September 30, 2004 and December 31, 2003:

 

    

September 30,

2004


  

December 31,

2003


     (in thousands)

6.30% senior, unsecured notes due 2018, net of unamortized discount of $795 at September 30, 2004 and $838 at December 31, 2003

   $ 299,205    $ 299,162

7.25% senior, unsecured notes due 2006, net of unamortized discount of $268 at September 30, 2004 and $376 at December 31, 2003

     299,733      299,624

Fair value of interest rate swap agreements

     8,695      12,754

Deferred gain from interest rate swap exchange

     18,832      26,175
    

  

Total senior notes

     626,465      637,715

Other long-term borrowings

     4,447      4,923
    

  

Total long-term debt

   $ 630,912    $ 642,638
    

  

 

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Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

 

Senior Notes

 

In order to term-out our short-term debt and take advantage of historically low interest rates, we issued $300 million 6.30% senior notes due August 1, 2018 on August 5, 2003. Our net proceeds, reduced for the cost of the offering, were approximately $295.8 million. The net proceeds were used for general corporate purposes, including the funding of our short term cash needs.

 

In order to hedge the risk of changes in the fair value of our $300 million 6.30% senior notes and our $300 million 7.25% senior notes attributable to fluctuations in interest rates, we entered into interest rate swap agreements. Interest rate swap agreements, which are considered derivatives, are contracts that exchange interest payments on a specified principal amount, or notional amount, for a specified period. The interest rate swap agreements have the same critical terms as our 6.30% senior notes and our 7.25% senior notes. Changes in the fair value of the 6.30% or 7.25% senior notes and the swap agreements due to changing interest rates are assumed to offset each other completely, resulting in no impact to earnings from hedge ineffectiveness. Our swap agreements are recognized in our condensed consolidated balance sheet at fair value with an equal and offsetting adjustment to the carrying value of our senior notes. The fair value of our interest rate swap agreements are estimated based on quoted market prices of comparable agreements, and reflect the amounts we would receive (or pay) to terminate the agreements at the reporting date.

 

In June 2003, we recorded a deferred gain and received proceeds of $31.6 million in exchange for new swap agreements discussed above related to our 7.25% senior notes. The corresponding deferred swap gain of $31.6 million is being amortized to reduce interest expense over the remaining term of the 7.25% senior notes. The carrying value of our 7.25% senior notes has been increased $18.8 million by the remaining deferred swap gain balance at September 30, 2004.

 

Our interest rate swap agreements exchange the fixed interest rate under our 6.30% and 7.25% senior notes for a variable interest rate. At September 30, 2004, the effective interest rate was 2.90% for the 6.30% senior notes and 3.86% for the 7.25% senior notes, including the amortization of the deferred swap gain. The $300 million swap agreements for the 6.30% senior notes mature on August 1, 2018, and the $300 million swap agreements for the 7.25% senior notes mature on August 1, 2006, and each has the same critical terms as the related senior notes.

 

At September 30, 2004, the $8.7 million fair value of our swap agreements is included in other long-term assets. Likewise, the carrying value of our senior notes has been increased $8.7 million to reflect its fair value. The counterparties to our swap agreements are major financial institutions with which we also have other financial relationships.

 

Credit Agreement

 

On September 29, 2004, we replaced our existing credit agreements with a new 5-year $600 million unsecured revolving credit agreement which will expire in September 2009. We previously maintained two unsecured revolving credit agreements consisting of a $265 million, 4-year revolving credit agreement and a $265 million, 364-day revolving credit agreement. There was no balance outstanding under the new agreement at September 30, 2004.

 

Under the new agreement, at our option, we can borrow on either a competitive advance basis or a revolving credit basis. The revolving credit portion of the agreement 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 50 to 112.5 basis points. We also pay an annual facility fee regardless of utilization. This facility fee, initially 15 basis points, may fluctuate between 12.5 and 37.5 basis points, depending upon our credit ratings. In addition, a utilization fee of 12.5 basis points is payable for any day in which borrowings under the facility exceeds 50% of the total $600 million 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 5-year $600 million credit agreement contains customary restrictive and financial covenants as well as customary events of default, including financial covenants regarding the maintenance of net worth, minimum interest coverage, and maximum leverage ratios. At September 30, 2004, we were in compliance with all applicable financial covenant requirements. The terms of each of these credit agreements also include standard provisions

 

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Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

 

related to conditions of borrowing, including a customary material adverse effect clause which could limit our ability to borrow. We have not experienced a material adverse effect, and we know of no circumstances or events which would be reasonably likely to result in a material adverse effect. We do not believe the material adverse effect clause poses a material funding risk to Humana in the future.

 

We have other relationships, including financial advisory and banking, with some of the parties to the new agreement.

 

Commercial Paper Program

 

We maintain and may issue short-term debt securities under a commercial paper program when market conditions allow. The program is backed by our credit agreement described above. Aggregate borrowings under both the new credit agreement and commercial paper program generally will not exceed $600 million.

 

In connection with the new credit arrangement, the conduit commercial paper program allowing indirect access to the commercial paper market through a third party was cancelled.

 

At September 30, 2004, we had no commercial paper borrowings outstanding.

 

Other Borrowings

 

Other borrowings of $4.4 million at September 30, 2004 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

 

On April 1, 2003, our universal shelf registration became effective with the Securities and Exchange Commission. This allows us to register debt or equity securities, from time to time, with the amount, price and terms to be determined at the time of the sale. After the issuance of our $300 million, 6.30% senior notes in August 2003, we have up to $300 million remaining from a total of $600 million under the universal shelf registration. The universal shelf registration allows us to use the net proceeds from any future sales of our securities 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.

 

(10) Guarantees and Contingencies

 

Indemnifications and Guarantees

 

Our operating lease of an airplane, which expires January 1, 2010, provides for a residual value payment of no more than $4.8 million at the end of the lease term. At the end of the term we have the right to exercise a purchase option or the airplane can be sold to a third party. If we decide not to exercise our purchase option, we must pay the lessor a maximum amount of $4.8 million. This amount will be reduced by the net sales proceeds in excess of $4.2 million from the sale of the airplane to a third party.

 

Through indemnity agreements approved by the state regulatory authorities, certain of our regulated subsidiaries generally are guaranteed by Humana Inc., our parent company, in the event of insolvency for (1), member coverage for which premium payment has been made prior to insolvency; (2), benefits for members then hospitalized until discharged; and (3), payment to providers for services rendered prior to insolvency. Our parent also has guaranteed the obligations of our TRICARE subsidiaries.

 

In the ordinary course of business, we enter into contractual arrangements under which we may agree to indemnify a third party to such arrangement from any losses incurred relating to the services they perform on behalf of us, or for losses arising from certain events as defined within the particular contract, which may include, for example, litigation or claims relating to past performance. Such indemnification obligations may not be subject to maximum loss clauses. Historically, payments made related to these indemnifications have been immaterial.

 

Government Contracts

 

Our HMO, PPO and Fee-For-Service products covered under the MedicareAdvantage contracts with the federal government are renewed for a one-year term each December 31 unless notice of termination is received at least 90 days prior thereto. We have filed our renewal contracts. In December 2003, the Medicare Prescription Drug, Improvement, and Modernization Act, or MMA, was signed into law. We believe MMA offers new opportunities in our HMO, PPO and Fee-For-Service Medicare products. We intend to make additional investments in the MedicareAdvantage program to enhance our ability to participate.

 

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Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

 

On November 1, 2004, approximately 1 million members transitioned to our TRICARE South Region contract which we were awarded in 2003. This was the final step in the transition of the implementation of the South Region contract. In total, the TRICARE South Region contract now covers approximately 2.8 million beneficiaries. The South Region is one of the three regions in the United States as defined by the Department of Defense. The contract is for a five-year period subject to annual renewals at the Government’s option.

 

We currently have Medicaid contracts with the Puerto Rico Health Insurance Administration through June 30, 2005. Our other Medicaid contracts are in Florida and Illinois, and are annual contracts. As of September 30, 2004, Puerto Rico accounted for approximately 82% of our total Medicaid membership.

 

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.

 

Legal Proceedings

 

Managed Care Industry Purported Class Action Litigation

 

We have been involved in several purported class action lawsuits that are part of a wave of generally similar actions that target the health care payer industry and particularly target managed care companies. These include a lawsuit against us and originally nine of our competitors that purports to be brought on behalf of physicians who have treated our members. As a result of action by the Judicial Panel on Multidistrict Litigation (“JPML”), the case was consolidated in the United States District Court for the Southern District of Florida, and has been styled In re Managed Care Litigation.

 

The plaintiffs assert that we and other defendants improperly paid providers’ claims and “downcoded” their claims by paying lesser amounts than they submitted. The complaint alleges, among other things, multiple violations under the Racketeer Influenced and Corrupt Organizations Act, or RICO, as well as various breaches of contract and violations of regulations governing the timeliness of claim payments. The complaint was subsequently amended to add as plaintiffs several medical societies, including the Texas Medical Association, the Medical Association of Georgia, the California Medical Association, the Florida Medical Association, and the Louisiana State Medical Society, each of which purports to bring its action against specified defendants.

