UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-K

 

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

For the fiscal year ended December 31, 20052006

OR

 

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

For the transition period fromto

For the transition period fromto

Commission file number 1-5975

 


HUMANA INC.

(Exact name of registrant as specified in its charter)

 

Delaware 61-0647538
(State of incorporation) (I.R.S. Employer Identification Number)

500 West Main Street

Louisville, Kentucky

 40202
(Address of principal executive offices) (Zip Code)

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

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

 

Title of each class

 

Name of exchange on which registered

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

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

None

 


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

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

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

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

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

Large accelerated filerþ        Accelerated filer¨        Non-accelerated filer¨

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

The aggregate market value of voting stock held by non-affiliates of the Registrant as of June 30, 20052006 was $6,396,835,252$8,784,278,391 calculated using the average price on such date of $39.79.$53.72.

The number of shares outstanding of the Registrant’s Common Stock as of January 31, 20062007 was 163,485,922.166,720,633.

DOCUMENTS INCORPORATED BY REFERENCE

Parts I, II and III incorporate herein by reference portions of the Registrant’s Proxy Statement to be filed pursuant to Regulation 14A covering the Annual Meeting of Stockholders scheduled to be held April 27, 2006.26, 2007.

 



HUMANA INC.

INDEX TO ANNUAL REPORT ON FORM 10-K

For the Year Ended December 31, 20052006

 

    Page
  Part I  

Item 1.

  Business  3

Item 1A.

  Risk Factors  1716

Item 1B.

  Unresolved Staff Comments  26

Item 2.

  Properties  2726

Item 3.

  Legal Proceedings  27

Item 4.

  Submission of Matters to a Vote of Security Holders  2827
  Part II  

Item 5.

  Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities  2928

Item 6.

  Selected Financial Data  30

Item 7.

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

Item 7A.

  Quantitative and Qualitative Disclosures about Market Risk  5860

Item 8.

  Financial Statements and Supplementary Data  5961

Item 9.

  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure  9796

Item 9A.

  Controls and Procedures  9796

Item 9B.

  Other Information  9897
  Part III  

Item 10.

  Directors, and Executive Officers of the Registrantand Corporate Governance  9998

Item 11.

  Executive Compensation  101100

Item 12.

  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters  102101

Item 13.

  Certain Relationships and Related Transactions, and Director Independence  102101

Item 14.

  Principal AccountantAccounting Fees and Services  102101
  Part IV  

Item 15.

  Exhibits, and Financial Statement Schedules  103102
  Signatures and Certifications  113112


PART I

 

ITEM 1.BUSINESS

General

Headquartered in Louisville, Kentucky, Humana Inc., referred to throughout this document as “we,” “us,” “our,” the “Company” or “Humana,” is one of the nation’s largest publicly traded health benefits companies, based on our 20052006 revenues of $14.4$21.4 billion. We offer coordinated health insurance coverage and related services through a variety of traditional and Internet-basedconsumer-choice plans for government-sponsored programs, employer groups, government-sponsored programs, and individuals. As of December 31, 2005,2006, we had approximately 7.111.3 million members in our medical insurancebenefit programs, as well as approximately 1.9 million members in our specialty products programs. We have approximately 559,000 contracts with physicians, hospitals, dentists, and other providers to provide health care to our members. During 2005, 51%2006, 67% of our premiums and administrative services fees were derived from contracts with the federal government, including 17% related to our TRICARE contracts and 20% related to our contracts in Florida with the Centers for Medicare and Medicaid Services, or CMS.CMS, and 12% related to our TRICARE contracts. Under our CMS contracts in Florida, we provide health insurance coverage to approximately 295,400518,900 members as of December 31, 2005.2006.

We were organized as a Delaware corporation in 1964. Our principal executive offices are located at 500 West Main Street, Louisville, Kentucky 40202, and the telephone number at that address is (502) 580-1000.580-1000, and our website address is www.humana.com.

We adopted SFAS No. 123 (revised 2004),Share-Based Payment, or SFAS 123R, on January 1, 2006. We have adjusted prior period amounts to reflect the effect of expensing stock awards under the modified retrospective application method of SFAS 123R as discussed in Note 11 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data.

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

Business Segments

We manage our business with two segments: Government and Commercial. The Government segment consists of members enrolled in government-sponsored programs, and includes three lines of business: Medicare, Advantage, TRICARE, and Medicaid. The Commercial segment consists of members enrolled in products marketed to employer groups and individuals, and includes threetwo lines of business: fully insured medical administrative services only, or ASO,(fully and self insured) and specialty. We identified our segments in accordance with the aggregation provisions of Statement of Financial Accounting Standards (SFAS) No. 131,Disclosures About Segments of an Enterprise and Related Information, or SFAS 131, which 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 often utilize the same medical provider networks, enabling us to obtain more favorable contract terms with providers. Our segments also share overhead costs and assets. As a result, the profitability of each segment is interdependent. We believe our customer, membership, revenue, and pretax income diversification across segments and products allows us to increase our chances of success.

Our Products

As more fully described in the products discussion that follows, we provide health insurance benefits under health maintenance organization, or HMO, Private Fee-For-Service, or PFFS, and preferred provider organization, or PPO, plans. The following table presents our segment membership at December 31, 2006, and premiums and administrative services only, or ASO, fees by product for the year ended December 31, 2005:2006:

 

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

Government:

        

Medicare Advantage:

            

HMO

  427,900  —    $4,092,166  $—    $4,092,166  28.7%

PFFS

  121,300  —     459,474   —     459,474  3.2%

PPO

  8,600  —     38,722   —     38,722  0.3%
                      

Total Medicare Advantage

  557,800  —     4,590,362   —     4,590,362  32.2%

Medicaid

  457,900  —     548,714   —     548,714  3.8%

TRICARE

  1,750,900  —     2,407,653   —     2,407,653  16.9%

TRICARE ASO

  1,138,200  —     —     50,059   50,059  0.4%
                      

Total Government

  3,904,800  —     7,546,729   50,059   7,596,788  53.3%
                      

Commercial:

        

Fully insured:

            

PPO

  1,295,200  —     3,635,347   —     3,635,347  25.5%

HMO

  704,600  —     2,432,768   —     2,432,768  17.1%
                      

Total fully insured

  1,999,800  —     6,068,115   —     6,068,115  42.6%

ASO

  1,171,000  —     —     209,378   209,378  1.4%

Specialty

  —    1,902,100   386,747   —     386,747  2.7%
                      

Total Commercial

  3,170,800  1,902,100   6,454,862   209,378   6,664,240  46.7%
                      

Total

  7,075,600  1,902,100  $14,001,591  $259,437  $14,261,028  100.0%
                      

*As of December 31, 2005.
  Medical
Membership
 Specialty
Membership
 Premiums ASO Fees Total
Premiums and
ASO Fees
 Percent of
Total
Premiums
and ASO
Fees
 
  (dollars in thousands) 

Government:

 

Medicare Advantage:

      

HMO

 457,900 —   $4,869,044 $—   $4,869,044 23.1%

PFFS

 473,000 —    3,136,200  —    3,136,200 14.9%

PPO

 71,700 —    493,820  —    493,820 2.3%
                

Total Medicare Advantage

 1,002,600 —    8,499,064  —    8,499,064 40.3%
                

Medicare stand-alone PDP

 3,536,600 —    3,050,304  —    3,050,304 14.5%
                

Total Medicare

 4,539,200 —    11,549,368  —    11,549,368 54.8%
                

Medicaid

 390,700 —    520,520  —    520,520 2.5%

Medicaid ASO

 178,400 —    —    1,423  1,423 —  %
                

Total Medicaid

 569,100 —    520,520  1,423  521,943 2.5%
                

TRICARE

 1,716,400 —    2,543,930  —    2,543,930 12.1%

TRICARE ASO

 1,163,600 —    —    48,019  48,019 0.2%
                

Total TRICARE

 2,880,000 —    2,543,930  48,019  2,591,949 12.3%
                

Total Government

 7,988,300 —    14,613,818  49,442  14,663,260 69.6%
                

Commercial:

      

Fully insured:

      

PPO

 1,246,500 —    3,684,442  —    3,684,442 17.4%

HMO

 507,700 —    2,019,936  —    2,019,936 9.6%
                

Total fully insured

 1,754,200 —    5,704,378  —    5,704,378 27.0%

ASO

 1,529,600 —    —    291,769  291,769 1.4%

Specialty

 —   1,902,800  410,986  —    410,986 2.0%
                

Total Commercial

 3,283,800 1,902,800  6,115,364  291,769  6,407,133 30.4%
                

Total

 11,272,100 1,902,800 $20,729,182 $341,211 $21,070,393 100.0%
                

Our Products Marketed to Government Segment Members and Beneficiaries

Medicare Advantage Products

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

We contract with CMS under the Medicare Advantage program to provide a comprehensive array of health insurance benefits including wellness programs to Medicare eligible persons under health maintenance organization, or HMO, preferred provider organization, or PPO, and Private Fee-For-Service, or PFFS plans in exchange for contractual payments received from CMS, usually a fixed payment per member per month. We refer to beneficiaries enrolled in these plans collectively as Medicare Advantage or MA-PD members. With each of these products, the beneficiary generally receives benefits in excess of traditional Medicare, typically including areduced cost sharing, enhanced prescription drug benefit,benefits, care coordination, data mining techniques to help identify member needs, complex case management, tools to guide members in their health care decisions, disease management programs, wellness and prevention programs, and a reduced monthly Part B premium, or reduced cost sharing. Beginning inpremium. Since 2006, Medicare beneficiaries have had more health plan options, including a prescription drug benefit option and greater access to a PPO offering with the roll-out of Regional

PPO plans. Prior to 2006, PPO plans were offered on a local basis only. Most Medicare Advantage plans must offer the prescription drug benefit under Part D as part of the basic plan, subject to cost sharing and other limitations. Accordingly, all of the provisions of the Medicare Part D program described in connection with our stand-alone prescription drug plans in the following section are also applicable to our Medicare Advantage plans. Medicare Advantage plans may charge beneficiaries monthly premiums and other copayments for Medicare-covered services or for certain extra benefits.

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

Our Medicare PFFS plans which cover eligible Medicare beneficiaries in certain states, have no preferred network. Individuals in these plans pay us a monthly premium to receive enhanced prescription drugtypical Medicare Advantage benefits and havealong with the freedom to choose any health care provider that accepts individuals at reimbursement rates equivalent to traditional Medicare payment rates.

MedicareCMS uses monthly rates per person for each county to determine the fixed monthly payments per member to pay to managed carehealth benefit plans. InThese rates are adjusted under CMS’s risk adjustment model which uses health status indicators, or risk scores, to improve the last decade, Congress has made several changesaccuracy of payment. The risk adjustment model, which CMS implemented pursuant to how CMS must calculate these rates. The old (pre-1998) methodology was based on the Adjusted Average Per Capita Cost methodology, or AAPCC. Under AAPCC, CMS projected average county-level fee-for-service spending for the coming year to set the fixed monthly payments for Medicare health plans at 95 percent of the full AAPCC amount.

Under the AAPCC system, payment rates per county varied widely. For example, the 1997 payment rate for beneficiaries 65 and older for Part A and Part B services ranged from a low of $220.92 in Arthur County, Nebraska to a high of $767.35 in Richmond County, Staten Island, New York. Some states saw differences of more than 20 percent between adjacent counties. Since county fee-for-service costs were used to estimate county managed care payment rates, the rates reflected differences among counties and regions in fee-for-service utilization patterns and cost structures.

In the Balanced Budget Act of 1997 (BBA) and the Benefits and Improvement Protection Act of 2000 (BIPA), Congress created a new rate-setting methodology, eliminating the direct link in the AAPCC method between managed care rates and local fee-for-service costs. As a result, the wide disparities in county payment rates were reduced, bringing all payment rates closer to the national average.

Additionally, the BBA required CMS to implement a risk adjustment payment system for Medicare health plans. Risk adjustment uses health status indicators to improve the accuracy of payments and establish incentives for plans to enroll and treat less healthy Medicare beneficiaries. CMS initially phased-in this payment methodology with a risk adjustment model that based payment on principal hospital inpatient diagnoses as well as demographic factors such as gender, age, and Medicaid eligibility. From 2000 to 2003, risk adjusted payment accounted for only 10 percent of Medicare health plans payment, with the remaining 90 percent being based on demographic factors.

Pursuant to the Benefits and Improvements Protection Act of 2000 (BIPA), CMS implemented a new risk adjustment model that uses additional diagnosis data from ambulatory treatment settings (hospital outpatient department and physician visits). CMS has also redesigned itstransitioned to this risk-based reimbursement model while the old reimbursement model based on demographic data collectionincluding gender, age, and processing system to further reduce administrative data burden on Medicare health plans.disability status was phased out. In 2005,2006, the portion of risk adjusted payment was increased to 50 percent,75%, from 30 percent50% in 2004.2005. The phase-in of risk adjusted payment will behas increased to 75% in 2006 and to 100% in 2007. Under the new risk adjustment methodology, all managed carehealth benefit organizations must capture, collect, and submit the necessary diagnosis code information to CMS within prescribed deadlines.

Commensurate with phase-in of the new risk-adjustment methodology, payments to Medicare Advantage plans have beenwere increased by a “budget neutrality” factor. The budget neutrality factor was implemented to prevent overall health plan payments from being reduced during the transition from the previous reimbursement model, based upon average original Medicare fee-for-service spending, to the new risk-adjustment

payment model. The payment adjustments for budget neutrality were first developed in 2002 and began to befirst used with the 2003 payments.

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

At December 31, 2005,2006, we provided health insurance coverage under CMS contracts to approximately 557,800 Medicare Advantage1,002,600 MA-PD members for which we received premium revenues of approximately $4.6$8.5 billion, or 32.2%40.3% of our total premiums and ASO fees for the year ended December 31, 2005.2006. Under our Medicare Advantage contracts with CMS in Florida, we provided health insurance coverage to approximately 295,400324,600 members. These contracts accounted for premium revenues of approximately $2.8$3.5 billion, which represented approximately 60.9%41.2% of our Medicare Advantage premium revenues, or 19.9%16.6% of our total premiums and ASO fees for the year ended December 31, 2005.2006.

Our HMO, PPOPFFS, and PFFSPPO products covered under Medicare Advantage contracts with CMS are renewed generally for a one-year term each December 31 unless CMS notifies Humana of its decision not to renew by May 1 of the contract year, or Humana notifies CMS of its decision not to renew by the first Monday in June of the contract year.

Medicare Stand-Alone Prescription Drug Products

On January 1, 2006, we began covering members inoffering stand-alone prescription drug plans, or PDPs, under Medicare Part D. For 2006 coverage,Generally, Medicare-eligible individuals may enroll between November 15, 2005 and May 15, 2006 in one of our three plan choices. These three plan choices Standard, Enhancedbetween November 15 and Complete, may vary in termsDecember 31 for coverage that begins January 1. The enrollment period was extended to May 31 during 2006 because it was the first year of the program. Our stand-alone PDP offerings consist of plans offering basic coverage levels andwith benefits mandated by Congress, as well as plans providing enhanced coverage with varying degrees of out-of-pocket costs for premiums, deductibles and co-insurance withco-insurance. Our revenues from CMS and the Standard plan offeringbeneficiary are determined from our bids submitted annually to CMS. These revenues also reflect the minimum benefits mandated by Congress. Our bid amount generally represents the payment we receive from CMS. However, this payment is subject to adjustments and subsidies in order for Humana and CMS to share the risk associated with financing the ultimate costhealth status of the health benefit. Further, the amount of the payment we receive from CMS is subject to thebeneficiary and risk adjustment payment process previouslysharing provisions as more fully described in order to take into account beneficiaries’ health status risk factors. Unlike our Medicare Advantage products, there is no phase-in of the risk adjustment payment process for ourbeginning on page 55. Our stand-alone PDP products. Our PDP products covered under Medicare Part D contracts with CMS are renewed generally for a one-year term each December 31 unless CMS notifies Humana of its decision not to renew by May 1 of the contract year, or Humana notifies CMS of its decision not to renew by the first Monday in June of the contract year.

Medicare Presence

We now have a national presence, offering our Medicare PFFS and stand-alone PDP products in all 50 states. The following table sets forth the number of markets in which we sold our Medicare Advantage and stand-alone PDP products as of January 1, 2006,2007, as compared with January 1, 20052006 and 2004:2005:

 

  2006  2005  2004  2007  2006  2005

PFFS (states)

  50  35  35

HMO (localities)

  12  12  11  12  12  12

Regional PPO (states)

  23  23  —  

Local PPO (localities)

  33  30  1  26  33  30

Regional PPO (states)

  23  —    —  

PFFS (states)

  35  35  12

PDP (states)

  46  —    —  

Stand-alone PDP (states)

  50  46  —  

In addition, we are marketingmarket our HMO and PFFS products in Puerto Rico for coverage beginning January 1, 2006.as well as our stand-alone PDP products in the District of Columbia and Puerto Rico.

Medicaid Product

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

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

Our Medicaid business, which accounted for approximately 3.8%2.5% of our total premiums and ASO fees for the year ended December 31, 2005,2006, consisted of contracts in Puerto Rico Florida and Illinois. Our 3-year Medicaid contractsFlorida, with the Puerto Rico Health Insurance Administration, which accounted for approximately 2.8%contract representing 75.2% of our total premium and ASO fees for the year ended December 31, 2005, were extended a fourth year and these contracts expire on June 30, 2006. We are preparing to bid on the new contracts that will be effective July 2006 although a request for such proposal has not yet been issued by the Puerto Rico Health Insurance Administration. At this time we are unable to predict the ultimate impact that any government policy decisions might have on our Medicaid contracts in Puerto Rico.

Our other current Medicaid contract, which is in Florida, is scheduled to expire on June 30, 2006. Due to Medicaid reform in Florida, we are currently negotiating the terms and rates for the renewal contract. We expect the current contract to be extended until August 31, 2006, and the subsequent renewal contract to be effective for a two-year term beginning September 1, 2006. Due to continual decreases in the reimbursement from the state of Illinois, we exited the Illinois Medicaid market effective July 31, 2005. The Illinois and Florida Medicaid contracts accounted for approximately 1.0% of our total premiums and ASO fees for the year ended December 31, 2005.fees.

TRICARE

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

We have participated in the TRICARE program since 1996 under contracts with the United States Department of Defense. Our current TRICARE South Region contract, which we were awarded in 2003, covers approximately 2.9 million eligible beneficiaries as of December 31, 20052006 in Florida, Georgia, South Carolina, Mississippi, Alabama, Tennessee, Louisiana, Arkansas, Texas and Oklahoma. The South Region is one of the three regions in the United States as defined by the Department of Defense. Of these eligible beneficiaries, 1.11.2 million were TRICARE ASO members representing active duty beneficiaries, seniors over the age of 65 and beneficiaries in Puerto Rico for which the Department of Defense retains all of the risk of financing the cost of their health benefit. The TRICARE South Region contract is for a five-year period subject to annual renewals at the federal government’s option, with the thirdfourth option period scheduled to begin April 1, 2006.2007. We have subcontracted with third parties to provide selected administration and specialty services under the contract.

The TRICARE South Region contract contains provisions that require us to negotiate a target health care cost amount annually with the federal government. Any variance from the target health care cost is shared with the federal government. As such, events and circumstances not contemplated in the negotiated target health care

cost amount could have a material adverse effect on our business. These changes may include, for example, an increase or reduction in the number of persons enrolled or eligible to enroll due to the federal government’s decision to increase or decrease U.S. military presence around the world.deployments. In the event government reimbursements were to decline from projected amounts, our failure to reduce the health care costs associated with these programs could have a material adverse effect on our business.

During 2004, we completed a contractual transition of our TRICARE business. On July 1, 2004, our Regions 2 and 5 contract servicing approximately 1.1 million TRICARE members became part of the new North Region, which was awarded to another contractor. On August 1, 2004, our Regions 3 and 4 contract became part of our new South Region contract. On November 1, 2004, the Region 6 contract with approximately 1 million members became part of the South Region contract. The members added with the Region 6 contract essentially offset the members lost four months earlier with the expiration of our Regions 2 and 5 contract. For the year ended December 31, 2005,2006, TRICARE premium revenues were approximately $2.4$2.5 billion, or 16.9%12.1% of our total premiums and ASO fees.

Part of the TRICARE transition during 2004 included the carve out of the TRICARE Senior Pharmacyfees, and TRICARE for Life program which we previously administered on as ASO basis. On June 1, 2004 and August 1, 2004, administrative services under these programs were transferred to another contractor. For the year ended December 31, 2005, TRICARE administrative services fees totaled $50.1$48.0 million, or 0.4%0.2% of our total premiums and ASO fees.

Our Products Marketed to Commercial Segment Employers and Members

Consumer-Choice Products

Over the last several years, we have developed and offered various commercial products designed to provide options and choices to employers that are annually facing substantial premium increases driven by double-digit medical cost inflation. These consumer-choice products, which can be offered on either a fully insured or ASO basis, provided coverage to approximately 371,100437,900 members at December 31, 2005,2006, representing approximately 11.7%13.3% of our total commercial medical membership as detailed below.

 

  Consumer-Choice
Membership
  Other Commercial
Membership
  Commercial
Medical
Membership
  Consumer-Choice
Membership
  Other Commercial
Membership
  

Commercial
Medical

Membership

Fully insured

  184,000  1,815,800  1,999,800  231,900  1,522,300  1,754,200

Administrative services only

  187,100  983,900  1,171,000

ASO

  206,000  1,323,600  1,529,600
                  

Total Commercial medical

  371,100  2,799,700  3,170,800  437,900  2,845,900  3,283,800
                  

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

Paramount to our consumer-choice product strategy, we have developed a group of innovative consumer products, styled as “Smart” products, that we believe will be a long-term solution for employers. We believe this new generation of products provides more (1) choices for the individual consumer, (2) transparency of provider costs, and (3) benefit designs that engage consumers in the costs and effectiveness of health care choices. Innovative tools and technology are available to assist consumers with these decisions, including the trade-offs between higher premiums and point-of-service costs at the time consumers choose their plans, and to suggest ways in which the consumers can maximize their individual benefits at the point they use their plans. We believe that when consumers can make informed choices about the cost and effectiveness of their health care, a sustainable long term solution for employers can be realized. Smart products, which accounted for approximately 65.1%63% of enrollment in all of our consumer-choice plans as of December 31, 2005,2006, are only are sold to employers who use Humana as their sole health insurance carrier.

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

HMO

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

An HMO member, typically through the member’s employer, pays a monthly fee, which generally covers, together with some copayments, health care services received from, or approved by, the member’s primary care physician. We participate in the Federal Employee Health Benefits Program, or FEHBP, primarily with our HMO offering in certain markets. FEHBP is the government’s health insurance program for Federal employees, retirees, former employees, family members, and former spouses. For the year ended December 31, 2005,2006, commercial HMO premium revenues totaled approximately $2.4$2.0 billion, or 17.1%9.6% of our total premiums and ASO fees.

PPO

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

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

For the year ended December 31, 2005, commercial2006, employer and individual commercial PPO premium revenues totaled approximately $3.6$3.7 billion, or 25.5%17.4% of our total premiums and ASO fees.

Administrative Services OnlyASO

WeIn addition to fully insured consumer-choice, HMO and PPO products, we also offer ASO products to employers who self-insure their employee health plans. We receive fees to provide administrative services which generally include the processing of claims, offering access to our provider networks and clinical programs, and responding to customer service inquiries from members of self-funded employers. These products may include all of the same benefit and product design characteristics of our fully insured PPO, HMO or consumer-choice products described above.previously. Under ASO contracts, self-funded employers

retain the risk of financing substantially all of the cost of health benefits. However, most ASO customers purchase stop loss insurance coverage from us to cover catastrophic claims or to limit aggregate annual costs. For the year ended December 31, 2005,2006, commercial ASO fees totaled $209.4$291.8 million, or 1.4% of our total premiums and ASO fees.

Specialty Products

We additionally offer various specialty products including dental, group and individual life, and short-term disability. At December 31, 2005,2006, we had approximately 1.9 million specialty members, including 1.5 million dental members. For the year ended December 31, 2005,2006, specialty product premium revenues were approximately $386.7$411.0 million, or 2.7%2.0% of our total premiums and ASO fees.

The following table summarizes our total medical membership at December 31, 2005,2006, by market and product:

 

  Commercial  Government  

Total

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

Florida

  161.4  150.9  101.9  295.4  54.8  —    764.4  10.8% 324.6 194.3 46.0 —   144.6 152.4 81.4 943.3 8.4%

Texas

  65.5  299.1  237.9  25.3  —    —    627.8  8.9  56.0 265.5 —   —   265.0 60.5 189.4 836.4 7.4%

Kentucky

 16.5 72.5 —   —   181.0 30.4 484.3 784.7 7.0%

Illinois

 45.1 94.2 —   —   129.7 73.3 146.4 488.7 4.3%

Ohio

 30.6 124.9 —   —   64.7 60.4 187.5 468.1 4.2%

Puerto Rico

  18.9  69.1  6.9  7.1  403.1  —    505.1  7.1  23.7 —   344.7 —   43.7 17.8 —   429.9 3.8%

Illinois

  98.5  154.8  158.4  36.8  —    —    448.5  6.3 

Kentucky

  23.2  162.4  195.2  2.0  —    —    382.8  5.4 

Ohio

  98.9  60.3  188.8  4.1  —    —    352.1  5.0 

Wisconsin

  52.3  64.3  179.1  17.5  —    —    313.2  4.4  31.5 58.7 —   —   70.4 35.6 199.6 395.8 3.5%

Missouri/Kansas

 48.8 185.2 —   —   33.8 18.9 11.1 297.8 2.6%

California

 —   269.6 —   —   1.5 —   —   271.1 2.4%

Louisiana

  118.8  31.6  9.7  38.1  —    —    198.2  2.8  51.7 58.4 —   —   34.4 21.1 102.4 268.0 2.4%

Arizona

  17.6  52.4  31.1  19.7  —    —    120.8  1.7 

Missouri/Kansas

  27.4  27.2  12.8  24.2  —    —    91.6  1.3 

Indiana

  0.4  51.1  36.5  1.3  —    —    89.3  1.3  17.4 111.3 —   —   53.0 0.6 50.1 232.4 2.1%

Tennessee

 16.7 103.3 —   —   30.1 —   35.9 186.0 1.7%

Georgia

  21.7  29.2  1.9  13.1  —    —    65.9  0.9  33.2 91.2 —   —   23.6 27.1 1.7 176.8 1.6%

Michigan

  —    58.3  1.7  1.8  —    —    61.8  0.9  14.8 107.0 —   —   50.0 —   1.0 172.8 1.5%

North Carolina

 41.5 124.5 —   —   4.1 —   —   170.1 1.5%

Arizona

 29.4 50.2 —   —   46.6 9.6 27.4 163.2 1.4%

New York

 —   139.1 —   —   —   —   —   139.1 1.2%

Pennsylvania

 10.6 120.1 —   —   3.6 —   —   134.3 1.2%

Virginia

 35.0 98.4 —   —   0.3 —   —   133.7 1.2%

Colorado

  —    43.1  —    0.5  —    —    43.6  0.6  9.8 41.7 —   —   50.9 —   2.6 105.0 0.9%

Tennessee

  —    22.9  3.9  5.0  —    —    31.8  0.4 

South Carolina

  —    1.4  0.2  17.1  —    —    18.7  0.3 

North Carolina

  —    4.1  1.5  13.0  —    —    18.6  0.3 

Mississippi

 11.4 82.9 —   —   8.4 —   0.8 103.5 0.9%

Alabama

 7.4 94.1 —   —   0.1 —   —   101.6 0.9%

Minnesota

  —    —    0.3  11.3  —    —    11.6  0.2  26.9 73.8 —   —   —   —   0.2 100.9 0.9%

Puerto Rico ASO

 —   —   178.4 —   —   —   7.8 186.2 1.7%

TRICARE

  —    —    —    —    —    1,750.9  1,750.9  24.7  —   —   —   1,716.4 —   —   —   1,716.4 15.2%

TRICARE ASO

  —    —    —    —    —    1,138.2  1,138.2  16.1  —   —   —   1,163.6 —   —   —   1,163.6 10.3%

Others

  —    13.0  3.2  24.5  —    —    40.7  0.6  120.0 975.7 —   —   7.0 —   —   1,102.7 9.8%
                                            

Totals

  704.6  1,295.2  1,171.0  557.8  457.9  2,889.1  7,075.6  100.0% 1,002.6 3,536.6 569.1 2,880.0 1,246.5 507.7 1,529.6 11,272.1 100.0%
                                            

Provider Arrangements

We provide our members with access to health care services through our networks of health care providers with whom we have contracted, including hospitals and other independent facilities such as outpatient surgery centers, primary care physicians, specialist physicians, dentists and providers of ancillary health care services and facilities. We have approximately 559,000809,000 contracts with health care providers participating in our networks, which consist of approximately 336,300539,800 physicians, 3,6005,300 hospitals, and 219,100263,900 ancillary providers and dentists. These ancillary services and facilities include ambulance services, medical equipment services, home health agencies, mental health providers, rehabilitation facilities, nursing homes, optical services, and pharmacies. Our membership base and the ability to influence where our members seek care generally enable us to obtain contractual discounts with providers.

We use a variety of techniques to provide access to effective and efficient use of health care services for our members. These techniques include the coordination of care for our members, product and benefit designs, hospital inpatient management systems and enrolling members into various disease management programs. The

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

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

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

Capitation

For 4.4%2.4% of our December 31, 20052006 medical membership, we contract with hospitals and physicians to accept financial risk for a defined set of HMO membership. In transferring this risk, we prepay these providers a monthly fixed-fee per member, known as a capitation (per capita) payment, to coordinate substantially all of the medical care for their capitated HMO membership, including some health benefit administrative functions and claims processing. For these capitated HMO arrangements, we generally agree to reimbursement rates that target a medical expense ratio, or MER, ranging from 82% to 89%. MER measures underwriting profitability and is computed by taking total medical expenses as a percentage of premium revenues. Providers participating in hospital-based capitated HMO arrangements generally receive a monthly payment for all of the services within their system for their HMO membership. Providers participating in physician-based capitated HMO arrangements generally have subcontracted directly with hospitals and specialist physicians, and are responsible for reimbursing such hospitals and physicians for services rendered to their HMO membership.

For 7.8%another 4.8% of our December 31, 20052006 medical membership, we contract with physicians under risk-sharing arrangements whereby physicians have assumed some level of risk for all or a portion of the medical costs of their HMO membership. Although these arrangements do include capitation payments for services rendered, we process substantially all of the claims under these arrangements.

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

Medical membership under these various arrangements was as follows at December 31, 20052006 and 2004:2005:

 

 Commercial Segment Government Segment 

Consol.

Total

Medical

  Government Segment Commercial Segment Total
Medical
 
 

Fully

Insured

 ASO 

Total

Segment

 Medicare
Advantage
 Medicaid TRICARE 

TRICARE

ASO

 

Total

Segment

  Medicare
Advantage
 Medicare
Stand-alone
PDP
 TRICARE TRICARE
ASO
 Medicaid Total
Segment
 Fully
Insured
 ASO Total
Segment
 

Medical Membership:

         

Medical Membership:

 

         

December 31, 2006

          

Capitated HMO hospital system based

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

Capitated HMO physician group based

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

Risk-sharing

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

Other

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

Total

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

December 31, 2005

                   

Capitated HMO hospital system based

 42,600  —    42,600  35,200  —    —    —    35,200  77,800  35,200  —    —    —    —    35,200  42,600  —    42,600  77,800 

Capitated HMO physician group based

 39,500  —    39,500  23,300  170,400  —    —    193,700  233,200  23,300  —    —    —    170,400  193,700  39,500  —    39,500  233,200 

Risk-sharing

 49,700  —    49,700  230,200  274,200  —    —    504,400  554,100  230,200  —    —    —    274,200  504,400  49,700  —    49,700  554,100 

Other

 1,868,000  1,171,000  3,039,000  269,100  13,300  1,750,900  1,138,200  3,171,500  6,210,500  269,100  —    1,750,900  1,138,200  13,300  3,171,500  1,868,000  1,171,000  3,039,000  6,210,500 
                                                         

Total

 1,999,800  1,171,000  3,170,800  557,800  457,900  1,750,900  1,138,200  3,904,800  7,075,600  557,800  —    1,750,900  1,138,200  457,900  3,904,800  1,999,800  1,171,000  3,170,800  7,075,600 
                                                         

December 31, 2004

         

Medical Membership Distribution:

Medical Membership Distribution:

 

        

December 31, 2006

          

Capitated HMO hospital system based

 70,300  —    70,300  38,400  17,400  —    —    55,800  126,100  3.0% —    —    —    —    0.4% 1.9% —    1.0% 0.6%

Capitated HMO physician group based

 56,300  —    56,300  4,200  188,200  —    —    192,400  248,700  2.4% —    —    —    26.1% 2.2% 1.7% —    0.9% 1.8%

Risk-sharing

 68,000  —    68,000  208,300  240,700  —    —    449,000  517,000  27.9% —    —    —    42.1% 6.4% 1.5% —    0.8% 4.8%

Other

 2,091,900  1,018,600  3,110,500  126,300  32,300  1,789,400  1,082,400  3,030,400  6,140,900 

All other membership

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

Total

 2,286,500  1,018,600  3,305,100  377,200  478,600  1,789,400  1,082,400  3,727,600  7,032,700  100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
                           

Medical Membership Distribution:

 

        
                              

December 31, 2005

                   

Capitated HMO hospital system based

 2.1% —    1.3% 6.3% —    —    —    0.9% 1.1% 6.3% —    —    —    —    0.9% 2.1% —    1.3% 1.1%

Capitated HMO physician group based

 2.0% —    1.2% 4.2% 37.2% —    —    5.0% 3.3% 4.2% —    —    —    37.2% 5.0% 2.0% —    1.2% 3.3%

Risk-sharing

 2.5% —    1.6% 41.3% 59.9% —    —    12.9% 7.8% 41.3% —    —    —    59.9% 12.9% 2.5% —    1.6% 7.8%

All other membership

 93.4% 100.0% 95.9% 48.2% 2.9% 100.0% 100.0% 81.2% 87.8% 48.2% —    100.0% 100.0% 2.9% 81.2% 93.4% 100.0% 95.9% 87.8%
                                                         

Total

 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% —    100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
                                                         

December 31, 2004

         

Capitated HMO hospital system based

 3.1% —    2.1% 10.2% 3.6% —    —    1.5% 1.8%

Capitated HMO physician group based

 2.5% —    1.7% 1.1% 39.3% —    —    5.2% 3.5%

Risk-sharing

 3.0% —    2.1% 55.2% 50.4% —    —    12.0% 7.4%

All other membership

 91.4% 100.0% 94.1% 33.5% 6.7% 100.0% 100.0% 81.3% 87.3%
                           

Total

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

Capitation expense as a percentage of total medical expense was as follows for the years ended December 31, 2006, 2005 2004 and 2003:2004:

 

  2005 2004 2003  2006 2005 2004 
  (dollars in thousands)  (dollars in thousands) 

Medical Expenses:

           

Capitated HMO expense

  $456,123  3.9% $465,231  4.4% $597,244  6.0% $382,584 2.2% $456,123 3.9% $465,231 4.4%

Other medical expense

   11,195,347  96.1%  10,204,416  95.6%  9,282,177  94.0%  17,038,620 97.8%  11,195,347 96.1%  10,204,416 95.6%
                                  

Consolidated medical expense

  $11,651,470  100.0% $10,669,647  100.0% $9,879,421  100.0% $17,421,204 100.0% $11,651,470 100.0% $10,669,647 100.0%
                                  

Accreditation Assessment

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

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

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

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

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

AAHC/URAC performs reviews for utilization management standards and for health plan and health network standards in quality management, credentialing, rights and responsibilities, and network management. We continue to maintain URAC accreditation in select markets and certain operations.

Humana has also pursued ISO 9001:2000 certification over the past several years. ISO is the international standards organization, which has developed an international commercial set of certifications as to quality and process, called ISO 9001:2000.

Sales and Marketing

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

At December 31, 2005,2006, we employed approximately 1,700 sales representatives, who are each paid a salary and/orand per member commission and used approximately 62,900 licensed independent brokers and agents to market our Medicare and Medicaid products in the continental United States and Puerto Rico. We also employed approximately 500600 telemarketing representatives who assisted in the marketing of Medicare and Medicaid products by making appointments for sales representatives with prospective members. During 2005, we expanded the number of ways weWe also market our Medicare products including, among others,via a strategic alliancesalliance with Wal-Mart Stores, Inc., or Wal-Mart, State Farm®, and USAA. TheWal-Mart. This alliance with Wal-Mart includes stationing Humana representatives in thecertain Wal-Mart stores, SAM’S CLUB locations and Neighborhood Markets across the country providing an opportunity to enroll Medicare eligible individuals in person. In addition, we market our Medicare products through licensed independent brokers and agents including strategic alliances with State Farm® and USAA. We generally pay brokers a commission based on premiums, including bonuses based on sales volume.

Individuals become members of our commercial HMOs and PPOs through their employers or other groups which typically offer employees or members a selection of health insurance products, pay for all or part of the premiums, and make payroll deductions for any premiums payable by the employees. We attempt to become an employer’s or group’s exclusive source of health insurance benefits by offering a variety of HMO, PPO, and specialty products that provide cost-effective quality health care coverage consistent with the needs and expectations of their employees or members. We also offer commercial health insurance products directly to individuals.

At December 31, 2005,2006, we used approximately 51,300 licensed independent brokers and agents and approximately 700 licensed employees to sell our commercial products. Many of our employer group customers are represented by insurance brokers and consultants who assist these groups in the design and purchase of health care products. We generally pay brokers a commission based on premiums, with commissions varying by market and premium volume. In addition to a commission based directly on premium volume for sales to particular

customers, we also have programs that pay brokers and agents based on other bases.metrics. These include commission bonuses based on sales that attain certain levels or involve particular products. We also pay additional commissions based on aggregate volumes of sales involving multiple customers.