 

On September 26, 2002, the Court certified a global class consisting of all medical doctors who provided services to any person insured by any defendant from August 4, 1990, to September 26, 2002. The class included two subclasses. A national subclass consisted of medical doctors who provided services to any person insured by a defendant when the doctor had a claim against such defendant and was not required to arbitrate that claim. A California subclass consisted of medical doctors who provided services to any person insured in California by any defendant when the doctor was not bound to arbitrate the claim.

 

On September 1, 2004, the Court of Appeals for the Eleventh Circuit (“Eleventh Circuit”) agreed with the District Court’s ruling as to the class for the RICO claims, although it suggested that the class should be split so that claims involving capitation and fee-for-service payments would be handled separately. However, it reversed the lower court as to state law claims, including breach of contract, unjust enrichment and violations of prompt pay laws. It found that the state claims were too individualized to be dealt with in a class action. The California subclass was not specifically challenged and therefore was permitted to remain. On October 15, 2004, the defendants filed a Petition for a Writ of Certiorari to the United States Supreme Court, asking for review of the Eleventh Circuit’s decision.

 

On September 15, 2004, the Court issued an order rescheduling the trial for March 21, 2005.

 

Meanwhile, on September 17, 2004, the plaintiffs filed an amended motion for class certification, seeking a global fee-for-service class and five subclasses for the time period from January 1, 1996, to the date of certification. The global class would consist of any medical doctor who provided service on a fee-for-service basis to any person insured by Cigna Corporation or any other defendant for claims of RICO conspiracy and aiding and abetting. The motion seeks subclasses for the conspiracy counts for capitation damages and capitation injunctive relief consisting of all medical doctors who provided services on a capitated basis. The motion also requests a subclass for a direct RICO claim consisting of medical doctors who provided services on a fee-for-service basis to any person insured by

 

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Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

 

Humana pursuant to a contract without an arbitration clause or without a contract. The motion also seeks two California subclasses, one involving physicians who provided services on a fee-for-service basis and the other for capitated physicians.

 

On September 20, 2004, all proceedings were halted. The defendants had earlier filed a request with the Eleventh Circuit for the stay of proceedings pending an appeal to that court from an order denying enforcement of certain arbitration agreements. On September 20, 2004, the Eleventh Circuit issued the stay. On November 5, 2004, the Eleventh Circuit rejected the defendants’ appeal on the arbitration issues.

 

At the defendants’ request, the Court had previously filed a motion with the Judicial Panel on Multidistrict Litigation, (“JPML”), asking the JPML to determine whether the suits that were consolidated in Miami should be returned for trial to the courts in which they were initially filed. The JPML initially refused to consider the request because of the pendency of the Eleventh Circuit decision on class certification. After the Eleventh Circuit ruled, the defendants again asked the JPML for a ruling. On October 27, 2004, the JPML refused to rule again, citing the status of the case.

 

Two of the defendants, Aetna Inc. and Cigna Corporation, have entered into settlement agreements which have been approved by the Court.

 

We intend to continue to defend this action vigorously.

 

Government Audits and Other Litigation and Proceedings

 

Insurance Industry Brokerage Practices Matters

 

We have received requests for information from the Departments of Insurance in the states of Ohio and North Carolina with respect to an industry wide investigation into certain insurance brokerage practices, including broker compensation arrangements, and bid quoting practices. Additionally, the National Association of Insurance Commissioners has announced that it is in the process of developing recommendations in this area of the industry, which we will immediately review.

 

In connection with this industry wide review, we may receive requests for information or subpoenas from other regulators or attorneys general. We intend to cooperate fully with any inquiries.

 

Other

 

In July 2000, the Office of the Florida Attorney General initiated an investigation, apparently relating to some of the same matters that are involved in the managed care industry purported class action litigation described above. On September 21, 2001, the Texas Attorney General initiated a similar investigation. No actions have been filed against us by either state. These investigations are ongoing, and we have cooperated with the regulators in both states.

 

On May 31, 2000, we entered into a five-year Corporate Integrity Agreement, or CIA, with the Office of Inspector General, or OIG, of the Department of Health and Human Services. Under the CIA, we are obligated to, among other things, provide training, conduct periodic audits and make periodic reports to the OIG.

 

In addition, our business practices are subject to review by various state insurance and health care regulatory authorities and federal regulatory authorities. There has been increased scrutiny by these regulators of the managed health care companies’ business practices, including allegations of anticompetitive and unfair business activities, claims payment practices, commission payment practices, and utilization management practices. We have been and continue to be subject to such reviews. Some of these have resulted in fines and could require changes in some of our practices and could also result in additional fines or other sanctions.

 

We also are involved in other lawsuits that arise in the ordinary course of our business operations, including claims of medical malpractice, bad faith, nonacceptance or termination of providers, improper rate setting, failure to disclose network discounts and various other provider arrangements, as well as 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 and challenges to the use of certain software products in processing claims. Pending state and federal legislative activity may increase our exposure for any of these types of claims.

 

In addition, some courts have issued rulings which make it easier to hold plans liable for medical negligence on the part of network providers on the theory that providers are agents of the plans and that the plans are therefore vicariously liable for the injuries to members by providers.

 

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Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

 

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 likelihood or outcome of current or future suits, like the purported class action lawsuit described above, or governmental investigations, cannot be accurately predicted with certainty. In addition, the potential for increased liability for medical negligence arising from claims adjudication, along with the increased litigation that has accompanied the negative publicity and public perception of our industry, adds to this uncertainty. Therefore, such legal actions and government audits and investigations could have a material adverse effect on our financial position, results of operations, and cash flows.

 

(11) Segment Information

 

We manage our business with two segments: Commercial and Government. The Commercial segment consists of members enrolled in products marketed to employer groups and individuals, and includes three lines of business: fully insured medical, administrative services only, or ASO, and specialty. The Government segment consists of members enrolled in government-sponsored programs, and includes three lines of business: MedicareAdvantage, Medicaid, and TRICARE. We identified our segments in accordance with the aggregation provisions of Statement of Financial Accounting Standards No. 131, Disclosures About Segments of an Enterprise and Related Information 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 income, interest expense, and goodwill, but no other assets or liabilities, to our segments. Members served by our two segments generally 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.

 

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Humana Inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Unaudited

 

Our segment results for the three and nine months ended September 30, 2004 and 2003 are as follows:

 

     Commercial Segment

    

Three months ended

September 30,


  

Nine months ended

September 30,


     2004

   2003

   2004

   2003

     (in thousands)

Revenues:

                           

Premiums:

                           

Fully insured

                           

PPO

   $ 945,906    $ 856,793    $ 2,831,450    $ 2,481,317

HMO

     717,457      710,491      2,149,792      2,174,539
    

  

  

  

Total fully insured

     1,663,363      1,567,284      4,981,242      4,655,856

Specialty

     87,822      81,199      259,932      238,737
    

  

  

  

Total premiums

     1,751,185      1,648,483      5,241,174      4,894,593

Administrative services fees

     41,324      31,035      123,788      90,981

Investment and other income

     27,226      24,700      88,801      83,451
    

  

  

  

Total revenues

     1,819,735      1,704,218      5,453,763      5,069,025
    

  

  

  

Operating expenses:

                           

Medical

     1,464,234      1,379,781      4,399,424      4,046,845

Selling, general and administrative

     291,705      277,981      874,040      838,061

Depreciation and amortization

     19,802      16,442      52,267      66,941
    

  

  

  

Total operating expenses

     1,775,741      1,674,204      5,325,731      4,951,847
    

  

  

  

Income from operations

     43,994      30,014      128,032      117,178

Interest expense

     5,288      4,062      13,328      10,230
    

  

  

  

Income before income taxes

   $ 38,706    $ 25,952    $ 114,704    $ 106,948
    

  

  

  

     Government Segment

    

Three months ended,

September 30,


  

Nine months ended,

September 30,


     2004

   2003

   2004

   2003

     (in thousands)

Revenues:

                           

Premiums:

                           

MedicareAdvantage

   $ 814,612    $ 626,840    $ 2,295,534    $ 1,893,114

TRICARE

     386,439      620,477      1,651,844      1,627,212

Medicaid

     131,318      120,498      377,895      357,733
    

  

  

  

Total premiums

     1,332,369      1,367,815      4,325,273      3,878,059

Administrative services fees

     18,513      35,949      95,632      108,807

Investment and other income

     5,656      3,783      20,032      17,548
    

  

  

  

Total revenues

     1,356,538      1,407,547      4,440,937      4,004,414
    

  

  

  

Operating expenses:

                           

Medical

     1,086,677      1,148,342      3,624,743      3,297,689

Selling, general and administrative

     168,466      180,400      542,655      533,135

Depreciation and amortization

     11,436      10,670      32,448      33,291
    

  

  

  

Total operating expenses

     1,266,579      1,339,412      4,199,846      3,864,115
    

  

  

  

Income from operations

     89,959      68,135      241,091      140,299

Interest expense

     1,192      675      3,196      2,243
    

  

  

  

Income before income taxes

   $ 88,767    $ 67,460    $ 237,895    $ 138,056
    

  

  

  

 

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Item 2. 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 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 the “Cautionary Statements” section of this document. 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 2003 revenues of $12.2 billion. We offer a diversified portfolio of health insurance products and related services through traditional and consumer-choice plans to employer groups, government-sponsored programs, and individuals. As of September 30, 2004, we had approximately 6.0 million members in our medical insurance programs, as well as approximately 1.7 million members in our specialty products programs. On November 1, 2004, we added approximately 1 million TRICARE members to our South Region contract, completing the membership transition associated with the implementation of this contract, which began on August 1, 2004.