Risk Management

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

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

Competition

The health benefits industry is highly competitive. Our competitors vary by local market and include other managed care companies, national insurance companies, and other HMOs and PPOs, including HMOs and PPOs owned by Blue Cross/Blue Shield plans. Many of our competitors have larger memberships and/or greater financial resources than our health plans in the markets in which we compete. Our ability to sell our products and to retain customers may be influenced by such factors as those described on page 1817 in Item 1A.—Risk Factors.

Government Regulation

Federal regulation

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

Federal regulation

Medicare

The MMA made many significant changes to the Medicare fee-for-service and Medicare Advantage programs, as well as other changes to the commercial health insurance marketplace. Most significantly, the MMA created a voluntary prescription drug benefit, called “Part D” benefit, for Medicare beneficiaries beginning in 2006, established a new Medicare Advantage program to replace the Medicare+Choice program, and enacted tax-advantaged health savings accounts, or HSAs, for non-Medicare eligible individuals and groups. See the description of our Medicare products beginning on page 4 for additional discussion.

CMS conducts audits of plans qualified under its Medicare program at least biannually and may perform other reviews more frequently to determine compliance with federal regulations and contractual obligations. These audits include review of the plans’ administration and management, including management information and data collection systems, fiscal stability, utilization management and physician incentive arrangements, health services delivery, quality assurance, marketing, enrollment and disenrollment activity, claims processing, and complaint systems.

CMS regulations require submission of quarterly and annual financial statements. In addition, CMS requires certain disclosures to CMS and to Medicare beneficiaries concerning operations of a health plan contracted under the Medicare program. CMS’s rules require disclosure to members upon request of information concerning financial arrangements and incentive plans between the plan and physicians in the plan’s networks. These rules also require certain levels of stop loss coverage to protect contracted physicians against major losses relating to patient care, depending on the amount of financial risk they assume. The reporting of certain health care data contained in HEDIS is another important CMS disclosure requirement.

Fraud and abuse laws

Enforcement of health care fraud and abuse laws has become a top priority for the nation’s law enforcement entities. The funding of such law enforcement efforts has increased dramatically in the past few years and is expected to continue. The focus of these efforts has been directed at participants in federal government health care programs such as Medicare, Medicaid, and the FEHBP. We participate extensively in these programs and have continued our stringent regulatory compliance efforts for these programs. The programs are subject to very technical rules. When combined with law enforcement intolerance for any level of noncompliance, these rules mean that compliance efforts in this area continue to be challenging.

Federal HMO Act

Of our nine licensed and active HMO subsidiaries as of February 1, 2006, eight are qualified under the Federal Health Maintenance Organization Act of 1973, as amended. To obtain federal qualification, an HMO must meet certain requirements, including conformance with benefit, rating, and financial reporting standards. Federal qualification allows us to participate in the FEHBP program. In certain markets, and for certain products, we operate HMOs that are not federally qualified because this provides greater flexibility with respect to product design and pricing than is possible for federally qualified HMOs.

Privacy regulations

The use of individually identifiable data by our business is regulated at federal and state levels. These laws and rules are changed frequently by legislation or administrative interpretation. Various state laws address the use and maintenance of individually identifiable health data. Most are derived from the privacy provisions in the federal Gramm-Leach-Bliley Act and the Health Insurance Portability and Accountability Act of 1996, or HIPAA. HIPAA includes administrative provisions directed at simplifying electronic data interchange through standardizing transactions, establishing uniform health care provider, payer, and employer identifiers and seeking protections for confidentiality and security of patient data. Violations of these rules could subject us to significant penalties.

State and local regulation

We are also subject to substantial regulation by the states in which we do business. We regularly are audited and subject to various enforcement actions by state departments of insurance. These departments enforce laws relating to all aspects of our operations, including benefit offerings, marketing, claim payments, subsidiary capital requirements, and premium setting, especially with regard to our small group business. Although any of the pending government actions could result in assessment of damages, civil or criminal fines or penalties, and other sanctions against us, including exclusion from participation in government programs, we do not believe the results of any of these actions, individually or in the aggregate, will have a material adverse effect on our financial position, results of operations, or cash flows.

Our Medicaid products are regulated by the applicable state agency in the state in which we sell a Medicaid product and by the Puerto Rico Health Insurance Administration, in conformance with federal approval of the applicable state plan, and are subject to periodic reviews by these agencies. The reviews are similar in nature to those performed by CMS.

Laws in each of the states (including Puerto Rico) in which we operate our HMOs, PPOs and other health insurance-related services regulate our operations, including the scope of benefits, rate formulas, delivery systems, utilization review procedures, quality assurance, complaint systems, enrollment requirements, claim payments, marketing, and advertising. The HMO, PPO, and other health insurance-related products we offer are sold under licenses issued by the applicable insurance regulators. Under state laws, our HMOs and health insurance companies are audited by state departments of insurance for financial and contractual compliance, and our HMOs are audited for compliance with health services standards by respective state departments of health. Most states’ laws require such audits to be performed at least once every three years.

Our licensed subsidiaries are subject to regulation under state insurance holding company and Puerto Rico regulations. Certain of our subsidiaries operate in states that regulate the payment of dividends, loans, or other cash transfers to Humana Inc., our parent company, and require minimum levels of equity as well as limit investments to approved securities. The amount of dividends that may be paid to Humana Inc. by these subsidiaries, without prior approval by state regulatory authorities, is limited based on the entity’s level of statutory income and statutory capital and surplus. For additional information regarding our regulated subsidiaries’ statutory capital requirements see page 22 in Item 1A.—Risk Factors.

Audits and investigations

We are subject to various governmental audits, investigations, and enforcement actions as more fully described on page 24 in Item 1A.—Risk Factors.

Pending federal and state legislation

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

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

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

Other

Captive Insurance Company

We bear general business risks associated with operating our Company such as professional and general liability, employee workers’ compensation, and officer and director errors and omissions risks. Professional and general liability risks may include, for example, medical malpractice claims and disputes with members regarding benefit coverage. We retain certain of these risks through our wholly-owned, captive insurance subsidiary. We reduce exposure to these risks by insuring levels of coverage for losses in excess of our retained limits with a number of third-party insurance companies. We remain liable in the event these insurance companies are unable to pay their portion of the losses. In an effort to minimize credit risk, we insure our risks with a number of insurance companies having a long history of strong financial ratings. Since January 1, 2003,Over the past few years, we have reduced the amount of coverage purchased from third-party insurance carriers and increased the amount of risk we retain based on the financial strength and liquidity of our captive insurance subsidiary. We provide a detail of the significant assets and liabilities as well as a rollforward of reserve activity related to our captive insurance subsidiary in Note 10 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data.

Centralized Management Services

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

Employees

As of December 31, 2005,2006, we had approximately 18,70022,300 employees, including 1931 employees covered by collective bargaining agreements. We believe we have good relations with our employees and have not experienced any work stoppages.

ITEM 1A.RISK FACTORS

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

If the premiums we charge are insufficient to cover the cost of health care services delivered to our members, or if our estimates of 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, many factors may and often do cause actual health care costs to exceed what was estimated and used to set our premiums. These factors may include:

 

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

 

increased cost of such services;

 

our membership mix;

 

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

 

membership in markets lacking adequate provider networks;

changes in the demographic characteristics of an account or market;

 

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

 

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

 

possible changes in our pharmacy rebate program with drug manufacturers;

 

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

 

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

 

medical cost inflation; and

 

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. ManySome of our competitors are more established in the health care industry in terms of a larger market share and have greater financial resources than we do in some markets. In addition, other companies may enter our markets in the future, including emerging competitors in the Medicare program and in consumer-choice health plans, such as high deductible health plans with HSAs. We believe that barriers to entry in many markets are not substantial, so the addition of new competitors can occur relatively easily, and customers enjoy significant flexibility in moving between competitors. Contracts for the sale of commercial products are generally bid upon or renewed annually. While health plans compete on the basis of many factors, including service and the quality and depth of provider networks, we expect that price will continue to be a significant basis of competition. In addition to the challenge of controlling health care costs, we face intense competitive pressure to contain premium prices. Factors such as business consolidations, strategic alliances, legislative reform and marketing practices create pressure to contain premium price increases, despite being faced with increasing medical costs. The commercial pricing environment, particularly in the 2 to 300 member groups, is extremely competitive. SeveralWe believe some 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 also affect our membership levels. Other actions that could affect membership levels include our possible exit from or entrance into Medicare or Commercial markets, or the termination of a large contract, including our TRICARE contract.

If we do not compete effectively in our markets, if we set rates too high or too low in highly competitive markets to keep or increase our market share, if membership does not increase as we expect, if membership declines, or if we lose accounts with favorable medical cost experience while retaining or increasing membership in accounts with unfavorable medical cost experience, our business and results of operations could be materially adversely affected.

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

Our future performance depends in large part upon our management team’s ability to execute our strategy to position the Company for the future. This strategy includes opportunities created by the MMA. The MMA offers new opportunities in our Medicare programs, including our HMO, PPO, and PFFS Medicare Advantage

products, as well as our stand-alone PDP products. We have made substantial additional investments in the Medicare program to enhance our ability to participate in these expanded programs. WeOver the last few years we have doubledincreased the size of our Medicare geographic reach since the enactment of the MMA through expanded Medicare product offerings. We are offering both the stand-alone Medicare Prescription Drug Coverage (PDP) and Medicare Advantage Health Plan with Prescription Drug Coverage (MA-PD) in addition to our other product offerings. Our Medicare presence as of February 1, 2006, included more than 700,000 Medicare Advantage members and approximately 1.7 million PDP members in 12 HMO markets, 33 local PPO markets, and 35 states in which we have a private fee-for-service offering. Enrollment in the new Part D prescription drug plans began on November 15, 2005, and the plans became effective January 1, 2006. We have been approved to offer the Medicare prescription drug plan in 4650 states as well as Puerto Rico and the District of Columbia.

The timing of our new membership enrollmentgrowth in our Medicare Advantagemembership and PDP products is an important factor in meeting our business objectives. Therevenues impacts the pattern of our quarterly earnings, for 2006 is subject to certain assumptions including the timing of when a member enrolls in a plan, the plan type the member selects,membership enrollment and the speed with which the individual members meet their deductibles and cost-sharing provisions.

We have also made substantial investments in the service personnel and technology necessary to administer the growing Medicare business. ServiceWe continue to work with CMS to devise solutions to certain CMS systems issues intensified due to an enormous numberthat have created some difficulty receiving correct information about eligibility of individuals being eligiblecertain low income persons in the new program on January 1. We have to implement various initiatives such as hiring additional service representatives to address the service issues.Part D program.

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

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

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

If we fail to properly maintain the integrity of our data, to strategically implement new information systems, or to protect our proprietary rights to our systems, our business could be materially adversely affected.

Our business depends significantly on effective information systems and the integrity and timeliness of the data we use to run our business. Our business strategy involves providing members and providers with easy to use products that leverage our information to meet their needs. Our ability to adequately price our products and services, provide effective and efficient service to our customers, and to timely and accurately report our financial results depends significantly on the integrity of the data in our information systems. As a result of our past and on-going acquisition activities, we have acquired additional information systems. We have been taking steps to reduce the number of systems we operate, have upgraded and expanded our information systems capabilities, and are gradually migrating existing business to fewer systems. Our information systems require an ongoing commitment of significant resources to maintain, protect and enhance existing systems and develop new systems to keep pace with continuing changes in information processing technology, evolving industry and regulatory standards, and changing customer preferences. If the information we rely upon to run our businesses

was found to be inaccurate or unreliable or if we fail to maintain effectively our information systems and data integrity, we could have operational disruptions, have problems in determining medical cost estimates and establishing appropriate pricing, have customer and physician and other health care provider disputes, have regulatory or other legal problems, have increases in operating expenses, lose existing customers, have difficulty in attracting new customers, or suffer other adverse consequences.

We depend on independent third parties for significant portions of our systems-related support, equipment, facilities, and certain data, including data center operations, data network, voice communication services and pharmacy data processing. This dependence makes our operations vulnerable to such third parties’ failure to perform adequately under the contract, due to internal or external factors. We have recently changed vendors in our pharmacy benefits program. A change in service providers could result in a decline in service quality and effectiveness or less favorable contract terms which could adversely affect our operating results.

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

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

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

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

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

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

 

claims relating to the methodologies for calculating premiums;

 

claims relating to the denial of health care benefit payments;

 

claims relating to the denial or rescission of insurance coverage;

 

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

 

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

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

 

allegations of anti-competitive and unfair business activities;

 

provider disputes over compensation and termination of provider contracts;

 

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

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

 

claims relating to customer audits and contract performance.performance; and

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

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

A description of material legal actions in which we are currently involved is included under “Legal Proceedings” in Note 14 to the condensed consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data. 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 Medicare, TRICARE, and Medicaid programs. Our Government Segmentsegment accounted for approximately 53%70% of our total premiums and ASO fees for the year ended December 31, 20052006 and we expect the Government Segmentsegment to account for a greater percentage of our total premiums and ASO fees in 2006.2007. These programs involve various risks, including:

 

at December 31, 2005,2006, under our contracts with CMS we provided health insurance coverage to approximately 295,400518,900 Medicare members in Florida. These contracts accounted for approximately 20%17% of our total premiums and ASO fees for the year ended December 31, 2005.2006. The loss of these and other CMS contracts or significant changes in the Medicare program as a result of legislative or administrative action, including reductions in premium payments to us, or increases in member benefits to members without corresponding increases in premium payments may have a material adverse effect on our financial condition, results of operations and cash flows;

at December 31, 2005, our TRICARE business, which accounted for approximately 17% of our total premiums and ASO fees during the year ended December 31, 2005, primarily consisted of the South Region contract. The South Region contract is a five-year contract, subject to annual renewals at the Government’s option, with the the third option period scheduled to begin April 1, 2006, that covers approximately 2.9 million beneficiaries. The loss of our current TRICARE contract wouldus, may have a material adverse effect on our financial position, results of operations, and cash flows. Thisflows;

at December 31, 2006, our TRICARE business, which accounted for approximately 12% of our total premiums and ASO fees during the year ended December 31, 2006, primarily consisted of the South Region contract. The 5-year South Region contract contains provisionsis subject to negotiateannual renewals on April 1 of each year at the government’s option. Effective April 1, 2006, the South Region contract was extended into the third option period, which runs from April 1, 2006 to March 31, 2007 and covers 2.9 million beneficiaries. We have received a notice from the government of its intent to renew the fourth option period. The 5-year South Region contract expires March 31, 2009. As required under the contract, the target underwritten health care cost amount annually withand underwriting fee amounts for the federal government.third option period were negotiated. Any variance from the target health care cost is shared with the federal government. As such,Accordingly, events and circumstances not contemplated in the negotiated target health care cost amount could have a material adverse effect on our business. These changes may include, for example, an increase or reduction in the number of persons enrolled or eligible to enroll due to the federal government’s decision to increase or decrease U.S. military presence around the world.deployments. In the event government reimbursements were to decline from projected amounts, our failure to reduce the health care costs associated with these programs could have a material adverse effect on our business;

 

at December 31, 2005,2006, under our contracts with the Puerto Rico Health Insurance Administration, we provided health insurance coverage to approximately 403,100523,100 Medicaid members in Puerto Rico. These contracts accounted for approximately 3%2% of our total premiums and ASO fees for the year ended December 31, 2006. We currently are operating under the terms of our contracts that expired October 31, 2006. Due to several ongoing and unresolved issues with the program, the government of Puerto Rico has decided to delay the bid process for new contracts. We currently are working with the Puerto Rico Health Insurance Administration regarding terms and rates which is expected to result in an extension of the existing contracts through September 30, 2007. There is no assurance that the Puerto Rico Health Insurance Administration will request such an extension, and we are unable to predict the ultimate impact that any government policy or fiscal decisions might have on the continuation of our Medicaid contracts in Puerto Rico. The loss of these contracts or significant changes in the Puerto Rico Medicaid program as a result of legislative action, including reductions in premium payments to us, or increases in member benefits without corresponding increases in premium payments to us, may have a material adverse effect on our financial position, results of operations, and cash flows;

December 31, 2005. We currently have Medicaid contracts with the Puerto Rico Health Insurance Administration that expire on June 30, 2006. We are preparing to bid on the new contracts that will be effective July 2006 although a request for such proposal has not yet been issued by the Puerto Rico Health Insurance Administration. The loss of these contracts or significant changes in the Puerto Rico Medicaid 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;

 

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

 

CMS has implemented a risk adjustment model which apportions premiums paid to Medicare health plans according to health severity. A risk adjustment model pays more for enrollees with predictably higher costs. Under the new risk adjustment methodology, all Medicare health plans must collect, capture and submit the necessary diagnosis code information from inpatient and ambulatory treatment settings to CMS within prescribed deadlines. The CMS risk adjustment model uses this diagnosis data to calculate the risk adjusted premium payment to Medicare health plans. CMS is transitioning to the risk adjustment model for Medicare Advantage plans as follows: 50% in 2005, 75% in 2006 and 100% in 2007. The PDP payment methodology is based 100% on the risk adjustment model beginning in 2006;

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

 

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

 

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

The premiums from CMS are subject to risk corridor provisions which compare costs targeted in our annual bids to actual prescription drug costs, limited to actual costs that would have been incurred under the standard coverage as defined by CMS. Variances exceeding certain thresholds may result in CMS making additional payments to us or require us to refund to CMS a portion of the premiums we received. We estimate and recognize an adjustment to premium revenues related to the risk corridor payment settlement based upon pharmacy claims experience. The estimate of the settlement associated with these risk corridor provisions, which is not expected to be applied against the rigors of a final settlement with CMS until mid-2007, requires us to consider factors that may not be certain. These factors include some first year implementation issues such as member eligibility differences with CMS, as well as interpretations of CMS operational guidance. Beginning in 2008, the risk corridor thresholds increase which means we will bear more risk. Our estimate of the settlement associated with the Medicare Part D risk corridor provisions was a net liability of $738.7 million at December 31, 2006.

Reinsurance and low-income cost subsidies represent reimbursements from CMS in connection with the Medicare Part D program for which we assume no risk. Reinsurance subsidies represent reimbursements for CMS’s portion of claims costs which exceed the member’s out-of-pocket threshold, or the catastrophic coverage level. Low-income cost subsidies represent reimbursements from CMS for all or a portion of the deductible, the coinsurance and co-payment amounts above the out-of-pocket threshold for low-income beneficiaries. Monthly prospective payments from CMS for reinsurance and low-income cost subsidies are based on assumptions submitted with our annual bid. A reconciliation and settlement of CMS’s prospective subsidies against actual prescription drug costs we paid is made after the end of the year.

Settlement of the reinsurance and low-income cost subsidies as well as the risk corridor payment is based on a reconciliation made approximately 6 months after the close of each calendar year. This reconciliation process requires us to submit claims data necessary for CMS to administer the program. Our claims data may not pass CMS’s claims edit processes due to various reasons, including but not limited to, discrepancies in eligibility or classification of low-income members. To the extent our data does not pass CMS’s claim edit processes, we may bear the risk for all or a portion of the claim which otherwise may have been subject to the risk corridor provision or reimbursement as a low-income or

reinsurance claim. In addition, in the event the settlement represents an amount CMS owes us, there is a negative impact on our cash flows and financial condition as a result of financing CMS’s share of the risk. The opposite is true in the event the settlement represents an amount we owe CMS;

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

 

higher comparative medical costs;

 

government regulatory and reporting requirements; and

 

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

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

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

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

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

As of December 31, 2005,2006, we maintained aggregate statutory capital and surplus of $1,203.2$2,066.0 million in our state regulated subsidiaries. Each of these subsidiaries was in compliance with applicable statutory requirements which aggregated $722.2$1,430.3 million. Although the minimum required levels of equity are largely based on premium volume, product mix, and the quality of assets held, minimum requirements can vary significantly at the state level. Given our anticipated continued premium growth in 2006 resulting from the expansion of our Medicare products,2007, capital requirements will increase. We expect to fund these increased requirements with capital contributions from Humana Inc., our parent company, in the range of $450$325 million to $650$425 million in 2006.2007.

Most states rely on risk-based capital requirements, or RBC, to define thetheir required levels of equity.equity discussed above. RBC is a model developed by the National Association of Insurance Commissioners to monitor an entity’s solvency. This calculation indicates recommended minimum levels of required capital and surplus and signals regulatory measures should actual surplus fall below these recommended levels. If RBC were adopted by allthe remaining states and Puerto Rico at December 31, 2005, we2006, each of our subsidiaries would be required to fund $14.7 million in one of our Puerto Rico subsidiaries to meet all requirements. After this funding,substantial compliance and we would have $378.2$516.2 million of aggregate capital and surplus above any of the levels that require corrective action under RBC.RBC, or individual state requirements.

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

The rules do not provide for complete federal preemption of state laws, but rather preempt all inconsistent state laws unless the state law is more stringent.

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

Another area receiving increased focus isLaws in each of the timestates (including Puerto Rico) in which various laws requirewe operate our HMOs, PPOs and other health insurance-related services regulate our operations, including the paymentscope of benefits, rate formulas, delivery systems, utilization review procedures, quality assurance, complaint systems, enrollment requirements, claim payments, marketing, and advertising. The HMO, PPO, and other health 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,insurance-related products we expect additional regulatory scrutiny and supplemental legislation with respect to claims payment practices. The provider-sponsored billsoffer are characterizedsold under licenses issued by stiff penalties for late payment, including high interest rates payable to providers and costly fines levied by statethe applicable insurance departments and attorneys general. This legislation and possible future regulation and oversight could expose us to additional liability and penalties.

We are implementing a mail order pharmacy business that subjects us to extensive federal, state and local regulation. Weregulators. Our licensed subsidiaries are also subject to risks inherent in the packagingregulation under state insurance holding company and distribution of pharmaceuticals and other health care products.Puerto Rico regulations.

We are also subject to various governmental audits and investigations. These can include auditsUnder state laws, our HMOs and health insurance companies are audited by state departments of insurance for financial and contractual compliance. Our HMOs are audited for compliance with health services by state departments of health. Audits and investigations are also conducted by state attorneys general, CMS, the Office of the Inspector General of Health and Human Services, the Office of Personnel Management, the Department of Justice, the Department of Labor, the Defense Contract Audit Agency, and state Departments of Insurance and Departments of Health. Several state attorneys general and Departments of Insurance are currently investigating the practices of insurance brokers, including some of those ofused by certain of the companies in the health 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 civil and criminal sanctions. In addition, disclosure of any adverse investigation or audit results or sanctions could negatively affect our industry or our reputation in various markets and make it more difficult for us to sell our products and services.

Other areas subject to substantial regulation include:

 

licensing requirements;

 

approval of policy language and benefits;

 

mandated benefits and processes;

 

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

 

premium rates; and

 

periodic examinations by state and federal agencies.

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

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

 

health insurance access and affordability;

 

e-connectivity;

 

universal health coverage;

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

 

disclosure of provider quality information; and

 

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

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

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

Our abilityAny failure to manage administrative costs could hamper profitability.

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

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

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

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

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

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

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

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

IfOur recently implemented mail order pharmacy business subjects us to additional regulations in addition to those we fail to manage prescription drug programs successfully,face with our financial results could suffer.core health benefits businesses.

In general, prescription drug costsWe have been rapidly rising overopened a mail order pharmacy business that subjects us to extensive federal, state and local regulation. We are also subject to risks inherent in the past few years. These increases are duepackaging and distribution of pharmaceuticals and other health care products, and the application of state laws related to the introductionoperation of new drugs costing significantly more than existing drugs, directinternet and mail-services pharmacies. The failure to consumer advertising by the pharmaceutical industry that creates consumer demand for particular brand-name drugs,adhere to these laws and members seeking medicationsregulations could expose our pharmacy subsidiary 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, Rx4civil and an Rx allowance program structured to account for those drugs that treat more pervasive conditions and are suggested to be more effective by empirical data.

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.criminal penalties.

Our ability to obtain funds from our subsidiaries is restricted.

Because we operate as a holding company, we are dependent upon dividends and administrative expense reimbursements from our subsidiaries to fund the obligations of Humana Inc., our parent company. These subsidiaries generally are regulated by states’ Departments of Insurance. We are also required by law to maintain specific prescribed minimum amounts of capital in these subsidiaries. The levels of capitalization required depend primarily upon the volume of premium generated. A significant increase in premium volume will require additional capitalization from our parent company. To fund our expanding business opportunities, including the enhanced Medicare business, we anticipate additional required capital ranging from $450 million to $650 million in 2006. In most states, we are required to seek prior approval by these state regulatory authorities before we transfer money or pay dividends from these subsidiaries that exceed specified amounts, or, in some states, any amount. In addition, we normally notify the state Departments of Insurance prior to making payments that do not require approval. In the event that we are unable to provide sufficient capital to fund the obligations of Humana Inc., our operations or financial position may be adversely affected.

Ratings are an important factorDowngrades in our competitive position.debt ratings, should they occur, may adversely affect our business, financial condition and results of operations.

Claims paying ability, financial strength, and debt ratings by recognized rating organizations are an increasingly important factor in establishing the competitive position of insurance companies. Ratings information is broadly disseminated and generally used throughout the industry. We believe our claims paying ability and financial strength ratings are an important factor in marketing our products to certain of our customers. Our debt ratings impact both the cost and availability of future borrowings. Each of the rating

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

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

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

 

ITEM 1B.UNRESOLVED STAFF COMMENTS

None.

ITEM 2.PROPERTIES

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

We own or lease these principal operating facilities in addition to other administrative market offices and medical centers. We no longer operate most of these medical centers but, rather, lease or sublease them to their provider operators. The following table lists the location of properties we owned or leased, including our principal operating facilities, at December 31, 2005:2006:

 

  Medical Centers  Administrative
Offices
     Medical Centers  Administrative
Offices
   
  Owned  Leased  Owned  Leased  Total  Owned  Leased  Owned  Leased  Total

Florida

  2  49  6  66  123  3  52  5  65  125

Texas

  —    —    3  32  35  —    —    3  32  35

Kentucky

  1  —    16  9  26  —    —    17  10  27

Puerto Rico

  —    —    —    16  16

Georgia

  —    —    —    15  15  —    —    —    13  13

Illinois

  6  1  —    6  13

Puerto Rico

  —    —    —    12  12

Louisiana

  —    —    —    11  11  —    —    —    11  11

Ohio

  —    —    —    9  9  —    —    —    10  10

Illinois

  3  1  —    5  9

Alabama

  —    —    —    8  8

Tennessee

  —    —    —    8  8  —    —    —    8  8

Alabama

  —    —    —    7  7

Wisconsin

  —    —    1  7  8

Indiana

  —    —    —    7  7  —    —    —    6  6

Mississippi

  —    —    —    7  7  —    —    —    5  5

Wisconsin

  —    —    1  6  7

Oklahoma

  —    —    —    5  5  —    —    —    5  5

Others

  —    1  —    53  54  —    1  —    72  73
                              

Total

  9  51  26  253  339  6  54  26  273  359
                              

ITEM 3.LEGAL PROCEEDINGS

Managed Care Industry Purported Class Action Litigation

Since 1999, we have been involved in several purported class action lawsuits that were part of a wave of generally similar actions targeting the health care payer industryOur current and particularly managed care companies. These included a lawsuit against us and originally nine of our competitors that purported to be brought on behalf of physicians who treated our members since January 1, 1990. The plaintiffs asserted that we and other defendants paid providers’ claims incorrectly by paying lesser amounts than they submitted. These cases were consolidated in the United States District Court for the Southern District of Florida (the “Court”), and styledIn re Managed Care Litigation.

On October 17, 2005, we and representatives of over 700,000 physicians and several state medical societies reached an agreement (“Settlement Agreement”) to settle the lawsuit by payment of $40 million for the physicians and an amount up to $18 million for the plaintiffs’ attorneys, subject to approval by the Court. The Settlement Agreement recognizes that we have undertaken certain initiatives to facilitate relationships with, and payments to, physicians and provides for additional initiatives over its four-year term. The Court preliminarily approved the Settlement Agreement on October 19, 2005, and set a Settlement Hearing for March 6, 2006.

Three other defendants, Aetna Inc., Cigna Corporation, and The Prudential Insurance Company of America previously entered into settlement agreements that have been approved by the Court. Health Net, Inc. announced a settlement agreement on May 2, 2005, and Wellpoint, Inc. (formerly WellPoint Health Networks, Inc. and Anthem, Inc.) announced a settlement agreement on July 11, 2005.

In connection with the settlement and other related litigation costs, we recorded pretax administrative expense of $71.9 million ($44.8 million after taxes, or $0.27 per diluted common share) in the third quarter of 2005.

Other Litigation and Proceedings

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.

In addition, ourpast business practices are subject to review by various state insurance and health care regulatory authorities and other state and federal regulatory authorities. There has been increased scrutiny by these regulators ofThese authorities regularly scrutinize the business practices of managed care companies,health insurance and benefits companies. These reviews focus on numerous facets of our business, including allegations of anticompetitive and unfair business activities, claims payment practices, competitive practices, commission paymentpayments, privacy issues, utilization management practices, and utilization managementsales practices. Some of these reviews have historically resulted in fines imposed on us and some have required changes into some of our practices. We continue to be subject to these reviews, which could result in additional fines or other sanctions being imposed on us or additional changes in some of our practices.

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

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

The outcome of current suits or likelihood or outcome of future suits or governmental investigations cannot be accurately predicted with certainty. In addition, the potential for increased liability for medical negligence arising from claims adjudication, along with the increased litigation that has accompanied the negative publicitycertainty, and public perception of our industry, adds to this uncertainty. Therefore,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.

 

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

Not applicable.

PART II

 

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

 

a)Market Information

Our common stock trades on the New York Stock Exchange under the symbol HUM. The following table shows the range of high and low closing sales prices as reported on the New York Stock Exchange Composite TapePrice for each quarter in the years ended December 31, 20052006 and 2004:2005:

 

  High  Low

Year Ended December 31, 2006

    

First quarter

  $57.67  $48.91

Second quarter

  $53.76  $41.60

Third quarter

  $67.94  $51.54

Fourth quarter

  $67.97  $51.60
  High  Low

Year Ended December 31, 2005

        

First quarter

  $34.86  $29.10  $34.86  $29.10

Second quarter

  $39.74  $30.96  $39.74  $30.96

Third quarter

  $50.03  $38.30  $50.03  $38.30

Fourth quarter

  $55.29  $42.11  $55.29  $42.11

Year Ended December 31, 2004

    

First quarter

  $23.91  $19.02

Second quarter

  $19.36  $15.55

Third quarter

  $19.98  $15.70

Fourth quarter

  $30.02  $17.66

 

b)Holders of our Capital Stock

As of January 31, 2006,2007, there were approximately 5,7005,400 holders of record of our common stock and approximately 26,300 beneficial holders of our common stock.

Our stockholders’ rights plan expired in accordance with its terms in February 2006.

 

c)Issuer Purchases of Equity Securities

There were no common shares acquired by the Company in open market transactions in 2005. During 2005, we acquired 68,296 shares of our common stock in connection with employee stock plans at an aggregate cost of $2.4 million, or an average of $34.62 per share.

d)Dividends

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

 

e)d)Equity Compensation Plan

The information required by this part of Item 5 is incorporated herein by reference from our Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on April 27, 200626, 2007 appearing under the caption “Equity Compensation Plan Information” of such Proxy Statement.

e)Stock Performance

The following graph compares the performance of the our common stock to the Standard & Poor’s Composite 500 Index (“S&P 500”) and the Morgan Stanley Health Care Payer Index (“Peer Group”) for the five years ended December 31, 2006. The graph assumes an investment of $100 in each of our common stock, the S&P 500, and the Peer Group on December 31, 2001.

   12/31/01  12/31/02  12/31/03  12/31/04  12/31/05  12/31/06

HUM

  100  85  194  252  461  469

S&P 500

  100  77  97  106  109  124

Peer Group

  100  115  193  283  388  414

f)Issuer Purchases of Equity Securities

There were no common shares acquired by the Company in open market transactions in 2006. During 2006, we acquired 467,767 shares of our common stock in connection with employee stock plans at an aggregate cost of $26.2 million, or an average of $56.03 per share.

ITEM 6.SELECTED FINANCIAL DATA

 

  2005(a) 2004(b) 2003(c) 2002(d)(e) 2001(e)      2006         2005(a)(b)         2004(a)(c)         2003(a)(d)         2002(a)(e)     
  (in thousands, except per common share results, membership and ratios)  (in thousands, except per common share results, membership and ratios) 

Summary of Operations:

   

Revenues:

           

Premiums

  $14,001,591  $12,689,432  $11,825,283  $10,930,397  $9,938,961  $20,729,182  $14,001,591  $12,689,432  $11,825,283  $10,930,397 

Administrative services fees

   259,437   272,796   271,676   244,396   137,090   341,211   259,437   272,796   271,676   244,396 

Investment and other income

   157,099   142,097   129,352   86,388   118,835 

Investment income

  291,880   142,976   132,838   122,041   78,833 

Other revenue

  54,264   14,123   9,259   7,311   7,555 
                               

Total revenues

   14,418,127   13,104,325   12,226,311   11,261,181   10,194,886   21,416,537   14,418,127   13,104,325   12,226,311   11,261,181 
                               

Operating expenses:

           

Medical

   11,651,470   10,669,647   9,879,421   9,138,196   8,279,844   17,421,204   11,651,470   10,669,647   9,879,421   9,138,196 

Selling, general and administrative

   2,176,770   1,877,864   1,858,028   1,775,069   1,545,129   3,021,509   2,195,604   1,894,336   1,866,531   1,781,457 

Depreciation and amortization

   128,858   117,792   126,779   120,730   161,531   148,598   128,858   117,792   126,779   120,730 
                               

Total operating expenses

   13,957,098   12,665,303   11,864,228   11,033,995   9,986,504   20,591,311   13,975,932   12,681,775   11,872,731   11,040,383 
                               

Income from operations

   461,029   439,022   362,083   227,186   208,382   825,226   442,195   422,550   353,580   220,798 

Interest expense

   39,315   23,172   17,367   17,252   25,302   63,141   39,315   23,172   17,367   17,252 
                               

Income before income taxes

   421,714   415,850   344,716   209,934   183,080   762,085   402,880   399,378   336,213   203,546 

Provision for income taxes

   113,231   135,838   115,782   67,179   65,909   274,662   106,150   129,431   112,474   64,694 
                               

Net income

  $308,483  $280,012  $228,934  $142,755  $117,171  $487,423  $296,730  $269,947  $223,739  $138,852 
                               

Basic earnings per common share

  $1.91  $1.75  $1.44  $0.87  $0.71  $2.97  $1.83  $1.68  $1.41  $0.85 
                               

Diluted earnings per common share

  $1.87  $1.72  $1.41  $0.85  $0.70  $2.90  $1.79  $1.66  $1.38  $0.83 
                               

Financial Position:

       

Cash and investments

  $3,477,955  $3,074,189  $2,927,213  $2,415,914  $2,327,139  $5,347,454  $3,477,955  $3,074,189  $2,927,213  $2,415,914 

Total assets

   6,869,614   5,657,617   5,379,814   4,956,754   4,681,693   10,127,496   6,869,614   5,657,617   5,379,814   4,977,029 

Medical and other expenses payable

   1,909,682   1,422,010   1,272,156   1,142,131   1,086,386   2,488,261   1,909,682   1,422,010   1,272,156   1,142,131 

Debt

   815,044   636,696   642,638   604,913   578,489   1,269,100   815,044   636,696   642,638   604,913 

Stockholders’ equity

   2,474,105   2,090,124   1,835,949   1,606,474   1,507,949   3,053,886   2,508,874   2,124,248   1,868,972   1,641,115 

Key Financial Indicators:

       

Medical expense ratio

   83.2%  84.1%  83.5%  83.6%  83.3%  84.0%  83.2%  84.1%  83.5%  83.6%

SG&A expense ratio

   15.3%  14.5%  15.4%  15.9%  15.3%  14.3%  15.4%  14.6%  15.4%  15.9%

Medical Membership by Segment:

       

Government:

           

Medicare Advantage

   557,800   377,200   328,600   344,100   393,900   1,002,600   557,800   377,200   328,600   344,100 

Medicaid

   457,900   478,600   468,900   506,000   490,800 

Medicare stand-alone PDP

  3,536,600   —     —     —     —   
               

Total Medicare

  4,539,200   557,800   377,200   328,600   344,100 
               

TRICARE

   1,750,900   1,789,400   1,849,700   1,755,800   1,714,600   1,716,400   1,750,900   1,789,400   1,849,700   1,755,800 

TRICARE ASO

   1,138,200   1,082,400   1,057,200   1,048,700   942,700   1,163,600   1,138,200   1,082,400   1,057,200   1,048,700 
               

Total TRICARE

  2,880,000   2,889,100   2,871,800   2,906,900   2,804,500 
               

Medicaid

  390,700   457,900   478,600   468,900   506,000 

Medicaid ASO

  178,400   —     —     —     —   
               

Total Medicaid

  569,100   457,900   478,600   468,900   506,000 
                               

Total Government

   3,904,800   3,727,600   3,704,400   3,654,600   3,542,000   7,988,300   3,904,800   3,727,600   3,704,400   3,654,600 
                               

Commercial:

           

Fully insured

   1,999,800   2,286,500   2,352,800   2,340,300   2,301,300   1,754,200   1,999,800   2,286,500   2,352,800   2,340,300 

Administrative services only

   1,171,000   1,018,600   712,400   652,200   592,500   1,529,600   1,171,000   1,018,600   712,400   652,200 
                               

Total Commercial

   3,170,800   3,305,100   3,065,200   2,992,500   2,893,800   3,283,800   3,170,800   3,305,100   3,065,200   2,992,500 
                               

Total Medical Membership

   7,075,600   7,032,700   6,769,600   6,647,100   6,435,800 

Total medical membership

  11,272,100   7,075,600   7,032,700   6,769,600   6,647,100 
                               

Commercial Specialty Membership:

       

Dental

   1,456,500   1,246,700   1,147,400   1,094,600   1,123,300   1,452,000   1,456,500   1,246,700   1,147,400   1,094,600 

Other

   445,600   461,500   520,700   545,400   571,300   450,800   445,600   461,500   520,700   545,400 
                               

Total specialty membership

   1,902,100   1,708,200   1,668,100   1,640,000   1,694,600   1,902,800   1,902,100   1,708,200   1,668,100   1,640,000 
                               

(a)Prior period amounts have been adjusted to reflect the expensing of stock awards under the modified retrospective application method of SFAS 123R as more fully discussed in Note 11 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data.
(b)Includes the acquired operations of CarePlus Health Plans of Florida from February 16, 2005, and the acquired operations of Corphealth, Inc. from December 20, 2005. Also includes expenses of $71.9 million ($44.8 million after tax, or $0.27 per diluted common share) for a class action litigation settlement, as well as expenses of $27.0 million ($16.9 million after tax, or $0.10 per diluted common share) related to Hurricane Katrina. These expenses were partially offset by the realization of a tax gain contingency of $22.8 million, or $0.14 per diluted share.
(b)(c)Includes the acquired operations of Ochsner Health Plan from April 1, 2004.
(c)(d)Includes expenses of $30.8 million pretax ($18.8 million after tax, or $0.12 per diluted common share) for the writedown of building and equipment and software abandonment expenses. These expenses were partially offset by a gain of $15.2 million pretax ($10.1 million after tax, or $0.06 per diluted common share) for the sale of a venture capital investment. The net impact of these items reduced pretax income by $15.6 million ($8.7 million after tax, or $0.05 per diluted common share).
(d)(e)Includes expenses of $85.6 million pretax ($58.2 million after tax, or $0.35 per diluted common share) for severance and facility costs related to reducing our administrative cost structure with the elimination of three customer service centers and an enterprise-wide workforce reduction, reserves for liabilities related to a previous acquisition and the impairment in the fair value of certain private debt and equity investments.
(e)We ceased amortizing goodwill upon adopting Statement of Financial Accounting Standards (SFAS) No. 142, or SFAS 142, on January 1, 2002. Assuming the non-amortization provisions of SFAS 142 were in effect as of January 1, 2001, diluted earnings per common share would have increased $0.31 in 2001.

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

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

Overview

Headquartered in Louisville, Kentucky, Humana Inc. is one of the nation’s largest publicly traded health benefits companies, based on our 20052006 revenues of $14.4$21.4 billion. We offer coordinated health insurance coverage and related services through a variety of traditional and Internet-basedconsumer-choice plans for government-sponsored programs, employer groups, government-sponsored programs, and individuals. As of December 31, 2005,2006, we had approximately 7.111.3 million members in our medical insurancebenefit programs, as well as approximately 1.9 million members in our specialty products programs.

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

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

We adopted SFAS No. 123 (revised 2004),Share-Based Payment, or SFAS 123R, on January 1, 2006. We have adjusted prior period amounts to reflect the effect of expensing stock awards under the modified retrospective application method of SFAS 123R as discussed in Note 11 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data.

Our results are impacted by many factors, but most notably are influenced by our ability to establish and maintain a competitive and efficient cost structure and to accurately and consistently establish competitive

premium, ASO fee, and plan benefit levels that are commensurate with our medical and administrative costs. Medical costs are subject to a high rate of inflation due to many forces, including new higher priced technologies

and medical procedures, increasing capacity and supply of medical services, new prescription drugs and therapies, an aging population, lifestyle challenges including obesity and smoking, the tort liability system, and government regulations.

Our industry relies on two key statistics to measure performance. MER, which is computed by taking total medical expenses as a percentage of premium revenues, represents a statistic used to measure underwriting profitability. The SG&A expense ratio, which is computed by taking total selling, general and administrative expenses as a percentage of premium revenues and administrative services fees, represents a statistic used to measure administrative spending efficiency.

Government Segment

In our Government segment, the passage of the MMA in December 2003 demonstrated the federal government’s commitment to providing health benefits and options to seniors by creating new product choices for Medicare-eligible individuals sold through the private sector. These new products include PFFS plans and local PPOs, with coverage effective in 2005, and regional PPOs and PDPs, with coverage effective in 2006. The PFFS plans generally offer additional benefits compared to traditional Medicare in exchange for a monthly premium paid by the member. These plans typically include a prescription drug benefit with no provider network restrictions. Local and regional PPO plans typically offer an even higher level of benefits to members, including a prescription drug benefit and a lower level of member cost-sharing on many benefits when the member uses medical services from in-network providers.

As a long-time participant in the Medicare program, we believe that we possess (1) business competencies and management experience with senior product design, (2) a robust and scalable multi-channel distribution system, (3) an established and competitive network including a national retail pharmacy network, and (4) an established brand awareness with seniors. Accordingly, we have developed a strategy to take full advantage of these expanded programs. This resulted in significant expenditures and commitments of resources during 2005, including, among other items:

increasing the number of markets where we sell our products,

designing products that offer a compelling combination of price and benefits to capture market share,

raising brand awareness with the launching of our “Let’s Talk” education campaign, as well as substantial marketing and advertising increases,

expanding the distribution network, including partnering with Wal-Mart Stores, Inc. and increasing our captive sales force,

increasing the size and scope of our provider network, and

adding employees to accommodate membership growth, including opening a dedicated Medicare service center in Tampa Bay, Florida.

Our strategy and commitment to thesethe expanded Medicare Advantage programs, hasincluding new product choices and pharmacy benefits for seniors, led to substantial growth during 2005.2006. Medicare Advantage membership increased to 1,002,600 members at December 31, 2006, up 79.7% from 557,800 members at December 31, 2005, up 47.9% from 377,200 members at December 31, 2004, primarily due to sales of our PFFS product. Our new PFFSMedicare stand-alone PDP products and the addition of 50,400added 3,536,600 members from our acquisition of CarePlus Health Plans of Florida in February 2005. Likewise,during 2006. Medicare premium revenues have increased 48.7%more than doubled to $4.6$11.5 billion for 2005 from $3.1 billion in 2004. We expect the Medicare line of business to continue to grow during 2006 primarily as a result of this membership growth.

Pretax earnings in the Government segment of $513.8 million in 2006 were 62% higher than 2005. This increase resulted primarily from continued geographic expansions ofthe membership and associated revenue growth in our Medicare Advantage plans, partially offset by results for the new Medicare stand-alone PDP offerings. Our Complete stand-alone PDP offering, one of three stand-alone PDP offerings andrepresenting 12% of our new PDP plans. As of February 1, 2006, Medicare Advantage membership totaled more than 700,000 members andstand-alone PDP membership, totaled approximately 1.7 million members. We expect 2006 Medicare premium revenuesoperated at a loss with a MER of 116% in 2006. The reason for the operating loss primarily related to more than double from 2005 from salesthe product’s design, including covering brand name prescription drugs in the coverage gap. The coverage gap represents the stage of coverage where the member would be responsible for the cost under a standard plan. The Complete stand-alone PDP offering was re-designed for 2007.

In addition, the new stand-alone PDP benefit designs impacted our quarterly earnings pattern. These benefit designs result in coverage that varies as a member’s cumulative out-of-pocket costs pass through successive stages of a member’s plan period as specified under the standard plan defined by CMS. These plan designs generally result in us sharing a greater portion of the responsibility for total pharmacy costs in the early stages of a member’s plan period and less in the later stages for the plans which comprise the majority of our Medicare Advantagemembership. This generally produces results that improve as the year progresses. For example, during 2006 our Standard and Enhanced stand-alone PDP plans and for selling, general and administrative expenses to continue to increaseofferings resulted in 2006. However, while our creationan MER of the infrastructure related to our Medicare expansion will be nearly completed by the end of97.7% during the first quarter, of 2006, we do not believeimproving to 74.7% during the resulting expected revenues and membership will peak until Medicare enrollment is completed on July 1, 2006. We believe this will result in lower earnings and margins in the first half of 2006 relative to the second half of 2006, when we believe our consolidated revenues will reach the level contemplated by our selling, general, and administrative expenses.

In our TRICARE business, 2005 marked our first full fiscal year under the South Region contract. After being awarded the South Region contract in 2003, we transitioned our TRICARE business to one of three newly-created regions under the government’s revised TRICARE program during 2004. We started the second option year under the South Region contract on April 1, 2005.fourth quarter.

Commercial Segment

Our strategy to drive Commercial segment profitability focuses on providing solutions for employersmedical membership increased 113,000 members, or 3.6% from December 31, 2005 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 and other consumer-choice health plans increased to 371,100 members3,283,800 at December 31, 2005,2006 as a 52% increase from December 31, 2004. We believe that growth in these products,result of the May 1, 2006 CHA acquisition which are offered both on a fully insuredadded 88,400 members and higher ASO, basisindividual and competitively priced to produce higher margins, is a key component, among other items, for further improvement in the results of our Commercial segment. Additionally, we have increased the diversification of our commercialconsumer-choice membership, base, not only through our consumer-choice products, but alsopartially offset by (1) expanding our ASO membership in the mid-market group segment to take advantage of our network discounts and (2) launching our HumanaOne individual product to address an increasing migration of insureds from small group. While we expect our consumer-choice products to become a driver of growth in the years ahead as health care inflation persists, we also are enhancing the traditional products which comprise the bulk of our commercial portfolio today by applying our consumer-choice innovation.

Other important factors which impact our Commercial segment profitability are both the competitive pricing environment and market conditions. With respect to pricing, there is a tradeoff between sustaining or increasing underwriting margins versus increasing or decreasing enrollment. We have experienced a decline in our fully insured commercialgroup membership. ASO membership as a resultat December 31, 2006 was up 31% from December 31, 2005. Individual membership increased 15% and consumer-choice membership increased 13% during 2006. These three areas, together with our small group business, now represent more than 84% of pricing actions by some competitors who we perceive as desiring to gain market share in certain markets. With respect to market conditions, we are impacted by economies of scale on administrative overhead. As a result of a decline in preference for tightly-managed HMO products, medical costs have become increasingly comparable among our larger competitors. Product design and consumer involvement have become more important drivers of medical services consumption, and administrative expense efficiency is becoming a more significant driver of commercial margin sustainability. Consequently, we continually evaluate our administrative expense structure and realize administrative expense savings through productivity gains. Additionally, because our Commercial segment shares overhead costs with our Government segment, an increase or decrease in the size of our Government operations impacts our Commercial segment profitability.medical membership.

Other Highlights

 

In

Year over year comparisons have been impacted by litigation and Hurricane Katrina expenses in 2005 that did not recur in 2006, as more fully discussed in the Government segment, CMS approved allnext section.

Cash flows from operations increased $1,076.6 million to $1,686.7 million for 2006 compared to $610.1 million for 2005 primarily due to Medicare enrollment growth, improved earnings and the 2006impact of our new Part D offering. Our operating cash flows were favorably impacted by the Part D provisions of our Medicare contracts, we applied for, giving us a wide array of productsincluding $738.7 million in estimated net amounts owed to sell and increasingCMS under the number of states where we sell them.Part D risk corridor provisions which are expected to be settled in mid-2007.

 

Our Commercial segment reached an

Net gains of $75.7 million from sales of venture capital investments contributed to investment income during 2006.

The effective income tax rate was 36.0% for 2006 compared to 26.3% for 2005. The lower effective tax rate in 2005 primarily reflects the favorable impact from the resolution of a contingent gain of $22.8 million.

We issued $500 million of 6.45% senior notes due June 1, 2016 in May 2006, replaced our existing 5-year $600 million unsecured revolving credit agreement to acquire CHA Service Companywith a new 5-year $1.0 billion unsecured revolving credit agreement in July 2006, and completed the acquisitionrepaid our $300 million of Corphealth, Inc. Our Government segment completed the acquisition of CarePlus Health Plans of Florida.7.25% senior notes in August 2006. These transactions are more fully-described on the following page andfully described in Note 310 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data.

Membership in Medicare Advantage products grew by 180,600 members, or 47.9%, from December 31, 2004, including 130,200 members from sales primarily related to our new PFFS offering, and 50,400 members from the acquisition of CarePlus Health Plans of Florida.

Commercial medical membership declined by 134,300 members, or 4.1%, from December 31, 2004, including the loss of an 89,000 member unprofitable account that lapsed on January 1, 2005. Excluding

the 89,000 member account, commercial medical membership declined 45,300 members, or 1.4%, since December 31, 2004, primarily due to continued competitive pricing pressures in the small to mid-market group account partially offset by an increase in ASO membership of 152,400 members.

We reached an agreement with representatives of more than 700,000 physicians to settle a nationwide class action suit, subject to court approval. This agreement is more fully-described below and under “Legal Proceedings” in Note 14 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data.

Certain of our operations, primarily the Louisiana market, were negatively affected by the impact of Hurricane Katrina in August 2005 as more fully-described below.

The resolution of a contingent tax gain during the first quarter of 2005 contributed to the lower effective tax rate of 26.9% during 2005 compared to 32.7% during 2004 as more fully-described in Note 8 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data.

Cash flows from operations increased 79.9% or $277.8 million to $625.6 in 2005 million compared to $347.8 million in 2004.

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

2005 Settlement of Class Action Litigation

On October 17, 2005, we reached an agreement with representatives of more than 700,000 physicians to settle a nationwide class action suit, subject to court approval.suit. In connection with the settlement and other related litigation costs, we recorded pretax administrative expenses of $71.9 million ($44.8 million after taxes, or $0.27 per diluted common share) in the third quarter of 2005. Of the $71.9 million, $33.4 million iswas included in the Government segment results and the remaining $38.5 million iswas included in the Commercial segment results. The settlement is more fully-described under “Legal Proceedings”These amounts were paid in Note 14 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data.2006.

2005 Hurricane Katrina

Certain of our operations, primarily the Louisiana market, were negatively affected by the impact of Hurricane Katrina in August 2005. Expenses related to Hurricane Katrina primarily stemstemmed from our efforts, in cooperation with Departments of Insurance in the affected states, to help our members by offering participating-provider benefits at non-participating providers’ rates, paying claims for members who were unable at the time to meet their premium obligations and similar measures. In connection with Hurricane Katrina, we recorded pretax medical and administrative expenses of $27.0 million ($16.9 million after taxes, or $0.10 per diluted common share) during the third and fourth quarters of 2005. Of the $27.0 million, $5.9 million iswas included in the Government segment results and the remaining $21.1 million iswas included in the Commercial segment results. We do not anticipate any significant additional costs for Hurricane Katrina related items in 2006.

Recent Acquisitions

In JanuaryOn May 1, 2006, our Commercial segment reached an agreement to acquireacquired CHA Service Company, or CHA Health, a health plan serving employer groups in Kentucky, for cash consideration of approximately $60.0$67.5 million, plus any excess statutory surplus.including a $1.7 million contingent purchase price settlement paid in January 2007. This acquisition strengthens our position in the Kentucky market. The acquisition of CHA Health a Kentucky health plan, is expected to addadded approximately 96,80060,100 fully insured group members and 28,300 ASO members to our Commercial segment medical membership. This transaction which is subject to regulatory approval, is expected to close effective in the second quarterdid not have a material impact on our results of operations or cash flows from operations for 2006.

On December 20, 2005, our Commercial segment acquired Corphealth, Inc., a behavioral health care management company, for cash consideration of approximately $54.2 million, including transaction costs.$54.0 million. This acquisition allows Humana to integrate coverage of medical and behavior health benefits.

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

On April 1, 2004, we acquired Ochsner Health Plan, or Ochsner, from the Ochsner Clinic Foundation for $157.1 million in cash. 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 Medicare Advantage program.

During 2006, we paid $5.8 million in contingent purchase price settlements related to the Corphealth, CarePlus, and Ochsner acquisitions.

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

Recently Issued Accounting Pronouncements

In December 2004,July 2006, the FASB issued FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement 109, or FIN 48. FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return. FIN 48 also revises disclosure requirements and introduces a prescriptive, annual, tabular roll-forward of the unrecognized tax benefits. FIN 48, which became effective for us beginning January 1, 2007, requires the change in net assets that results from the application of the new accounting model to be reflected as an adjustment to retained earnings. The adoption of FIN 48 did not have a material impact on our financial position or results of operations.

In September 2006, the FASB issued Statement of Financial Accounting Standards BoardNo. 158,Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, or SFAS 158. We adopted SFAS 158 prospectively in the fourth quarter of 2006 for the year ending December 31, 2006. SFAS 158 requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position, and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. SFAS 158 also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position and revises certain disclosure requirements. The benefit obligation is defined as the projected benefit obligation for pension plans and as the accumulated postretirement benefit obligation for any other postretirement benefit plan, such as a retiree health care plan. The adoption of SFAS 158 did not have a material impact on our financial position.

In September 2006, the FASB issued SFAS No. 123R,Share-Based Payment,157, Fair Value Measurements, or SFAS 123R, which requires companies to expense the157. SFAS 157 defines fair value, of employee stock options and other forms of stock-based compensation. This requirement representsestablishes a significant change because fixed-based stock option awards, a predominate form of stock compensationframework for us, were not recognized as compensation expense under Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees. SFAS 123R requires that the cost of the award, as determined on the date of grant atmeasuring fair value, be recognized over the period during which an employee isand expands disclosures about fair value measurements. SFAS 157 does not require new fair value measurements. We are required to provide service in exchange for the award (usually the vesting period). The grant-date fair value of the award will be estimated using option-pricing models. In addition, certain tax effects of stock option exercises will be reported as a financing activity rather than an operating activityadopt SFAS 157 in the statementsfirst quarter of cash flows.2008. We adoptedcurrently are evaluating the provisions of SFAS 123R on January 1, 2006 under the retrospective transition method using the Black-Scholes pricing model. The effect of expensing stock options under a fair value approach using the Black-Scholes pricing model reduced diluted earnings per common share, as retroactively restated for157, however, we do not expect the adoption of SFAS 123R, by $0.08 in 2005, $0.06 in 2004, and $0.03 in 2003 as more fully disclosed in Note 2 of the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data. In addition, the classification of cash inflows from any excess tax benefit associated with exercising stock options157 will change from an operating activity tohave a financing activity in the consolidated statements of cash flows with nomaterial impact on total cash flows. We estimate the impactour financial position or results of this change in classification will decrease operating cash flows (and increase financing cash flows) by approximately $15.5 million in 2005, $3.7 million in 2004, and $15.2 million in 2003.operations.

On February 23, 2006, the Board

Comparison of Directors approved the issuanceResults of 1,517,507 additional options and restricted stock awards. This grant was weighted more towards awards of restricted stock than stock options as compared to grants made in prior years. Consequently, compensation expenseOperations for 2006 is anticipatedand 2005

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

         Change 
   2006  2005  Dollars  Percentage 
   (dollars in thousands)    

Premium revenues:

     

Medicare Advantage

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

Medicare stand-alone PDP

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

Total Medicare

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

TRICARE

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

Medicaid

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

Total Government

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

Fully insured

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

Specialty

   410,986   386,747   24,239  6.3%
                

Total Commercial

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

Total

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

Administrative services fees:

     

Government

  $49,442  $50,059  $(617) (1.2)%

Commercial

   291,769   209,378   82,391  39.4%
                

Total

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

Income before income taxes(a):

     

Government

  $513,845  $316,676  $197,169  62.3%

Commercial

   248,240   86,204   162,036  188.0%
                

Total

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

Medical expense ratios(b):

     

Government

   85.0%  83.1%  1.9%

Commercial

   81.7%  83.3%  (1.6)%
             

Total

   84.0%  83.2%  0.8%
             

SG&A expense ratios(a)(c):

     

Government

   11.8%  12.7%  (0.9)%

Commercial

   20.2%  18.5%  1.7%
             

Total

   14.3%  15.4%  (1.1)%
             

(a)Prior period amounts have been adjusted to reflect the expensing of stock awards under the modified retrospective application method of SFAS 123R as more fully discussed in Note 11 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data.
(b)Represents total medical expenses as a percentage of premium revenue. Also known as MER.
(c)Represents total selling, general, and administrative expenses as a percentage of premium revenues and administrative services fees. Also known as the SG&A expense ratio.

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

         Change 
   2006  2005  Members  Percentage 

Government segment medical members:

       

Medicare Advantage

  1,002,600  557,800  444,800  79.7%

Medicare stand-alone PDP

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

Total Medicare

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

TRICARE

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

TRICARE ASO

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

Total TRICARE

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

Medicaid

  390,700  457,900  (67,200) (14.7)%

Medicaid ASO

  178,400  —    178,400  100.0%
             

Total Medicaid

  569,100  457,900  111,200  24.3%
             

Total Government

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

Commercial segment medical members:

       

Fully insured

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

ASO

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

Total Commercial

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

Total medical membership

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

This table of financial data should be $0.08 per diluted common share related to stock options due to adopting SFAS 123R and $0.05 per diluted common share related to restricted stock. These amounts, whichreviewed in total are in lineconnection with previous guidance, are dependentthe discussion on certain assumptions, including additional grants during 2006. As disclosed above, the pro forma effect of expensing stock optionsfollowing pages.

Summary

Net income was $0.08$487.4 million, or $2.90 per diluted common share, in 2006 compared to $296.7 million, or $1.79 per diluted common share, in 2005. Net income for 2005 included expenses resulting from the physician class action settlement ($44.8 million after taxes, or $0.27 per diluted common share) and costs associated with Hurricane Katrina ($16.9 million after taxes, or $0.10 per diluted common share) described previously. Net income for 2005 also included the beneficial effect of an effective tax rate of approximately 26.3% compared to 36.0% in 2006, primarily due to the resolution of a contingent gain ($22.8 million, or $0.14 per diluted common share) during the first quarter of 2005 in connection with the expiration of the statute of limitations on an uncertain tax position related to the 2000 tax year. After considering litigation and Hurricane Katrina expenses and the favorable tax gain contingency in 2005, the remaining year over year improvement in 2006 results from earnings increases in both the Government and Commercial segments.

Premium Revenues and Medical Membership

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

Government segment premium revenues increased $7.1 billion, or 93.6% to $14.6 billion for 2006, compared to $7.5 billion for 2005. This increase primarily was attributable to the expanded participation in various Medicare products and geographic markets. Sales of our PFFS products drove the majority of the 79.7%

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

Commercial segment premium revenues decreased 5.3% to $6.1 billion for 2006 compared to $6.5 billion for 2005. Lower premium revenues primarily resulted from a reduction of fully insured membership. Our fully insured membership decreased 12.3%, or 245,600 members, to 1,754,200 at December 31, 2006 compared to 1,999,800 at December 31, 2005 primarily as a result of continued attrition within the fully insured group accounts, partially offset by membership gains from the CHA acquisition, and membership increases in the individual and consumer-choice product lines. Attrition in the fully insured group accounts results from a competitive pricing environment. Average per member premiums for our fully insured group medical members increased approximately 5.7% from 2005 to 2006. The average per member premium increase reflects a shift in the mix in our fully insured group membership from large groups to individuals and small groups as large groups continue to move to an administrative services only offering. Average per member premiums are lower for individuals and small groups than large groups.

Administrative Services Fees

Our administrative services fees for 2006 were $341.2 million, an increase of $81.8 million, or 31.5%, from $259.4 million for 2005. The increase was due to increases in our Commercial segment administrative services fees.

For the Commercial segment, administrative services fees increased $82.4 million, or 39.4%, from $209.4 million for 2005 to $291.8 million for 2006. This increase resulted from increased membership. ASO membership of 1,171,000 members at December 31, 2005 increased 30.6% to 1,529,600 at December 31, 2006. Average per member fees increased approximately 19% in 2006. ASO fees from our Commercial segment represent 86% of total ASO fees.

Investment Income

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

Other Revenue

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

Medical Expense

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

The consolidated MER for 2006 was 84.0%, an 80 basis point increase from 83.2% for 2005. Higher medical expenses from Hurricane Katrina increased the 2005 MER 20 basis points. An improvement in the Commercial segment MER was more than offset by a higher Government segment MER impacted by the new Medicare stand-alone PDP offerings.

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

The Government segment’s MER for 2006 was 85.0%, a 190 basis point increase from 2005 of 83.1%. The increase was primarily attributable to the introduction of the stand-alone PDPs in January 2006 with an MER of 92.5% for 2006. The stand-alone PDP MER was negatively impacted by an MER in our Complete plan of 115.9% for 2006, one of three stand-alone PDP offerings representing approximately 12% of our stand-alone PDP members. We expect MER to improve in 2007 to approximately 82% to 84% for our combined Medicare Advantage and stand-alone PDP offerings.

The Commercial segment’s medical expenses decreased $382.3 million, or 7.1%, from 2005 to 2006. This decrease primarily results from the decrease in fully insured group membership partially offset by the increase in average per member claims costs. The increase in average per member claims costs for fully insured group members was approximately 6% for 2006 and is expected to range from 5% to 6% for 2007.

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

SG&A Expense

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

The consolidated SG&A expense ratio for 2006 was 14.3%, decreasing 110 basis points from 15.4% for 2005. Expenses related to the litigation settlement increased the SG&A expense ratio 50 basis points for 2005. After considering the effects of the litigation settlement, the remaining decrease resulted from growth in revenues from higher average medical membership outpacing the related increase in administrative spending on a consolidated basis during 2006.

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

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

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

The Commercial segment SG&A expenses increased $59.0 million, or 4.8%, during 2006 compared to 2005. The Commercial segment SG&A expense ratio of 20.2% for 2006 increased 170 basis points from 18.5% for 2005. Expenses related to the litigation settlement increased the SG&A expense ratio 60 basis points for 2005. After considering the effect of the litigation, the increase primarily resulted from an increase in the percentage of small group members comprising our total fully insured membership as well as the continued shift in the mix of membership towards ASO. At December 31, 2005, 37% of our Commercial segment medical membership related to ASO business compared to 47% at December 31, 2006. Small group accounts bear a higher SG&A ratio than larger group accounts and ASO business bears a significantly higher SG&A ratio than fully insured business.

Depreciation and Amortization

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

Interest Expense

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

Income Taxes

Our effective tax rate for 2006 of 36.0% increased 9.7% compared to the 26.3% effective tax rate for 2005. The higher effective tax rate for 2006 is primarily due to the resolution of a contingent tax gain of $22.8 million in the first quarter of 2005 in connection with the expiration of the statute of limitations on an uncertain tax position related to the 2000 tax year which did not recur in 2006. See Note 11 of9 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data compensation expense relatedfor a complete reconciliation of the federal statutory rate to restricted stock awards was $0.02 per diluted common sharethe effective tax rate. We expect the 2007 effective tax rate to be in 2005.the range of 36% to 37%.

Comparison of Results of Operations for 2005 and 2004

Certain financial data for our two segments was as follows for the years ended December 31, 2005 and 2004:

 

    Change     Change 
  2005 2004 Dollars Percentage   2005 2004 Dollars Percentage 
  (dollars in thousands)   (dollars in thousands) 

Premium revenues:

          

Medicare Advantage

  $4,590,362  $3,086,598  $1,503,764  48.7%  $4,590,362  $3,086,598  $1,503,764  48.7%

TRICARE

   2,407,653   2,127,595   280,058  13.2%   2,407,653   2,127,595   280,058  13.2%

Medicaid

   548,714   511,193   37,521  7.3%   548,714   511,193   37,521  7.3%
                          

Total Government

   7,546,729   5,725,386   1,821,343  31.8%   7,546,729   5,725,386   1,821,343  31.8%
                          

Fully insured

   6,068,115   6,614,482   (546,367) (8.3)%   6,068,115   6,614,482   (546,367) (8.3)%

Specialty

   386,747   349,564   37,183  10.6%   386,747   349,564   37,183  10.6%
                          

Total Commercial

   6,454,862   6,964,046   (509,184) (7.3)%   6,454,862   6,964,046   (509,184) (7.3)%
                          

Total

  $14,001,591  $12,689,432  $1,312,159  10.3%  $14,001,591  $12,689,432  $1,312,159  10.3%
                          

Administrative services fees:

          

Government

  $50,059  $106,764  $(56,705) (53.1)%  $50,059  $106,764  $(56,705) (53.1)%

Commercial

   209,378   166,032   43,346  26.1%   209,378   166,032   43,346  26.1%
                          

Total

  $259,437  $272,796  $(13,359) (4.9)%  $259,437  $272,796  $(13,359) (4.9)%
                          

Income before income taxes:

     

Income before income taxes(a):

     

Government

  $323,268  $273,840  $49,428  18.0%  $316,676  $269,063  $47,613  17.7%

Commercial

   98,446   142,010   (43,564) (30.7)%   86,204   130,315   (44,111) (33.8)%
                          

Total

  $421,714  $415,850  $5,864  1.4%  $402,880  $399,378  $3,502  0.9%
                          

Medical expense ratios(a):

     

Medical expense ratios(b):

     

Government

   83.1%  84.3%  (1.2)%   83.1%  84.3%  (1.2)%

Commercial

   83.3%  83.9%  (0.6)%   83.3%  83.9%  (0.6)%
                      

Total

   83.2%  84.1%  (0.9)%   83.2%  84.1%  (0.9)%
                      

SG&A expense ratios(b):

     

SG&A expense ratios(a)(c):

     

Government

   12.6%  12.2%  0.4%   12.7%  12.3%  0.4%

Commercial

   18.3%  16.4%  1.9%   18.5%  16.5%  2.0%
                      

Total

   15.3%  14.5%  0.8%   15.4%  14.6%  0.8%
                      

(a)Prior period amounts have been adjusted to reflect the expensing of stock awards under the modified retrospective application method of SFAS 123R as more fully discussed in Note 11 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data.
(b)Represents total medical expenses as a percentage of premium revenue. Also known as MER.
(b)(c)Represents total selling, general, and administrative expenses as a percentage of premium revenues and administrative services fees. Also known as the SG&A expense ratio.

Medical membership was as follows at December 31, 2005 and 2004:

 

     Change         Change 
  2005  2004  Members Percentage   2005  2004  Members Percentage 

Government segment medical members:

              

Medicare Advantage

  557,800  377,200  180,600  47.9%  557,800  377,200  180,600  47.9%

Medicaid

  457,900  478,600  (20,700) (4.3)%  457,900  478,600  (20,700) (4.3)%

TRICARE

  1,750,900  1,789,400  (38,500) (2.2)%  1,750,900  1,789,400  (38,500) (2.2)%

TRICARE ASO

  1,138,200  1,082,400  55,800  5.2%  1,138,200  1,082,400  55,800  5.2%
             

Total TRICARE

  2,889,100  2,871,800  17,300  0.6%
                          

Total Government

  3,904,800  3,727,600  177,200  4.8%  3,904,800  3,727,600  177,200  4.8%
                          

Commercial segment medical members:

              

Fully insured

  1,999,800  2,286,500  (286,700) (12.5)%  1,999,800  2,286,500  (286,700) (12.5)%

ASO

  1,171,000  1,018,600  152,400  15.0%  1,171,000  1,018,600  152,400  15.0%
                          

Total Commercial

  3,170,800  3,305,100  (134,300) (4.1)%  3,170,800  3,305,100  (134,300) (4.1)%
                          

Total medical membership

  7,075,600  7,032,700  42,900  0.6%  7,075,600  7,032,700  42,900  0.6%
                          

This table of financial data should be reviewed in connection with the discussion on the following pages.

Summary

Net income was $308.5$296.7 million, or $1.87$1.79 per diluted common share, in 2005 compared to $280.0$269.9 million, or $1.72$1.66 per diluted common share, in 2004. The increase in net income primarily resulted from improved profits in our Government segment, driven by gains in Medicare Advantage membership and improved underwritingpretax results in both our Medicare Advantage and TRICARE operations.

Net income for 2005 included expenses resulting from the class action litigation settlement ($44.8 million after taxes, or $0.27 per diluted common share) and costs associated with Hurricane Katrina ($16.9 million after taxes, or $0.10 per diluted common share). Net income for 2005 also included the favorable effect of an effective tax rate of approximately 26.9%26.3% compared to 32.7%32.4% in 2004, primarily due to the resolution of a contingent tax gain ($22.8 million, or $0.14 per diluted common share) during the first quarter of 2005 in connection with the expiration of the statute of limitations on an uncertain tax position related to the 2000 tax year.

Premium Revenues and Medical Membership

Premium revenues increased 10.3% to $14.0 billion for 2005, compared to $12.7 billion for 2004. Higher Government segment premium revenues were partially offset by a decrease in Commercial segment premium revenues. Premium revenues reflect changes in membership and increases in average per member premiums. Items impacting average per member premiums include changes in premium rates as well as changes in the geographic mix of membership, the mix of product offerings, and the mix of benefit plans selected by our membership.

Government segment premium revenues increased 31.8% to $7.5 billion for 2005, compared to $5.7 billion for 2004. This increase primarily was attributable to our Medicare Advantage operations and the effects of transitioning to the TRICARE South Region contract during 2004. Medicare Advantage membership was 557,800 at December 31, 2005, compared to 377,200 at December 31, 2004, an increase of 180,600 members, or 47.9%. This increase was due to expanded participation in various Medicare Advantage programs and geographic markets, as well as the CarePlus acquisition. The February 16, 2005 CarePlus acquisition added 50,400 members and $486.3 million in premium revenues in 2005. Average per member premiums for our Medicare Advantage business increased approximately 12% during 2005. This reflects a shift in our Medicare Advantage membership mix to higher reimbursement markets, due primarily to the South Florida CarePlus acquisition. Medicare geographic expansions during 2006 are anticipated to contribute to continued enrollment growth, with projected Medicare Advantage enrollment in the range of 900,000 to 1,100,000 at December 31, 2006 and PDP enrollment in the range of 1,900,000 to 2,200,000 at December 31, 2006. Total Medicare premium revenue for 2006 is projected to more than double from 2005. TRICARE premium revenues increased 13.2% in 2005, reflecting the transition to the new South Region contract during 2004 which included a temporary loss of approximately 1 million members for 4 months in 2004. Medicaid membership declined by 20,700 members from December 31, 2004 to December 31, 2005

primarily due to the fact that we did not renew our participation in the Medicaid program for the State of Illinois on July 31, 2005. The Illinois Medicaid business was not material to our results of operations, financial position, or cash flows.

Commercial segment premium revenues decreased 7.3% to $6.5 billion for 2005, compared to $7.0 billion for 2004. Lower premium revenues primarily resulted from a reduction of fully insured membership partially offset by increases in average per member premiums. Our fully insured membership decreased 12.5%, or 286,700 members, to 1,999,800 at December 31, 2005 compared to 2,286,500 at December 31, 2004. The decrease is primarily due to the relinquishment of an 89,000-member unprofitable account on January 1, 2005 and continued attrition due to the ongoing competitive environment within the fully insured group accounts, partially offset by membership gains in the individual and consumer-choice product lines. Average per member premiums for our fully insured group medical members increased approximately 7% to 9%7.4% in 2005 and are anticipated to further increase in the range of 7% to 9% in 2006.2005.

Administrative Services Fees

Our administrative services fees for 2005 were $259.4 million, a decrease of $13.4 million, or 4.9%, from $272.8 million for 2004.

Administrative services fees for the Government segment decreased $56.7 million, or 53.1%, from $106.8 million for 2004 to $50.1 million for 2005. This decline 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 transitioned services under these separate programs to other providers during 2004.

For the Commercial segment, administrative services fees increased $43.4 million, or 26.1%, from $166.0 million for 2004 to $209.4 million for 2005. This increase resulted from increased membership and higher average per member fees. ASO membership of 1,171,000 members at December 31, 2005 increased 15.0% compared to 1,018,600 at December 31, 2004. Average per member fees increased approximately 8% in 2005.

Investment and Other Income

Investment and other income totaled $157.1$143.0 million in 2005, an increase of $15.0$10.2 million from $142.1$132.8 million in 2004. This increase primarily was attributable to increased investment income from higher interest rates and average invested balances offset by lower capital gains. The average yield on investment securities was 4.0% in 2005 compared to 3.6% in 2004. The investment of cash flows from operations contributed to the increase in the average invested balance and added approximately $7.0 million to interest income. Net realized capital gains of $18.3 million in 2005 decreased $9.9 million from $28.2 million in 2004. As of December 31, 2005, we had an unrealized gain of $52.3 million related to a venture capital investment. Weinvestment which was realized this gain in the first quarter of 2006 with the sale of this venture capital investment.2006.

Medical Expense

Consolidated medical expenses increased $981.8 million or 9.2% during 2005. The increase was primarily driven by the increase in average per member claims costs primarily from the effects of health care inflation and incremental medical expenses related to the CarePlus acquisition.

The medical expense ratio, or MER, which is computed by taking total medical expenses as a percentage of premium revenues, represents a key industry statistic used to measure underwriting profitability.

The consolidated MER for 2005 was 83.2%, decreasing 90 basis points from 84.1% for 2004 due to improvements in both the Commercial and Government segments as further discussed below. The 2005 consolidated MER includes 20 basis points for expenses associated with Hurricane Katrina.

The Government segment’s medical expenses increased $1.4 billion, or 30.0% during 2005 primarily due to the increase in average per member claims costs and the increase in the number of Medicare Advantage members, including those related to the CarePlus acquisition. The increase in average per member claims costs for Medicare Advantage approximated 8% to 10% during 2005.

The Government segment’s MER for 2005 was 83.1%, a 120 basis point decrease from the 2004 rate of 84.3%. Excluding a 10 basis point increase in the 2005 MER from Hurricane Katrina, the decrease was primarily

attributable to the increase in Medicare Advantage revenues as a percentage of total Government segment revenues and average per member Medicare Advantage premiums outpacing average per member Medicare Advantage claim costs.