 

We manage our business with two segments: Commercial and Government. The Commercial segment consists of members enrolled in products marketed to employer groups and individuals, and includes three lines of business: fully insured medical, administrative services only, or ASO, and specialty. The Government segment consists of members enrolled in government-sponsored programs, and includes three lines of business: MedicareAdvantage, TRICARE, and Medicaid. We identified our segments in accordance with the aggregation provisions of Statement of Financial Accounting Standards No. 131, Disclosures About Segments of an Enterprise and Related Information 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 income, interest expense, and goodwill, but no other assets or liabilities, to our segments. Members served by our two segments generally 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 strategy to increase Commercial segment profitability focuses on providing solutions for employers to the rising cost of health care through the use of a variety of innovative and consumer-choice product designs. These products are supported by electronic informational capabilities, including education, tools, and technologies provided primarily through the Internet. To that end, we have developed an innovative suite of products styled as “Smart” products. We believe that these Smart products offer the best solution for many employers to the problem of quickly rising health care costs for their employees. Membership in our Smart products exceeded 240,000 members at September 30, 2004, up 121% from a year ago and 3% since the end of last quarter. We believe that growth in these products, which are offered on a fully-insured or ASO basis and may be competitively priced to produce higher margins, is a key component, among other items, for improvement in the Commercial segment. Additionally, we have amplified the diversification of our commercial membership base, not only through our Smart products, but also by expanding our ASO membership and by launching our Humana One Individual product to take advantage of the increasing migration of small group business to Individual products. While we expect our Smart products to become a driver of growth in the years ahead, we are enhancing the products that comprise the bulk of our commercial portfolio today by applying our consumer innovation across our existing products.

 

Other important elements which impact our Commercial segment profitability are the competitive pricing environment and market conditions. With respect to pricing, there is a complex balancing act between sustaining or

 

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increasing underwriting margins versus achieving enrollment growth. We have experienced a decline in our membership in the 3 to 300 life group size as a result of pricing actions by some competitors desiring to gain market share in certain markets. With respect to market conditions, there is the impact of economies of scale on administrative overhead. As a result of the decline in preference for tightly managed HMO products, medical costs have become increasingly comparable among the larger competitors. Consequently, product design and consumer involvement have become the more important drivers of medical services consumption. Administrative expense efficiency is becoming a primary driver of commercial margin sustainability. In line with that philosophy, we continue to examine our administrative expense structure, realize administrative expense savings through technology tools, and look at acquisition opportunities that align with our geographic presence and Commercial strategy.

 

In our Government segment, we have transitioned our TRICARE business after being awarded the South Region contract in 2003, one of three newly-created regions under the government’s revised TRICARE program. On July 1, 2004, our Regions 2 and 5 contracts servicing approximately 1.1 million TRICARE members became part of a new North Region, which was awarded to another contractor. On August 1, 2004, our current Regions 3 and 4 contracts became part of our new South Region contract. On November 1, 2004, the Region 6 contract, previously administered by another contractor, with approximately 1 million members, became part of the South Region. The members added with the Region 6 contract essentially offset the members lost with the Regions 2 and 5 contracts. Additionally, in our Medicare business, we believe the new Medicare legislation demonstrates the federal government’s financial commitment to the private payor program and the commitment to providing health benefits and options to seniors. The third quarter of 2004 was the fifth consecutive quarter in which our Medicare membership increased. We are also planning and spending for growth in the new Medicare PPO and Private Fee-For-Service offerings.

 

Highlights since December 31, 2003, our last year end, include:

 

  On April 1, 2004, we completed the acquisition of Ochsner Health Plan, or Ochsner, enhancing our presence in the Southern United States, an area growing in population and commercial activity. In addition to creating a new Humana market in New Orleans, Louisiana, the Ochsner acquisition is expected to facilitate sales opportunities in our existing Houston, Texas market and, we believe, will make us more attractive to national accounts. See Note 3 to the condensed consolidated financial statements.

 

  Diluted earnings per share of $1.43 for the nine month period ended September 30, 2004, or the 2004 period, an increase of 41.6% from $1.01 per share reported for the nine month period ended September 30, 2003, or the 2003 period, with our Government segment driving the growth.

 

  The Government segment pretax earnings during the 2004 period of $237.9 million increased $99.8 million, or 72.3% from $138.1 million during the 2003 period. The Commercial segment pretax earnings of $114.7 million in the 2004 period were 7.3% higher compared to pretax earnings of $106.9 million in the 2003 period.

 

  Consolidated revenues for the 2004 period of $9.9 billion increased 9.1% from $9.1 billion for the 2003 period resulting from the Ochsner acquisition and an increase in per member premiums.

 

  The 2004 period consolidated medical expense ratio of 83.9% increased from 83.7% in the 2003 period while the consolidated SG&A expense ratio of 14.5% in the 2004 period declined from 15.3% in the same period a year ago.

 

  Cash flows from operations of $328.3 million in the 2004 period increased from $122.9 million in the prior year period primarily due to cash generated by working capital changes and higher earnings. Due to the timing of MedicareAdvantage premium receipts more fully discussed in the Liquidity section, both the 2004 and 2003 periods include only eight monthly premium receipts instead of a normal nine.

 

  During the 2004 period, we acquired approximately 3.6 million common shares in the open market for an aggregate price of $63.6 million, or an average cost of $17.49 per share.

 

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Table of Contents

Comparison of Results of Operations

 

The following discussion primarily deals with our results of operations for the three months ended September 30, 2004, or the 2004 quarter, the three months ended September 30, 2003, or the 2003 quarter, the nine months ended September 30, 2004, or the 2004 period, and the nine months ended September 30, 2003, or the 2003 period.

 

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

 

     For the three months ended September 30,

    Change

 
     2004

    2003

    Dollars

    Percentage

 
     (in thousands, except ratios)        

Premium revenues:

                              

Fully insured

   $ 1,663,363     $ 1,567,284     $ 96,079     6.1 %

Specialty

     87,822       81,199       6,623     8.2 %
    


 


 


 

Total Commercial

     1,751,185       1,648,483       102,702     6.2 %
    


 


 


 

MedicareAdvantage

     814,612       626,840       187,772     30.0 %

TRICARE

     386,439       620,477       (234,038 )   (37.7 )%

Medicaid

     131,318       120,498       10,820     9.0 %
    


 


 


 

Total Government

     1,332,369       1,367,815       (35,446 )   (2.6 )%
    


 


 


 

Total

   $ 3,083,554     $ 3,016,298     $ 67,256     2.2 %
    


 


 


 

Administrative services fees:

                              

Commercial

   $ 41,324     $ 31,035     $ 10,289     33.2 %

Government

     18,513       35,949       (17,436 )   (48.5 )%
    


 


 


 

Total

   $ 59,837     $ 66,984     $ (7,147 )   (10.7 )%
    


 


 


 

Income before income taxes:

                              

Commercial

   $ 38,706     $ 25,952     $ 12,754     49.1 %

Government

     88,767       67,460       21,307     31.6 %
    


 


 


 

Total

   $ 127,473     $ 93,412     $ 34,061     36.5 %
    


 


 


 

Medical expense ratios:

                              

Commercial

     83.6 %     83.7 %           (0.1 )

Government

     81.6 %     84.0 %           (2.4 )
    


 


         

Total

     82.7 %     83.8 %           (1.1 )
    


 


         

SG&A expense ratios:

                              

Commercial

     16.3 %     16.6 %           (0.3 )

Government

     12.5 %     12.9 %           (0.4 )
    


 


         

Total

     14.6 %     14.9 %           (0.3 )
    


 


         

 

20


Table of Contents
     For the nine months ended September 30,

    Change

 
     2004

    2003

    Dollars

    Percentage

 
     (in thousands, except ratios)        

Premium revenues:

                              

Fully insured

   $ 4,981,242     $ 4,655,856     $ 325,386     7.0 %

Specialty

     259,932       238,737       21,195     8.9 %
    


 


 


 

Total Commercial

     5,241,174       4,894,593       346,581     7.1 %
    


 


 


 

MedicareAdvantage

     2,295,534       1,893,114       402,420     21.3 %

TRICARE

     1,651,844       1,627,212       24,632     1.5 %

Medicaid

     377,895       357,733       20,162     5.6 %
    


 