The Commercial segment’s medical expenses decreased $465.2 million, or 8.0%. This decrease primarily results from the decrease in fully insured group membership partially offset by the increase in average per member claims costs. The increase in average per member claims costs for fully insured group members was approximately 7% to 9% for 2005.

The MER for the Commercial segment of 83.3% in 2005 decreased 60 basis points from the 2004 MER of 83.9%. Higher medical expenses from Hurricane Katrina increased the 2005 MER 30 basis points. After considering the effect of Hurricane Katrina, the decrease in MER for the 2005 period primarily reflects the absence of the unprofitable 89,000-member large group account that lapsed on January 1, 2005.

SG&A Expense

Consolidated selling, general, and administrative (SG&A)SG&A expenses increased $298.9$301.3 million or 15.9% during 2005 primarily resulting from an increase in the number of employees due to the Medicare expansion, the class action litigation settlement, and increased advertising and marketing costs also due to the Medicare expansion. These increases were partially offset by a decrease in administrative expenses associated with transitioning to the TRICARE South Region contract in 2004. During 2005, the number of employees increased 5,000 to 18,700 at December 31, 2005, primarily in the sales and customer service functions associated with the growth in the Medicare business, as well as approximately 1,200 employees added with the CarePlus acquisition.

The SG&A expense ratio, which is computed by taking total selling, general, and administrative expenses as a percentage of premium revenues and administrative services fees, represents a key industry statistic used to measure administrative spending efficiency.

The consolidated SG&A expense ratio for 2005 was 15.3%15.4%, increasing 80 basis points from 14.5%14.6% for 2004. Expenses related to the class action litigation settlement increased the SG&A expense ratio 50 basis points for 2005. After considering the effect of the class action litigation expenses, the SG&A expense ratio increase primarily resulted from a commercial membership mix shift and increased spending associated with the Medicare expansion. The consolidated SG&A expense ratio is expected to be in the range of 12% to 13% for 2006 reflecting the continuing beneficial effect of growth in revenues and membership leveraging fixed costs.

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

SG&A expenses in the Government segment increased $246.2$248.1 million, or 34.7% during 2005 due to the CarePlus acquisition, increased spending associated with the Medicare expansion, and the class action litigation settlement. These increases were partially offset by a decrease in TRICARE expenses from the transition to the South Region contract in 2004. The Government segment SG&A expense ratio increased 40 basis points from 12.2%12.3% for 2004 to 12.6%12.7% for 2005. Expenses related to the class action litigation settlement increased the SG&A expense ratio 4050 basis points for 2005.

The Commercial segment SG&A expenses increased $52.7$53.2 million, or 4.5% during 2005. The Commercial segment SG&A expense ratio increased 190200 basis points from 16.4%16.5% for 2004 to 18.3%18.5% for 2005. Expenses related to the class action litigation settlement increased the SG&A expense ratio 60 basis points for 2005. After considering the effect of the class action litigation expenses, this increase resulted from the continued shift in the mix of membership towards ASO. ASO business bears a significantly higher SG&A ratio than fully insured business.

Depreciation and Amortization

Depreciation and amortization for 2005 totaled $128.9 million compared to $117.8 million for 2004, an increase of $11.1 million, or 9.4%. Amortization of other intangible assets increased $13.3 million during 2005 primarily as a result of intangible assets recorded in connection with the CarePlus acquisition.

Interest Expense

Interest expense was $39.3 million for 2005, compared to $23.2 million for 2004, an increase of $16.1 million. This increase primarily resulted from higher interest rates and higher average outstanding debt. The

higher average outstanding debt balance increased interest expense $5.0 million during 2005. The average interest rate during 2005 of 5.3% increased 140 basis points compared to 3.9% during 2004.

Income Taxes

Our effective tax rate in 2005 of 26.9%26.3% decreased 5.8%6.1% compared to the 32.7%32.4% effective tax rate in 2004. The effective tax rate for 2005 reflects the favorable impact from the resolution of a contingent tax gain of $22.8 million during the first quarter of 2005 in connection with the expiration of the statute of limitations on an uncertain tax position related to the 2000 tax year. See Note 89 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data for a complete reconciliation of the federal statutory rate to the effective tax rate. We expect the 2006 effective tax rate to be in the range of 35% to 37%.

Comparison of Results of Operations for 2004 and 2003

Certain financial data for our two segments was as follows for the years ended December 31, 2004 and 2003:

      Change 
   2004  2003  Dollars  Percentage 
   (dollars in thousands)    

Premium revenues:

     

Medicare Advantage

  $3,086,598  $2,527,446  $559,152  22.1%

TRICARE

   2,127,595   2,249,725   (122,130) (5.4)%

Medicaid

   511,193   487,100   24,093  4.9%
                

Total Government

   5,725,386   5,264,271   461,115  8.8%
                

Fully insured

   6,614,482   6,240,806   373,676  6.0%

Specialty

   349,564   320,206   29,358  9.2%
                

Total Commercial

   6,964,046   6,561,012   403,034  6.1%
                

Total

  $12,689,432  $11,825,283  $864,149  7.3%
                

Administrative services fees:

     

Government

  $106,764  $148,830  $(42,066) (28.3)%

Commercial

   166,032   122,846   43,186  35.2%
                

Total

  $272,796  $271,676  $1,120  0.4%
                

Income before income taxes:

     

Government

  $273,840  $223,706  $50,134  22.4%

Commercial

   142,010   121,010   21,000  17.4%
                

Total

  $415,850  $344,716  $71,134  20.6%
                

Medical expense ratios(a):

     

Government

   84.3%  84.3%  —  %

Commercial

   83.9%  82.9%  1.0%
             

Total

   84.1%  83.5%  0.6%
             

SG&A expense ratios(b):

     

Government

   12.2%  13.4%  (1.2)%

Commercial

   16.4%  16.9%  (0.5)%
             

Total

   14.5%  15.4%  (0.9)%
             

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

Medical membership was as follows at December 31, 2004 and 2003:

      Change 
   2004  2003  Members  Percentage 

Government segment medical members:

       

Medicare Advantage

  377,200  328,600  48,600  14.8%

Medicaid

  478,600  468,900  9,700  2.1%

TRICARE

  1,789,400  1,849,700  (60,300) (3.3)%

TRICARE ASO

  1,082,400  1,057,200  25,200  2.4%
             

Total Government

  3,727,600  3,704,400  23,200  0.6%
             

Commercial segment medical members:

       

Fully insured

  2,286,500  2,352,800  (66,300) (2.8)%

ASO

  1,018,600  712,400  306,200  43.0%
             

Total Commercial

  3,305,100  3,065,200  239,900  7.8%
             

Total medical membership

  7,032,700  6,769,600  263,100  3.9%
             

This table of financial data should be reviewed in connection with the discussion on the following pages.

Summary

Net income was $280.0 million, or $1.72 per diluted common share, in 2004 compared to $228.9 million, or $1.41 per diluted common share, in 2003. The increase in net income consisted of improved profits in both of our business segments, driven by higher earnings from our Medicare and commercial products. The 2003 results included expenses for asset impairments as more fully described in Note 5 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data.

Premium Revenues and Medical Membership

Premium revenues increased 7.3% to $12.7 billion for 2004, compared to $11.8 billion for 2003. Higher premium revenues resulted primarily from the Ochsner acquisition, as more fully described in Note 3 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data, and an increase in Medicare Advantage and fully insured commercial average per member premiums. Items impacting average per member premiums include changes in premium rates as well as changes in the geographic mix of membership, the mix of product offerings, and the mix of benefit plans selected by our membership.

Government segment premium revenues increased 8.8% to $5.7 billion for 2004, compared to $5.3 billion for 2003. This increase primarily was attributable to our Medicare Advantage operations. Medicare Advantage membership was 377,200 at December 31, 2004, compared to 328,600 at December 31, 2003, an increase of 48,600 members, or 14.8%, including 33,100 members added through the acquisition of Ochsner. Average per member premiums for our Medicare Advantage business increased approximately 10% for 2004, reflecting higher reimbursement from CMS. TRICARE premium revenues decreased 5.4% in 2004 reflecting the transition to the new South Region contract which included a temporary loss of approximately 1 million members for 4 months in 2004.

Commercial segment premium revenues increased 6.1% to $7.0 billion for 2004, compared to $6.5 billion for 2003. This increase resulted from the Ochsner acquisition and increases in average per member premiums in the 6% to 8% range on our fully insured commercial business partially offset by membership attrition. Average per member premium increases of 6% to 8% include the impact of an increasing mix of individual products into our fully insured membership. A lower premium corresponding to lower benefits on products sold to individuals reduced our average per member premium trend by approximately 150 to 200 basis points. Our fully insured commercial medical membership decreased 2.8%, or 66,300 members, to 2,286,500 at December 31, 2004 after

giving effect to the addition of 152,600 members from the acquisition of Ochsner. Without giving effect to the Ochsner acquisition, the decrease was primarily due to the lapse of certain under-performing large group accounts totaling approximately 94,000 members in 2004 and continued attrition due to the ongoing competitive environment within the small to mid-market group fully insured accounts, partially offset by membership gains in the Individual product lines.

Administrative Services Fees

Our administrative services fees for 2004 were $272.8 million, an increase of $1.1 million, or 0.4%, from $271.7 million for 2003. This increase resulted primarily from higher Commercial ASO membership partially offset by lower fees related to TRICARE’s change in government-contracted services as described below.

Administrative services fees for the Government segment decreased $42.1 million, or 28.3%, from $148.8 million for 2003 to $106.8 million for 2004. This decline 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 transitioned services under these separate programs to other providers during 2004.

For the Commercial segment, administrative services fees increased $43.2 million, or 35.2%, from $122.8 million for 2003 to $166.0 million for 2004. This increase resulted from a higher level of ASO membership at December 31, 2004, which was 1,018,600 members, compared to 712,400 members at December 31, 2003, an increase of 43%.

Investment and Other Income

Investment and other income totaled $142.1 million in 2004, an increase of $12.7 million from $129.4 million in 2003. This increase primarily resulted from an increase in the average invested balance partially offset by a decrease in net realized capital gains of approximately $8.4 million. The investment of cash flows from operations contributed to the increase in the average invested balance and added approximately $18.8 million to interest income. The average yield on investment securities was 3.6% in 2004 compared to 3.5% in 2003.

Medical Expense

Consolidated medical expenses increased $790.2 million, or 8.0%, to $10.7 billion in 2004 from $9.9 billion in 2003. The increase was primarily driven by the Ochsner acquisition and an increase in average per member claims costs primarily from the effects of health care inflation.

The consolidated MER for 2004 was 84.1%, increasing 60 basis points from 83.5% for 2003 primarily due to the increase in the MER for the Commercial segment.

The Government segment’s medical expenses increased $386.1 million, or 8.7%, during 2004 primarily due to the increase in the number of Medicare members, including those related to the Ochsner acquisition, and the increase in average per member claims costs, partially offset by lower medical expenses associated with transitioning to the TRICARE South contract.

The Government segment’s MER for 2004 was 84.3%, which was flat when compared to 2003. The Medicare Advantage premium increases were consistent with medical cost increases for 2004 reflecting our efforts of adjusting benefit levels commensurate with reimbursement rates.

The Commercial segment’s medical expenses increased $404.2 million, or 7.4%, during 2004. The increase was primarily driven by an increase in average per member claims costs primarily from the effects of health care inflation. The increase in average per member claims costs for fully insured group members was approximately 8% to 10% for 2004.

The Commercial segment’s MER for 2004 was 83.9%, increasing 100 basis points from 2003 of 82.9%. The 100 basis point increase was primarily due to underwriting losses associated with a large customer account serving approximately 89,000 members and a competitive pricing environment in the 2 to 300 life customer group. The 89,000-member large group account lapsed on January 1, 2005. Increasing per member premiums commensurate with claims trend becomes more difficult in a competitive pricing environment.

SG&A Expense

Consolidated SG&A expenses increased $19.8 million, or 1.1%, to $1.9 billion in 2004. Included in 2003 were costs of $17.2 million from the impairment of the Jacksonville, Florida service center building more fully described in Note 5 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data. Excluding the impairment, the increase resulted from higher Commercial segment SG&A expenses partially offset by lower Government segment SG&A expenses.

The consolidated SG&A expense ratio for 2004 was 14.5%, decreasing 90 basis points from 15.4% for 2003. This decrease, as well as the decrease in each of our segments’ SG&A expense ratios, was the result of the revenue growth in excess of administrative cost inflation and operational efficiencies including gains from completing the consolidation of seven service centers into four during 2003. The Jacksonville, Florida building writedown increased the 2003 SG&A expense ratio 10 basis points.

SG&A expenses in the Government segment decreased $15.7 million, or 2.2% during 2004 primarily due to a decrease in TRICARE SG&A expenses from transitioning to the South contract partially offset by the Ochsner acquisition. The Government segment SG&A expense ratio decreased 120 basis points from 13.4% for 2003 to 12.2% for 2004. The Government segment SG&A expense ratio for 2003 included an approximate 20 basis point impact from the Jacksonville, Florida building writedown.

The Commercial segment SG&A expenses increased $35.5 million, or 3.1% during 2004 primarily due to the Ochsner acquisition. The Commercial segment SG&A expense ratio decreased 50 basis points from 16.9% for 2003 to 16.4% for 2004. The Commercial segment SG&A expense ratio for 2003 included an approximate 10 basis point impact from the Jacksonville, Florida building writedown.

Depreciation and Amortization

Depreciation and amortization for 2004 totaled $117.8 million compared to $126.8 million for 2003, a decrease of $9.0 million, or 7.1%. Accelerated depreciation from reducing the estimated useful life of software increased depreciation expense $9.3 million in 2004 and $13.5 million in 2003. Amortization of other intangible assets decreased when the other intangible assets allocated to an acquired TRICARE contract 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 $23.2 million for 2004, compared to $17.4 million for 2003, an increase of $5.8 million. This increase primarily resulted from higher average outstanding debt, due to the issuance of $300 million senior notes in August 2003.

Income Taxes

Our effective tax rate in 2004 of 32.7% decreased 0.9% compared to the 33.6% effective tax rate in 2003. Our effective tax rate is lower than the federal statutory rate due primarily to tax-exempt investment income. See Note 8 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data for a complete reconciliation of the federal statutory rate to the effective tax rate.

Liquidity

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

Cash and cash equivalents increased to $1,740.3 million at December 31, 2006 from $732.0 million at December 31, 2005 from $580.1 million at December 31, 2004.2005. The change in cash and cash equivalents for the years ended December 31, 2006, 2005 2004 and 20032004 is summarized as follows:

 

  2005 2004 2003   2006 2005 2004 
  (in thousands)   (in thousands) 

Net cash provided by operating activities

  $625,627  $347,809  $413,140   $1,686,712  $610,082  $344,061 

Net cash used in investing activities

   (767,276)  (624,081)  (382,837)   (1,654,066)  (767,276)  (624,081)

Net cash provided by (used in) financing activities

   293,586   (75,053)  179,744    975,642   309,131   (71,305)
                    

Increase (decrease) in cash and cash equivalents

  $151,937  $(351,325) $210,047   $1,008,288  $151,937  $(351,325)
                    

Cash Flow from Operating Activities

OurThe increase in operating cash flows for 2006 resulted from Medicare enrollment growth, improved earnings, and the timing of cash flows associated with our new Medicare Part D offerings. Our Part D results related to both stand-alone PDP and MA-PD offerings reflect provisions for net amounts payable to CMS of $738.7 million under the risk corridor terms of our contracts with CMS. This risk corridor amount, which is expected to be paid mid-2007, reflects favorable experience on allowable risk corridor costs during the second half of 2006 compared to the expectations set out in our original annual bid for 2006 contracts with CMS. The favorable experience was associated with the Medicare Part D portion of our MA-PD offerings as well as our Standard and Enhanced stand-alone plans.

Comparisons of our operating cash flows between 2005 and 2004 were significantly impacted by the timing of the Medicare Advantage premium remittance which 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. As such, the Medicare Advantage receiptsreceipt for January 2004 of $211.9 million and January 2003 of $205.8 million werewas received in December 2003 and December 2002, respectively, because January 1 is a holiday.

Beginning in 2005, the monthly premium payment schedule included a change in timing from previous practice. This new practice made an exception to the holiday rule for the January 1 payment. Although January 1 always represents a holiday, the new practice results in the January 1 payment being received on the first business day of January. As a result of this change, the January 2005 payment of $290.3 million originally scheduled to be received on Friday, December 31, 2004, was changed to Monday, January 3, 2005, or one business day later. Therefore, we received 12 monthly Medicare Advantage premium remittances in 2006 and 2005, compared to only 11 in 2004, and 12 in 2003.2004.

In addition to the impact from the timing of the Medicare Advantage premium receipts, higher earnings and Medicare enrollment growth contributed to increased operating cash flows in 2005 2004 and 2003. 2004.

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

The detail of total net receivables was as follows at December 31, 2006, 2005 2004 and 2003:2004:

 

   Change         Change 
 2005 2004 2003 2005 2004   2006 2005 2004 2006 2005 
 (in thousands)   (in thousands) 

TRICARE:

           

Base receivable

 $509,444  $396,355  $266,656  $113,089  $129,699   $452,509  $509,444  $396,355  $(56,935) $113,089 

Bid price adjustments (BPAs)

  —     25,601   92,875   (25,601)  (67,274)   —     —     25,601   —     (25,601)

Change orders

  32,285   6,021   7,073   26,264   (1,052)   4,247   32,285   6,021   (28,038)  26,264 
                               
  541,729   427,977   366,604   113,752   61,373 

Less: long-term portion of BPAs

  —     —     (38,794)  —     38,794 
               

TRICARE subtotal

  541,729   427,977   327,810   113,752   100,167    456,756   541,729   427,977   (84,973)  113,752 

Medicare

  63,931   213   —     63,718   213    143,875   66,536   2,287   77,339   64,249 

Commercial and other

  165,549   185,931   178,577   (20,382)  7,354    125,899   162,944   183,857   (37,045)  (20,913)

Allowance for doubtful accounts

  (32,557)  (34,506)  (40,400)  1,949   5,894    (45,589)  (32,557)  (34,506)  (13,032)  1,949 
                               

Total net receivables

 $738,652  $579,615  $465,987   159,037   113,628   $680,941  $738,652  $579,615   (57,711)  159,037 
                       

Reconciliation to cash flow statement:

           

Change in long-term receivables

     —     (52,583)

Provision for doubtful accounts

     4,566   6,433       20,901   4,566 

Receivables from acquisition

     (2,289)  (16,420)      (843)  (2,289)
                   

Change in receivables in cash flow statement

    $161,314  $51,058 

Change in receivables per cash flow statement

     $(37,653) $161,314 
                   

TRICARE base receivables began increasingconsist of estimated amounts owed from the federal government for claims incurred including claims incurred but not reported, or IBNR, and underwriting fees. The claim reimbursement component of TRICARE base receivables is generally collected over a three to four month period. The $56.9 million decrease in base receivables resulted primarily from a timing difference in our claim reimbursements partially offset by an increase in underwriting fee receivables.

The increase in TRICARE base receivables from 2004 to 2005 was primarily due to the transition to the reimbursement model under the South Region contract beginning on August 1, 2004. Under2004 and higher claims inventories at our former TRICARE contracts with a fixed price, we bore the cost of changes in the underlying pattern of health care for which the government was at risk until subsequently reimbursed in a later period through a bid price adjustment, or BPA process. The fixed price and BPA process added variability to our revenues, related receivables and operating cash flows because the timing of the settlement was uncertain. Under the new TRICARE South region contract, the fixed price and BPA process was eliminated and replaced with a new reimbursement model. We are reimbursed by the federal government generally within 15 calendar days of when we pay the claim under the new reimbursement model.

The delivery of health care services under the TRICARE South region contract results in (1) a lag between the time the service is provided and when the claim is paid by us, generally three months, and (2) a lag between the time the claim is paid by us and ultimately reimbursed by the federal government, generally 15 calendar days. Thus, thethird party claims reimbursement component of TRICARE base receivables is generally collected over a three to four month period.processing vendor. The transition to the South region contract had the effect of increasing the TRICARE base receivable and by a like amount, increasingcorresponding increase in TRICARE claims payable.

In addition to the effect of transitioning to the new South region contract reimbursement model, TRICARE base receivables (and related claims payable) increased in 2005 from higher claims inventories at our third party claims processing vendor. The $26.3$28.0 million increasedecrease in TRICARE change order receivables from 2005 to 2006 resulted from negotiatingthe collection of receivables in 2006 related to an equitable adjustment to the contract price negotiated in late 2005 for services not originally specified in the contract. We expect to collect the majority of these receivables during the first half of 2006.

The $63.7$77.3 million increase in Medicare Advantage receivables as of December 31, 2005 as compared to December 31, 2004 primarilyin 2006 resulted from recording revenuesthe growth in Medicare membership while the $64.2 million increase in 2005 was due to an increase in receivables associated with CMS’s risk adjustment model. CMS has implemented a risk adjustment model which apportions premiums paid to all health plans, including Humana, according to health severity. This model pays more for enrollees with predictably higher costs. Under this risk adjustment methodology, diagnosis data

The decline in Commercial and other receivables since December 31, 2004 results from inpatient and ambulatory treatment settings are used to

calculate the risk adjusted premium payment to us. We collect, capture and submit the necessary diagnosis data to CMS weekly. We estimate risk adjustment revenues based upon the diagnosis data we submitted to CMS. This also resulted in a corresponding increasechange in the capitation payablemix of members from fully insured to physicians under risk sharing arrangements discussed below.ASO.

The detail of medical and other expenses payable was as follows at December 31, 2006, 2005 2004 and 2003:2004:

 

           Change            Change 
  2005  2004  2003  2005 2004   2006  2005  2004  2006 2005 
  (in thousands)   (in thousands) 

IBNR(1)

  $1,483,902  $1,164,518  $1,043,360  $319,384  $121,158   $1,678,052  $1,074,489  $879,871  $603,563  $194,618 

Reported claims in process(2)

   83,635   97,801   74,262   (14,166)  23,539 

Other medical expenses payable(3)

   342,145   159,691   154,534   182,454   5,157 

TRICARE claims payable(2)

   430,674   514,426   315,535   (83,752)  198,891 

Reported claims in process(3)

   98,033   67,065   73,883   30,968   (6,818)

Other medical expenses payable(4)

   281,502   253,702   152,721   27,800   100,981 
                                

Total medical and other expenses payable

  $1,909,682  $1,422,010  $1,272,156   487,672   149,854   $2,488,261  $1,909,682  $1,422,010   578,579   487,672 
                        

Reconciliation to cash flow statement:

                  

Medical and other expenses payable from acquisition

         (37,375)  (71,063)         (21,198)  (37,375)
                          

Change in medical and other expenses payable in cash flow statement

        $450,297  $78,791         $557,381  $450,297 
                          

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

Medical and other expenses payable primarily increased during 2006 due growth in Medicare membership and to a lesser extent medical claims inflation.

Medical and other expenses payable primarily increased during 2005 due to (1) growth in Medicare membership, (2) medical claims inflation, (3) the transition to the new South region contract, (4) an increase in the TRICARE payable resulting from an increase in claims inventory at our third party claims processing vendor as discussed under the total net receivables table on the previous page, and (5) an increase in the capitation payable to physicians under risk sharing arrangements.

Medical and other expenses payable increased during 2004 due primarily to medical claims inflation.

Cash Flow from Investing Activities

We reinvested a portion of our operating cash flows over the last several years in investment securities, primarily short-duration fixed income securities, totaling $862.1 million in 2006, $233.3 million in 2005, and $407.3 million in 2004. 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, excluding acquisitions, were $193.2 million

in 2006, $165.8 million in 2005, and $114.1 million in 2004. The increased spending in 2006 and 2005 primarily resulted from our Medicare expansion initiatives. Excluding acquisitions, we expect total capital expenditures in 2007 of approximately $200 million.

During 2006, we paid $22.3 million to acquire CHA Health, net of $43.5 million of cash acquired, and we paid $5.8 million in contingent purchase price settlements related to prior years acquisitions. During 2005, we paid $352.8 million to acquire CarePlus, net of $92.1 million of cash acquired, and we paid $50.0 million to acquire Corphealth, net of $4.0 million of cash acquired. During 2004, we paid $141.8 million to acquire Ochsner, net of $15.3 million of cash acquired.

We reinvested a portion of our operating cash flows over the last several years in investment securities, primarily short-duration fixed income securities, totaling $233.3 million in 2005, $407.3 million in 2004, and $283.1 million in 2003. 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, excluding acquisitions, were $165.8 million in 2005, $114.1 million in 2004, and $101.3 million in 2003. The increased spending in 2005 primarily resulted from our Medicare expansion initiatives. Excluding acquisitions, we expect our total capital expenditures in 2006 to range between $125 million and $135 million.

During 2004, and 2003, proceeds of $30.5 million from the sale of property and equipment relate primarily to consolidating our service centers in Jacksonville and San Antonio, including the sale of the Jacksonville office tower in 2004 for $14.8 million and a San Antonio office building for $5.9 million in 2003.million.

Cash Flow from Financing Activities

During 2006, we issued $500 million of 6.45% senior notes due June 1, 2016. Our net proceeds, reduced for the discount and cost of the offering were $494.3 million. We used the proceeds from the offering for the repayment of the outstanding balance under our credit agreement, which at the time of the issuance was $200 million, and the repayment of our $300 million 7.25% senior notes which matured on August 1, 2006.

During 2006, our borrowings of $550 million and repayments of $300 million under our credit agreements related to the timing of our senior notes issuance and repayment and funding of additional capital into certain subsidiaries during 2006 in conjunction with growth in Medicare revenues. During 2005, we borrowed $494 million under our 5-year $600 million credit agreement. This amount included $294 million which we borrowed temporarily to finance the CarePlus acquisition. Additional borrowings related primarily toacquisition and repaid in 2005.

Subsidies from CMS associated with Medicare Part D claims for which we do not assume risk were $122.3 million less than the anticipation of funding additional capital into certain subsidiaries during 2006claim payments, as described in conjunction with anticipated growth in revenues.

During 2003, we issued $300 million in 6.3% senior notes due August 1, 2018 in order to repay our short-term debt and take advantage of historically low interest rates. In addition, during 2003 we received proceeds of $31.6 million in exchange for new swap agreements. See Note 92 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data for more detailed information regarding our borrowings and swap agreements.Data.

The remainder of the cash provided by financing activities in 2006, 2005, 2004 and 20032004 resulted primarily from the change in the book overdraft,securities lending payable, proceeds from stock option exercises, tax benefits of stock-based compensation, and the change in the book overdraft. The increase in securities lending payable. During 2005, we acquired approximately 68,300in 2006 coincides with a change in banking vendors and higher average balances of our common shares ininvestments to lend. In connection with employee stock plans, atwe acquired common shares totaling 467,767 in 2006 and 68,296 in 2005 for an aggregate cost of $26.2 million in 2006 and $2.4 million or an average of $34.62 per share.in 2005. In 2004, we repurchased 3.6 million common shares in open market transactions and 0.2 million common shares in connection with employee stock plans for $67.0 million at an average price of $17.83 per share. In 2003, we repurchased 2.3 million common shares in open market transactions and 1.4 million common shares in connection with employee stock plans for $44.1 million at an average price of $12.03 per share. The Board of Directors’ authorization for open market transactions expired in January 2005.

Senior Notes

In May 2006, we issued $500 million of 6.45% senior notes due June 1, 2016 as discussed previously. We issued in the public debt capital markets,paid $300 million aggregate principal amount ofwhen our 7.25% senior unsecured notes that maturematured on August 1, 20062006. Our senior notes and $300 million aggregate principal amount of 6.30% senior unsecured notes that mature on August 1, 2018. We have entered into interest raterelated swap agreements to exchange the fixed interest rate under these senior notes for a variable interest rate based on LIBOR, asare more fully discussed in Note 910 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data.

Credit Agreement

OurOn July 14, 2006, we replaced our existing 5-year $600 million unsecured revolving credit agreement expires in September 2009.with a 5-year $1.0 billion unsecured revolving credit agreement. We entered into the credit agreement for general corporate purposes. Under the credit agreement, at our option, we can borrow on either a competitive advance

basis or a revolving credit basis. The revolving credit portion 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 5027 to 112.580 basis points. We also pay an annual facility fee regardless of utilization. This facility fee, currently 1510 basis points, may fluctuate between 12.58 and 37.520 basis points, depending upon our credit ratings. In addition, a utilization fee of 12.510 basis points is payable for any day in which borrowings under the facility exceed 50% of the total $600 million$1 billion commitment. The competitive advance portion of any borrowings will bear interest at market rates prevailing at the time of borrowing on either a fixed rate or a floating rate basis, at our option.

The 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 a minimum level of net worth minimum interest coverage, and a maximum leverage ratios. At December 31, 2005, we were in compliance with all applicable financial covenant requirements.ratio. The terms of thisthe credit agreement also include standard provisions related to conditions of borrowing, including a customary material adverse effect clause which could limit our

ability to borrow.borrow additional funds. We have not experienced a material adverse effect and we know of no circumstances or events which would be reasonably likely to result in a material adverse effect. At this time, we do not believe the material adverse effect clause poses a material funding risk to us. We have other relationships, including financial advisory and banking, with some of the parties to the credit agreement.

At December 31, 2005,2006, we had $200$450 million of borrowings under the credit agreement outstanding at an interest rate of 5.04%5.73%. In addition, we have outstanding letters of credit of $35.1$3.4 million secured under the credit agreement. No amounts have ever been drawn on these letters of credit. As of December 31, 2005,2006, we had $364.9$546.6 million of remaining borrowing capacity under the credit agreement.

Commercial Paper Program

We maintainhave other relationships, including financial advisory 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 bothbanking, with some parties to the credit agreement and commercial paper program generally may not exceed $600 million.

At December 31, 2005 and 2004, we had no commercial paper borrowings outstanding.agreement.

Other Long-Term Borrowings

Other long-term borrowings of $3.6$3.1 million at December 31, 20052006 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

OurOn March 31, 2006, we filed a universal shelf registration statement with the SEC. We are considered a “well known seasoned issuer” under the Securities and Exchange CommissionOffering Reform Act that became effective in December 2005. The universal shelf registration allows us to register the sale ofsell our debt or equity securities, from time to time, with the amount, price and terms to be determined at the time of the sale. We have up to $300 million remaining from a total of $600 million under the universal shelf registration. The net proceeds from any future sales of our debt securities under the universal shelf registration may be used for our operations and for other general corporate purposes, including repayment or refinancing of borrowings, working capital, capital expenditures, investments, acquisitions, or the repurchase of our outstanding securities. Given revised rules relating to universal shelf registration statements, we are exploring our options to file a new shelf registration statement.

Liquidity Requirements

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

Adverse changes in our credit rating may increase the rate of interest we pay and may impact the amount of credit available to us in the future. Our investment-grade credit rating at December 31, 20052006 was Baa3 according to Moody’s Investors Services, Inc., or Moody’s, and BBB, according to Standard & Poor’s Ratings Services, or S&P. A downgrade to Ba2 or lower by Moody’s and BB or lower by S&P would give the counterparties of three of our interest rate swap agreements with a $300 million notional amount, the right, but not the obligation, to cancel the interest rate swap agreement. If cancelled, we would pay or receive an amount based on the fair market value of the swap agreement. Assuming these swap agreements had been cancelled on December 31, 2005,

2006, we would have received $5.8$6.1 million, net, and future net interest payments would increase assuming LIBOR does not change. Other than the swap agreements, adverse changes in our credit ratings maydo not create, increase, or accelerate any liabilities.

In addition, we operate as a holding company in a highly regulated industry. Our parent company is dependent upon dividends and administrative expense reimbursements from our subsidiaries, most of which are

subject to regulatory restrictions. Cash, cash equivalents and short-term investments at the parent company decreased $19.7increased $4.8 million to $424.4 million at December 31, 2006 compared to $419.6 million at December 31, 2005 compared to $439.3 million at December 31, 2004 reflecting the usefunding of parent company cash for acquisition activityadditional capital into certain subsidiaries during 2005.2006 in conjunction with growth in Medicare revenues offset by additional borrowings in 2006. See Schedule I to this Form 10-K beginning on page 107106 for our parent company only financial information.

Regulatory Requirements

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

As of December 31, 2005,2006, we maintained aggregate statutory capital and surplus of $1,203.2$2,066.0 million in our state regulated subsidiaries. Each of these subsidiaries was in compliance with applicable statutory requirements which aggregated $722.2$1,430.3 million. Although the minimum required levels of equity are largely based on premium volume, product mix, and the quality of assets held, minimum requirements can vary significantly at the state level. Given our anticipated continued premium growth in 2006 resulting from the expansion of our Medicare products,2007, capital requirements will increase. We expect to fund these increased requirements with capital contributions from Humana Inc., our parent company, in the range of $450$325 million to $650$425 million in 2006.2007.

Most states rely on risk-based capital requirements, or RBC, to define thetheir required levels of equity.equity discussed above. RBC is a model developed by the National Association of Insurance Commissioners to monitor an entity’s solvency. This calculation indicates recommended minimum levels of required capital and surplus and signals regulatory measures should actual surplus fall below these recommended levels. If RBC were adopted by allthe remaining states and Puerto Rico at December 31, 2005, we2006, each of our subsidiaries would be required to fund $14.7 million in one of our Puerto Rico subsidiaries to meet all requirements. After this funding,substantial compliance and we would have $378.2$516.2 million of aggregate capital and surplus above any of the levels that require corrective action under RBC.RBC, or individual state requirements.

Contractual Obligations

We are contractually obligated to make payments for years subsequent to December 31, 20052006 as follows:

 

  Payments Due by Period  Payments Due by Period
  Total  Less than
1 Year
  1-3 Years  3-5 Years  More than
5 Years
  Total  Less than
1 Year
  1-3 Years  3-5 Years  More than
5 Years
  (in thousands)  (in thousands)

Debt

  $803,640  $300,574  $1,080  $201,080  $300,906  $1,253,065  $540  $1,080  $450,987  $800,458

Interest(1)

   285,720   50,333   66,900   45,396   123,091   633,181   76,880   153,727   141,078   261,496

Operating leases(2)

   297,113   84,993   121,622   62,325   28,173   284,879   88,196   117,191   64,124   15,368

Purchase and other obligations(3)

   46,433   24,044   18,346   4,043   —     49,668   27,395   18,212   4,061   —  
                              

Total

  $1,432,906  $459,944  $207,948  $312,844  $452,170  $2,220,793  $193,011  $290,210  $660,250  $1,077,322
                              

(1)Interest includes the estimated contractual interest payments under our debt agreements net of the effect of the associated swap agreements assuming no change in the LIBOR rate as of December 31, 2005.2006.

(2)We lease facilities, computer hardware, and other equipment under long-term operating leases that are noncancelable and expire on various dates through 2023.2017. We sublease facilities or partial facilities to third party tenants for space not used in our operations which partially mitigates our operating lease commitments. An operating lease, accounted for under the provisions of SFAS No. 13,Accounting for Leases, is a type of off-balance sheet arrangement. Assuming we acquired the asset, rather than leased such asset, we would have recognized a liability for the financing of these assets. See also Note 14 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data.

(3)Purchase and other obligations include agreements to purchase services, primarily information technology related services, or to make improvements to real estate, in each case that are enforceable and legally binding on us and that specify all significant terms, including: fixed or minimum levels of service to be purchased; fixed, minimum or variable price provisions; and the appropriate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty.

Off-Balance Sheet Arrangements

As part of our ongoing business, we do not participate or knowingly seek to participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or SPEs,special purpose entities (SPEs), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2005,2006, we are not involved in any SPE transactions.

Guarantees and Indemnifications

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 for $8.9 million 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 amountThe residual value payment 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.

Related Parties

No related party transactions had a material effect on our financial position, results of operations, or cash flows. Certain related party transactions not having a material effect are discussed in our Proxy Statement for the meeting to be held April 27, 2006 – 26, 2007—see “Certain Transactions with Management and Others.”

Government Contracts

Our Medicare business, which accounted for approximately 32%55% of our total premiums and ASO fees for the year ended December 31, 2005,2006, primarily consisted of HMO, PPO and PFFS products covered under the Medicare Advantage and stand-alone PDP contracts with the federal government. TheThese contracts are renewed generally for a one-year term each December 31 unless CMS notifies Humana of its decision not to renew by May 1 of the contract year, or Humana notifies CMS of its decision not to renew by the first Monday in June of the contract year. All material contracts between Humana and CMS relating to our Medicare business have been renewed for 2007.

Our TRICARE business, which accounted for approximately 17%12% of our total premiums and ASO fees for the year ended December 31, 2005,2006, primarily consisted of the South Region contract. The 5-year South Region contract is subject to annual renewals on April 1 of each year at the Government’sgovernment’s option. Effective April 1, 2006, the South Region contract was extended into the third option andperiod, which runs from April 1, 2006 to March 31, 2007. We have received a notice from the government of its intent to renew the fourth option period. The 5-year South Region contract expires March 31, 2009. ThisAs required under the contract, contains provisions to negotiate athe target underwritten health care cost amount annually withand underwriting fee amounts for the federal government.third option period were negotiated. Any variance from the target health care cost is shared with the federal government. As such,Accordingly, events and

circumstances not contemplated in the negotiated target health care cost amount could have a material adverse effect on our business. These changes may include, for example, an increase or reduction in the number of persons enrolled or eligible to enroll due to the federal government’s decision to increase or decrease U.S. military presence around the world.deployments. In the event government reimbursements were to decline from projected amounts, our failure to reduce the health care costs associated with these programs could have a material adverse effect on our business.

Our Medicaid business, which accounted for approximately 4%3% of our total premiums and ASO fees for the year ended December 31, 2005,2006, consisted of contracts in Puerto Rico Florida and Illinois.Florida. Our 3-yearMedicaid contracts with the Puerto Rico Health Insurance Administration which accounted for approximately 3%2% of our total premium and ASO fees for the year ended December 31, 2005, were extended a fourth year and these contracts expire on June 30, 2006. We currently are preparing to bid onoperating under the newterms of our contracts that will be effective July 2006 although a requestexpired October 31, 2006. Due to several ongoing and unresolved issues with the program, the government of Puerto Rico has decided to delay the bid process for such proposal has not yet been issued bynew contracts. We currently are working with the Puerto Rico Health Insurance Administration. At this timeAdministration regarding terms and rates which is expected to result in an extension of the existing contracts through September 30, 2007. There is no assurance that the Puerto Rico Health Insurance Administration will request such an extension, and we are unable to predict the ultimate impact that any government policy or fiscal decisions might have on the continuation of our Medicaid contracts in Puerto Rico.

Our other current Medicaid contract, which is in Florida, is scheduled to expire on June 30, 2006. Due to Medicaid reform in Florida, we are currently negotiating the terms and rates for the renewal contract. We expect the current contract to be extended until August 31, 2006, and the subsequent renewal contract to be effective for a two-year term beginning September 1, 2006. Due to continual decreases in the reimbursement from the state of Illinois, we exited the Illinois Medicaid market effective July 31, 2005. The Illinois and Florida Medicaid contracts accounted for approximately 1% of our total premiums and ASO fees for the year ended December 31, 2005.

Other than as described herein, 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

We are party to a variety of legal actions in the ordinary course of business, including employment matters, breach of contract actions, tort claims, and shareholder suits involving alleged securities fraud. A description of material legal actions in which we are currently involved is included under “Legal Proceedings” of Item 3 in Part 1. We cannot predict the outcome of these suits with certainty, and we are incurring expenses in defense of these matters. In addition, recent court decisions and legislative activity may increase our exposure for any of these types of claims. Therefore, these legal actions could have a material adverse effect on our financial position, results of operations and cash flows.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements and accompanying notes, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements and accompanying notes requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We continuously evaluate our estimates and those critical accounting policies related primarily to medical cost and revenue recognition as well as accounting for impairments related to our investment securities, goodwill, and long-lived assets. These estimates are based on knowledge of current events and anticipated future events, and accordingly, actual results ultimately may differ from those estimates. We believe the following critical accounting policies involve the most significant judgments and estimates used in the preparation of our consolidated financial statements.

Medical Expense Recognition

Medical expenses are recognized in the period in which services are provided and include an estimate of the cost of services which have been incurred but not yet reported, or IBNR. IBNR represents a substantial portion of our medical and other expenses payable as follows:

 

  December 31,
2005
  Percentage
of Total
 December 31,
2004
  Percentage
of Total
   December 31,
2006
  Percentage
of Total
 December 31,
2005
  Percentage
of Total
 
  (dollars in thousands)   (dollars in thousands) 

IBNR

  $1,483,902  77.7% $1,164,518  81.9%  $1,996,636  80.3% $1,483,902  77.7%

Reported claims in process

   83,635  4.4%  97,801  6.9%   115,424  4.6%  83,635  4.4%

Other medical expenses payable

   342,145  17.9%  159,691  11.2%   376,201  15.1%  342,145  17.9%
                          

Total medical and other expenses payable

  $1,909,682  100.0% $1,422,010  100.0%  $2,488,261  100.0% $1,909,682  100.0%
                          

Estimating IBNR is complex and involves a significant amount of judgment. Accordingly, it represents a critical accounting estimate. Changes in this estimate can materially affect, either favorably or unfavorably, our results fromof operations and overall financial position. For example,Accordingly, it represents a 100 basis point,critical accounting estimate. Most medical claims are paid within a few months of the member receiving service from a physician or 1 percent, change inother health care provider. As a result, these liabilities generally are described as having a “short-tail”. As such, we expect that substantially all of the December 31, 2006 estimate of our medical and other expenses payable at December 31, 2005, which represents approximately 43%will be known and paid during 2007.

Our reserving practice is to consistently recognize the actuarial best point estimate within a level of totalconfidence required by actuarial standards. Actuarial standards of practice generally require a level of confidence such that the liabilities would requireestablished for IBNR have a greater probability of being adequate versus being insufficient, or such that the liabilities established for IBNR are sufficient to cover obligations under an adjustmentassumption of approximately $19 million in a future periodmoderately adverse conditions. Adverse conditions are situations in which a revisionthe actual claims are expected to be higher than the otherwise estimated value of such claims at the time of the estimate. Therefore, in many situations, the claim amounts ultimately settled will be less than the estimate became known.that satisfies the actuarial standards of practice.

We develop our estimate for IBNR using actuarial methodologies and assumptions, primarily based upon historical claim payment and claim receipt patterns, as well as historical medical cost trends.experience. Depending on the period for which incurred claims are estimated, we apply a different method in determining our estimate. For periods prior to the most recent three months, the key assumption used in estimating our IBNR is that the completion factor pattern remains consistent over a rolling 12-month period after adjusting for known changes in claim inventory levels and known changes in claim payment processes. Completion factors result from the calculation of the percentage of claims incurred during a given period that have historically been adjudicated as of the reporting period. For the most recent three months, the incurred claims are estimated primarily from a trend analysis based upon per member per month claims trends developed from our historical experience in the preceding months, adjusted for known changes in estimates of recent hospital and drug utilization data, provider contracting changes, changes in benefit levels, product mix, and weekday seasonality.

The completion factor method is used for the months of incurred claims prior to the most recent three months because the historical percentage of claims processed for those months is at a level sufficient to produce a consistently reliable result. Conversely, for the most recent three months of incurred claims, the volume of claims processed historically is not at a level sufficient to produce a reliable result, which therefore requires us to examine historical trend patterns as the primary method of evaluation. Changes in claim processes, including receipt cycle times, inventories, recoveries of overpayments, outsourcing, system conversions, and disruptions due to weather affect views regarding the reasonable choice of completion factors. The receipt cycle time measures the average length of time between when a medical claim was initially incurred and when the claim form was received. Increased electronic claim submissions from providers have decreased the receipt cycle time over the last few years. For example, the average number of receipt cycle time days has decreased from 16.5 days in 2005 to 15.9 days in 2006 which represents a 3.6% reduction in cycle time.

Medical cost trends potentially are more volatile than other segments of the economy. The drivers of medical cost trends include increases in the utilization of hospital facilities, physician services, prescription drugs, and new medical technologies, as well as the inflationary effect on the cost per unit of each of these expense components. Other external factors such as government-mandated benefits or other regulatory changes, increases in medical services capacity, direct to consumer advertising for prescription drugs and medical services, an aging population, catastrophes, and epidemics also may impact medical cost trends. Internal factors such as system conversions, claims processing cycle times, changes in medical management practices and changes in provider contracts also may impact our ability to accurately predict estimates of historical completion factors or medical cost trends. All of these factors are considered in estimating IBNR and in estimating the per member per month claims trend for purposes of determining the reserve for the most recent three months. Additionally, we continually prepare and review follow-up studies to assess the reasonableness of the estimates generated by our process and methods over time. The results of these studies are also considered in determining the reserve for the most recent three months. Each of these factors requires significant judgment by management.

The completion and claims per member per month trend factors are the most significant factors impacting the IBNR estimate. The portion of IBNR estimated using completion factors for claims incurred prior to the most recent three months is less variable than the portion of IBNR estimated using trend factors. The following table illustrates the sensitivity of these factors assuming moderate adverse experience and the estimated potential impact on our operating results caused by reasonably likely changes in these factors based on December 31, 20052006 data:

 

                  Completion Factor(a):                   Claims Trend Factor(b): 

(Decrease)

Increase

in Factor

  

Increase

(Decrease) in

Medical and

Other Expenses

Payable

  

(Decrease)

Increase

in Factor

  

(Decrease)

Increase in

Medical and

Other Expenses

Payable

 
(dollars in thousands) 
(3%) $183,000  (3%) $(68,000)
(2%) $117,000  (2%) $(44,000)
(1%) $56,000  (1%) $(21,000)
1% $(53,000) 1% $26,000 
2% $(102,000) 2% $49,000 
3% $(150,000) 3% $73,000 

Completion Factor(a):

     Claims Trend Factor(b): 

Factor
Change

  Increase
(Decrease) in
Medical and
Other Expenses
Payable
     Factor
Change
  (Decrease)
Increase in
Medical and
Other Expenses
Payable
 
(dollars in thousands) 

 1.50%

  $(143,500)   (10%) $(347,500)

 1.00%

  $(95,700)   (8%) $(278,000)

 0.50%

  $(47,800)   (6%) $(208,500)

 0.25%

  $(23,900)   (4%) $(139,000)

(0.50%)

  $47,800    (2%) $(69,500)

(1.00%)

  $95,700    2% $69,500 

(a)Reflects estimated potential changes in medical and other expenses payable caused by changes in completion factors for incurred months prior to the most recent three months.
(b)Reflects estimated potential changes in medical and other expenses payable caused by changes in annualized claims trend used for the estimation of per member per month incurred claims for the most recent three months.

Most medical claims are paid within a few months of the member receiving service from a physician or other health care provider. As a result, these liabilities generally are described as having a “short-tail”, which causes less than 2% of our medical and other expenses payable as of the end of any given period to be outstanding for more than 12 months. As such, we expect that substantially all of the December 31, 2005 estimate of medical and other expenses payable will be known and paid during 2006.

Our reserving practice is to consistently recognize the actuarial best point estimate within a level of confidence required by actuarial standards. Actuarial standards of practice generally require a level of confidence such that the liabilities established for IBNR have a greater probability of being adequate versus being insufficient, or such that the liabilities established for IBNR are sufficient to cover obligations under an assumption of moderately adverse conditions. Adverse conditions are situations in which the actual claims are expected to be higher than the otherwise estimated value of such claims at the time of the estimate. Therefore, in many situations, the claim amounts ultimately settled will be less than the estimate that satisfies the actuarial standards of practice.

IBNR established in connection with our TRICARE contracts is typically more difficult to estimate than for our other operations, because there are more variables that impact the estimate. These additional variables include continual changes in the number of eligible beneficiaries, changes in the utilization of military treatment facilities and changes in levels of benefits versus the original contract provisions. Many of these variables are impacted by an increase or decrease in military activity involving the United States armed forces. We have considered all of these factors in establishing our IBNR estimate. Each of these factors requires significant judgment by management.

As more fully described on page 55,57, our TRICARE contract contains risk-sharing provisions with the Department of Defense and with subcontractors, which effectively limit profits and losses when actual claim experience varies from the targeted medical claim amount negotiated in our annual bid. As a result of these contract provisions, the impact of changes in estimates for prior year TRICARE medical claims payable on our results of operations is reduced substantially, whether positive or negative.

As more fully described on pages 11 and 12, we have a significant percentage of our Medicare and Medicaid membership under risk-sharing arrangements with providers. Accordingly, the impact of changes in

estimates for prior year medical claims payable on our results fromof operations that are attributable to our Medicare and Medicaid lines of business may also be significantly reduced, whether positive or negative.

The following table provides a reconciliationhistorical perspective regarding the accrual and payment of changes inour medical and other expenses payableexpense payable. Components of the total incurred claims for the years ended December 31, 2005, 2004 and 2003:each year include amounts accrued for current year estimated medical expense as well as adjustments to prior year estimated accruals.

 

  2005 2004 2003   2006 2005 2004 
  (in thousands)   (in thousands) 

Balances at January 1

  $1,422,010  $1,272,156  $1,142,131   $1,909,682  $1,422,010  $1,272,156 

Acquisitions

   37,375   71,063   —      21,198   37,375   71,063 

Incurred related to:

        

Current year

   11,765,662   10,763,105   9,955,491    17,696,654   11,765,662   10,763,105 

Prior years

   (114,192)  (93,458)  (76,070)   (275,450)  (114,192)  (93,458)
                    

Total incurred

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

Paid related to:

        

Current year

   (9,979,449)  (9,504,331)  (8,710,393)   (15,532,079)  (9,979,449)  (9,504,331)

Prior years

   (1,221,724)  (1,086,525)  (1,039,003)   (1,331,744)  (1,221,724)  (1,086,525)
                    

Total paid

   (11,201,173)  (10,590,856)  (9,749,396)   (16,863,823)  (11,201,173)  (10,590,856)
                    

Balances at December 31

  $1,909,682  $1,422,010  $1,272,156   $2,488,261  $1,909,682  $1,422,010 
                    

Amounts incurred related to prior years vary from previously estimated liabilities as the claims ultimately are settled. Negative amounts reported for incurred related to prior years result from claims being ultimately settled for amounts less than originally estimated (favorable development).

As summarized in the previous table, claim reserve balances at December 31, 20042005 ultimately settled during 2006 for $275.5 million less than the amounts originally estimated. During 2005, claim reserve balances at December 31, 2004 ultimately settled for $114.2 million less than the amounts originally estimated. This $161.3 million change in the amounts incurred related to prior years for 2006 as compared to 2005 consisted of $106.2 million attributable to our Medicare and commercial lines of business, as well as $55.1 million attributable to our TRICARE line of business. Amounts attributable to our TRICARE line of business are discussed separately due to the additional variability and risk sharing provisions with the Department of Defense and subcontractors. As previously described, our key assumptions consist of trend factors and completion factors using an assumption of moderately adverse conditions. In our Medicare and commercial operations, both our trend factor and completion factor assumptions at December 31, 2005 ultimately developed favorable versus our original estimate primarily due to (1) the utilization of hospital and physician services during the latter half of 2005 ultimately being lower than estimated, representing 1.1%(2) the impact of medicalhurricanes in Florida and Louisiana in the second half of 2005 on both utilization of services and claims processing, (3) significant growth in our Medicare PFFS product, (4) reductions in receipt cycle times driven by an increase in electronic claims submissions, and (5) an increase in claim expenses recordedoverpayment recovery levels versus our historical overpayment recovery rate. In our TRICARE line of business, both our trend factor and completion factor assumptions ultimately developed favorable versus our original estimate primarily due to the utilization of hospital and physician services during the latter half of 2005 ultimately being lower than estimated, changes in 2004. claim payment patterns resulting from fluctuations in claim inventory levels, and an increase in claim overpayment recovery levels versus our historical overpayment recovery rate.

During 2004, claim reserve balances at December 31, 2003 ultimately settled during 2004 for $93.5 million less than the amounts originally estimated, representing 0.9% of medical claim expenses recorded in 2003. Thisestimated. The $20.7 million change in the amounts incurred related to prior years for 2005 as compared to 2004 resulted primarily from favorable development inconsisted of $16.3 million attributable to our TRICARE line of business as a resultand

$4.4 million attributable to our Medicare and commercial lines of less than expectedbusiness. In each of these lines of business, our trend factor assumptions at December 31, 2004 ultimately developed favorable versus our original estimate primarily due to the utilization inof hospital and physician services during the latter half of 2004.2004 ultimately being lower than originally estimated.

During 2003, claimAs previously discussed, our reserving practice is to consistently recognize the actuarial best estimate of our ultimate liability for claims. Actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve balances at December 31, 2002 ultimately settled during 2003 for $76.1 million less than the amounts originally estimated, representing 0.8% of medical claim expenses recorded in 2002. The $17.4 million changedevelopment, or reserves that are considered redundant. An increase in the amounts incurred related to priorabsolute dollar amount of redundancy over the last three years for 2004 as compared to 2003has resulted primarily from favorable developmentthe growth in our Medicare linebusiness, coupled with the application of consistent reserving practices. When we recognize a release of the redundancy, we disclose the amount that is not in the ordinary course of business, as a result of less than expected utilizationif material. We believe we have consistently applied our methodology in the latter half of 2003.determining our best estimate for medical and other expenses payable.

Revenue Recognition

We generally establish one-year contracts with commercial employer groups, subject to cancellation by the employer group on 30-day written notice. Our Medicare contracts with the federal government renew annually while our Medicaid and TRICARE contracts with state and federal governments, respectively, are generally multi-year contracts subject to annual renewal provisions.

Our commercial contracts establish rates on a per member basis for each month of coverage.

Our contracts with federal or state governments are generally multi-year contracts subject to annual renewal provisions with the exception of our Medicare Advantage and PDP contracts with the federal government which renew annually. Except for TRICARE contracts discussed in the following section, our governmentMedicaid contracts also establish monthly rates per member but maymember. However, our Medicare contracts also have additional provisions as outlined in the following separate section.

Premium revenues and ASO fees are estimated by multiplying the membership covered under the various contracts by the contractual rates. In addition, we adjust revenues for estimated changes in an employer’s enrollment and individuals that ultimately may fail to pay. Enrollment changes not yet reported by an employer group, an individual, or the government, also known as retroactive membership adjustments, are estimated based on available data and historical trends. We monitor the collectibility of specific accounts, the aging of receivables, as well as prevailing and anticipated economic conditions, and reflect any required adjustments in the current period’s revenue.

We bill and collect premium and ASO fee remittances from employer groups, the federal and state governments, and individual members monthly. Premium and ASO fee receivables are presented net of allowances for estimated uncollectible accounts and retroactive membership adjustments. Premiums and ASO fees received prior to the period members are entitled to receive services are recorded as unearned revenues.

Medicare Part D Provisions

On January 1, 2006, we began covering prescription drug benefits in accordance with Medicare Part D under multiple contracts with CMS. The payments we receive monthly from CMS and members, which are determined from our annual bid, represent amounts duefor providing prescription drug insurance coverage. We recognize premium revenues for providing this insurance coverage ratably over the term of our annual contract. Our CMS payment is subject to risk sharing through the Medicare Part D risk corridor provisions. In addition, we receive and disburse amounts for portions of prescription drug costs for which we are not at risk, as described more fully below.

The risk corridor provisions compare costs targeted in our annual bids to actual prescription drug costs, limited to actual costs that would have been incurred under the standard coverage as defined by CMS. Variances exceeding certain thresholds may result in CMS making additional payments to us or require us to refund to CMS a portion of the premiums we received. We estimate and recognize an adjustment to premium revenues

related to these risk corridor provisions based upon pharmacy claims experience to date as if the annual contract were to terminate at the end of the reporting period. Accordingly, this estimate provides no consideration to future pharmacy claims experience. We record a receivable or payable at the contract level and classify the amount as current or long-term in the consolidated balance sheets based on itemsthe expected settlement.

The estimate of the settlement associated with risk corridor provisions, which is not expected to be applied against the rigors of a final settlement with CMS until mid-2007, requires us to consider factors that may not be certain. These factors include some first year implementation issues such as age, working status, or specific health issuesmember eligibility differences with CMS, as well as interpretations of CMS operational guidance. Our estimate of the member. For example, settlement associated with the Medicare Part D risk corridor provisions was a net liability of $738.7 million at December 31, 2006.

Reinsurance and low-income cost subsidies represent reimbursements from CMS in connection with the Medicare Part D program for which we assume no risk. Reinsurance subsidies represent reimbursements for CMS’s portion of prescription drug costs which exceed the member’s out-of-pocket threshold, or the catastrophic coverage level. Low-income cost subsidies represent reimbursements from CMS for all or a portion of the deductible, the coinsurance and co-payment amounts above the out-of-pocket threshold for low-income beneficiaries. Monthly prospective payments from CMS for reinsurance and low-income cost subsidies are based on assumptions submitted with our annual bid. A reconciliation and related settlement of CMS’s prospective subsidies against actual prescription drug costs we paid is made after the end of the year. We account for these subsidies as a deposit in our consolidated balance sheets and as a financing activity in our consolidated statements of cash flows. We do not recognize premium revenues or claims expense for these subsidies. Receipt and payment activity is accumulated at the contract level and recorded in our consolidated balance sheets in other current assets or trade accounts payable and accrued expenses depending on the contract balance at the end of the reporting period. Gross financing receipts were $2,002.5 million and gross financing withdrawals were $2,124.7 million during 2006. CMS subsidy activity recorded to the consolidated balance sheets at December 31, 2006 was $450.0 million to other current assets and $327.7 million to trade accounts payable and accrued expenses.

In order to allow plans offering enhanced benefits the maximum flexibility in designing alternative prescription drug coverage, CMS provided a demonstration payment option in lieu of the reinsurance subsidy for plans offering enhanced coverage, or coverage beyond CMS’s defined standard benefits. The demonstration payment option is an arrangement in which CMS pays a capitation amount to a plan for assuming the government’s portion of prescription drug costs in the catastrophic layer of coverage. The capitation amount represents a fixed monthly amount per member to provide prescription drug coverage in the catastrophic layer. We chose the demonstration payment option for all of our enhanced benefit plans. This capitation amount, derived from our annual bid submissions, is recorded as premium revenue. The variance between the capitation amount and actual drug costs in the catastrophic layer is subject to risk sharing as part of the risk corridor settlement.

Settlement of the reinsurance and low-income cost subsidies as well as the risk corridor payment is based on a reconciliation made approximately 6 months after the close of each calendar year. This reconciliation process requires us to submit claims data necessary for CMS to administer the program.

Medicare Risk Adjustment Provisions

CMS has implemented a risk adjustment model which apportions premiums paid to all health plans according to health severity.

The CMS risk adjustment model pays more for members with predictably higher costs, as more fully described on page 5. Under this risk adjustment methodology, diagnosis data from inpatient and ambulatory treatment settings are used to calculate the risk adjusted premium payment to us. We collect, capture, and submit the necessary and available diagnosis data to CMS within prescribed deadlines. We estimate risk adjustment revenues based upon the diagnosis data submitted to CMS and ultimately accepted by CMS. We do not have access to diagnosis data with respect to our stand-alone PDP members.

CMS is transitioninghas transitioned to the risk adjustment model while the old demographic model iswas phased out. The demographic model based the monthly premiums paid to health plans on factors such as age, sex and disability status. The monthly premium amount for each member is separately determined under both the risk adjustment and demographic model. These separate payment amounts are then blended according to the transition schedule. CMS is transitioningtransitioned to the risk adjustment model for Medicare Advantage plans as follows: 30% in 2004, 50% in 2005, 75% in 2006 and 100% in 2007. The stand-alone PDP payment methodology is based 100% on the risk adjustment model beginning in 2006.model. As a result of this process and the phasing in of the risk adjustment model, as well as budget neutrality as described on page 5, our CMS monthly premium payments per member may change materially, either favorably or unfavorably.

Premium revenues and ASO fees are estimated by multiplying the membership covered under the various contracts by the contractual rates. In addition, we adjust revenues for estimated changes in an employer’s enrollment and customers that ultimately may fail to pay. Enrollment changes not yet reported by an employer group, an individual, or the government, also known as retroactive membership adjustments, are estimated based on historical trends. We monitor the collectibility of specific accounts, the aging of receivables, as well as prevailing and anticipated economic conditions, and reflect any required adjustments in the current period’s revenue.

We bill and collect premium and ASO fee remittances from employer groups, the federal and state governments, and individual Medicare Advantage members monthly. Premium and ASO fee receivables are presented net of allowances for estimated uncollectible accounts and retroactive membership adjustments. Premiums and ASO fees received prior to the period members are entitled to receive services are recorded as unearned revenues.

TRICARE Contract

In 2005,2006, TRICARE revenues represented 17%12% of total premiums and administrative services fees. The single TRICARE contract for the South Region includes multiple revenue generating activities and as such was evaluated under Emerging Issues Task Force (EITF) Issue No. 00-21,Accounting for Revenue Arrangements with Multiple Deliverables. We allocate the consideration to the various components based on the relative fair values of the components. TRICARE revenues consist generally of (1) an insurance premium for assuming underwriting risk for the cost of civilian health care services delivered to eligible beneficiaries; (2) health care services provided to beneficiaries which are in turn reimbursed by the federal government; and (3) administrative serviceASO fees related to claim processing, customer service, enrollment, disease management and other services. We recognize the insurance premium as revenue ratably over the period coverage is provided. Health care services reimbursements are recognized as revenue in the period health care services are provided. Administrative service fees are recognized as revenue in the period services are performed.

The TRICARE contract contains provisions whereby the federal government bears a substantial portion of the risk associated with financing the cost of health benefits. Annually, we negotiate a target health care cost amount, or target cost, with the federal government and determine an underwriting fee. Any variance from the target cost is shared. We earn more revenue or incur additional costs based on the variance in actual health care costs versus the negotiated target cost. We receive 20% for any cost underrun, subject to a ceiling that limits the underwriting profit to 10% of the target cost. We pay 20% for any cost overrun, subject to a floor that limits the underwriting loss to negative 4% of the target cost. A final settlement occurs 12 to 18 months after the end of each contract year to which it applies. We defer the recognition of any revenues for favorable contingent underwriting fee adjustments related to cost underruns until the amount is determinable and the collectibility is

reasonably assured. We estimate and recognize unfavorable contingent underwriting fee adjustments related to cost overruns currently in operations as an increase in medical expenses. We continually review these medical expense estimates of future payments to the government for cost overruns and make necessary adjustments to our reserves.

The TRICARE contract contains provisions to negotiate change orders. Change orders occur when we perform services or incur costs under the directive of the federal government that were not originally specified in our contract. Under federal regulations we may be entitled to an equitable adjustment to the contract price in these situations. Change orders may be negotiated and settled at any time throughout the year. We record revenue applicable to change orders when services are performed and these amounts are determinable and the collectibility is reasonably assured.

Our former TRICARE contracts for Regions 3 and 4 and Regions 2 and 5, which expired during 2004, contained provisions not only for change orders but for bid price adjustments, or BPAs, as well. There are no provisions for BPAs in our current TRICARE contract. BPAs were utilized to retroactively adjust revenues for the impact of the items for which the federal government retains risk, including the risks associated with changes in usage levels at military treatment facilities, or MTFs, change in the number of persons eligible for TRICARE benefits, and medical unit cost inflation. We worked closely with the federal government to obtain and review eligibility and MTF workload data, and to quantify and negotiate amounts recoverable or payable under our contractual BPA requirements. Final settlement of BPAs occurred only at specified intervals, typically in excess of 6 months after the end of a contract year. We recorded revenues applicable to BPAs when these amounts were determinable and collectibility was reasonably assured.

Investment Securities

Investment securities totaled $2,745.9$3,607.2 million, or 40%36% of total assets at December 31, 2005.2006. Debt securities totaled $2,720.8$3,598.3 million, or 99% of this investment portfolio. More than 97% of our debt securities were of investment-grade quality, with an average credit rating of AA+ by S&P at December 31, 2005.2006. Most of the debt securities that are below investment grade are rated at the higher end (BB or better) of the non-investment grade spectrum. Our investment policy limits investments in a single issuer and requires diversification among various asset types.

Duration is indicative of the relationship between changes in market value and changes in interest rates, providing a general indication of the sensitivity of the fair values of our debt securities to changes in interest rates. However, actual market values may differ significantly from estimates based on duration. The average duration of our debt securities was approximately 3.43.3 years at December 31, 2005.2006. Given that short term interest rates were higher than long term rates during most of 2006, cash was invested in cash equivalents instead of longer duration investment securities. Including cash equivalents, the average duration lowers to 2.2 years. Based on thisthe duration including cash equivalents, a 1% increase in interest rates would generally decrease the fair value of our debt securities by approximately $90$117 million.

Our investment securities are categorized as available for sale and, as a result, are stated at fair value. Fair value of publicly traded debt and equity securities are based on quoted market prices. Non-traded debt securities are priced independently by a third party vendor. Fair value of venture capital debt securities that are privately held are estimated using a variety of valuation methodologies where an observable quoted market price does not exist. Such methodologies include reviewing the value ascribed to the most recent financing, comparing the security with securities of publicly traded companies in a similar line of business, and reviewing the underlying financial performance including estimating discounted cash flows. Unrealized holding gains and losses, net of applicable deferred taxes, are included as a component of stockholders’ equity and comprehensive income until realized from a sale or impairment.

Gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2005,2006, included the following:

 

  Less than 12 months 12 months or more Total  Less than 12 months 12 months or more Total 

2005

  Fair Value  Unrealized
Losses
 Fair Value  Unrealized
Losses
 Fair Value  Unrealized
Losses
 

2006

 Fair Value Unrealized
Losses
 Fair Value Unrealized
Losses
 Fair Value Unrealized
Losses
 
  (in thousands)  (in thousands) 

U.S. Government obligations

  $611,683  $(3,790) $272,176  $(8,481) $883,859  $(12,271) $389,393 $(3,073) $339,043 $(7,255) $728,436 $(10,328)

Tax exempt municipal securities

   470,477   (4,846)  258,825   (7,914)  729,302   (12,760)  533,409  (1,659)  501,129  (10,943)  1,034,538  (12,602)

Corporate and other securities

   248,016   (4,932)  131,166   (4,867)  379,182   (9,799)  162,169  (846)  167,415  (2,978)  329,584  (3,824)

Mortgage-backed securities

   51,921   (742)  36,987   (2,225)  88,908   (2,967)  184,394  (1,523)  72,449  (3,136)  256,843  (4,659)

Redeemable preferred stocks

   —     —     6,862   (338)  6,862   (338)
                                  

Debt securities

   1,382,097   (14,310)  706,016   (23,825)  2,088,113   (38,135)  1,269,365  (7,101)  1,080,036  (24,312)  2,349,401  (31,413)

Non-redeemable preferred stocks

   4,409   (37)  5,477   (206)  9,886   (243)  7,959  (16)  —    —     7,959  (16)
                                  

Total investment securities

  $1,386,506  $(14,347) $711,493  $(24,031) $2,097,999  $(38,378) $1,277,324 $(7,117) $1,080,036 $(24,312) $2,357,360 $(31,429)
                                  

We regularly evaluate our investment securities for impairment. We consider factors affecting the issuer, factors affecting the industry the issuer operates within, and general debt and equity market trends. We consider the length of time an investment’s fair value has been below carrying value,cost, the severity of the decline, the near term prospects for recovery to carrying valuecost and our intent and ability to hold the investment until maturity or market recovery is realized. If and when a determination is made that a decline in fair value below the cost basis is other than temporary, the related investment is written down to its estimated fair value through a charge to earnings. The risks inherent in assessing the impairment of an investment include the risk that market factors may differ from our expectations; facts and circumstances factored into our assessment may change with the passage of time; or we may decide to subsequently sell the investment. The determination of whether a decline in the value of an investment is other than temporary requires us to exercise significant diligence and judgment. The discovery of new information and the passage of time can significantly change these judgments. The status of the general economic environment and significant changes in the national securities markets influence the determination of fair value and the assessment of investment impairment.

Unrealized losses at December 31, 20052006 resulted from 447425 positions out of a total of 731758 positions held. Approximately 26%30% of the carrying value of our consolidated investment securities have been in an unrealized loss position greater than one year. Of these investment securities in an unrealized loss position longer than a

year, approximately 97% are within 5% of recovering fair value up to cost. No single issue was below cost by more than 15%. The unrealized losses at December 31, 20052006 primarily were caused by increases in interest rates. All issuers of securities trading at an unrealized loss remain current on all contractual payments and we believe it is probable that we will be able to collect all amounts due according to the contractual terms of the debt securities. After taking into account these and other factors, including the severity of the decline and our ability and intent to hold these securities until recovery or maturity, we determined the unrealized losses on these investment securities were temporary and, as such, no impairment was required.

There were no impairment losses recordedof $0.2 million in 2006, and none in 2005 or 2004. We recorded $3.2 million in 2003 after an evaluation indicated that a decline in fair value below the cost basis was other than temporary.

Goodwill and Long-lived Assets

At December 31, 2005,2006, goodwill and other long-lived assets represented 27%19% of total assets and 75%64% of total stockholders’ equity.

SFAS No. 142,Goodwill and Other Intangible Assets, requires that we not amortize goodwill to earnings, but instead that we test goodwill at least annually for impairment at a level of reporting referred to as the reporting unit and more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. A reporting unit is one level below our Commercial and Government segments. The Commercial segment’s two reporting units consist of fullymedical (fully and self-insured medicalself insured) and specialty. The Government segment’s

three reporting units consist of Medicare, Advantage, TRICARE and Medicaid. Goodwill is assigned to the reporting unit that is expected to benefit from a specific acquisition.

Our strategy, long-range business plan, and annual planning process support our goodwill impairment tests. These tests are based primarily on an evaluation of future discounted cash flows under several scenarios. Outcomes from the discounted cash flow analysis were compared to other market approach valuation methodologies for reasonableness. We used a range of discount rates that correspond to oura market-based weighted-average cost of capital. Key assumptions, including changes in membership, premium yields, medical cost trends and certain government contract extensions, are consistent with those utilized in our long-range business plan and annual planning process. If these assumptions differ from actual, the estimates underlying our goodwill impairment tests could be adversely affected. Goodwill impairment tests completed in each of the last three years did not result in an impairment loss.

Long-lived assets consist of property and equipment and other finite-lived intangible assets. These assets are depreciated or amortized over their estimated useful life, and are subject to impairment reviews. We periodically review long-lived assets whenever adverse events or changes in circumstances indicate the carrying value of the asset may not be recoverable. In assessing recoverability, we must make assumptions regarding estimated future cash flows and other factors to determine if an impairment loss may exist, and, if so, estimate fair value. We also must estimate and make assumptions regarding the useful life we assign to our long-lived assets. If these estimates or their related assumptions change in the future, we may be required to record impairment losses or change the useful life, including accelerating depreciation or amortization for these assets. There were no impairment losses in 2006 or 2005. We recognized losses due to impairment and accelerated depreciation from changes in estimated useful life of $9.3 million in 2004 and $30.8 million in 2003.2004. See Note 56 to the consolidated financial statements included in Item 8.—Financial Statements and Supplementary Data.

ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The level of our pretax earnings is subject to market risk due to changes in investment income from our fixed income portfolio which is partially offset by both our debt position and the short-term duration of the fixed income investment portfolio.

We evaluated the impact on our investment income and debt expense resulting from a hypothetical change in interest rates of 100, 200 and 300 basis points over the next twelve-month period, as reflected in the following table. The evaluation was based on our fixed incomeinvestment portfolio and our debt position as of December 31, 20052006 and 2004.2005. Our investment portfolio consists of cash, cash equivalents and investment securities. The modeling technique used to calculate the pro forma net change in pretax earnings considered the cash flows related to fixed income investments and debt, which are subject to interest rate changes during a prospective twelve-month period. This evaluation measures parallel shifts in interest rates and may not account for certain unpredictable events that may effect interest income, including, among others, unexpected changes of cash flow into and out of the portfolio, shifts in the asset mix between taxable and tax-exempt securities, and spread changes specific to various investment categories. In the past ten years, changes in 3 month LIBOR rates during the year have exceeded 300 basis points twice,once, have not changed between 200 and 300 basis points, have changed between 100 and 200 basis points oncethree times and have changed by less than 100 basis points sevensix times. LIBOR was 4.54%5.36% at December 31, 2005.2006.

 

  

Increase (decrease) in

pretax earnings given an

interest rate decrease of

X basis points

 

Increase (decrease) in

pretax earnings given an

interest rate increase of

X basis points

   

Increase (decrease) in

pretax earnings given an

interest rate decrease of

X basis points

 

Increase (decrease) in

pretax earnings given an

interest rate increase of

X basis points

 
  (300) (200) (100) 100 200 300   (300) (200) (100) 100 200 300 
  (in thousands)   (in thousands) 

As of December 31, 2005

       

Fixed income portfolio

  $(54,167) $(35,833) $(17,331) $17,375  $34,661  $52,924 

As of December 31, 2006

       

Investment portfolio

  $(100,088) $(66,422) $(30,927) $30,809  $61,808  $93,019 

Debt

   33,842   22,561   11,281   (11,281)  (22,561)  (33,842)   30,910   20,607   10,303   (10,303)  (20,607)  (30,910)
                                      

Total

  $(20,325) $(13,272) $(6,050) $6,094  $12,100  $19,082   $(69,178) $(45,815) $(20,624) $20,506  $41,201  $62,109 
                                      

As of December 31, 2004

       

Fixed income portfolio

  $(20,530) $(18,258) $(8,974) $9,212  $18,439  $27,299 

As of December 31, 2005

       

Investment portfolio

  $(54,167) $(35,833) $(17,331) $17,375  $34,661  $52,924 

Debt

   14,200   14,200   7,100   (7,100)  (14,200)  (21,300)   33,842   22,561   11,281   (11,281)  (22,561)  (33,842)
                                      

Total

  $(6,330) $(4,058) $(1,874) $2,112  $4,239  $5,999   $(20,325) $(13,272) $(6,050) $6,094  $12,100  $19,082 
                                      

ITEM 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Humana Inc.