 


 

Total Government

     4,325,273       3,878,059       447,214     11.5 %
    


 


 


 

Total

   $ 9,566,447     $ 8,772,652     $ 793,795     9.0 %
    


 


 


 

Administrative services fees:

                              

Commercial

   $ 123,788     $ 90,981     $ 32,807     36.1 %

Government

     95,632       108,807       (13,175 )   (12.1 )%
    


 


 


 

Total

   $ 219,420     $ 199,788     $ 19,632     9.8 %
    


 


 


 

Income before income taxes:

                              

Commercial

   $ 114,704     $ 106,948     $ 7,756     7.3 %

Government

     237,895       138,056       99,839     72.3 %
    


 


 


 

Total

   $ 352,599     $ 245,004     $ 107,595     43.9 %
    


 


 


 

Medical expense ratios:

                              

Commercial

     83.9 %     82.7 %           1.2  

Government

     83.8 %     85.0 %           (1.2 )
    


 


         

Total

     83.9 %     83.7 %           0.2  
    


 


         

SG&A expense ratios:

                              

Commercial

     16.3 %     16.8 %           (0.5 )

Government

     12.3 %     13.4 %           (1.1 )
    


 


         

Total

     14.5 %     15.3 %           (0.8 )
    


 


         

Medical membership was as follows at September 30, 2004 and 2003:

 

             
                 Change

 
     2004

    2003

    Members

    Percentage

 

Commercial segment medical members:

                              

Fully insured

     2,296,400       2,324,600       (28,200 )   (1.2 )%

ASO

     1,018,800       711,800       307,000     43.1 %
    


 


 


 

Total Commercial

     3,315,200       3,036,400       278,800     9.2 %
    


 


 


 

Government segment medical members:

                              

MedicareAdvantage

     371,300       324,600       46,700     14.4 %

TRICARE

     1,138,600       1,746,300       (607,700 )   (34.8 )%

TRICARE ASO

     674,700       1,057,000       (382,300 )   (36.2 )%

Medicaid

     475,800       460,800       15,000     3.3 %
    


 


 


 

Total Government

     2,660,400       3,588,700       (928,300 )   (25.9 )%
    


 


 


 

Total medical membership

     5,975,600       6,625,100       (649,500 )   (9.8 )%
    


 


 


 

 

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Table of Contents

Summary

 

Net income was $84.3 million, or $0.52 per diluted share, in the 2004 quarter compared to $62.1 million, or $0.38 per diluted share, in the 2003 quarter. Net income was $232.9 million, or $1.43 per diluted share, in the 2004 period compared to $162.6 million, or $1.01 per diluted share, in the 2003 period. The increase in net income primarily was due to improved profits in the Government segment. The 2003 period results included expenses for asset impairments as more fully described in Note 4 to the condensed consolidated financial statements.

 

Premium Revenues and Medical Membership

 

Premium revenues increased 2.2% to $3.08 billion for the 2004 quarter, compared to $3.02 billion for the 2003 quarter. For the 2004 period, premium revenues were $9.57 billion, an increase of 9.0% compared to $8.77 billion for the 2003 period. Higher premium revenues resulted primarily from the Ochsner acquisition and an increase in MedicareAdvantage and fully insured commercial premium rates. Items impacting premium rates include changes in premium and government reimbursement 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.

 

Commercial segment premium revenues increased 6.2% to $1.75 billion for the 2004 quarter, compared to $1.65 billion for the 2003 quarter. For the 2004 period, commercial segment premium revenues were $5.24 billion, an increase of 7.1% compared to $4.89 billion for the 2003 period. This increase resulted from the Ochsner acquisition and increases in per member premiums in the 6% to 8% range on our fully insured commercial business. Our fully insured commercial medical membership decreased 1.2%, or 28,200 members, to 2,296,400 at September 30, 2004 despite the addition of 152,600 members from the acquisition of Ochsner. The decrease is primarily due to the lapse of certain under-performing large group accounts totaling approximately 94,000 members in the 2004 quarter and continued attrition due to the ongoing competitive environment within the small to mid-market group accounts, partially offset by membership gains in the Individual product lines. We expect fully insured commercial per member premiums to increase in the 6% to 8% range for the full year 2004, including our Individual at-risk business. The growth in Individual membership as a percentage of the total block lowered the composite per member premium trend by approximately 150 to 200 basis points due to the lower benefits of this product.

 

Government segment premium revenues decreased 2.6% to $1.33 billion for the 2004 quarter, compared to $1.37 billion for the 2003 quarter. For the 2004 period, government segment premium revenues were $4.33 billion, an increase of 11.5% compared to $3.88 billion for the 2003 period. This increase primarily was attributable to our MedicareAdvantage operations. MedicareAdvantage membership was 371,300 at September 30, 2004, compared to 324,600 at September 30, 2003, an increase of 46,700 members, or 14.4%, including 33,100 members added through the acquisition of Ochsner. Per member premiums for our MedicareAdvantage business increased in the 12% to 14% range for the 2004 quarter and includes cumulative adjustments as a result of our efforts to ensure premiums are commensurate with the risk profile of our membership base. Including the Ochsner acquisition, we expect MedicareAdvantage membership to grow approximately 15% with premium revenues increasing on a per member basis in the 9% to 11% range for the full year 2004. TRICARE premium revenues decreased 37.7% in the 2004 quarter and increased 1.5% in the 2004 period, reflecting the transition to the new South Region contract.

 

Administrative Services Fees

 

Our administrative services fees for the 2004 quarter were $59.8 million, a decrease of $7.1 million, or 10.7%, from $67.0 million for the 2003 quarter. This decrease was the result of lower fees related to TRICARE’s change in government-contracted services. For the 2004 period, administrative services fees were $219.4 million, an increase of $19.6 million, or 9.8%, compared to $199.8 million for the 2003 period. This increase resulted primarily from higher Commercial ASO membership partially offset by lower fees related to TRICARE’s change in government-contracted services.

 

For the Commercial segment, administrative services fees increased $10.3 million, or 33.2%, from $31.0 million for the 2003 quarter to $41.3 million for the 2004 quarter, and increased $32.8 million, or 36.1%, from $91.0 million to $123.8 million when comparing the 2004 period to the 2003 period. This increase corresponds to the higher level of ASO membership at September 30, 2004, which was 1,018,800 members, compared to 711,800 at September 30, 2003. We expect Commercial segment medical membership, both fully insured and ASO, to grow between 220,000 and 230,000 members by December 31, 2004, with the previously discussed attrition in fully insured business somewhat offsetting the growth in ASO accounts.

 

Administrative fees for the Government segment decreased $17.4 million, or 48.5%, when comparing the 2004 quarter to the 2003 quarter, and decreased $13.2 million, or 12.1%, when comparing the 2004 period to the 2003 period. This expected decline for the quarter and period resulted from the transition to the new South Region contract which carved out certain government programs including the administration of pharmacy and medical benefits to senior members over the age of 65. We are not participating in these separate programs.

 

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Table of Contents

Investment and Other Income

 

Investment and other income totaled $32.9 million for the 2004 quarter, an increase of $4.4 million from $28.5 million for the 2003 quarter. For the 2004 period, investment and other income totaled $108.8 million, an increase of $7.8 million from $101.0 million for the 2003 period. This increase primarily resulted from an increase in the average invested balance. Investment securities acquired as part of the Ochsner transaction and the investment of cash flows from operations contributed to the increase in the average invested balance. The 2004 period included a $16.0 million capital gain and the 2003 period included a $15.2 million capital gain from the sale of privately held venture capital investments.

 

Medical Expense

 

Total medical expenses as a percentage of premium revenues, or medical expense ratio (MER), for the 2004 quarter was 82.7%, decreasing 110 basis points from 83.8% for the 2003 quarter. For the 2004 period, our MER was 83.9%, increasing 20 basis points from the 2003 period of 83.7%.

 

The Commercial segment’s MER for the 2004 quarter was 83.6%, decreasing 10 basis points from the 2003 quarter of 83.7%, and an increase of 120 basis points from 82.7% to 83.9% was experienced comparing the 2004 period with the 2003 period. The 10 basis point improvement over the 2003 quarter was primarily due to the combined effect of the lapse of approximately 94,000 members in under-performing accounts partially offset by the continued losses associated with a single large account with approximately 89,000 members. The MER increase for the period is primarily due to the large single account with approximately 89,000 members, a competitive pricing environment, and an additional day of medical expense due to the leap year. Increasing per member premiums commensurate with claims trend becomes more difficult in a competitive pricing environment. Fully insured commercial medical cost trends, which are expected to rise in the range of 6.5% to 8.5% for the full year of 2004, has been impacted by a growing mix of Individual membership. The growth in Individual membership as a percentage of the total block lowers the composite trend by approximately 200 basis points.