CONSOLIDATED BALANCE SHEETS

 

  December 31,   December 31, 
  2005 2004   2006 2005 
  (in thousands, except
share amounts)
   

(in thousands, except

share amounts)

 
ASSETS     

Current assets:

     

Cash and cash equivalents

  $732,016  $580,079   $1,740,304  $732,016 

Investment securities

   2,354,904   2,145,645    3,192,273   2,354,904 

Receivables, less allowance for doubtful accounts of $32,557 in 2005 and $34,506 in 2004:

   

Receivables, less allowance for doubtful accounts of $45,589 in 2006 and $32,557 in 2005:

   

Premiums

   723,190   554,661    667,657   723,190 

Administrative services fees

   15,462   24,954    13,284   15,462 

Securities lending collateral

   47,610   77,840    627,990   47,610 

Other

   333,004   212,958    1,091,465   333,004 
              

Total current assets

   4,206,186   3,596,137    7,332,973   4,206,186 
              

Property and equipment, net

   484,412   399,506    545,004   484,412 

Other assets:

      

Long-term investment securities

   391,035   348,465    414,877   391,035 

Goodwill

   1,264,575   885,572    1,310,631   1,264,575 

Other

   523,406   427,937    524,011   523,406 
              

Total other assets

   2,179,016   1,661,974    2,249,519   2,179,016 
              

Total assets

  $6,869,614  $5,657,617   $10,127,496  $6,869,614 
              
LIABILITIES AND STOCKHOLDERS’ EQUITY      

Current liabilities:

      

Medical and other expenses payable

  $1,909,682  $1,422,010   $2,488,261  $1,909,682 

Trade accounts payable and accrued expenses

   560,550   488,332    1,626,658   560,550 

Book overdraft

   280,005   192,060    293,605   280,005 

Securities lending payable

   47,610   77,840    627,990   47,610 

Unearned revenues

   120,489   146,326    155,298   120,489 

Current portion of long-term debt

   301,254   —      —     301,254 
              

Total current liabilities

   3,219,590   2,326,568    5,191,812   3,219,590 

Long-term debt

   513,790   636,696    1,269,100   513,790 

Other long-term liabilities

   662,129   604,229    612,698   627,360 
              

Total liabilities

   4,395,509   3,567,493    7,073,610   4,360,740 
              

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; 179,062,807 shares issued in 2005 and 176,044,649 shares issued in 2004

   29,843   29,340 

Common stock, $0.16 2/3 par; 300,000,000 shares authorized; 182,947,691 shares issued in 2006 and 179,062,807 shares issued in 2005

   30,491   29,843 

Capital in excess of par value

   1,098,117   1,017,156    1,357,077   1,235,888 

Retained earnings

   1,538,306   1,229,823    1,909,098   1,421,675 

Accumulated other comprehensive income

   24,832   16,526 

Unearned stock compensation

   (13,629)  (1,721)

Treasury stock, at cost, 15,846,384 shares in 2005 and 15,778,088 shares in 2004

   (203,364)  (201,000)

Accumulated other comprehensive (loss) income

   (13,205)  24,832 

Treasury stock, at cost, 16,314,151 shares in 2006 and 15,846,384 shares in 2005

   (229,575)  (203,364)
            ��  

Total stockholders’ equity

   2,474,105   2,090,124    3,053,886   2,508,874 
              

Total liabilities and stockholders’ equity

  $6,869,614  $5,657,617   $10,127,496  $6,869,614 
              

The accompanying notes are an integral part of the consolidated financial statements.

Humana Inc.

CONSOLIDATED STATEMENTS OF INCOME

 

  For the year ended December 31,  For the year ended December 31,
  2005  2004  2003  2006  2005  2004
  (in thousands, except per share results)  (in thousands, except per share results)

Revenues:

            

Premiums

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

Administrative services fees

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

Investment and other income

   157,099   142,097   129,352

Investment income

   291,880   142,976   132,838

Other revenue

   54,264   14,123   9,259
                  

Total revenues

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

Operating expenses:

            

Medical

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

Selling, general and administrative

   2,176,770   1,877,864   1,858,028   3,021,509   2,195,604   1,894,336

Depreciation and amortization

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

Total operating expenses

   13,957,098   12,665,303   11,864,228   20,591,311   13,975,932   12,681,775
                  

Income from operations

   461,029   439,022   362,083   825,226   442,195   422,550

Interest expense

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

Income before income taxes

   421,714   415,850   344,716   762,085   402,880   399,378

Provision for income taxes

   113,231   135,838   115,782   274,662   106,150   129,431
                  

Net income

  $308,483  $280,012  $228,934  $487,423  $296,730  $269,947
                  

Basic earnings per common share

  $1.91  $1.75  $1.44  $2.97  $1.83  $1.68
                  

Diluted earnings per common share

  $1.87  $1.72  $1.41  $2.90  $1.79  $1.66
                  

The accompanying notes are an integral part of the consolidated financial statements.

Humana Inc.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

 

 Common Stock Capital In
Excess of
Par Value
  

Retained

Earnings

 

Accumulated

Other

Comprehensive

Income

  

Unearned

Stock

Compensation

  

Treasury

Stock

  

Total

Stockholders’

Equity

  Common Stock Capital In
Excess of
Par Value
  

Retained

Earnings

 

Accumulated
Other

Comprehensive

Income (Loss)

  

Treasury

Stock

  

Total

Stockholders’

Equity

 
 

Issued

Shares

 Amount  

Issued

Shares

  Amount  
 (in thousands)   

Accumulated
Other

Comprehensive

Income (Loss)

 

Balances, January 1, 2003

 171,335  $28,556  $931,089  $720,877 $22,455  $(6,516) $(89,987) $1,606,474 

Comprehensive income:

        

Net income

 —     —     —     228,934  —     —     —     228,934 

Other comprehensive loss:

        

Net unrealized investment losses, net of $(3,531) tax

 —     —     —     —    (5,546)  —     —     (5,546)
           (in thousands) 

Comprehensive income

         223,388 

Common stock repurchases

 —     —     —     —    —     —     (44,147)  (44,147)

Restricted stock forfeitures

 (72)  (13)  (527)  —    —     540   —     —   

Restricted stock amortization

 —     —     —     —    —     5,808   —     5,808 

Stock option exercises

 2,646   441   27,598   —    —     —     —     28,039 

Stock option and restricted stock tax benefit

 —     —     15,858   —    —     —     —     15,858 

Other stock compensation

 —     —     957   —    —     (586)  158   529 
                       

Balances, December 31, 2003

 173,909   28,984   974,975   949,811  16,909   (754)  (133,976)  1,835,949 

Balances, January 1, 2004

 173,909  $28,984  $1,102,057  $854,998 $16,909  $(133,976) $1,868,972 

Comprehensive income:

               

Net income

 —     —     —     280,012  —     —     —     280,012  —     —     —     269,947  —     —     269,947 

Other comprehensive loss:

               

Net unrealized investment losses, net of $(243) tax

 —     —     —     —    (383)  —     —     (383) —     —     —     —    (383)  —     (383)
                   

Comprehensive income

         279,629         269,564 

Common stock repurchases

 —     —     —     —    —     —     (67,024)  (67,024) —     —     —     —    —     (67,024)  (67,024)

Stock-based compensation

 —     —     20,492   —    —     —     20,492 

Restricted stock grants

 10   2   295   —    —     (295)  —     2  37   6   —     —    —     —     6 

Restricted stock amortization

 —     —     —     —    —     173   —     173 

Stock option exercises

 2,099   350   29,613   —    —     —     —     29,963  2,099   350   29,613   —    —     —     29,963 

Stock option and restricted stock tax benefit

 —     —     7,585   —    —     —     —     7,585  —     —     2,275   —    —     —     2,275 

Other stock compensation

 27   4   4,688   —    —     (845)  —     3,847 
                                           

Balances, December 31, 2004

 176,045   29,340   1,017,156   1,229,823  16,526   (1,721)  (201,000)  2,090,124  176,045   29,340   1,154,437   1,124,945  16,526   (201,000)  2,124,248 

Comprehensive income:

               

Net income

 —     —     —     308,483  —     —     —     308,483  —     —     —     296,730  —     —     296,730 

Other comprehensive income:

               

Net unrealized investment gains, net of $4,441 tax

 —     —     —     —    8,306   —     —     8,306  —     —     —     —    8,306   —     8,306 
                   

Comprehensive income

         316,789         305,036 

Common stock repurchases

 —     —     —     —    —     —     (2,364)  (2,364) —     —     —     —    —     (2,364)  (2,364)

Stock-based compensation

 —     —     30,153   —    —     —     30,153 

Restricted stock grants

 495   83   16,318   —    —     (16,396)  —     5  525   88   (83)  —    —     —     5 

Restricted stock forfeitures

 (16)  (3)  (504)  —    —     507   —     —    (16)  (3)  3   —    —     —     —   

Restricted stock amortization

 —     —     —     —    —     4,454   —     4,454 

Stock option exercises

 2,509   418   35,959   —    —     —     —     36,377  2,509   418   35,960   —    —     —     36,378 

Stock option and restricted stock tax benefit

 —     —     21,855   —    —     —     —       21,855  —     —     15,418   —    —     —     15,418 

Other stock compensation

 30   5   7,333   —    —     (473)  —     6,865 
                                           

Balances, December 31, 2005

 179,063  $29,843  $1,098,117  $1,538,306 $24,832  $(13,629) $(203,364) $2,474,105  179,063   29,843   1,235,888   1,421,675  24,832   (203,364)  2,508,874 

Comprehensive income:

       

Net income

 —     —     —     487,423  —     —     487,423 

Other comprehensive loss:

       

Net unrealized investment losses, net of $(20,853) tax

 —     —     —     —    (34,608)  —     (34,608)
                                

Comprehensive income

        452,815 

Adjustment to initially apply SFAS 158, net of $(2,064) tax

 —     —     —     —    (3,429)  —     (3,429)

Common stock repurchases

 —     —     —     —    —     (26,211)  (26,211)

Stock-based compensation

 —     —     32,558   —    —     —     32,558 

Restricted stock grants

 728   121   —     —    —     —     121 

Restricted stock forfeitures

 (68)  (11)  8   —    —     —     (3)

Stock option exercises

 3,225   538   49,982   —    —     —     50,520 

Stock option and restricted stock tax benefit

 —     —     38,641   —    —     —     38,641 
                    

Balances, December 31, 2006

 182,948  $30,491  $1,357,077  $1,909,098 $(13,205) $(229,575) $3,053,886 
                    

The accompanying notes are an integral part of the consolidated financial statements.

Humana Inc.

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

  For the year ended December 31,   For the year ended December 31, 
  2005 2004 2003   2006 2005 2004 
  (in thousands)   (in thousands) 

Cash flows from operating activities

        

Net income

  $308,483  $280,012  $228,934   $487,423  $296,730  $269,947 

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

        

Depreciation and amortization

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

Restricted stock and other stock compensation

   11,319   4,020   6,337 

Stock-based compensation

   32,558   30,153   20,492 

Loss (gain) on sale of property and equipment, net

   152   (935)  298    1,153   152   (935)

Gain on sale of investment securities, net

   (18,323)  (28,206)  (36,651)   (67,496)  (18,323)  (28,206)

(Benefit) provision for deferred income taxes

   (38,362)  53,608   32,251 

Provision (benefit) for deferred income taxes

   70,062   (39,007)  52,507 

Provision for doubtful accounts

   4,566   6,433   7,416    20,901   4,566   6,433 

Writedown of property and equipment

   —     —     17,233 

Changes in operating assets and liabilities excluding the effects of acquisitions:

        

Receivables

   (161,314)  (51,058)  (22,636)   37,653   (161,314)  (51,058)

Other assets

   (63,962)  3,991   25,110    (365,454)  (63,962)  3,991 

Medical and other expenses payable

   450,297   78,791   130,025    557,381   450,297   78,791 

Other liabilities

   47,598   65,732   (107,432)   734,718   25,617   56,678 

Unearned revenues

   (45,610)  (190,759)  (2,686)   29,870   (45,610)  (190,759)

Other

   1,925   8,388   8,162    (655)  1,925   8,388 
                    

Net cash provided by operating activities

   625,627   347,809   413,140    1,686,712   610,082   344,061 
                    

Cash flows from investing activities

        

Acquisitions, net of cash acquired

   (402,844)  (141,810)  —      (28,062)  (402,844)  (141,810)

Purchases of property and equipment

   (165,846)  (114,096)  (101,268)   (193,151)  (165,846)  (114,096)

Proceeds from sales of property and equipment

   4,497   30,491   11,182    9,623   4,497   30,491 

Purchases of investment securities

   (3,717,916)  (4,106,210)  (4,572,577)   (4,269,221)  (3,717,916)  (4,106,210)

Maturities of investment securities

   1,761,588   1,015,144   769,436    1,664,332   1,761,588   1,015,144 

Proceeds from sales of investment securities

   1,723,015   2,683,749   3,520,064    1,742,793   1,723,015   2,683,749 

Change in securities lending collateral

   30,230   8,651   (9,674)   (580,380)  30,230   8,651 
                    

Net cash used in investing activities

   (767,276)  (624,081)  (382,837)   (1,654,066)  (767,276)  (624,081)
                    

Cash flows from financing activities

        

Receipts from CMS contract deposits

   2,002,451   —     —   

Withdrawals from CMS contract deposits

   (2,124,717)  —     —   

Borrowings under credit agreement

   494,000   —     —      550,000   494,000   —   

Repayments under credit agreement

   (294,000)  —     —      (300,000)  (294,000)  —   

Net conduit commercial paper (repayments) borrowings

   —     —     (265,000)

Proceeds from issuance of senior notes

   —     —     299,139    498,545   —     —   

Proceeds from swap exchange

   —     —     31,556 

Repayment of senior notes

   (300,000)  —     —   

Debt issue costs

   —     (1,954)  (3,331)   (5,980)  —     (1,954)

Change in book overdraft

   87,945   (26,994)  124,172    13,600   87,945   (26,994)

Change in securities lending payable

   (30,230)  (8,651)  9,674    580,380   (30,230)  (8,651)

Common stock repurchases

   (2,364)  (67,024)  (44,147)   (26,211)  (2,364)  (67,024)

Tax benefit from stock-based compensation

   38,839   15,545   3,748 

Proceeds from stock option exercises and other

   38,235   29,570   27,681    48,735   38,235   29,570 
                    

Net cash provided by (used in) financing activities

   293,586   (75,053)  179,744    975,642   309,131   (71,305)
                    

Increase (decrease) in cash and cash equivalents

   151,937   (351,325)  210,047    1,008,288   151,937   (351,325)

Cash and cash equivalents at beginning of year

   580,079   931,404   721,357    732,016   580,079   931,404 
                    

Cash and cash equivalents at end of year

  $732,016  $580,079  $931,404   $1,740,304  $732,016  $580,079 
                    

Supplemental cash flow disclosures:

        

Interest payments

  $45,258  $30,779  $18,096   $66,579  $45,258  $30,779 

Income tax payments, net

  $179,300  $51,086  $59,622   $160,233  $179,300  $51,086 

Details of businesses acquired in purchase transactions:

        

Fair value of assets acquired, net of cash acquired

  $508,443  $243,422    $63,961  $508,443  $243,422 

Less: Fair value of liabilities assumed

   (105,599)  (101,612)    (35,899)  (105,599)  (101,612)
                  

Cash paid for acquired businesses, net of cash acquired

  $402,844  $141,810    $28,062  $402,844  $141,810 
                  

The accompanying notes are an integral part of the consolidated financial statements.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. REPORTING ENTITY

Nature of Operations

Headquartered in Louisville, Kentucky, Humana Inc. is one of the nation’s largest publicly traded health benefits companies, based on our 20052006 revenues of $14.4$21.4 billion. References throughout this document to “we,” “us,” “our,” “Company,” and “Humana,” mean Humana Inc. and its subsidiaries. We offer coordinated health insurance coverage and related services through a variety of traditional and Internet-basedconsumer-choice plans for government-sponsored programs, employer groups, government-sponsored programs, and individuals. We derived approximately 51%67% of our premiums and administrative services fees from contracts with the federal government in 2005.2006. Under our federal government contracts with the Centers for Medicare and Medicaid Services, or CMS, we provide health and pharmacy insurance coverage for Medicare members in Florida, accounting for approximately 17% of our total premiums and administrative services fees in 2006. CMS is the federal government’s agency responsible for administering the Medicare program. Under a federal government contract with the Department of Defense, we provide health insurance coverage to TRICARE members, accounting for approximately 17%12% of our total premiums and administrative services fees in 2005. Under our federal government contracts with the Centers for Medicare and Medicaid Services, or CMS, we provide health insurance coverage for Medicare Advantage members in Florida, accounting for approximately 20% of our total premiums and administrative services fees in 2005.2006.

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

The accounting policies of each segment are the same and are described in Note 2. 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 often utilize the same medical provider networks, enabling us to obtain more favorable contract terms with providers. Our segments also share overhead costs and assets. As a result, the profitability of each segment is interdependent.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

Our financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America. Our consolidated financial statements include the accounts of Humana Inc., and subsidiaries that the Company controls. All significant intercompany balances and transactions have been eliminated.

We adopted SFAS No. 123 (revised 2004),Share-Based Payment, or SFAS 123R, on January 1, 2006. We have adjusted prior period amounts to reflect the effect of expensing stock awards under the modified retrospective application method of SFAS 123R as discussed in Note 11.

The preparation of financial statements in accordance with accounting principles generally accepted accounting principlesin the United States of America requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. The areas involving the most significant use of estimates are the estimation of medical expenses payable, the impact of risk sharing provisions related to our

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Medicare and TRICARE and Medicare contracts, the valuation and related impairment recognition of investment securities, and the valuation and related impairment recognition of long-lived assets, including goodwill. These estimates are based on knowledge of current events and anticipated future events, and accordingly, actual results may ultimately differ materially from those estimates.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Cash and Cash Equivalents

Cash and cash equivalents include cash, time deposits, money market funds, commercial paper, other money market instruments, and certain U.S. Government securities with an original maturity of three months or less. Carrying value approximates fair value due to the short-term maturity of the investments.

Investment Securities

Investment securities, which consist primarily of debt securities, have been categorized as available for sale and, as a result, are stated at fair value. Fair value of publicly traded debt and equity securities are based on quoted market prices. Non-traded debt securities are priced independently by a third party. Fair value of venture capital debt securities that are privately held are estimated using a variety of valuation methodologies where an observable quoted market price does not exist. Such methodologies include reviewing the value ascribed to the most recent financing, comparing the security with securities of publicly traded companies in a similar line of business, and reviewing the underlying financial performance including estimating discounted cash flows. Investment securities available for current operations are classified as current assets. Investment securities available for our professional liability and long-term insurance product funding requirements, as well as restricted statutory deposits and venture capital investments, are classified as long-term assets. Unrealized holding gains and losses, net of applicable deferred taxes, are included as a component of stockholders’ equity and comprehensive income until realized from a sale or impairment.

For the purpose of determining gross realized gains and losses, which are included as a component of investment and other income in the consolidated statements of income, the cost of investment securities sold is based upon specific identification. We regularly evaluate our investment securities for impairment. We consider factors affecting the issuer, factors affecting the industry the issuer operates within, and general debt and equity market trends. We consider the length of time an investment’s fair value has been below carrying value, the severity of the decline, the near term prospects for recovery to carrying value,cost, and our intent and ability to hold the investment until maturity or market recovery is realized. If and when a determination is made that a decline in fair value below the cost basis is other than temporary, the related investment is written down to its estimated fair value through a charge to earnings.

We participate in a securities lending program to maximize investment income. We loan certain investment securities for short periods of time in exchange for collateral initially equal to at least 102% of the fair value of the investment securities on loan. The fair value of the loaned investment securities is monitored on a daily basis, with additional collateral obtained or refunded as the fair value of the loaned investment securities fluctuates. The collateral, which may be in the form of cash or U.S. Government securities, is deposited by the borrower with an independent lending agent. Any cash collateral is invested by the lending agent according to our investment guidelines, primarily in cash equivalents or other liquid investments. Cash collateral is recorded on our consolidated balance sheet,sheets, along with a liability to reflect our obligation to return the collateral. Collateral received in the form of securities is not recorded in our consolidated balance sheetsheets because we do not have the right to sell, pledge or otherwise reinvest securities collateral. Loaned securities continue to be carried as investment securities on the consolidated balance sheets. Revenue, net of related expense, is recorded as investment income.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Receivables and Revenue Recognition

We generally establish one-year commercial membership contracts with employer groups, subject to cancellation by the employer group on 30-day written notice. Our TRICARE contract with the federal government and our contracts with various state Medicaid programs generally are multi-year contracts subject to annual renewal provisions. Our Medicare Advantage contracts with the federal governmentCMS renew annually.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

We bill and collect premium and administrative fee remittances from employer groups and somemembers in our Medicare and individual Medicare Advantage membersproducts monthly. We receive monthly premiums and administrative fees from the federal government and various states according to government specified reimbursement rates and various contractual terms. Changes in revenues from CMS for our Medicare products resulting from the periodic changes in risk adjustment scores for our membership are recognized when the amounts become determinable and the collectibility is reasonably assured.

Premium revenues are recognized as income in the period members are entitled to receive services, and are net of estimated uncollectible amounts and retroactive membership adjustments. Retroactive membership adjustments result from enrollment changes not yet processed, or not yet reported by an employer group or the government. We routinely monitor the collectibility of specific accounts, the aging of receivables, historical retroactivity trends, as well as prevailing and anticipated economic conditions, and reflect any required adjustments in current operations.

Medicare Part D

On January 1, 2006, we began covering prescription drug benefits in accordance with Medicare Part D under multiple contracts with CMS. The payments we receive monthly from CMS and members, which are determined from our annual bid, represent amounts for providing prescription drug insurance coverage. We recognize premium revenues for providing this insurance coverage ratably over the term of our annual contract. Our CMS payment is subject to risk sharing through the Medicare Part D risk corridor provisions. In addition, receipts for reinsurance and low-income cost subsidies represent reimbursements of prescription drug costs for which we are not at risk.

The risk corridor provisions compare costs targeted in our bids to actual prescription drug costs, limited to actual costs that would have been incurred under the standard coverage as defined by CMS. Variances exceeding certain thresholds may result in CMS making additional payments to us or require us to refund to CMS a portion of the premiums we received. We estimate and recognize an adjustment to premium revenues related to these risk corridor provisions based upon pharmacy claims experience to date as if the annual contract were to terminate at the end of the reporting period. Accordingly, this estimate provides no consideration to future pharmacy claims experience. We record a receivable or payable at the contract level and classify the amount as current or long-term in the consolidated balance sheets based on the expected settlement.

Reinsurance and low-income cost subsidies represent reimbursements from CMS in connection with the Medicare Part D program for which we assume no risk. Reinsurance subsidies represent reimbursements for CMS’s portion of prescription drug costs which exceed the member’s out-of-pocket threshold, or the catastrophic coverage level. Low-income cost subsidies represent reimbursements from CMS for all or a portion of the deductible, the coinsurance and co-payment amounts above the out-of-pocket threshold for low-income beneficiaries. Monthly prospective payments from CMS for reinsurance and low-income cost subsidies are based on assumptions submitted with our annual bid. A reconciliation and related settlement of CMS’s prospective subsidies against actual prescription drug costs we paid is made after the end of the year. We account for these subsidies as a deposit in our consolidated balance sheets and as a financing activity in our consolidated statements of cash flows. We do not recognize premium revenues or claims expense for these subsidies. Receipt and payment activity is accumulated

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

at the contract level and recorded in our consolidated balance sheets in other current assets or trade accounts payable and accrued expenses depending on the contract balance at the end of the reporting period.

For plans where we provide enhanced benefits and selected the alternative demonstration payment option in lieu of the reinsurance subsidy, we receive a monthly per member capitation amount from CMS determined from our annual bid submissions. The capitation amount we receive from CMS for assuming the government’s portion of prescription drug costs in the catastrophic layer of coverage is recorded as premium revenue. The variance between the capitation amount and actual drug costs in the catastrophic layer is subject to risk sharing as part of the risk corridor settlement.

See Note 5 for detail regarding amounts recorded to the consolidated balance sheets related to the risk corridor settlement and subsidies from CMS.

TRICARE

We account for the TRICARE South Region contract under EITF Issue No. 00-21,Accounting for Revenue Arrangements with Multiple Deliverables, and as such allocate the consideration to the various components of the contract based on the relative fair value of the components. TRICARE revenues consist generally of (1) an insurance premium for assuming underwriting risk for the cost of civilian health care services delivered to eligible beneficiaries; (2) health care services provided to beneficiaries which are in turn reimbursed by the federal government; and (3) administrative service fees related to claim processing, customer service, enrollment, disease management and other services. We recognize the insurance premium as revenue ratably over the period coverage is provided. Health care services reimbursements are recognized as revenue in the period health services are provided. Administrative services fees are recognized as revenue in the period services are performed. Our TRICARE South Region contract contains provisions to share the risk associated with financing the cost of health benefits with the federal government. We earn more revenue or incur additional costs based on the variance of actual health care costs versus a negotiated target cost. We defer the recognition of any contingent revenues for favorable variances until the amount is determinable and the collectibility is reasonably assured. We estimate and recognize contingent medical expense for unfavorable variances currently in our results of operations. We continually review the contingent medical expense estimates of future payments to the government for cost overruns and make necessary adjustments to our reserves.

Revenues also may include change orders and bid price adjustments attributable to our TRICARE contracts. Change orders represent equitable adjustments for services not originally specified in the contracts. Bid price adjustments, or BPAs, represent adjustments defined in our former contracts subject to negotiations with the federal government. Revenues for these adjustments are recognized when a settlement amount becomes determinable and the collectibility is reasonably assured.

ASO Fees

ASO fees are recognized as income in the period services are performed. Administrative servicesASO fees cover the processing of claims, offering access to our provider networks and clinical programs, and responding to customer service inquiries from members of self-funded groups. Under ASO contracts, self-funded employers retain the risk of financing substantially all of the cost of health benefits. However, most ASO customers purchase stop loss insurance coverage from us to cover catastrophic claims or to limit aggregate annual costs. Accordingly, we have recorded premiums and medical expenses related to these stop loss arrangements.

Premium and ASO fee receivables are shown net of allowances for estimated uncollectible accounts and retroactive membership adjustments. Premiums and ASO fees received prior to the service period are recorded as unearned revenues.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Other Revenue

Other revenues primarily relate to an in-house mail order pharmacy operation. These revenues are recognized in connection with the shipment of the prescriptions.

Policy Acquisition Costs

Policy acquisition costs are those costs that vary with and primarily are related to the acquisition of new and renewal business. Such costs include broker commissions, costs of policy issuance and underwriting, and other costs we incur to acquire new business or renew existing business. We expense policy acquisition costs related to our employer-group prepaid health services policies as incurred in accordance with theHealth Care Organization Audit and Accounting Guide. These short-duration employer-group prepaid health services policies typically have a one-year term and may be cancelled upon 30 days notice by the employer group.

Our health and life policies sold to individuals, when aggregated as a block of policies, are expected to remain in force for an extended period beyond one year because, by law, these contracts are guaranteed renewable. Accordingly, we account for these policies as long-duration insurance products under the provisions of SFAS No. 60,Accounting and Reporting by Insurance Enterprises,or SFAS 60.60. As a result, we defer policy acquisition costs and amortize them over the estimated life of the policies in proportion to premiums earned. Deferred acquisition costs are regularly reviewed to determine if they are recoverable from future income.

Long-Lived Assets

Property and equipment is recorded at cost. Gains and losses on sales or disposals of property and equipment are included in administrative expense. Certain costs related to the development or purchase of internal-use software are capitalized in accordance with AICPA Statement of Position 98-1,Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. Depreciation is computed using the straight-line method over estimated useful lives ranging from 3 to 10 years for equipment, 3 to 7 years for computer software, and 20 to 40 years for buildings. Improvements to leased facilities are depreciated over the shorter of the remaining lease term or the anticipated life of the improvement.

We periodically review long-lived assets, including property and equipment and other intangible assets, for impairment whenever adverse events or changes in circumstances indicate the carrying value of the asset may not be recoverable. Losses are recognized for a long-lived asset to be held and used in our operations when the undiscounted future cash flows expected to result from the use of the asset are less than its carrying value. We recognize an impairment loss based on the excess of the carrying value over the fair value of the asset. A long-lived asset held for sale is reported at the lower of the carrying amount or fair value less costs to sell. Depreciation expense is not recognized on assets held for sale. Losses are recognized for a long-lived asset to be abandoned when the asset ceases to be used. In addition, we periodically review the estimated lives of all long-lived assets for reasonableness.

Goodwill and Other Intangible Assets

Goodwill represents the unamortized excess of cost over the fair value of the net tangible and other intangible assets acquired. SFAS No. 142,Goodwill and Other Intangible Assets, or SFAS 142, requires that we not amortize goodwill to earnings, but instead requires that we test at least annually for impairment at a level of reporting referred to as the reporting unit and more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. A reporting unit is one level below our Commercial and Government segments. The Commercial segment’s two reporting units consist of health insurancemedical (fully insured and ASO)self insured) and specialty products.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

specialty. The Government segment’s three reporting units consist of Medicare, Advantage, TRICARE and Medicaid. Goodwill is assigned to the reporting unit that is expected to benefit from a specific acquisition.

SFAS 142 requires a two-step process to review goodwill for impairment. The first step is a screen for potential impairment, and the second step measures the amount of impairment, if any. Impairment tests are performed, at a minimum, in the fourth quarter of each year supported by our long-range business plan and annual planning process. Impairment tests completed for 2006, 2005 2004 and 20032004 did not result in an impairment loss.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Other intangible assets primarily relate to acquired subscriber and provider contracts and are included with other long-term assets in the consolidated balance sheets. Other intangible assets are amortized over the useful life, based upon the pattern of future cash flows attributable to the asset. This sometimes results in an accelerated method of amortization for subscriber contracts because the asset tends to dissipate at a more rapid rate in earlier periods. Other than subscriber contracts, other intangible assets generally are amortized using the straight-line method. We review other finite-lived intangible assets for impairment under our long-lived asset policy.

Medical and Other Expenses Payable and Medical Cost Recognition

Medical costs include claim payments, capitation payments, pharmacy costs net of rebates, allocations of certain centralized expenses and various other costs incurred to provide health insurance coverage to members, as well as estimates of future payments to hospitals and others for medical care provided prior to the balance sheet date. Capitation payments represent monthly contractual fees disbursed to primary care physicians and other providers who are responsible for providing medical care to members. Pharmacy costs represent payments for members’ prescription drug benefits, net of rebates from drug manufacturers. Receivables for such pharmacy rebates are included in other current assets in the consolidated balance sheet.sheets.

We estimate the costs of our medical claims and other medical expense payments using actuarial methods and assumptions based upon claim payment patterns, medical cost inflation, historical developments such as claim inventory levels and claim receipt patterns, and other relevant factors, and record medical claims reserves for future payments. We continually review estimates of future payments relating to medical claims costs for services incurred in the current and prior periods and make necessary adjustments to our reserves.

We reassess the profitability of our contracts for providing health insurance coverage to our members when current operating results or forecasts indicate probable future losses. We establish a premium deficiency liability in current operations to the extent that the sum of expected future medical costs, claim adjustment expenses, and maintenance costs exceeds related future premiums under contract without consideration of investment income. For purposes of premium deficiencies, contracts are grouped in a manner consistent with our method of acquiring, servicing, and measuring the profitability of such contracts. Losses recognized as a premium deficiency result in a beneficial effect in subsequent periods as operating losses under these contracts are charged to the liability previously established. There were no premium deficiency liabilities recorded at December 31, 20052006 and 2004.2005. Because the majority of our member contracts renew annually, we do not anticipate recording a premium deficiency liability, except when unanticipated adverse events or changes in circumstances indicate otherwise.

For our health and life policies sold to individuals and accounted for as long-duration insurance products under the provisions of SFAS 60, medical and other expenses payable include liabilities for future policy benefits for which some of the premium received in the earlier years is intended to pay anticipated benefits to be incurred in future years.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

We believe our medical and other expenses payable are adequate to cover future claims payments required. However, such estimates are based on knowledge of current events and anticipated future events. Therefore, the actual liability could differ materially from the amounts provided.

Book Overdraft

Under our cash management system, checks issued but not yet presented to banks frequently result in overdraft balances for accounting purposes and are classified as a current liability in the consolidated balance sheets. Changes in book overdrafts from period to period are reported in the consolidated statement of cash flows as a financing activity.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Income Taxes

We recognize an asset or liability for the deferred tax consequences of temporary differences between the tax bases of assets or liabilities and their reported amounts in the consolidated financial statements. These temporary differences will result in taxable or deductible amounts in future years when the reported amounts of the assets or liabilities are recovered or settled. We also recognize the future tax benefits such as net operating and capital loss carryforwards as deferred tax assets. A valuation allowance is provided against these deferred tax assets if it is more likely than not that some portion or all of the deferred tax assets will not be realized. Future years’ tax expense may be increased or decreased by adjustments to the valuation allowance or to the estimated accrual for income taxes.

We record reserves for contingent tax benefits when it is not probable that the tax return position taken with respect to a particular transaction will be sustained. The contingency is not considered resolved until (1) the tax audit statute of limitations has expired, (2) a settlement is reached with the appropriate level of taxing authorities, or (3) the law changes such that there is objective evidence that it is probable that the uncertain tax position will be sustained.

Professional Liability Risk

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

We accrue for professional liability claims reported and outstanding and an estimate of claims incurred but not reported (based on actuarial determinations using past experience, modified for current trends) and corresponding loss adjustment expenses incurred to adjudicate such claims. We continually review these estimated liabilities, and make necessary adjustments. We believe our professional liabilities are adequate to cover future payments required. However, given the nature and degree of uncertainty involved in projecting professional liability losses and the potential size of a claim, the actual liability could differ significantly from the amounts provided. We record the provision for professional liability losses, including any necessary adjustments to the estimated liability as well as the cost of third party insurance coverage and related legal expenses, as an administrative expense. We record estimated recoveries from third party insurers as a reduction of administrative expense. The recoverable from third party insurers is included as an asset in the accompanying consolidated balance sheet, as discussed in Note 10.

Derivative Financial Instruments

We use interest rate swap agreements to manage our exposure to interest rate risk. The differential between fixed and variable rates to be paid or received is accrued and recognized over the life of the agreements as adjustments to interest expense in the consolidated statements of income. Our interest rate swap agreements convert the fixed interest rates on our senior notes to a variable rate and are accounted for as fair value hedges. Our interest rate swap agreements are more fully described in Note 9.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

10.

Stock-Based Compensation

We haverecognize stock-based employee compensation plans, which are described more fully in Note 11. We account for stock options granted to our employees 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 stockexpense, as determined on the date of grant. Generally, if a fixed-based stock optiongrant at fair value, over the period during which an employee is required to provide service in exchange for the award is subsequently modified,(usually the vesting period). We estimate expected forfeitures and recognize compensation expense if any, is recordedonly for those awards which are expected to vest. We estimate 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 for performance-based stock options is recognized over the performance period which varies based on the marketgrant-date fair value of the underlying common stock at the end of each period. Compensation expense is recorded for restricted stock grants ratably over their vesting periods, generally three years from the date of grant, based on fair value, which is equal to the market price of Humana common stock on the date of the grant. The effect on net income and earnings per common share if we had applied the fair value recognition provisions of SFAS No. 123,Accounting for Stock-Based Compensation, or SFAS 123, to our fixed-based stock option awards using the Black-Scholes pricing model wasoption-pricing model. In addition, we report certain tax effects of stock-based compensation as follows fora financing activity rather than an operating activity in the years ended December 31, 2005, 2004 and 2003.consolidated statement of cash flows. Additional detail regarding our stock-based compensation plans is included in Note 11.

   2005  2004  2003 
   (in thousands, except per share
results)
 

Net income, as reported

  $308,483  $280,012  $228,934 

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

   7,063   2,456   3,872 

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

   (18,816)  (12,521)  (9,067)
             

Adjusted net income

  $296,730  $269,947  $223,739 
             

Earnings per common share:

    

Basic, as reported

  $1.91  $1.75  $1.44 
             

Basic, pro forma

  $1.83  $1.68  $1.41 
             

Diluted, as reported

  $1.87  $1.72  $1.41 
             

Diluted, pro forma

  $1.79  $1.66  $1.38 
             

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

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

average number of unrestricted common shares outstanding plus the dilutive effect of outstanding employee stock options and restricted shares using the treasury stock method.

Recently Issued Accounting Pronouncements

In December 2004,July 2006, the FASB issued FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement 109, or FIN 48. FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return. FIN 48 also revises disclosure requirements and introduces a prescriptive, annual, tabular roll-forward of the unrecognized tax benefits. FIN 48, which became effective for us beginning January 1, 2007, requires the change in net assets that results from the application of the new accounting model to be reflected as an adjustment to retained earnings. The adoption of FIN 48 did not have a material impact on our financial position or results of operations.

In September 2006, the FASB issued Statement of Financial Accounting Standards Board issuedNo. 158,Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, or SFAS 123R,158. We adopted SFAS 158 prospectively in the fourth quarter of 2006 for the year ending December 31, 2006. SFAS 158 requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position, and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. SFAS 158 also requires companiesan employer to expensemeasure the fair valuefunded status of employee stock options and other formsa plan as of stock-based compensation. This requirement represents a significant change because fixed-based stock option awards, a predominate form of stock compensation for us, were not recognized as compensation expense under APB No. 25. SFAS 123R requires that the cost of the award, as determined on the date of grant atits year-end statement of financial position and revises certain disclosure requirements. The benefit obligation is defined as the projected benefit obligation for pension plans and as the accumulated postretirement benefit obligation for any other postretirement benefit plan, such as a retiree health care plan. The adoption of SFAS 158 did not have a material impact on our financial position.

In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements, or SFAS 157. SFAS 157 defines fair value, be recognized over the period during which an employee isestablishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 does not require new fair value measurements. We are required to provide service in exchange for the award (usually the vesting period).

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The grant-date fair value of the award will be estimated using option-pricing models. In addition, certain tax effects of stock option exercises will be reported as a financing activity rather than an operating activityadopt SFAS 157 in the statementsfirst quarter of cash flows.2008. We adoptedcurrently are evaluating the provisions of SFAS 123R on January 1, 2006 under157, however, we do not expect the retrospective transition method using the Black-Scholes pricing model. The effectadoption of expensing stock options underSFAS 157 will have a fair value approach using the Black-Scholes pricing model on diluted earnings per common share for the years ended December 31, 2005, 2004 and 2003 is disclosed on page 69. In addition, the classification of cash inflows from any excess tax benefit associated with exercising stock options will change from an operating activity to a financing activity in the consolidated statements of cash flows with nomaterial impact on total cash flows. We estimate the impactour financial position or results of this change in classification will decrease operating cash flows (and increase financing cash flows) by approximately $15.5 million in 2005, $3.7 million in 2004, and $15.2 million in 2003. Stock option expense after adopting SFAS 123R is not expected to be materially different than our pro forma disclosure on page 69 and is dependent on levels of stock options granted during 2006.operations.