 

The Government segment’s MER for the 2004 quarter was 81.6%, decreasing 240 basis points from the 2003 quarter of 84.0%, and a decrease of 120 basis points from 85.0% to 83.8% was experienced comparing the 2004 period with the 2003 period. The decrease was due to MedicareAdvantage and TRICARE premium increases that were higher than medical cost increases. As previously discussed, MedicareAdvantage results include cumulative premium that better reflects the risk profile of our membership base. TRICARE premiums reflect bid price adjustments settled during the 2004 quarter.

 

SG&A Expense

 

Total selling, general and administrative, or SG&A, expenses as a percentage of premium revenues and administrative services fees, or SG&A expense ratio, for the 2004 quarter was 14.6%, decreasing 30 basis points from the 2003 quarter of 14.9%. For the 2004 period, the SG&A expense ratio was 14.5%, decreasing 80 basis points when compared to the 2003 period of 15.3%. This decrease is the result of operational efficiencies gained from completing the consolidation of seven service centers into four and workforce reductions favorably impacting both segments. Included in the 2003 period were costs of $17.2 million from the impairment of the Jacksonville, Florida service center building more fully described in Note 4 to the condensed consolidated financial statements. These costs increased the 2003 period’s SG&A expense ratio 30 basis points. The consolidated SG&A expense ratio is expected to be in the range of 14% to 15% for the full year 2004.

 

The Commercial segment SG&A expense ratio decreased 30 basis points from 16.6% to 16.3% for the 2004 quarter versus the 2003 quarter. For the 2004 period compared to the 2003 period, the Commercial segment SG&A expense ratio decreased 50 basis points from 16.8% to 16.3% and is expected to be in the range of 16% to 17% for the full year 2004. The Commercial segment SG&A expense ratio for the 2003 period included an approximate 10 basis point impact from the Jacksonville, Florida building writedown.

 

The Government segment SG&A expense ratio decreased 40 basis points from 12.9% to 12.5% for the 2004 quarter versus the 2003 quarter and decreased 110 basis points from 13.4% to 12.3% for the 2004 period compared to the 2003 period. The Government segment SG&A expense ratio for the 2003 period included an approximate 50 basis point impact from the Jacksonville, Florida building writedown. The Government segment SG&A expense ratio is expected to be in the range of 11% to 12% for the full year 2004.

 

23


Table of Contents

Depreciation and amortization for the 2004 quarter totaled $31.2 million compared to $27.1 million for the 2003 quarter, an increase of $4.1 million, or 15.2%. For the 2004 period, depreciation and amortization totaled $84.7 million compared to $100.2 million for the 2003 period, a decrease of $15.5 million, or 15.5%. After finalizing plans at the beginning of the third quarter of 2004 to abandon some enrollment software, we reduced the estimated useful life of the software effective July 1, 2004. The change in the useful life increased depreciation expense during the 2004 quarter by approximately $4.0 million. The decrease in the 2004 period resulted from accelerated depreciation of software of $13.5 million included in the 2003 period and a net decrease of amortization of other intangible assets when the government contract acquired with the TRICARE Regions 2 and 5 transaction became fully amortized in the second quarter of 2003. This was partially offset by the increased amortization expense associated with other intangible assets recorded in connection with the April 1, 2004 Ochsner acquisition.

 

Interest Expense

 

Interest expense was $6.5 million for the 2004 quarter, compared to $4.7 million for the 2003 quarter, an increase of $1.8 million. For the 2004 period, interest expense was $16.5 million compared to $12.5 million for the 2003 period, an increase of $4.0 million. This increase primarily resulted from higher average outstanding debt, due to the issuance of $300 million senior notes in August 2003, offset by lower interest rates.

 

Income Taxes

 

On an interim basis, the provision for income taxes is provided for at the anticipated effective tax rate for the year. Our effective tax rate was 33.9% for the 2004 quarter and 34.0% for the 2004 period, compared to 33.5% for the 2003 quarter and 33.6% for the 2003 period. This increase primarily reflects a higher proportion of pretax income to tax-exempt investment income.

 

Membership

 

The following table presents our medical and specialty membership at September 30, 2004, June 30, 2004, March 31, 2004, and at the end of each quarter in 2003:

 

     2004

   2003

     Sept. 30

   June 30

   March 31

   Dec. 31

   Sept. 30

   June 30

   March 31

Medical Membership:

                                  

Commercial segment:

                                  

Fully insured

   2,296,400    2,407,700    2,298,600    2,352,800    2,324,600    2,350,400    2,348,800

ASO

   1,018,800    996,700    997,000    712,400    711,800    670,300    654,600
    
  
  
  
  
  
  

Total Commercial

   3,315,200    3,404,400    3,295,600    3,065,200    3,036,400    3,020,700    3,003,400
    
  
  
  
  
  
  

Government segment:

                                  

MedicareAdvantage

   371,300    367,900    333,200    328,600    324,600    324,200    327,100

TRICARE

   1,138,600    1,856,900    1,860,100    1,849,700    1,746,300    1,750,800    1,752,500

TRICARE ASO

   674,700    786,000    1,057,900    1,057,200    1,057,000    1,052,500    1,050,800

Medicaid

   475,800    466,400    468,200    468,900    460,800    492,700    491,400
    
  
  
  
  
  
  

Total Government

   2,660,400    3,477,200    3,719,400    3,704,400    3,588,700    3,620,200    3,621,800
    
  
  
  
  
  
  

Total medical members

   5,975,600    6,881,600    7,015,000    6,769,600    6,625,100    6,640,900    6,625,200
    
  
  
  
  
  
  

Specialty Membership:

                                  

Commercial segment

   1,714,300    1,691,400    1,703,200    1,668,100    1,639,100    1,642,000    1,650,100
    
  
  
  
  
  
  

 

Liquidity

 

Cash and cash equivalents decreased to $375.1 million at September 30, 2004 from $931.4 million at December 31, 2003. The primary reason for the decrease in cash and cash equivalents during the 2004 period was the purchase of investment securities and the timing of the MedicareAdvantage premium receipts.

 

The timing of MedicareAdvantage premium receipts may significantly impact our cash flows from operations in a particular period as the MedicareAdvantage premium receipt is payable to us on the first day of each month. When the first day of a month falls on a weekend or holiday, we have historically received this payment at the end of the previous month. Since the amount is significant, the timing of its receipt could cause a material fluctuation in our operating cash flows from period to period. The MedicareAdvantage premium receipts for January 2004 of $211.9 million and January 2003 of $205.8 million were received in December 2003 and December 2002, respectively, because January 1 is a holiday. This timing accounts for a significant portion of the unearned revenues balance on our condensed consolidated balance sheet at December 31, 2003. This timing also accounts for only eight premium receipts for the nine month period ended September 30, 2004 and 2003.

 

24


Table of Contents

Beginning in 2005, the monthly premium payment schedule includes a change in timing from previous practice. As a result of this change, the January 2005 payment originally scheduled to be received on Friday, December 31, 2004, has been changed to Monday, January 3, 2005, or one business day later. Therefore, we will be receiving only 11 monthly MedicareAdvantage premium payments during 2004.

 

The change in cash and cash equivalents for the nine months ended September 30, 2004 and 2003 is summarized as follows:

 

     Nine months ended
September 30


 
     2004

    2003

 
     (in thousands)  

Net cash provided by operating activities

   $ 328,324     $ 122,920  

Net cash used in investing activities

     (730,553 )     (367,984 )

Net cash (used in) provided by financing activities

     (154,085 )     159,544  
    


 


Decrease in cash and cash equivalents

   $ (556,314 )   $ (85,520 )
    


 


 

The primary drivers of operating cash flow in our business are premium collections and medical claim payments. Because premiums generally are collected in advance of claims payments by a period up to several months in many instances, our business normally should produce strong cash flows during a period of increasing enrollment. Conversely, cash flows should be impacted negatively during a period of shrinking enrollment. An exception to this general rule is the collection of certain TRICARE receivables, some of which takes place at least six months after the end of a contract year. Other activities that impact our cash flows are the collection of ASO fees and investment income, and the payment of operating expenses, interest expense and taxes.

 

Operating cash flow in the 2004 period of $328.3 million increased $205.4 million from $122.9 million in the 2003 period primarily due to cash generated by working capital changes and higher earnings. Contributing to the improved working capital during the 2004 period was the collection of TRICARE receivables as the following table details:

 

    

September 30,

2004


    December 31,
2003


    Change

 
     (in thousands)  

TRICARE:

                        

Base receivable

   $ 230,639     $ 266,656     $ (36,017 )

Bid price adjustments (BPAs)

     22,955       92,875       (69,920 )

Change orders

     3,216       7,073       (3,857 )
    


 


 


       256,810       366,604       (109,794 )

Less: long-term portion of BPAs

     —         (38,794 )     38,794  
    


 


 


TRICARE subtotal

     256,810       327,810       (71,000 )

Commercial and other

     197,535       178,577       18,958  

Allowance for doubtful accounts

     (29,475 )     (40,400 )     10,925  
    


 


 


Total net receivables

   $ 424,870     $ 465,987     $ (41,117 )
    


 


 


 

TRICARE base receivables are collected monthly in the ordinary course of business. Base receivables are expected to grow in connection with the transition to the reimbursement model under the South Region contract. Certain TRICARE Regions 3 and 4 BPAs were settled during the 2004 quarter. Increases in premium and ASO fee revenues contributed to higher Commercial and other receivables.

 

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Table of Contents

The timing of payments for claims can significantly impact comparisons of our operating cash flows between years. The following table presents the estimated valuation and number of unprocessed claims on hand, performance metrics we regularly review. Claims on hand represent the estimated number of provider requests for reimbursement that have been received but not yet processed.

 

    

Estimated

Valuation


  

Claims on

Hand


  

Number of

Days Claims

On-hand


     (dollars in thousands)

December 31, 2000

   $ 257,400    1,157,900    11.0

December 31, 2001

   $ 125,400    518,100    5.0

December 31, 2002

   $ 92,300    424,200    4.5

December 31, 2003

   $ 109,700    443,000    4.9

September 30, 2004

   $ 122,300    453,300    4.4

 

Medical and other expenses payable increased during the 2004 quarter due primarily to medical claims inflation. The detail of medical and other expenses payable was as follows at September 30, 2004 and December 31, 2003:

 

    

September 30,

2004


  

December 31,

2003


   Change

 
     (in thousands)  

IBNR (1)

   $ 1,184,446    $ 1,034,858    $ 149,588  

Unprocessed claim inventories (2)

     122,300      109,700      12,600  

Processed claim inventories (3)

     79,895      74,262      5,633  

Payable to pharmacy benefit

administrator and other (4)

     49,494      53,336      (3,842 )
    

  

  


Total medical and other expenses payable

   $ 1,436,135    $ 1,272,156    $ 163,979  
    

  

  



(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).
(2) Unprocessed claim inventories represent the estimated valuation of claims received but not yet fully processed. Further detail regarding unprocessed claim inventories is provided above.
(3) Processed claim inventories represent the estimated valuation of processed claims that are in the post claim adjudication process, which consists of administrative functions such as audit and check batching and handling.
(4) The balance due to our pharmacy benefit administrator fluctuates due to bi-weekly payments and the month-end cutoff.

 

Cash Flow from Investing Activities

 

We paid $116.0 million to acquire Ochsner, net of cash and cash equivalents acquired. The purchase price is subject to adjustment in accordance with the terms and conditions of the purchase agreement. As early as the fourth quarter of 2004, the purchase price will be adjusted to reflect changes in net equity from the amount estimated as of the date the purchase agreement was signed in December 2003 until the transaction closed on April 1, 2004, giving effect for items such as higher cash balances from earnings and changes in Ochsner’s ultimate claims liability as of April 1, 2004 using claims paid data during a six month run-out period.

 

During the 2004 period, we reinvested a portion of our cash and cash equivalents in investment securities, primarily short-duration fixed income securities, totaling $570.7 million. Our ongoing capital expenditures primarily relate to our technology initiatives and administrative facilities necessary for activities such as claims processing, billing and collections, medical utilization review, and customer service. Total capital expenditures were $72.9 million for the 2004 period and $65.0 million for the 2003 period. Excluding acquisitions, we expect our total capital expenditures in 2004 to range from $100 million to $110 million, most of which will be used for our technology initiatives and improvement of administrative facilities. Proceeds from the sale of the Jacksonville service center building increased investing cash flows $14.8 million.

 

Cash Flow from Financing Activities

 

The cash used in financing activities in the 2004 period resulted primarily from common stock repurchases more fully discussed below and change in the book overdraft, partially offset by proceeds from stock option exercises.

 

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In July 2003, the Board of Directors authorized the use of up to $100 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 or in privately negotiated transactions. For the nine months ended September 30, 2004, 3,636,000 common shares were acquired in open market transactions at an aggregate cost of $63.6 million, or an average of $17.49 per share. As of November 1, 2004, $36.4 million of the July 2003 authorization remains available for share repurchases until January 2005, the expiration date of the authorization. See also the chart in Part II, Item 2 on page 38.

 

Long-term Debt

 

Long-term debt outstanding was as follows at September 30, 2004 and December 31, 2003:

 

    

September 30,

2004


  

December 31,

2003


     (in thousands)

6.30% senior, unsecured notes due 2018, net of unamortized discount of $795 at September 30, 2004 and $838 at December 31, 2003

   $ 299,205    $ 299,162

7.25% senior, unsecured notes due 2006, net of unamortized discount of $268 at September 30, 2004 and $376 at December 31, 2003

     299,733      299,624

Fair value of interest rate swap agreements

     8,695      12,754

Deferred gain from interest rate swap exchange

     18,832      26,175
    

  

Total senior notes

     626,465      637,715

Other long-term borrowings

     4,447      4,923
    

  

Total long-term debt

   $ 630,912    $ 642,638
    

  

 

Senior Notes

 

In order to term-out our short-term debt and take advantage of historically low interest rates, we issued $300 million 6.30% senior notes due August 1, 2018 on August 5, 2003. Our net proceeds, reduced for the cost of the offering, were approximately $295.8 million. The net proceeds were used for general corporate purposes, including the funding of our short term cash needs.

 

In order to hedge the risk of changes in the fair value of our $300 million 6.30% senior notes and our $300 million 7.25% senior notes attributable to fluctuations in interest rates, we entered into interest rate swap agreements. Interest rate swap agreements, which are considered derivatives, are contracts that exchange interest payments on a specified principal amount, or notional amount, for a specified period. The interest rate swap agreements have the same critical terms as our 6.30% senior notes and our 7.25% senior notes. Changes in the fair value of the 6.30% or 7.25% senior notes and the swap agreements due to changing interest rates are assumed to offset each other completely, resulting in no impact to earnings from hedge ineffectiveness. Our swap agreements are recognized in our condensed consolidated balance sheet at fair value with an equal and offsetting adjustment to the carrying value of our senior notes. The fair value of our interest rate swap agreements are estimated based on quoted market prices of comparable agreements, and reflect the amounts we would receive (or pay) to terminate the agreements at the reporting date.

 

In June 2003, we recorded a deferred gain and received proceeds of $31.6 million in exchange for new swap agreements discussed above related to our 7.25% senior notes. The corresponding deferred swap gain of $31.6 million is being amortized to reduce interest expense over the remaining term of the 7.25% senior notes. The carrying value of our 7.25% senior notes has been increased $18.8 million by the remaining deferred swap gain balance at September 30, 2004.

 

Our interest rate swap agreements exchange the fixed interest rate under our 6.30% and 7.25% senior notes for a variable interest rate. At September 30, 2004, the effective interest rate was 2.90% for the 6.30% senior notes and 3.86% for the 7.25% senior notes, including the amortization of the deferred swap gain. The $300 million swap agreements for the 6.30% senior notes mature on August 1, 2018, and the $300 million swap agreements for the 7.25% senior notes mature on August 1, 2006, and each has the same critical terms as the related senior notes.

 

At September 30, 2004, the $8.7 million fair value of our swap agreements is included in other long-term assets. Likewise, the carrying value of our senior notes has been increased $8.7 million to reflect its fair value. The counterparties to our swap agreements are major financial institutions with which we also have other financial relationships.

 

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Credit Agreement

 

On September 29, 2004, we replaced our existing credit agreements with a new 5-year $600 million unsecured revolving credit agreement which will expire in September 2009. We previously maintained two unsecured revolving credit agreements consisting of a $265 million, 4-year revolving credit agreement and a $265 million, 364-day revolving credit agreement. There was no balance outstanding under the new agreement at September 30, 2004.

 

Under the new agreement, at our option, we can borrow on either a competitive advance basis or a revolving credit basis. The revolving credit portion of the agreement 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 50 to 112.5 basis points. We also pay an annual facility fee regardless of utilization. This facility fee, initially 15 basis points, may fluctuate between 12.5 and 37.5 basis points, depending upon our credit ratings. In addition, a utilization fee of 12.5 basis points is payable for any day in which borrowings under the facility exceeds 50% of the total $600 million 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 5-year $600 million credit agreement contains customary restrictive and financial covenants as well as customary events of default, including financial covenants regarding the maintenance of net worth, minimum interest coverage, and maximum leverage ratios. At September 30, 2004, we were in compliance with all applicable financial covenant requirements. The terms of each of these credit agreements also include standard provisions related to conditions of borrowing, including a customary material adverse effect clause which could limit our ability to borrow. We have not experienced a material adverse effect, and we know of no circumstances or events which would be reasonably likely to result in a material adverse effect. We do not believe the material adverse effect clause poses a material funding risk to Humana in the future.

 

We have other relationships, including financial advisory and banking, with some of the parties to the new agreement.

 

Commercial Paper Program

 

We maintain and may issue short-term debt securities under a commercial paper program when market conditions allow. The program is backed by our credit agreement described above. Aggregate borrowings under both the new credit agreement and commercial paper program generally will not exceed $600 million.

 

In connection with the new credit arrangement, the conduit commercial paper program allowing indirect access to the commercial paper market through a third party was cancelled.