3. ACQUISITIONS

In JanuaryOn May 1, 2006, our Commercial segment reached an agreement to acquireacquired CHA Service Company, or CHA Health, a health plan serving employer groups in Kentucky, for cash consideration of approximately $60.0$67.5 million, plus any excess statutory surplus.including a $1.7 million contingent purchase price settlement paid in January 2007. This transaction, which is subject to regulatory approval, is expected to close effectiveacquisition strengthens our position in the second quarterKentucky market. The fair value of 2006.

On December 20, 2005, our Commercial segment acquired Corphealth, Inc., or Corphealth, a behavioral health care management company, for cash consideration of approximately $54.2 million, including transaction costs. This acquisition allows Humana to integrate coverage of medical and behavior health benefits. Netnet tangible assets acquired of $6.0$20.0 million primarily consisted of cash and cash equivalents. The purchase price exceeded the estimated fair value of the net tangible assets acquired by approximately $48.2$47.5 million. We preliminarily allocated this excess purchase price to other intangible assets of $8.6$12.2 million and associated deferred tax liabilities of $3.2$4.6 million, and non-deductible goodwill of $42.8$39.9 million. The other intangible assets, which primarily consist primarily of customer contracts, have a weighted average useful life of 14.76.8 years. The allocation is subject to change pending completion of the valuation by aWe used an independent third party valuation specialist firm assistingto assist us in evaluating the fair value of the assets acquired.

On December 20, 2005, our Commercial segment acquired Corphealth, Inc., or Corphealth, a behavioral health care management company, for cash consideration of $54.0 million.

On February 16, 2005, our Government segment acquired CarePlus Health Plans of Florida, or CarePlus, as well as its affiliated 10 medical centers and pharmacy company. CarePlus provides Medicare Advantage HMO plans and benefits to Medicare Advantage members in Miami-Dade, Broward and Palm Beach counties. This acquisition enhances our Medicare market position in South Florida. We paid approximatelycompany, for cash consideration of $444.9 million in cash, including transaction costs. We financed the transaction with $294.0 million of borrowings under our credit agreement and $150.9 million of cash on hand. The purchase price is subject to a balance sheet settlement process with a nine month claims run-out period. This settlement, which will be reflected as an adjustment to goodwill, is not expected to be material. The fair value of the acquired tangible assets (assumed liabilities) consisted of the following:million.

   (in thousands) 

Cash and cash equivalents

  $92,116 

Premiums receivable and other current assets

   6,510 

Property and equipment and other assets

   21,315 

Medical and other expenses payable

   (37,375)

Other current liabilities

   (23,359)

Other liabilities

   (5,915)
     

Net tangible assets acquired

  $53,292 
     

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The purchase price exceeded the estimated fair value of the net tangible assets acquired by approximately $391.6 million. We allocated the excess purchase price over the fair value of the net tangible assets acquired to other intangible assets of $88.9 million and associated deferred tax liabilities of $33.5 million, and goodwill of $336.2 million. The other intangible assets, which consist primarily of subscriber contracts, have a weighted-average useful life of approximately 10 years. Approximately $47.4 million of the acquired goodwill is 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.

On April 1, 2004, we acquired Ochsner Health Plan, or Ochsner, from the Ochsner Clinic Foundation for $157.1 million in cash.

During 2006, we paid $5.8 million in contingent purchase price settlements related to the Corphealth, CarePlus, and Ochsner acquisitions.

The results of operations and financial condition of CHA Health, Corphealth, CarePlus, and Ochsner have been included in our consolidated statements of income and consolidated balance sheets from the respective acquisition dates. The pro forma financial information assuming the acquisition of CHA Health had occurred as of the beginning of each respective period was not material to our results of operations. The pro forma financial information presented below assumes that the acquisitions of Corphealth, CarePlus and 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 Corphealth, CarePlus and Ochsner acquisitions been consummated at the beginning of the respective periods.

 

  For the year ended December 31,  For the year ended December 31,
            2005(1)                      2004(2)                      2005(1)                      2004(2)          
  (in thousands, except per share results)  (in thousands, except per share results)

Revenues

  $14,500,064  $13,786,237  $14,500,064  $13,786,237

Net income

  $312,951  $303,427  $301,198  $293,362

Earnings per common share:

        

Basic

  $1.94  $1.89  $1.86  $1.83

Diluted

  $1.89  $1.87  $1.82  $1.80

(1)This period includes the pro forma impact of Corphealth for approximately 11.5 months and CarePlus for approximately 1.5 months.
(2)This period includes the pro forma impact of Corphealth and CarePlus for 12 months and Ochsner for 3 months.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

4. INVESTMENT SECURITIES

Investment securities classified as current assets were as follows at December 31, 20052006 and 2004:2005:

 

  2005 2004
  Amortized
Cost
 Gross
Unrealized
Gains
 Gross
Unrealized
Losses
  Fair
Value
 Amortized
Cost
 Gross
Unrealized
Gains
 Gross
Unrealized
Losses
  Fair
Value
  (in thousands)

U.S. Government obligations

 $791,322 $84 $(9,729) $781,677 $650,200 $3,437 $(2,952) $650,685

Tax exempt municipal securities

  971,330  1,112  (11,637)  960,805  888,592  11,379  (3,722)  896,249

Corporate and other securities

  422,127  566  (9,182)  413,511  469,375  8,593  (3,121)  474,847

Mortgage-backed securities

  105,859  142  (2,761)  103,240  78,722  839  (1,146)  78,415

Redeemable preferred stocks

  19,668  52,285  (289)  71,664  7,310  —    (134)  7,176
                          

Debt securities

  2,310,306  54,189  (33,598)  2,330,897  2,094,199  24,248  (11,075)  2,107,372

Non-redeemable preferred stocks

  24,237  13  (243)  24,007  38,221  621  (569)  38,273
                          

Investment securities

 $2,334,543 $54,202 $(33,841) $2,354,904 $2,132,420 $24,869 $(11,644) $2,145,645
                          

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

During the first quarter of 2006, we sold CorSolutions Medical, Inc., a disease management venture capital investment classified as a redeemable preferred stock in the previous table, for cash proceeds of $65.9 million, resulting in a realized gain of $52.3 million ($32.6 million after tax).

  2006 2005
  Amortized
Cost
 Gross
Unrealized
Gains
 Gross
Unrealized
Losses
  

Fair

Value

 Amortized
Cost
 Gross
Unrealized
Gains
 Gross
Unrealized
Losses
  

Fair

Value

  (in thousands)

U.S. Government obligations

 $843,798 $2,029 $(8,539) $837,288 $791,322 $84 $(9,729) $781,677

Tax exempt municipal securities

  1,331,894  3,200  (11,462)  1,323,632  971,330  1,112  (11,637)  960,805

Corporate and other securities

  459,888  1,258  (3,559)  457,587  422,127  566  (9,182)  413,511

Mortgage-backed securities

  566,748  4,137  (4,355)  566,530  105,859  142  (2,761)  103,240

Redeemable preferred stocks

  —    —    —     —    19,668  52,285  (289)  71,664
                          

Debt securities

  3,202,328  10,624  (27,915)  3,185,037  2,310,306  54,189  (33,598)  2,330,897

Non-redeemable preferred stocks

  7,251  —    (15)  7,236  24,237  13  (243)  24,007
                          

Investment securities

 $3,209,579 $10,624 $(27,930) $3,192,273 $2,334,543 $54,202 $(33,841) $2,354,904
                          

Investment securities classified as long-term assets were as follows at December 31, 20052006 and 2004:2005:

 

 2005 2004 2006 2005
 Amortized
Cost
 Gross
Unrealized
Gains
 Gross
Unrealized
Losses
 Fair
Value
 Amortized
Cost
 Gross
Unrealized
Gains
 Gross
Unrealized
Losses
 Fair
Value
 Amortized
Cost
 Gross
Unrealized
Gains
 Gross
Unrealized
Losses
 

Fair

Value

 Amortized
Cost
 Gross
Unrealized
Gains
 Gross
Unrealized
Losses
 

Fair

Value

 (in thousands) (in thousands)

U.S. Government obligations

 $174,397 $36 $(2,542) $171,891 $146,221 $514 $(901) $145,834 $156,770 $63 $(1,789) $155,044 $174,397 $36 $(2,542) $171,891

Tax exempt municipal securities

  96,875  119  (1,123)  95,871  69,529  686  (271)  69,944  106,453  90  (1,140)  105,403  96,875  119  (1,123)  95,871

Corporate and other securities

  73,562  88  (617)  73,033  69,514  1,077  (143)  70,448  108,004  120  (265)  107,859  73,562  88  (617)  73,033

Mortgage-backed securities

  11,104  —    (206)  10,898  14,258  143  (37)  14,364  27,684  116  (304)  27,496  11,104  —    (206)  10,898

Redeemable preferred stocks

  14,552  23,728  (49)  38,231  31,348  12,767  (36)  44,079  12,741  4,750  —     17,491  14,552  23,728  (49)  38,231
                                    

Debt securities

  370,490  23,971  (4,537)  389,924  330,870  15,187  (1,388)  344,669  411,652  5,139  (3,498)  413,293  370,490  23,971  (4,537)  389,924

Non-redeemable preferred stocks

  —    —    —     —    2,491  24  —     2,515  724  —    (1)  723  —    —    —     —  

Common stocks

  1,111  —    —     1,111  1,281  —    —     1,281  861  —    —     861  1,111  —    —     1,111
                                    

Equity securities

  1,111  —    —     1,111  3,772  24  —     3,796  1,585  —    (1)  1,584  1,111  —    —     1,111
                                    

Long-term investment securities

 $371,601 $23,971 $(4,537) $391,035 $334,642 $15,211 $(1,388) $348,465 $413,237 $5,139 $(3,499) $414,877 $371,601 $23,971 $(4,537) $391,035
                                    

Long-term investment securities with a fair value of $99.1 million at December 31, 2006 and $93.5 million at December 31, 2005 and $95.4 million at December 31, 2004 were on deposit at financial institutions in certain states pursuant to the respective states’ insurance regulations.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Gross unrealized losses and fair value aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position were as follows at December 31, 20052006 and 2004:2005:

 

   Less than 12 months  12 months or more  Total 

2005

  Fair
Value
  Unrealized
Losses
  Fair
Value
  Unrealized
Losses
  Fair
Value
  Unrealized
Losses
 
   (in thousands) 

U.S. Government obligations

  $611,683  $(3,790) $272,176  $(8,481) $883,859  $(12,271)

Tax exempt municipal securities

   470,477   (4,846)  258,825   (7,914)  729,302   (12,760)

Corporate and other securities

   248,016   (4,932)  131,166   (4,867)  379,182   (9,799)

Mortgage-backed securities

   51,921   (742)  36,987   (2,225)  88,908   (2,967)

Redeemable preferred stocks

   —     —     6,862   (338)  6,862   (338)
                         

Debt securities

   1,382,097   (14,310)  706,016   (23,825)  2,088,113   (38,135)

Non-redeemable preferred stocks

   4,409   (37)  5,477   (206)  9,886   (243)
                         

Total investment securities

  $1,386,506  $(14,347) $711,493  $(24,031) $2,097,999  $(38,378)
                         
   Less than 12 months  12 months or more  Total 

2004

  Fair
Value
  Unrealized
Losses
  Fair
Value
  Unrealized
Losses
  Fair
Value
  Unrealized
Losses
 
   (in thousands) 

U.S. Government obligations

  $486,209  $(3,717) $4,351  $(136) $490,560  $(3,853)

Tax exempt municipal securities

   316,913   (3,346)  26,869   (647)  343,782   (3,993)

Corporate and other securities

   171,048   (1,846)  32,719   (1,418)  203,767   (3,264)

Mortgage-backed securities

   28,865   (430)  16,581   (753)  45,446   (1,183)

Redeemable preferred stocks

   6,266   (158)  1,238   (12)  7,504   (170)
                         

Debt securities

   1,009,301   (9,497)  81,758   (2,966)  1,091,059   (12,463)

Non-redeemable preferred stocks

   8,455   (240)  10,789   (329)  19,244   (569)
                         

Total investment securities

  $1,017,756  $(9,737) $92,547  $(3,295) $1,110,303  $(13,032)
                         

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

   Less than 12 months  12 months or more  Total 

2006

  Fair
Value
  Unrealized
Losses
  Fair
Value
  Unrealized
Losses
  Fair
Value
  Unrealized
Losses
 
   (in thousands) 

U.S. Government obligations

  $389,393  $(3,073) $339,043  $(7,255) $728,436  $(10,328)

Tax exempt municipal securities

   533,409   (1,659)  501,129   (10,943)  1,034,538   (12,602)

Corporate and other securities

   162,169   (846)  167,415   (2,978)  329,584   (3,824)

Mortgage-backed securities

   184,394   (1,523)  72,449   (3,136)  256,843   (4,659)
                         

Debt securities

   1,269,365   (7,101)  1,080,036   (24,312)  2,349,401   (31,413)

Non-redeemable preferred stocks

   7,959   (16)  —     —     7,959   (16)
                         

Total investment securities

  $1,277,324  $(7,117) $1,080,036  $(24,312) $2,357,360  $(31,429)
                         

 

   Less than 12 months  12 months or more  Total 

2005

  

Fair

Value

  Unrealized
Losses
  

Fair

Value

  Unrealized
Losses
  

Fair

Value

  Unrealized
Losses
 
   (in thousands) 

U.S. Government obligations

  $611,683  $(3,790) $272,176  $(8,481) $883,859  $(12,271)

Tax exempt municipal securities

   470,477   (4,846)  258,825   (7,914)  729,302   (12,760)

Corporate and other securities

   248,016   (4,932)  131,166   (4,867)  379,182   (9,799)

Mortgage-backed securities

   51,921   (742)  36,987   (2,225)  88,908   (2,967)

Redeemable preferred stocks

   —     —     6,862   (338)  6,862   (338)
                         

Debt securities

   1,382,097   (14,310)  706,016   (23,825)  2,088,113   (38,135)

Non-redeemable preferred stocks

   4,409   (37)  5,477   (206)  9,886   (243)
                         

Total investment securities

  $1,386,506  $(14,347) $711,493  $(24,031) $2,097,999  $(38,378)
                         

Unrealized losses at December 31, 20052006 resulted from 447425 positions out of a total of 731758 positions held. Approximately 26%30% of the carrying value of our consolidated investment securities have been in an unrealized loss position greater than one year. Of these investment securities in an unrealized loss position longer than a year, approximately 97% are within 5% of recovering fair value up to cost. No single issue was below cost by more than 15%. The unrealized losses at December 31, 20052006 primarily were caused by increases in interest rates. All issuers of securities trading at an unrealized loss remain current on all contractual payments and we believe it is probable that we will be able to collect all amounts due according to the contractual terms of the debt securities. After taking into account these and other factors, including the severity of the decline and our ability and intent to hold these securities until recovery or maturity, we determined the unrealized losses on these investment securities were temporary and, as such, no impairment was required.

The contractual maturities of debt securities available for sale at December 31, 2005,2006, regardless of their balance sheet classification, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

  Amortized
Cost
  Fair Value  Amortized
Cost
  Fair Value
  (in thousands)  (in thousands)

Due within one year

  $262,934  $313,692  $262,925  $262,354

Due after one year through five years

   819,201   806,441   1,064,931   1,055,582

Due after five years through ten years

   581,570   572,478   628,358   624,094

Due after ten years

   1,017,091   1,028,210   1,657,766   1,656,300
            

Total debt securities

  $2,680,796  $2,720,821  $3,613,980  $3,598,330
            

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Gross realized investment gains were $82.0 million in 2006, $21.8 million in 2005, and $36.6 million in 2004, and $52.8 million in 2003.2004. Gross realized gains included gains from the sale of venture capital investments of $76.2 million in 2006, $5.7 million in 2005, and $16.0 million in 2004, and $15.2 million in 2003.2004.

Gross realized investment losses were $13.6 million in 2006, $3.5 million in 2005, and $8.4 million in 2004, and $16.22004. There were impairment losses of $0.2 million in 2003. There were no impairment losses2006, and none in 2005 or 2004. Gross realized losses included impairment losses of $3.2 million in 2003 after an evaluation indicated that a decline in fair value below the cost basis was other than temporary.

We participate in a securities lending program where we loan certain investment securities for short periods of time in exchange for collateral, consisting of cash or U.S. Government securities, initially equal to at least 102% of the fair value of the investment securities on loan. As of December 31, 2005,2006, investment securities with a fair value of $134.2$618.3 million were on loan. Net investment income earned on securities lending transactions was $1.1 million in 2006 and $0.2 million in 2005 2004 and 2003.2004.

5. MEDICARE PART D

As discussed in Note 2, on January 1, 2006, we began covering prescription drug benefits in accordance with Medicare Part D under multiple contracts with CMS. Other current assets and trade accounts payable and accrued expenses in the accompanying consolidated balance sheets include the following amounts associated with Medicare Part D as of December 31, 2006:

   Risk Corridor
Settlement
  CMS
Subsidies
 
   (in thousands) 

Other current assets

  $18,365  $449,984 

Trade accounts payable and accrued expenses

   (757,084)  (327,718)
         

Net (liability) asset

  $(738,719) $122,266 
         

6. PROPERTY AND EQUIPMENT, NET

Property and equipment was comprised of the following at December 31, 20052006 and 2004:2005:

 

   2005  2004 
   (in thousands) 

Land

  $16,699  $19,329 

Buildings

   278,405   256,997 

Equipment and computer software

   936,463   786,713 

Assets held for sale

   9,786   6,172 
         
   1,241,353   1,069,211 

Accumulated depreciation

   (756,941)  (669,705)
         

Property and equipment, net

  $484,412  $399,506 
         

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

   2006  2005 
   (in thousands) 

Land

  $15,912  $16,699 

Buildings

   291,437   278,405 

Equipment and computer software

   1,080,093   936,463 

Assets held for sale

   3,645   9,786 
         
   1,391,087   1,241,353 

Accumulated depreciation

   (846,083)  (756,941)
         

Property and equipment, net

  $545,004  $484,412 
         

Depreciation expense was $128.6 million in 2006, $105.1 million in 2005, and $107.3 million in 2004, and $115.2 million in 2003.2004. Depreciation expense in 2004 and 2003 included the impact of accelerating depreciation related to abandoned software more fully described below.

Accelerated Depreciation in 2004 and 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

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

accelerated the depreciation of the remaining software balance. The change in the useful life increased depreciation expense during 2004 by approximately $9.3 million ($5.7 million after tax).

After finalizing plans during the first quarter, all 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.

2003 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’ servicewhich 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 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.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The allocation of the non-cash pretax expenses relatedallocated to the accelerated depreciation and writedown of certain long-lived assets to our Commercial and Government segments was as follows for the years ended December 31, 2004 and 2003:segment.

   2004
   Commercial  Government  Total
   (in thousands)

Line item affected:

      

Depreciation and amortization

  $9,349  $  —    $9,349
            

Total pretax impact

  $9,349  $  —    $9,349
            

   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
            

6.7. GOODWILL AND OTHER INTANGIBLE ASSETS

Changes in the carrying amount of goodwill, by operating segment, for the year ended December 31, 20052006 were as follows:

 

   Commercial  Government  Total
   (in thousands)

Balance at December 31, 2004

  $698,430  $187,142  $885,572

CarePlus acquisition

   —     336,173   336,173

Corphealth acquisition

   42,830   —     42,830
            

Balance at December 31, 2005

  $741,260  $523,315  $1,264,575
            
   Commercial  Government  Total
   (in thousands)

Balance at December 31, 2005

  $741,260  $523,315  $1,264,575

CHA acquisition

   39,912   —     39,912

Contingent purchase price settlements related to:

      

Prior years acquisitions

   1,329   4,815   6,144
            

Balance at December 31, 2006

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

Other intangible assets primarily relate to acquired subscriber contracts and are included with other long-term assets in the consolidated balance sheets. Amortization expense for other intangible assets was approximately $20.0 million in 2006, $23.8 million in 2005 and $10.5 million in 2004 and $11.6 million in 2003.2004. The following table presents our estimate of amortization expense for each of the five next succeeding fiscal years:

 

   (in thousands)

For the years ending December 31,:

  

2006

  $17,782

2007

  $14,550

2008

  $11,951

2009

  $8,126

2010

  $7,582

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

   (in thousands)

For the years ending December 31,:

  

2007

  $16,989

2008

  $14,076

2009

  $10,096

2010

  $9,511

2011

  $9,440

The following table presents details of our other intangible assets included in other non-current assets in the accompanying consolidated balance sheets at December 31, 20052006 and 2004:2005:

 

 

Weighted

Average
Life

 2005 2004 

Weighted

Average
Life

 2006 2005
 Cost Accumulated
Amortization
 Net Cost Accumulated
Amortization
 Net Cost Accumulated
Amortization
 Net Cost Accumulated
Amortization
 Net
 (in thousands) (in thousands)

Other intangible assets:

              

Subscriber contracts

 10.5 yrs $103,251 $18,483 $84,768 $97,256 $82,343 $14,913 10.2 yrs $114,944 $36,449 $78,495 $103,251 $18,483 $84,768

Provider contracts

 15.0 yrs  10,300  1,202  9,098  22,428  11,022  11,406 14.5 yrs  11,500  2,012  9,488  10,300  1,202  9,098

Licenses and other

 17.8 yrs  12,890  2,741  10,149  5,790  1,787  4,003 16.7 yrs  11,602  3,929  7,673  12,890  2,741  10,149
                            

Total other intangible assets

 11.5 yrs $126,441 $22,426 $104,015 $125,474 $95,152 $30,322 11.0 yrs $138,046 $42,390 $95,656 $126,441 $22,426 $104,015
                            

7.Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

8. MEDICAL AND OTHER EXPENSES PAYABLE

Activity in medical and other expenses payable was as follows for the years ended December 31, 2006, 2005 2004 and 2003:2004:

 

  2005 2004 2003   2006 2005 2004 
  (in thousands)   (in thousands) 

Balances at January 1

  $1,422,010  $1,272,156  $1,142,131   $1,909,682  $1,422,010  $1,272,156 

Acquisitions

   37,375   71,063   —      21,198   37,375   71,063 

Incurred related to:

        

Current year

   11,765,662   10,763,105   9,955,491    17,696,654   11,765,662   10,763,105 

Prior years

   (114,192)  (93,458)  (76,070)   (275,450)  (114,192)  (93,458)
                    

Total incurred

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

Paid related to:

        

Current year

   (9,979,449)  (9,504,331)  (8,710,393)   (15,532,079)  (9,979,449)  (9,504,331)

Prior years

   (1,221,724)  (1,086,525)  (1,039,003)   (1,331,744)  (1,221,724)  (1,086,525)
                    

Total paid

   (11,201,173)  (10,590,856)  (9,749,396)   (16,863,823)  (11,201,173)  (10,590,856)
                    

Balances at December 31

  $1,909,682  $1,422,010  $1,272,156   $2,488,261  $1,909,682  $1,422,010 
                    

Amounts incurred related to prior years vary from previously estimated liabilities as the claims ultimately are settled. Negative amounts reported for incurred related to prior years result from claims being ultimately settled for amounts less than originally estimated (favorable development).

As summarized in the previous table, claim reserve balances at December 31, 20042005 ultimately settled during 2006 for $275.5 million less than the amounts originally estimated. During 2005, claim reserve balances at December 31, 2004 ultimately settled for $114.2 million less than the amounts originally estimated. This $161.3 million change in the amounts incurred related to prior years for 2006 as compared to 2005 consisted of $106.2 million attributable to our Medicare and commercial lines of business, as well as $55.1 million attributable to our TRICARE line of business. Amounts attributable to our TRICARE line of business are discussed separately due to the additional variability associated with this business and risk sharing provisions with the Department of Defense and subcontractors as further described below. The favorable development experienced in our Medicare and commercial operations primarily was due to (1) the utilization of hospital and physician services during the latter half of 2005 ultimately being lower than estimated, representing 1.1%(2) the impact of medicalhurricanes in Florida and Louisiana in the second half of 2005 on both utilization of services and claims processing, (3) significant growth in our Medicare PFFS product, (4) reductions in receipt cycle times driven by an increase in electronic claims submissions, and (5) an increase in claim expenses recordedoverpayment recovery levels versus our historical overpayment recovery rate. The favorable development experienced in 2004. our TRICARE line of business primarily was due to the utilization of hospital and physician services during the latter half of 2005 ultimately being lower than estimated, changes in claim payment patterns resulting from fluctuations in claim inventory levels, and an increase in claim overpayment recovery levels versus our historical overpayment recovery rate.

During 2004, claim reserve balances at December 31, 2003 ultimately settled during 2004 for $93.5 million less than the amounts originally estimated, representing 0.9% of medical claim expenses recorded in 2003. Thisestimated. The $20.7 million change in the amounts incurred related to prior years for 2005 as compared to 2004 resulted primarily from favorable development inconsisted of $16.3 million attributable to our TRICARE line of business as a resultand $4.4 million attributable to our Medicare and commercial lines of less than expectedbusiness. In each of these lines of business, the favorable development primarily was due to the utilization inof hospital and physician services during the latter half of 2004.2004 ultimately being lower than originally estimated.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

During 2003, claim reserve balances at December 31, 2002 ultimately settled during 2003 for $76.1 million less than the amounts originally estimated, representing 0.8% of medical claim expenses recorded in 2002. The $17.4 million change in the amounts incurred related to prior years for 2004 as compared to 2003 resulted primarily from favorable development in our Medicare line of business as a result of less than expected utilization in the latter half of 2003.

Our TRICARE contract contains risk-sharing provisions with the Department of Defense and with subcontractors, which effectively limit profits and losses when actual claim experience varies from the targeted medical claim amount negotiated annually. As a result of these contract provisions, the impact of changes in estimates for prior year TRICARE medical claims payable on our results of operations is reduced substantially, whether positive or negative.

We have 52%Certain of our Medicare membershipAdvantage and 97% of our Medicaid membershipmembers are also under risk-sharing arrangements with providers. Accordingly, the impact of changes in estimates for prior year medical claims payable on our results fromof operations that are attributable to our Medicare and Medicaid lines of business may also be significantly reduced, whether positive or negative.

8.9. INCOME TAXES

The provision for income taxes consisted of the following for the years ended December 31, 2006, 2005 2004 and 2003:2004:

 

  2005 2004  2003  2006  2005 2004
  (in thousands)  (in thousands)

Current provision:

          

Federal

  $133,404  $77,768  $69,643  $192,878  $127,653  $73,280

States and Puerto Rico

   18,189   4,462   13,888   11,722   17,504   3,644
                  

Total current provision

   151,593   82,230   83,531   204,600   145,157   76,924

Deferred (benefit) provision

   (38,362)  53,608   32,251

Deferred provision (benefit)

   70,062   (39,007)  52,507
                  

Provision for income taxes

  $113,231  $135,838  $115,782  $274,662  $106,150  $129,431
                  

The provision for income taxes was different from the amount computed using the federal statutory rate for the years ended December 31, 2006, 2005 2004 and 20032004 due to the following:

 

  2005 2004 2003   2006 2005 2004 
  (in thousands)   (in thousands) 

Income tax provision at federal statutory rate

  $147,600  $145,547  $120,650   $266,730  $141,008  $139,782 

States, net of federal benefit and Puerto Rico

   13,658   14,003   13,365    18,301   13,169   13,361 

Tax exempt investment income

   (11,917)  (12,700)  (10,546)   (15,713)  (11,917)  (12,700)

Capital loss valuation allowance

   (5,198)  (6,855)  (9,492)   —     (5,198)  (6,855)

Contingent tax benefits

   (27,365)  (6,409)  —   

Contingent tax reserves (benefits)

   1,570   (27,365)  (6,409)

Examination settlements

   (3,518)  —     —      —     (3,518)  —   

Other, net

   (29)  2,252   1,805    3,774   (29)  2,252 
                    

Provision for income taxes

  $113,231  $135,838  $115,782   $274,662  $106,150  $129,431 
                    

The $27.4 million reduction in 2005 tax expense primarily related to the recognition of a $22.8 million contingent tax benefit and associated $3.1 million reversal of accrued interest resulting from the resolution of an uncertain tax position associated with the 2000 tax year during the first quarter of 2005 in connection with the

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

expiration of the statute of limitations. In addition, during 2005 the Internal Revenue Service completed their audit of all open years prior to 2003 which also resulted in a $3.5 million reduction in 2005 tax expense associated with revisions to prior year’s estimated taxes.

Changes in the capital loss valuation allowance in 2005 and 2004 resulted from our regular evaluation of probable capital gain realization in the allowable carryforward period given our recent and historical capital gain experience and the consideration of alternative tax planning strategies. The capital loss carryforward expired on December 31, 2005. As such, the remaining unused deferred tax asset and associated allowance were written off.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Deferred income tax balances reflect the impact of temporary differences between the tax bases of assets or liabilities and their reported amounts in our consolidated financial statements, and are stated at enacted tax rates expected to be in effect when the reported amounts are actually recovered or settled. Principal components of our net deferred tax balances at December 31, 20052006 and 20042005 were as follows:

 

  Assets (Liabilities)   Assets (Liabilities) 
  2005 2004   2006 2005 
  (in thousands)   (in thousands) 

Investment securities

  $(14,963) $(10,522)  $5,891  $(14,963)

Depreciable property and intangible assets

   (133,672)  (110,369)   (138,593)  (133,672)

Medical and other expenses payable

   (4,119)  (2,538)   37,969   44,971 

Unearned revenues

   5,718   8,858    7,618   5,718 

Professional liability risks

   13,650   13,193    13,866   13,650 

Compensation and other accruals

   78,893   45,047 

Stock-based awards

   40,453   39,452 

Net operating loss carryforwards

   11,987   13,970    10,810   11,987 

Capital loss carryforward

   —     22,078 

Valuation allowance—capital loss carryforward

   —     (20,123)

Prepaid expenses and other accruals

   (26,600)  25,120 
              

Total net deferred income tax liabilities

  $(42,506) $(40,406)  $(48,586) $(7,737)
              

Amounts recognized in the consolidated balance sheets:

      

Other current assets

  $68,510  $19,428   $29,467  $68,510 

Other long-term liabilities

   (111,016)  (59,834)   (78,053)  (76,247)
              

Total net deferred income tax liabilities

  $(42,506) $(40,406)  $(48,586) $(7,737)
              

At December 31, 2005,2006, we had approximately $31.9$28.7 million of net operating losses to carryforward related to prior acquisitions. These net operating loss carryforwards, if not used to offset future taxable income, will expire from 20062007 through 2020. Based on our historical record of producing taxable income and profitability, we have concluded that future operating income will be sufficient to give rise to tax expense to recover all deferred tax assets.

10. DEBT

Long-term debt outstanding was as follows at December 31, 2006 and 2005:

   2006  2005
   (in thousands)

Long-term debt:

    

6.45% senior, unsecured notes due 2016, net of unamortized discount of $1,393 at December 31, 2006

  $498,607  $—  

6.30% senior, unsecured notes due 2018, net of unamortized discount of $665 at December 31, 2006 and $724 at December 31, 2005

   299,335   299,276

7.25% senior, unsecured notes due 2006, net of unamortized discount of $86 at December 31, 2005

   —     299,914

Fair value of interest rate swap agreements

   18,093   6,084

Deferred gain from interest rate swap exchange

   —     6,131
        

Total senior notes

   816,035   611,405

Credit agreement

   450,000   200,000

Other long-term borrowings

   3,065   3,639
        

Total debt

   1,269,100   815,044

Less: Current portion of long-term debt

   —     301,254
        

Total long-term debt

  $1,269,100  $513,790
        

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

9. DEBTSenior Notes

Long-term debtIn May 2006, we issued $500 million of 6.45% senior notes due June 1, 2016. Our net proceeds, reduced for the discount and cost of the offering, were $494.3 million. We used the proceeds from the offering for the repayment of the outstanding balance under our credit agreement, which at the time of the issuance was as follows at December 31, 2005$200 million, and 2004:the repayment of $300 million of 7.25% senior notes which matured on August 1, 2006.

   2005  2004
   (in thousands)

Long-term debt:

  

6.30% senior, unsecured notes due 2018, net of unamortized discount of $724 at December 31, 2005 and $780 at December 31, 2004

  $299,276  $299,220

7.25% senior, unsecured notes due 2006, net of unamortized discount of $86 at December 31, 2005 and $231 at December 31, 2004

   299,914   299,769

Fair value of interest rate swap agreements

   6,084   17,082

Deferred gain from interest rate swap exchange

   6,131   16,338
        

Total senior notes

   611,405   632,409

Credit agreement

   200,000   —  

Other long-term borrowings

   3,639   4,287
        

Total debt

   815,044   636,696

Less: Current portion of long-term debt

   301,254   —  
        

Total long-term debt

  $513,790  $636,696
        

Swap Agreements

In order to hedge the risk of changes in the fair value of all 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. Our interest rate swap agreements exchange the fixed interest rate under all our senior notes for a variable interest rate based on LIBOR. At December 31, 2006, the weighted average effective interest rate for all of our senior notes was 6.25%.

The interest rate swap agreements, which have the same critical terms as our 6.30% senior notes and our 7.25% senior notes, are designated as fair value hedges. 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 consolidated balance sheetsheets at fair value with an equal and offsetting adjustment to the carrying value of our senior notes. The fair value of our interest rate swap agreements are estimated based on quoted market prices of comparable agreements, and reflect the amounts we would receive (or pay) to terminate the agreements at the reporting date.

Our interest rate swap agreements exchange the fixed interest rate under our 6.30% and 7.25% senior notes for a variable interest rate based on LIBOR. At December 31, 2005, the effective interest rate was 5.41% for the 6.30% senior notes and 6.22% 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 December 31, 2005, the fair value of all our swap agreements related to the 6.30% senior notes was in our favor by $10.9$18.1 million and is included in other long-term assets and the fair value of our swap agreements related to the 7.25% senior notes was out of our favor by $4.8 million and is included in trade accounts payable and accrued expenses.assets. Likewise, the carrying valuevalues of all of our senior notes hashave been increased $6.1$18.1 million to reflect their fair value.values. The counterparties to our swap agreements are major financial institutions with which we also have other financial relationships.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

In June 2003, we recorded a deferred gain and received proceeds of $31.6 million in exchange for new swap agreements discussed previously related to our 7.25% senior notes. The corresponding deferred swap gain of $31.6 million iswas being amortized to reduce interest expense over the remaining term of the 7.25% senior notes.notes which matured August 1, 2006. Amortization of the deferred swap gain reduced interest expense by $6.1 million in 2006, $10.2 million in 2005, and $9.8 million in 2004 and $5.5 million in 2003.2004.

Credit Agreement

OurOn July 14, 2006, we replaced our existing 5-year $600 million unsecured revolving credit agreement expires in September 2009.with a 5-year $1.0 billion unsecured revolving credit agreement. We entered into the credit agreement for general corporate purposes. Under the credit agreement, at our option, we can borrow on either a competitive advance basis or a revolving credit basis. The revolving credit portion 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 5027 to 112.580 basis points. We also pay an annual facility fee regardless of utilization. This facility fee, currently 1510 basis points, may fluctuate between 12.58 and 37.520 basis points, depending upon our credit ratings. In addition, a utilization fee of 12.510 basis points is payable for any day in which borrowings under the facility exceed 50% of the total $600 million$1 billion commitment. The competitive advance portion of any borrowings will bear interest at market rates prevailing at the time of borrowing on either a fixed rate or a floating rate basis, at our option.

The 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 a minimum level of net worth minimum interest coverage, and a maximum leverage ratios. At December 31, 2005, we were in compliance with all applicable financial covenant requirements. The terms of this credit agreement also include standard provisions related to conditions of borrowing, including a customary material adverse effect clause which could limit our ability to borrow. We have not experienced a material adverse effect, and we know of no circumstances or events which would be reasonably likely to result in a material adverse effect. At this time, we do not believe the material adverse effect clause poses a material funding risk to us. We have other relationships, including financial advisory and banking, with some of the parties to the credit agreement.ratio.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

At December 31, 2005,2006, we had $200$450 million of borrowings under the credit agreement outstanding at an interest rate of 5.04%5.73%. In addition, we have outstanding letters of credit of $35.1$3.4 million secured under the credit agreement. No amounts have ever been drawn on these letters of credit. As of December 31, 2005,2006, we had $364.9$546.6 million of remaining borrowing capacity under the credit agreement.

Commercial Paper Program

We maintainhave other relationships, including financial advisory 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 bothbanking, with some parties to the credit agreement and commercial paper program generally may not exceed $600 million.

At December 31, 2005 and 2004, we had no commercial paper borrowings outstanding.agreement.

Other Long-Term Borrowings

Other long-term borrowings of $3.6$3.1 million at December 31, 20052006 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.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Shelf Registration

OurOn March 31, 2006, we filed a universal shelf registration statement with the SEC. We are considered a “well known seasoned issuer” under the Securities and Exchange CommissionOffering Reform Act that became effective in December 2005. The universal shelf registration allows us to registersell our debt or equity securities, from time to time, with the amount, price and terms to be determined at the time of the sale. We have up to $300 million remaining from a total of $600 million under the universal shelf registration. The net proceeds from any future sales of our debt securities under the universal shelf registration may be used for our operations and for other general corporate purposes, including repayment or refinancing of borrowings, working capital, capital expenditures, investments, acquisitions, or the repurchase of our outstanding securities.