 

At September 30, 2004, we had no commercial paper borrowings outstanding.

 

Other Borrowings

 

Other borrowings of $4.4 million at September 30, 2004 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

 

On April 1, 2003, our universal shelf registration became effective with the Securities and Exchange Commission. This allows us to register debt or equity securities, from time to time, with the amount, price and terms to be determined at the time of the sale. After the issuance of our $300 million, 6.30% senior notes in August 2003, we have up to $300 million remaining from a total of $600 million under the universal shelf registration. The universal shelf registration allows us to use the net proceeds from any future sales of our securities 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.

 

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, 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.

 

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As of September 30, 2004, we maintained aggregate statutory capital and surplus of $1,126.6 million in our state regulated health insurance subsidiaries. Each of these subsidiaries was in compliance with applicable statutory requirements which aggregated $704.1 million. Although the minimum required levels of equity are largely based on premium volume, product mix, and the quality of assets held, minimum requirements can vary significantly at the state level. Certain states rely on risk-based capital requirements, or RBC, to define the required levels of equity. RBC is a model developed by the National Association of Insurance Commissioners to monitor an entity’s solvency. This calculation indicates recommended minimum levels of required capital and surplus and signals regulatory measures should actual surplus fall below these recommended levels. If RBC were adopted by all states at September 30, 2004, each of our subsidiaries would be in compliance and we would have $363.5 million of aggregate capital and surplus above any of the levels that require corrective action under RBC.

 

Future Liquidity Needs

 

Because of the items discussed in this Liquidity section, we believe that funds from future operating cash flows, funds available under our credit agreement, and our demonstrated ability to successfully access the capital markets are sufficient to meet short and intermediate-term liquidity needs. We also believe these sources of funds are adequate to allow us to fund selected expansion opportunities, as well as to fund capital requirements.

 

Cautionary Statements

 

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 medical claim reserves based upon our estimates of future medical 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, allocations of some centralized expenses 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 medical cost projections generally are not recovered in the contract year through higher premiums. We estimate the costs of our future medical 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 medical claims reserves for future payments. We continually review estimates of future payments relating to medical claims costs for services incurred in the current and prior periods and make necessary adjustments to our reserves. However, increases in the use or cost of services by our members, competition, government regulations and many other factors may and often do cause actual health care costs to exceed what was estimated and reflected in premiums.

 

These factors may include:

 

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

 

  increased cost of such services;

 

  the Company’s membership mix;

 

  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;

 

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

 

  catastrophes, including acts of terrorism, epidemics, or severe weather;

 

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

 

  medical cost inflation; and

 

  new government mandated benefits or other regulatory changes.

 

Failure to adequately price our products or estimate sufficient medical claim reserves may result in a material adverse effect on our financial position, results of operations and cash flows.

 

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. Many of our competitors are more established in the health care industry and have a larger market share and greater financial resources than we do in some markets. In addition, other companies may enter our markets in the future, including emerging competitors in the MedicareAdvantage program, in e-commerce insurance or benefit programs and in consumer-directed health plans, such as Health Savings Accounts (“HSA”). 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. The commercial pricing environment, particularly in the smaller-sized groups, is extremely competitive, and several of our competitors, including public and not-for-profit companies, are pricing aggressively to gain market share.

 

Premium increases, introduction of new product designs, and our relationship with our providers in various markets, among other issues, could affect our membership levels. Other actions that could affect membership levels include the possible exit of or entrance to MedicareAdvantage or Commercial markets. If we do not compete effectively in our markets, if we set rates too high or too low in highly competitive markets to keep or increase our market share, if membership does not increase as we expect, or if it declines, or if we lose accounts with favorable medical cost experience while retaining or increasing membership in accounts with unfavorable medical cost experience, our business and results of operations could be materially adversely affected.

 

If we fail to effectively implement our operational and strategic 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 the growth of our Commercial segment business, introduction of new products and benefit designs, including our Smart products, the successful implementation of our e-business initiatives, the adoption of new technologies and the integration of acquired businesses and contracts. We believe that the adoption of new technologies will contribute toward a reduction in administrative costs. One of the ways we reduce administrative costs is to more closely align our workforce with our membership. This alignment is achieved through reductions in workforce or by employing additional people in certain strategic operating areas such as sales and underwriting. There can be no assurance that we will be able to successfully implement our operational and strategic initiatives that are intended to position the Company for future growth. Failure to implement this strategy or to contain our administrative expenses in line with our membership 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, or 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 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

 

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existing business to fewer systems. 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 problems, have increases in operating expenses, lose existing customers, have difficulty in attracting new customers, or suffer other adverse consequences. 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.

 

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.

 

There can be no assurance that our process of improving existing systems, developing new systems to support our 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.

 

If we fail to manage prescription drug costs successfully, our financial results could suffer.

 

In general, prescription drug costs have been rising over the past few years. These increases are due to the introduction of new drugs costing significantly more than existing drugs, direct to consumer advertising by the pharmaceutical industry that creates consumer demand for particular brand-name drugs, and members seeking medications to address lifestyle changes. In order to control prescription drug costs, we have implemented multi-tiered copayment benefit designs for prescription drugs, including our four-tiered copayment benefit design, Rx4 and an Rx allowance program. We cannot assure that these efforts will be successful in controlling costs. Failure to control these costs could have a material adverse effect on our financial position, results of operations and cash flows.

 

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.

 

We, together with some of our competitors in the health benefits business are defendants in a number of purported class action lawsuits. These include an action originally filed against us and nine of our competitors that purports to be brought on behalf of health care providers. Two companies have now settled this action. This suit alleges breaches of federal statutes, including ERISA and RICO. Depending upon the outcome of these cases, these lawsuits may cause or force changes in the practices of the managed care industry.

 

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 benefits;

 

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

 

  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;

 

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  allegations of anti-competitive and unfair business activities;

 

  provider disputes over compensation and termination of provider contracts;

 

  disputes related to self-funded business, including actions alleging claim administration errors;

 

  claims related to the failure to disclose some business practices; and

 

  claims relating to customer audits and contract performance.

 

In some cases, substantial non-economic or punitive damages as well as treble damages under the federal False Claims Act, RICO 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 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. We believe that we are adequately insured for claims in excess of our self-insurance. However, some types of damages, like punitive damages, may not be covered by insurance, particularly in those jurisdictions in which coverage of punitive damages is prohibited. Insurance coverage for all or some forms of liability may become unavailable or prohibitively expensive in the future.

 

A description of material legal actions in which we are currently involved is included under “Legal Proceedings” in Note 10 to the condensed consolidated financial statements. We cannot predict the outcome of these suits with certainty, and we are incurring expenses in the defense of these matters. Therefore, these legal actions could have a material adverse effect on our financial position, results of operations and cash flows.

 

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 TRICARE, MedicareAdvantage, and Medicaid programs. These programs involve various risks, including:

 

  At September 30, 2004, under one of our contracts with the Centers for Medicare and Medicaid Services, or CMS, we provided health insurance coverage to approximately 230,500 members in Florida. This contract accounted for approximately 15% of our total premiums and ASO fees for the nine months ended September 30, 2004. The loss of this and other CMS contracts or significant changes in the MedicareAdvantage program as a result of legislative or administrative action, including reductions in payments to us or increases in benefits to members without corresponding increases in payments, may have a material adverse effect on our financial condition, results of operations and cash flows;

 

  On November 1, 2004, approximately 1 million members transitioned to our TRICARE South Region contract. This was the final step in the transition of the implementation of the South Region contract. In total, the TRICARE South Region contract now covers approximately 2.8 million beneficiaries. The South Region contract is a five-year contract, subject to annual renewals at the Government’s option. This contract also is generally subject to frequent change from events and circumstances such as the escalated conflict in the Middle East. These changes may include a reduction or increase in the number of persons enrolled or eligible to enroll, in revenue we receive, or in our administrative or health care costs. In the event government reimbursement were to decline from projected amounts, our failure to reduce the health care costs associated with these programs could have a material adverse effect on our business. The loss of our current TRICARE contract would have a material adverse effect on our financial position, results of operations and cash flows;

 

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

 

  higher comparative medical costs;

 

  government regulatory and reporting requirements;

 

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

 

  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.

 

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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 health maintenance organizations, or HMOs, and preferred provider organizations, or PPOs, are subject to substantial federal and state government regulation, including:

 

  regulation relating to minimum net worth;

 

  licensing requirements;

 

  approval of policy language and benefits;

 

  mandated benefits and processes;

 

  provider compensation arrangements;

 

  member disclosure;

 

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

 

  premium rates; and

 

  periodic examinations by state and federal agencies.

 

State regulations require our licensed, operating subsidiaries to maintain minimum net worth requirements and restrict some investment activities. Additionally, those regulations restrict the ability of our subsidiaries to make dividend payments, loans, loan repayments or other payments to us.

 

In recent years, significant federal and state legislation affecting our business has been enacted. State and federal governmental authorities are continually considering changes to laws and regulations applicable to us and are currently considering regulations relating to:

 

  mandatory benefits and products;

 

  rules tightening time periods in which claims must be paid;

 

  medical malpractice reform;

 

  defining medical necessity;

 

  health insurance access;

 

  provider compensation and contract language;

 

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

 

  product flexibility and use of innovative technology;

 

  disclosure of provider quality information;

 

  health plan liability to members who fail to receive appropriate care;

 

  disclosure and composition of physician networks;

 

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

 

  adding further restrictions and administrative requirements on the use, retention, transmission, processing, production and disclosure of personally identifiable health information;

 

  physicians’ ability to collectively negotiate contract terms with carriers, including fees; and

 

  mental health parity.

 

All of these proposals could apply to us.

 

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There can be no assurance that we will be able to continue to obtain or maintain required governmental approvals or licenses or that legislative or regulatory changes will not have a material adverse effect on our business. Delays in obtaining or failure to obtain or maintain required approvals could adversely affect our revenue or the number of our members, increase costs or adversely affect our ability to bring new products to market as forecasted.

 

On October 22, 2004, the President signed into law the American Jobs Creation Act of 2004 (the “Jobs Act”). We are currently evaluating the Jobs Act and are awaiting the interpretive advice; however, we do not believe that any provisions of the Jobs Act will have a material impact on the Company.

 

The National Association of Insurance Commissioners, or NAIC, has adopted risk-based capital requirements, also known as RBC, which is subject to state-by-state adoption and to the extent implemented, sets minimum capitalization requirements for insurance and HMO companies. The NAIC recommendations for life insurance companies were adopted in all states and the prescribed calculation for HMOs has been adopted in most states in which we operate. The HMO rules may increase the minimum capital required for some of our subsidiaries.

 

The NAIC is also evaluating the adoption of Sarbanes-Oxley type audit committee standards and requirements for additional attestations by management and external auditors. We expect the proposal to be amended during the review process. However, as currently drafted, the proposal would cause us to expend substantial resources.

 

The Health Insurance Portability and Accountability Act of 1996, or 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. Under the HIPAA standard transactions and code sets rules, we have made significant systems enhancements and invested in new technological solutions. The compliance and enforcement date for standard transactions and code sets rules was October 16, 2003. We have continued to be in compliance with this regulation. However, as many providers indicated that they could not yet comply, CMS stated that covered entities making a good faith effort to comply with HIPAA transactions and code-set standards would be allowed to implement contingency plans to maintain their operations and cash flows. On October 15, 2003, we announced implementation of a contingency plan to accept non-compliant electronic transactions from our providers. We have continued to accept and process transactions sent in pre-HIPAA electronic formats from providers who are showing a good-faith effort and currently expect to do so until all providers and clearinghouses are capable of transmitting fully compliant standards transactions as defined in the HIPAA implementation guidelines or until CMS begins enforcement of the HIPAA Electronic Data Interchange regulations. Management believes that the implementation of our contingency plans has minimized any disruptions in our business operations during this transition. However, if entities with which we do business do not ultimately comply with the HIPAA transactions and code set standards, it could result in disruptions of certain of our business operations.

 

Additionally, under the new HIPAA privacy rules, which became effective on April 14, 2003, we have complied with a variety of requirements concerning the use and disclosure of individuals’ protected health information, established rigorous internal procedures to protect health information and entered into business associate contracts with those companies to whom protected health information is disclosed. Regulations issued in February 2003 set standards for the security of electronic health information requiring compliance by April 21, 2005. Violations of these rules will subject us to significant penalties. Compliance with HIPAA regulations requires significant systems enhancements, training and administrative effort. The final rules do not provide for complete federal preemption of state laws, but rather preempt all inconsistent state laws unless the state law is more stringent. HIPAA could also expose us to additional liability for violations by our business associates.

 

Another area receiving increased focus is the time in which various laws require the payment of health care claims. Many states already have legislation in place covering payment of claims within a specific number of days. However, due to provider groups advocating for laws or regulations establishing even stricter standards, procedures and penalties, we expect additional regulatory scrutiny and supplemental legislation with respect to claims payment practices. The provider-sponsored bills are characterized by stiff penalties for late payment, including high interest rates payable to providers and costly fines levied by state insurance departments and attorneys general. This legislation and possible future regulation and oversight could expose our Company to additional liability and penalties.

 

We are also subject to various governmental audits and investigations. These can include audits and investigations 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, the Defense Contract Audit Agency, and state Departments of Insurance and Departments of Health. Several Attorneys General are currently investigating the practices of insurance brokers, including those of certain of the companies in the health

 

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care industry. 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 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.

 

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.

 

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/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, in some cases, 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 (i.e. capitation). 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 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., the parent company. These subsidiaries generally are regulated by states’ Departments of Insurance. 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. We are also required by law to maintain specific prescribed minimum amounts of capital in these subsidiaries.

 

Debt ratings are an important factor in our competitive position.

 

Claims paying ability, financial strength, and debt ratings by recognized rating organizations have become 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 ability and financial strength ratings are an important factor in marketing our products to certain of our customers, and 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.

 

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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.

 

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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, 2003.

 

Item 4. Controls and Procedures

 

We carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer, or CEO and Chief Financial Officer, or CFO, of the effectiveness of the design and operation of our disclosure controls and procedures including our internal controls over financial reporting for the quarter ended September 30, 2004.

 

The Company’s management, including the CEO and CFO, does not expect that our disclosure controls and procedures including our internal controls over financial reporting will prevent all error and all fraud. However, they have been designed to give reasonable assurance about the effectiveness of the design and operation of our disclosure controls and procedures including our internal controls over financial reporting. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Control system limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

 

Based on our evaluation, our CEO and CFO concluded that our disclosure controls and procedures, including our internal controls over financial reporting, are effective in timely alerting them to material information required to be included in our periodic SEC reports. There have been no significant changes in our internal controls over financial reporting or in other factors that are reasonably likely to affect those controls over financial reporting during the Company’s quarter ended September 30, 2004.

 

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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 10 to the condensed financial statements beginning on page 14 of this Form 10-Q.

 

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

 

The following table provides information about purchases by us during the nine months ended September 30, 2004 of equity securities that are registered by us pursuant to Section 12 of the Exchange Act:

 

Period

  Total Number
of Shares
Purchased (1)


  Average
Price Paid
per Share


  Total Number of
Shares Purchased
as Part of Publicly
Announced Plans
or Programs (2)(3)


  Dollar Value of
Shares that May
Yet Be Purchased
Under the Plans
or Programs


January 2004   150,000   $ 20.7130   150,000   $ 96,893,049
February 2004   129,000   $ 21.2539   129,000   $ 94,151,299
March 2004   407,000   $ 19.9013   407,000   $ 86,051,470
   
 

 
 

        Total 1Q04   686,000   $ 20.3331   686,000   $ 86,051,470
   
 

 
 

April 2004   400,000   $ 18.1595   400,000   $ 78,787,668
May 2004   1,050,000   $ 16.2339   1,050,000   $ 61,742,092
June 2004   717,500   $ 16.3821   717,500   $ 49,987,941
   
 

 
 

        Total 2Q04   2,167,500   $ 16.6383   2,167,500   $ 49,987,941
   
 

 
 

July 2004   382,500   $ 16.7066   382,500   $ 43,597,650
August 2004   400,000   $ 17.9669   400,000   $ 36,410,905
September 2004   —     $ —     —     $ 36,410,905
   
 

 
 

        Total 3Q04   782,500   $ 17.3508   782,500   $ 36,410,905
   
 

 
 

                Total   3,636,000   $ 17.4888   3,636,000   $ 36,410,905
   
 

 
 


(1) We repurchased an aggregate of 3,636,000 shares of our common stock pursuant to the repurchase program that we publicly announced in July 2003 (the “Program”).
(2) Our board of directors approved the repurchase by us of shares of our common stock having a value of up to $100 million in the aggregate pursuant to the Program. The expiration date of this program is January 2005.
(3) Excludes 34,970 shares repurchased in connection with employee equity-based compensation plans.

 

Item 3: Defaults Upon Senior Securities

 

None.

 

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

 

None.

 

Item 5: Other Information

 

None.

 

Item 6: Exhibits

 

Exhibit Index:

 

10 (a)   Executive Long-Term Disability Program
10 (b)   Five-Year $600 Million Credit Agreement among Humana Inc., and J.P. Morgan Chase Bank, as Agent and as CAF Loan Agent, Bank of America, N.A., Citibank, N.A., U.S. Bank National Association, and Wachovia Bank, National Association as Syndication Agents and J.P. Morgan Securities Inc., as Sole Lead Arranger and Sole Lead Bookrunner.

 

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Part II. Other Information, continued

 

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: November 5, 2004

  

By:

 

/s/ STEVEN E. MCCULLEY


         Steven E. McCulley
         Vice President
         And Controller
         (Principal Accounting Officer)

Date: November 5, 2004

  

By:

 

/s/ ARTHUR P. HIPWELL


         Arthur P. Hipwell
         Senior Vice President and
         General Counsel

 

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