10. PROFESSIONAL LIABILITY RISKS

Activity in the reserve for our professional liability risks was as follows for the years ended December 31, 2005, 2004 and 2003:

   2005  2004  2003 
   (in thousands) 

Gross reserve at January 1

  $231,494  $242,516  $262,763 

Less recoverables from insurance

   (52,423)  (95,008)  (142,595)
             

Net reserve at January 1

   179,071   147,508   120,168 
             

Acquisition

   8,276   —     —   

Incurred related to:

    

Current year

   53,184   53,525   48,778 

Prior years

   (9,196)  (688)  —   
             

Total incurred

   43,988   52,837   48,778 
             

Paid related to:

    

Current year

   (251)  (659)  (1,356)

Prior years

   (11,771)  (20,615)  (20,082)
             

Total paid

   (12,022)  (21,274)  (21,438)
             

Net reserve at December 31

   219,313   179,071   147,508 

Plus recoverables from insurance

   65,790   52,423   95,008 
             

Gross reserve at December 31

  $285,103  $231,494  $242,516 
             

As a result of changes in estimates of insured exposures in prior years, the total incurred losses decreased by $9.2 million in 2005 and $0.7 million in 2004 reflecting favorable loss development related to professional and general liability exposures. In 2004, this was partially offset by required strengthening related to our director and officer errors and omissions exposures.

For the past several years, we have reduced the amount of coverage purchased from third party insurance companies. This increased level of retention resulted in an increasing net reserve balance.

The total cost associated with our professional liabilities, including the cost of purchasing insurance coverage from a number of third party insurance companies not included in the table above, totaled $48.2 million in 2005, $58.4 million in 2004 and $52.5 million in 2003.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Amounts classified as current and non-current and their respective location in the consolidated balance sheets were as follows at December 31, 2005 and 2004:

   2005  2004
   (in thousands)

Gross reserve included in:

    

Trade accounts payable and accrued expenses (current)

  $39,471  $37,619

Other long-term liabilities (non-current)

   245,632   193,875
        

Total gross reserve

   285,103   231,494
        

Recoverables from insurance included in:

    

Other current assets (current)

   7,886   8,441

Other assets (non-current)

   57,904   43,982
        

Total recoverables from insurance

   65,790   52,423
        

Total net reserve

  $219,313  $179,071
        

11. EMPLOYEE BENEFIT PLANS

Employee Savings Plan

We have defined contribution retirement and savings plans covering eligible employees. Our contribution to these plans is based on various percentages of compensation, and in some instances, on the amount of our employees’ contributions to the plans. The cost of these plans amounted to approximately $56.0 million in 2006, $42.9 million in 2005, and $37.6 million in 2004, and $37.9 million in 2003, all of which was funded currently to the extent it was deductible for federal income tax purposes. Based on the year end closing stock price of $54.33,$55.31, approximately 31%26% of the retirement and savings plan’s assets were invested in our common stock representing less than 4%3% of the shares outstanding as of December 31, 2005. The2006. Through December 31, 2006, the Company match iswas invested in the Humana common stock fund. However, a participant maycould reinvest any funds, including the Company match in the Humana common stock fund, in any other plan investment option at any time. Beginning January 1, 2007, the Company match in cash is invested in the same way as a participant’s contributions to the plan as directed by the participant.

Severance Benefits

We provide severance and related employee benefits based upon our existing employee benefit plans and policies. Severance benefits are generally determined based on years of service and salary. We accrue severance benefits when payment is probable and reasonably estimable in accordance with SFAS No. 112,Employers’Accounting for Postemployment Benefits.The cost of this benefit amounted to approximately $2.7 million in 2006, $0.7 million in 2005 and $15.5 million in 2004 and $11.2 million in 2003.2004. Severance is paid bi-weekly resulting in payments in periods subsequent to termination. We continually review estimates of future payments for probable severance benefits and make necessary adjustments to our liability for severance benefits.

Stock BasedStock-Based Compensation

We have plans under which restricted stock awards and options to purchase our common stock and restricted stock awards have been granted to executive officers, directors, key employees and consultants. The terms and vesting schedules for stock-based awards vary by type of grant. Generally, the awards vest upon time-based conditions. Upon exercise,

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Activitystock-based compensation awards are settled with authorized but unissued company stock. The compensation expense that has been charged against income for our restricted stock awardsthese plans was as follows for the years ended December 31, 2006, 2005, 2004 and 2003:2004:

 

   2005  2004  2003 

Balance, January 1,

  10,000  155,000  4,131,726 

Granted

  494,800  10,000  —   

Vested

  —    (155,000) (3,904,382)

Forfeited

  (15,500) —    (72,344)
          

Balance, December 31,

  489,300  10,000  155,000 
          
   2006  2005  2004 
   (in thousands) 

Stock-based compensation expense by type:

    

Stock options

  $18,025  $24,304  $19,648 

Restricted stock awards

   14,533   5,849   844 
             

Total stock-based compensation expense

   32,558   30,153   20,492 

Tax benefit recognized

   (12,028)  (11,337)  (7,971)
             

Stock-based compensation expense, net of tax

  $20,530  $18,816  $12,521 
             

The weighted average grant date fair valueA greater proportion of ourthe awards granted to employees, excluding executive officers, during 2006 were restricted stock awards was $32.98as opposed to stock options when compared to grants made in prior years.

The tax benefit recognized in our consolidated financial statements is based on the amount of compensation expense recorded for book purposes. The actual tax benefit realized in our tax return is based on the intrinsic value, or the excess of the market value over the exercise or purchase price, of stock options exercised and restricted stock awards vested during the period. The actual tax benefit realized for the deductions taken on our tax returns from option exercises and restricted stock vesting totaled $47.8 million in 2006, $22.3 million in 2005, and $29.54$9.0 million in 2004. Compensation expense recognized relatedThere was no capitalized stock-based compensation expense.

Beginning April 2006, the stock plans provide that one restricted share is equivalent to our restricted1.7 stock options. At December 31, 2006, there were 19,559,951 shares reserved for stock award plans, was $4.5 million in 2005, $0.2 million in 2004, and $5.8 million in 2003.including 12,190,484 shares of common stock available for future grants assuming all stock options or 7,170,873 shares available for future grants assuming all restricted shares.

Stock Options

Stock options are granted atwith an exercise price equal to the average market pricevalue of the underlying common stock on the date of grant. Our stock plans, as approved by the Board of Directors and stockholders, define average market value as the average of the highest and lowest stock prices reported by the New York Stock Exchange on a given date. Exercise provisions vary, but most options vest in whole or in part 1 to 53 years after grant and expire 7 to 10 years after grant. At December 31, 2005, there were 12,513,939 shares reserved for employee and directorUpon grant, stock option plans, including 2,852,181 shares of common stock available for future grants. On February 23, 2006,options are assigned a fair value based on the Board of Directors approvedBlack-Scholes valuation model. Compensation expense is recognized on a straight-line basis over the issuance of 1,517,507 additional options and restricted stock awards.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Activity for our option plans was as followstotal requisite service period, generally the total vesting period, for the years ended December 31, 2005, 2004 and 2003:entire award.

   

Shares

Under

Option

  Exercise Price Per Share  

Weighted

Average

Exercise

Price

Balance, January 1, 2003

  10,526,871  $6.41  to  $26.94  $13.11

Granted

  2,500,000   9.26  to   19.73   11.51

Exercised

  (2,646,578)  6.41  to   20.16   10.59

Canceled or lapsed

  (686,316)  6.50  to   23.06   15.47
                 

Balance, December 31, 2003

  9,693,977   6.50  to   26.94   13.22

Granted

  2,784,000   15.45  to   29.71   21.03

Exercised

  (2,098,679)  6.50  to   22.63   14.28

Canceled or lapsed

  (286,612)  6.50  to   21.28   15.51
                 

Balance, December 31, 2004

  10,092,686   6.50  to   29.71   15.09

Granted

  2,314,900   31.96  to   46.61   33.51

Exercised

  (2,508,871)  6.50  to   29.71   14.50

Canceled or lapsed

  (236,957)  9.26  to   46.61   21.38
                 

Balance, December 31, 2005

  9,661,758  $6.50  to  $46.61  $19.50
                 

A summary of our stock options outstanding and exercisable was as follows at December 31, 2005:

         Stock Options Outstanding  Stock Options Exercisable

Range of Exercise Prices

          Shares          

Weighted
Average
Remaining

Contractual Life

  

Weighted
Average Exercise

Price

          Shares          

Weighted

Average Exercise

Price

$    6.50  to  $  9.26  2,168,267  5.88 Years  $  8.36  1,603,490  $  8.05
9.37  to  16.20  1,970,195  4.13 Years  13.69  1,835,041  13.67
16.46  to  21.25  1,083,834  4.94 Years  19.30  763,535  19.27
21.28  to  21.28  2,092,029  8.15 Years  21.28  560,464  21.28
21.72  to  46.61  2,347,433  6.21 Years  33.17  67,635  23.24
                     
$    6.50  to          $46.61          9,661,758        5.99 Years          $19.50          4,830,165          $13.70
                     

At December 31, 2004, there were 5,335,418 options exercisable with a weighted average exercise price of $13.30.

Compensation expense related to performance-based stock option awards, stock granted to directors and modifications to fixed-based stock option awards was $6.9 million in 2005, $3.8 million in 2004, and $0.5 million in 2003.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The effects on net income and earnings per common share if we had applied the fair value recognition provisions of SFAS 123 to our fixed-based stock option awards are included in Note 2. The weighted average fair value of each option granted during 2006, 2005, 2004 and 20032004 is provided below. The fair value was estimated on the date of grant using the Black-Scholes pricing model with the following weighted average assumptions for the years ended December 31, 2005, 2004 and 2003:indicated below:

 

  2005 2004 2003   2006 2005 2004 

Weighted average fair value at grant date

  $12.93  $9.95  $5.33   $19.10  $12.93  $9.95 

Dividend yield

   None   None   None 

Expected option life (years)

   4.8   5.0   6.0 

Expected volatility

   37.2%  44.6%  44.5%   31.6%  37.2%  44.6%

Risk-free interest rate

   3.9%  3.4%  3.4%   4.6%  3.9%  3.4%

Expected option life (years)

   5.0   6.0   6.5 

Dividend yield

   None   None   None 

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

When valuing employee stock options, we stratify the employee population into homogenous groups that exhibithistorically have exhibited similar exercise behaviors. These groups include executive officers, directors, executives, and all other employees. We then value the stock options based on the unique assumptions for each of these employee groups.

We calculate the expected term for our employee stock options based on historical employee exercise behavior. The increase in our stock price in recent years and more notably in recent months,reduction of the contractual term from 10 years to 7 years has led to a pattern of earlier exercise by employees, therefore contributing to the gradual decline in the average expected term from 6.5 years in 2003, to 6.0 years in 2004, to 5.0 years in 2005. Also contributing toover the decline in the expected term is the change in the contractual term of stock options granted in 2005. Prior to 2005, the contractual term of employee stock options was 10 years. For stock options granted in 2005 the contractual term was reduced to 7last few years.

The volatility used to value employee stock options is based on historical volatility. We calculate historical volatility using a simple average calculation methodology based on daily price intervals as measured over the expected term of the option. We have consistently applied this methodology since our adoption of the disclosure provisions of SFAS No. 123,Accounting for Stock-Based Compensation, or SFAS 123. The decrease in the historical volatility used to value our employee stock options is due to changes in the stock price pattern over the past several years. Our stock price was more volatile in 1998 and 1999 than in recent years. As noted above, we measure volatility over

We base the risk-free interest rate on a periodtraded zero-coupon U.S. Treasury bond with a term substantially equal to the option’s expected term.

Activity for our option plans was as follows for the year ended December 31, 2006:

   Shares Under
Option
  Weighted
Average
Exercise Price

Options outstanding at December 31, 2005

  9,661,758  $19.50

Granted

  1,004,412   54.16

Exercised

  (3,225,064)  15.24

Forfeited

  (154,695)  21.28

Expired

  (400)  32.70
       

Options outstanding at December 31, 2006

  7,286,011  $26.12
       

   Shares
Under
Option
  Weighted
Average
Exercise
Price
  Weighted
Average
Remaining
Contractual
Term
  Aggregate
Intrinsic
Value Per
Share(1)
  Aggregate
Intrinsic
Value
($000)(1)

Options exercisable at December 31, 2006

  3,850,609  $17.35  4.9 Years  $38.03  $146,455

Options vested and expected to vest at December 31, 2006(2)

  7,235,837  $26.00  5.2 Years  $29.42  $212,883

(1)Computed based upon the amount by which the fair market value of our common stock at December 29, 2006 of $55.38 per share exceeded the weighted average exercise price.
(2)We began estimating forfeitures under SFAS 123R upon adoption on January 1, 2006.

The average expected term was 6.0 years in 2004, and therefore the period over which volatility was measured when valuing the 2004total intrinsic value of stock options included these more volatileexercised during 2006 was $133.7 million, compared with $57.8 million during 2005 and $18.9 million during 2004. Cash received from stock option exercises for the years ended December 31, 2006, 2005, and 2004 totaled $49.2 million, $36.4 million, and $30.0 million, respectively.

Total compensation expense related to nonvested options not yet recognized was $19.3 million at December 31, 2006. We expect to recognize this compensation expense over a weighted average period of approximately 1.7 years. The combination of the passage of time and the reduction of the expected term to 5.0 years therefore reduced the volatility used to value stock options granted in 2005.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Restricted Stock Awards

Restricted stock awards are granted with a fair value equal to the market price of our common stock on the date of grant. Compensation expense is recorded straight-line over the vesting period, generally three years from the date of grant.

The weighted average grant date fair value of our restricted stock awards was $54.36, $32.81, and $24.77 for the years ended December 31, 2006, 2005, and 2004, respectively. Activity for our restricted stock awards was as follows for the year ended December 31, 2006:

   Shares  Weighted
Average
Grant-Date
Fair Value

Nonvested restricted stock at December 31, 2005

  489,300  $32.92

Granted

  728,307   54.36

Vested

  (41,665)  54.02

Forfeited

  (68,487)  38.82
       

Nonvested restricted stock at December 31, 2006

  1,107,455  $45.86
       

The fair value of shares vested during the years ended December 31, 2006, 2005, and 2004 was $2.3 million, $0.6 million, and $0.6 million, respectively. Total compensation expense related to nonvested restricted stock awards not yet recognized was $26.9 million at December 31, 2006. We expect to recognize this compensation expense over a weighted average period of approximately 1.8 years. There are no other contractual terms covering restricted stock awards once vested.

Restrospective Application

We adopted SFAS 123R effective January 1, 2006. In accordance with the modified retrospective application method, we have adjusted previously reported results to reflect the effect of expensing stock awards. The cumulative effect adjustment for a change in accounting principle relating to the estimate of forfeitures on all unvested awards at January 1, 2006 was immaterial and is included in compensation expense for the year ended December 31, 2006. The following table illustrates the effect of the retrospective application on the beginning balances of the specified balance sheet accounts as if the fair value method described in SFAS 123R had been applied to all prior years for which the original provisions of SFAS 123 were effective.

   As of
December 31,
2005
  As of
December 31,
2004
 
   (in thousands) 

Other long-term liabilities (net deferred tax liability), before adoption

  $662,129  $604,229 

Adjustment for SFAS 123

   (34,769)  (34,124)
         

Other long-term liabilities (net deferred tax liability), after adoption

  $627,360  $570,105 
         

Capital in excess of par value, before adoption

  $1,098,117  $1,017,156 

Adjustment for SFAS 123

   137,771   137,281 
         

Capital in excess of par value, after adoption

  $1,235,888  $1,154,437 
         

Retained earnings, before adoption

  $1,538,306  $1,229,823 

Adjustment for SFAS 123

   (116,631)  (104,878)
         

Retained earnings, after adoption

  $1,421,675  $1,124,945 
         

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The effect of the retrospective adoption of SFAS 123R on the consolidated statements of income and cash flows for the years presented is as follows:

   For the years ended
December 31,
 
   2005  2004 
   (in thousands, except
per share results)
 

Income from operations, before adoption

  $461,029  $439,022 

Adjustment for SFAS 123

   (18,834)  (16,472)
         

Income from operations, after adoption

  $442,195  $422,550 
         

Income before income taxes, before adoption

  $421,714  $415,850 

Adjustment for SFAS 123

   (18,834)  (16,472)
         

Income before income taxes, after adoption

  $402,880  $399,378 
         

Net income, before adoption

  $308,483  $280,012 

Adjustment for SFAS 123

   (11,753)  (10,065)
         

Net income, after adoption

  $296,730  $269,947 
         

Basic earnings per common share, before adoption

  $1.91  $1.75 

Adjustment for SFAS 123

   (0.08)  (0.07)
         

Basic earnings per common share, after adoption

  $1.83  $1.68 
         

Diluted earnings per common share, before adoption

  $1.87  $1.72 

Adjustment for SFAS 123

   (0.08)  (0.06)
         

Diluted earnings per common share, after adoption

  $1.79  $1.66 
         

Net cash provided by operating activities, before adoption

  $625,627  $347,809 

Adjustment for SFAS 123

   (15,545)  (3,748)
         

Net cash provided by operating activities, after adoption

  $610,082  $344,061 
         

Net cash provided by (used in) financing activities, before adoption

  $293,586  $(75,053)

Adjustment for SFAS 123

   15,545   3,748 
         

Net cash provided by (used in) financing activities, after adoption

  $309,131  $(71,305)
         

12. EARNINGS PER COMMON SHARE COMPUTATION

Detail supporting the computation of basic and diluted earnings per common share was as follows for the years ended December 31, 2006, 2005 2004 and 2003:2004:

 

  2005  2004  2003  2006  2005  2004
  (in thousands, except per share results)  (in thousands, except per share results)

Net income available for common stockholders

  $308,483  $280,012  $228,934  $487,423  $296,730  $269,947
                  

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

   161,714   160,421   158,968   164,137   161,714   160,421

Dilutive effect of:

            

Employee stock options

   3,565   1,999   1,240   3,542   3,751   2,448

Restricted stock awards

   95   36   1,752   317   95   36
                  

Shares used to compute diluted earnings per common share

   165,374   162,456   161,960   167,996   165,560   162,905
                  

Basic earnings per common share

  $1.91  $1.75  $1.44  $2.97  $1.83  $1.68
                  

Diluted earnings per common share

  $1.87  $1.72  $1.41  $2.90  $1.79  $1.66
                  

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Stock options to purchase 9,934854,379 shares in 2006, 826,587 shares in 2005, 2,134,184and 2,865,166 shares in 2004 and 4,209,266 shares in 2003 were anti-dilutive and, therefore, were not included in the computations of diluted earnings per common share.

13. STOCKHOLDERS’ EQUITY

Stock Repurchases

During 2005,2006, we acquired 68,296467,767 of our common shares in connection with employee stock plans at an aggregate cost of $2.4$26.2 million, or an average of $34.62$56.03 per share.

Stockholders’ Rights Plan

Our stockholders’ rights plan expired in accordance with its terms in February 2006.

Regulatory Requirements

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

As of December 31, 2005,2006, we maintained aggregate statutory capital and surplus of $1,203.2$2,066.0 million in our state regulated subsidiaries. Each of these subsidiaries was in compliance with applicable statutory requirements

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

which aggregated $722.2$1,430.3 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.

Most states rely on risk-based capital requirements, or RBC, to define thetheir required levels of equity.equity discussed above. RBC is a model developed by the National Association of Insurance Commissioners to monitor an entity’s solvency. This calculation indicates recommended minimum levels of required capital and surplus and signals regulatory measures should actual surplus fall below these recommended levels. If RBC were adopted by allthe remaining states and Puerto Rico at December 31, 2005, we2006, each of our subsidiaries would be required to fund $14.7 million in one of our Puerto Rico subsidiaries to meet all requirements. After this funding,substantial compliance and we would have $378.2$516.2 million of aggregate capital and surplus above any of the levels that require corrective action under RBC.RBC, or individual state requirements.

14. COMMITMENTS, GUARANTEES AND CONTINGENCIES

Leases

We lease facilities, computer hardware, and other equipment under long-term operating leases that are noncancelable and expire on various dates through 2023.2017. We sublease facilities or partial facilities to third party tenants for space not used in our operations. Rent with scheduled escalation terms are accounted for on a straight-line basis over the lease term. Rent expense and sublease rental income, which are recorded net as an administrative expense, for all operating leases was as follows for the years ended December 31, 2006, 2005 2004 and 2003:2004:

 

  2005 2004 2003   2006 2005 2004 
  (in thousands)   (in thousands) 

Rent expense

  $81,357  $78,222  $70,815   $104,711  $81,357  $78,222 

Sublease rental income

   (11,192)  (11,291)  (12,007)   (10,442)  (11,192)  (11,291)
                    

Net rent expense

  $70,165  $66,931  $58,808   $94,269  $70,165  $66,931 
                    

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Future annual minimum payments due subsequent to December 31, 20052006 under all of our noncancelable operating leases with initial terms in excess of one year are as follows:

 

  Minimum
Lease
Payments
  Sublease
Rental
Receipts
 Net Lease
Commitments
  Minimum
Lease
Payments
  Sublease
Rental
Receipts
 Net Lease
Commitments
  (in thousands)  (in thousands)

For the years ending December 31:

          

2006

  $84,993  $(4,163) $80,830

2007

   71,969   (3,562)  68,407  $88,196  $(1,988) $86,208

2008

   49,653   (1,863)  47,790   66,974   (774)  66,200

2009

   31,882   (889)  30,993   50,217   (173)  50,044

2010

   30,443   (515)  29,928   41,103   —     41,103

2011

   23,021   —     23,021

Thereafter

   28,173   (1,325)  26,848   15,368   —     15,368
                  

Total

  $297,113  $(12,317) $284,796  $284,879  $(2,935) $281,944
                  

Purchase Obligations

We have agreements to purchase services, primarily information technology related services, or to make improvements to real estate, in each case that are enforceable and legally binding on us and that specify all significant terms, including: fixed or minimum levels of service to be purchased; fixed, minimum or variable

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

price provisions; and the appropriate timing of the transaction. We have purchase obligation commitments of $24.0 million in 2006, $11.6$27.4 million in 2007, $6.7$14.5 million in 2008, $2.4$3.7 million in 2009, $2.8 million in 2010 and $1.7$1.3 million thereafter. Purchase obligations exclude agreements that are cancelable without penalty.

Off-Balance Sheet Arrangements

As part of our ongoing business, we do not participate or knowingly seek to participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or SPEs,special purpose entities (SPEs), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2005,2006, we are not involved in any SPE transactions.

Guarantees and Indemnifications

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 for $8.9 million 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 amountThe residual value payment 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

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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 Medicare business, which accounted for approximately 32%55% of our total premiums and ASO fees for the year ended December 31, 2005,2006, primarily consisted of HMO, PPO and Fee-For-Service products covered under the Medicare Advantage and stand-alone PDP contracts with the federal government. TheThese contracts are renewed generally for a one-year term each December 31 unless CMS notifies Humana of its decision not to renew by May 1 of the contract year, or Humana notifies CMS of its decision not to renew by the first Monday in June of the contract year. All material contracts between Humana and CMS relating to our Medicare business have been renewed for 2007.

Our TRICARE business, which accounted for approximately 17%12% of our total premiums and ASO fees for the year ended December 31, 2005,2006, primarily consisted of the South Region contract. The 5-year South Region contract is subject to annual renewals on April 1 of each year at the Government’sgovernment’s option. Effective April 1, 2006, the South Region contract was extended into the third option andperiod, which runs from April 1, 2006 to March 31, 2007. We have received a notice from the government of its intent to renew the fourth option period. The 5-year South Region contract expires March 31, 2009. ThisAs required under the contract, contains provisions to negotiate athe target underwritten health care cost amount annually withand underwriting fee amounts for the federal government.third option period were negotiated. Any variance from the target health care cost is shared with the federal government. As such,Accordingly, events and circumstances not contemplated in the negotiated target health care cost amount could have a material adverse effect on our business. These changes may include, for example, an increase or reduction in the number of

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

persons enrolled or eligible to enroll due to the federal government’s decision to increase or decrease U.S. military presence around the world.deployments. In the event government reimbursements were to decline from projected amounts, our failure to reduce the health care costs associated with these programs could have a material adverse effect on our business.

Our Medicaid business, which accounted for approximately 4%3% of our total premiums and ASO fees for the year ended December 31, 2005,2006, consisted of contracts in Puerto Rico Florida and Illinois.Florida. Our 3-yearMedicaid contracts with the Puerto Rico Health Insurance Administration which accounted for approximately 3%2% of our total premium and ASO fees for the year ended December 31, 2005, were extended a fourth year and these contracts expire on June 30, 2006. We currently are preparing to bid onoperating under the newterms of our contracts that will be effective July 2006 although a requestexpired October 31, 2006. Due to several ongoing and unresolved issues with the program, the government of Puerto Rico has decided to delay the bid process for such proposal has not yet been issued bynew contracts. We currently are working with the Puerto Rico Health Insurance Administration. At this timeAdministration regarding terms and rates which is expected to result in an extension of the existing contracts through September 30, 2007. There is no assurance that the Puerto Rico Health Insurance Administration will request such an extension, and we are unable to predict the ultimate impact that any government policy or fiscal decisions might have on the continuation of our Medicaid contracts in Puerto Rico.

Our other current Medicaid contract, which is in Florida, is scheduled to expire on June 30, 2006. Due to Medicaid reform in Florida, we are currently negotiating the terms and rates for the renewal contract. We expect the current contract to be extended until August 31, 2006, and the subsequent renewal contract to be effective for a two-year term beginning September 1, 2006. Due to continual decreases in the reimbursement from the state of Illinois, we exited the Illinois Medicaid market effective July 31, 2005. The Illinois and Florida Medicaid contracts accounted for approximately 1% of our total premiums and ASO fees for the year ended December 31, 2005.

Other than as described herein, 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

Since 1999, we have been involved in several purported class action lawsuits that were part of a wave of generally similar actions targeting the health care payer industryOur current and particularly managed care companies. These included a lawsuit against us and originally nine of our competitors that purported to be brought on behalf of physicians who treated our members since January 1, 1990. The plaintiffs asserted that we and other defendants paid providers’ claims incorrectly by paying lesser amounts than they submitted. These cases were consolidated in the United States District Court for the Southern District of Florida (“the Court”), and styledIn re Managed Care Litigation.

On October 17, 2005, we and representatives of over 700,000 physicians and several state medical societies reached an agreement (“Settlement Agreement”) to settle the lawsuit by payment of $40 million for the physicians and an amount up to $18 million for the plaintiffs’ attorneys, subject to approval by the Court. The Settlement Agreement recognizes that we have undertaken certain initiatives to facilitate relationships with, and payments to, physicians and provides for additional initiatives over its four-year term. The Court preliminarily approved the Settlement Agreement on October 19, 2005, and set a Settlement Hearing for March 6, 2006.

Three other defendants, Aetna Inc., Cigna Corporation, and The Prudential Insurance Company of America previously entered into settlement agreements that have been approved by the Court. Health Net, Inc. announced a settlement agreement on May 2, 2005, and Wellpoint, Inc. (formerly WellPoint Health Networks, Inc. and Anthem, Inc.) announced a settlement agreement on July 11, 2005.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

In connection with the settlement and other related litigation costs, we recorded pretax administrative expense of $71.9 million ($44.8 million after taxes, or $0.27 per diluted common share) in the third quarter of 2005.

Other Litigation and Proceedings

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.

In addition, ourpast business practices are subject to review by various state insurance and health care regulatory authorities and other state and federal regulatory authorities. There has been increased scrutiny by these regulators ofThese authorities regularly scrutinize the business practices of managed care companies,health insurance and benefits companies. These reviews focus on numerous facets of our business, including allegations of anticompetitive and unfair business activities, claims payment practices, competitive practices, commission paymentpayments, privacy issues,

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

utilization management practices, and utilization managementsales practices. Some of these reviews have historically resulted in fines imposed on us and some have required changes into some of our practices. We continue to be subject to these reviews, which could result in additional fines or other sanctions being imposed on us or additional changes in some of our practices.

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

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

The outcome of current suits or likelihood or outcome of future suits or governmental investigations cannot be accurately predicted with certainty. In addition, the potential for increased liability for medical negligence arising from claims adjudication, along with the increased litigation that has accompanied the negative publicitycertainty, and public perception of our industry, adds to this uncertainty. Therefore,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.

15. SEGMENT INFORMATION

We manage our business with two segments: Government and Commercial. The Government segment consists of members enrolled in government-sponsored programs, and includes three lines of business: Medicare, Advantage, TRICARE, and Medicaid. The Commercial segment consists of members enrolled in products marketed to employer groups and individuals, and includes threetwo lines of business: fully insured medical ASO,

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(fully and self insured) and specialty. We identified our segments in accordance with the aggregation provisions of SFAS 131, which is consistent with information used by our Chief Executive Officer in managing our business. The segment information aggregates products with similar economic characteristics. These characteristics include the nature of customer groups and pricing, benefits and underwriting requirements.

The accounting policies of each segment are the same and are described in Note 2. 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 often utilize the same medical provider networks, enabling us to obtain more favorable contract terms with providers. Our segments also share overhead costs and assets. As a result, the profitability of each segment is interdependent.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Our segment results were as follows for the years ended December 31, 2006, 2005, 2004, and 2003:2004:

 

  Government Segment  Government Segment
  2005  2004  2003  2006  2005  2004
  (in thousands)  (in thousands)

Revenues:

            

Premiums:

            

Medicare Advantage

  $4,590,362  $3,086,598  $2,527,446  $8,499,064  $4,590,362  $3,086,598

Medicare stand-alone PDP

   3,050,304   —     —  
         

Total Medicare

   11,549,368   4,590,362   3,086,598

TRICARE

   2,407,653   2,127,595   2,249,725   2,543,930   2,407,653   2,127,595

Medicaid

   548,714   511,193   487,100   520,520   548,714   511,193
                  

Total premiums

   7,546,729   5,725,386   5,264,271   14,613,818   7,546,729   5,725,386

Administrative services fees

   50,059   106,764   148,830   49,442   50,059   106,764

Investment and other income

   21,123   26,261   22,839   117,858   21,123   26,261
                  

Total revenues

   7,617,911   5,858,411   5,435,940   14,781,118   7,617,911   5,858,411
                  

Operating expenses:

            

Medical

   6,272,045   4,825,064   4,439,007   12,424,047   6,272,045   4,825,064

Selling, general and administrative

   956,762   710,522   726,185   1,730,243   963,354   715,299

Depreciation and amortization

   56,310   44,488   43,831   85,071   56,310   44,488
                  

Total operating expenses

   7,285,117   5,580,074   5,209,023   14,239,361   7,291,709   5,584,851
                  

Income from operations

   332,794   278,337   226,917   541,757   326,202   273,560

Interest expense

   9,526   4,497   3,211   27,912   9,526   4,497
                  

Income before income taxes

  $323,268  $273,840  $223,706  $513,845  $316,676  $269,063
                  

Premium and administrative services revenues derived from our contracts with the federal government, as a percentage of our total premium and ASO revenues, were approximately 67% for 2006, 51% for 2005 and 43% for 2004 and 42% for 2003.2004.

   Commercial Segment
   2006  2005  2004
   (in thousands)

Revenues:

      

Premiums:

      

Fully insured:

      

PPO

  $3,684,442  $3,635,347  $3,786,501

HMO

   2,019,936   2,432,768   2,827,981
            

Total fully insured

   5,704,378   6,068,115   6,614,482

Specialty

   410,986   386,747   349,564
            

Total premiums

   6,115,364   6,454,862   6,964,046

Administrative services fees

   291,769   209,378   166,032

Investment and other income

   228,286   135,976   115,836
            

Total revenues

   6,635,419   6,800,216   7,245,914
            

Operating expenses:

      

Medical

   4,997,157   5,379,425   5,844,583

Selling, general and administrative

   1,291,266   1,232,250   1,179,037

Depreciation and amortization

   63,527   72,548   73,304
            

Total operating expenses

   6,351,950   6,684,223   7,096,924
            

Income from operations

   283,469   115,993   148,990

Interest expense

   35,229   29,789   18,675
            

Income before income taxes

  $248,240  $86,204  $130,315
            

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

   Commercial Segment
   2005  2004  2003
   (in thousands)

Revenues:

      

Premiums:

      

Fully insured:

      

PPO

  $3,635,347  $3,786,501  $3,369,109

HMO

   2,432,768   2,827,981   2,871,697
            

Total fully insured

   6,068,115   6,614,482   6,240,806

Specialty

   386,747   349,564   320,206
            

Total premiums

   6,454,862   6,964,046   6,561,012

Administrative services fees

   209,378   166,032   122,846

Investment and other income

   135,976   115,836   106,513
            

Total revenues

   6,800,216   7,245,914   6,790,371
            

Operating expenses:

      

Medical

   5,379,425   5,844,583   5,440,414

Selling, general and administrative

   1,220,008   1,167,342   1,131,843

Depreciation and amortization

   72,548   73,304   82,948
            

Total operating expenses

   6,671,981   7,085,229   6,655,205
            

Income from operations

   128,235   160,685   135,166

Interest expense

   29,789   18,675   14,156
            

Income before income taxes

  $98,446  $142,010  $121,010
            

16. REINSURANCE

Certain old blocks of run-off insurance assumed in acquisitions, primarily life insurance and annuities, are subject to 100% coinsurance agreements where the underwriting risk and all administrative functions, including premium collections and claim payments, related to these policies has been ceded to a third-party. Coinsurance is a form of reinsurance. We acquired these policies and the related reinsurance agreements with the purchase of the stock of the companies in which the policies were originally written. We acquired these companies for business reasons unrelated to these policies, including the companies’ licenses necessary to fulfill strategic plans.

A reinsurance agreement between two entities transfers the underwriting risk of policyholder liabilities to a reinsurer; while the primary insurer retains the contractual relationship with the ultimate insured. As such, these reinsurance agreements do not completely relieve us of our potential liability to the ultimate insured. However, given the transfer of underwriting risk, our potential liability is limited to the credit exposure which exists should the reinsurer be unable to meet theirits obligations assumed under these reinsurance agreements.

Given that all policies are 100% reinsured by third parties, the following amounts pertaining to the reinsurance agreements had no effect on our results of operations. Premiums ceded were $15.7 million in 2006, $21.7 million in 2005, and $30.0 million in 2004, and $45.3 million in 2003.2004. Liabilities, included in other long-term liabilities, and related reinsurance recoverables, included in other long-term assets, in the accompanying consolidated balance sheets under these coinsurance agreements were $242.7 million at December 31, 2006 and $253.4 million at December 31, 2005 and $260.6 million at December 31, 2004.

Humana Inc.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

2005.

We evaluate the financial condition of these reinsurers on a regular basis. These reinsurers are well-known and well-established, as evidenced by the strong financial ratings at December 31, 20052006 presented below:

 

Reinsurer

  Total
Recoverable
  

Rating(a)

  Total
Recoverable
  Rating(a)
  (in thousands)     (in thousands)

Protective Life Insurance Company

  $229,019  A+ (superior)  $222,639  A+ (superior)

All others

   24,400  A to A- (excellent)   20,080  A to A- (excellent)
          
  $253,419    $242,719  
          

(a)Ratings are published by A.M. Best Company Inc.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and ShareholdersStockholders

    of Humana Inc.:

We have completed integrated audits of Humana Inc.’s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005, and an audit of its 2003 consolidated financial statements2006, in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements and financial statement schedules

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of stockholders’ equity and of cash flows present fairly, in all material respects, the financial position of Humana Inc. and its subsidiaries at December 31, 20052006 and 2004,2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 20052006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15 (2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

As discussed in Note 2 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004),Share-Based Payment, in accordance with the modified retrospective method effective January 1, 2006.

Internal control over financial reporting

Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 20052006 based on criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005,2006, based on criteria established inInternal Control—Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/    PRICEWATERHOUSECOOPERS LLP

Louisville, Kentucky

March 3, 2006February 23, 2007

Humana Inc.

QUARTERLY FINANCIAL INFORMATION

(Unaudited)

A summary of our quarterly unaudited results of operations for the years ended December 31, 20052006 and 20042005 follows:

 

  2005  2006
  First(a)  Second  Third  Fourth(b)  First  Second(a)  Third  Fourth
  (in thousands, except per share results)  (in thousands, except per share results)

Total revenues

  $3,387,225  $3,546,361  $3,821,461  $3,663,080  $4,704,365  $5,407,169  $5,649,784  $5,655,219

Income before income taxes

   121,687   129,307   71,504   99,216   131,208   140,322   249,374   241,181

Net income

   109,795   84,137   49,944   64,607   83,715   89,489   159,198   155,021

Basic earnings per common share

   0.68   0.52   0.31   0.40   0.51   0.55   0.97   0.94

Diluted earnings per common share

   0.67   0.51   0.30   0.39   0.50   0.53   0.95   0.92
  2004  2005
  First  Second(c)  Third  Fourth
  (in thousands, except per share results)  First(b)(d)  Second(d)  Third(d)  Fourth(c)(d)
  (in thousands, except per share results)

Total revenues

  $3,286,949  $3,431,478  $3,176,273  $3,209,625  $3,387,225  $3,546,361  $3,821,461  $3,663,080

Income before income taxes

   102,773   122,353   127,473   63,251   116,680   124,848   66,678   94,674

Net income

   67,830   80,753   84,303   47,126   106,735   81,412   46,807   61,776

Basic earnings per common share

   0.42   0.50   0.53   0.30   0.66   0.50   0.29   0.38

Diluted earnings per common share

   0.41   0.50   0.52   0.29   0.65   0.49   0.28   0.37

(a)Includes the operations of CHA Health since May 1, 2006, the date of its acquisition.
(b)Includes the operations of CarePlus since February 16, 2005, the date of its acquisition.
(b)(c)Includes the operations of Corphealth since December 20, 2005, the date of its acquisition.
(c)(d)IncludesWe adopted Statement of Financial Accounting Standards No. 123 (revised 2004),Share-Based Payment, or SFAS 123R, on January 1, 2006. We have adjusted prior period amounts to reflect the operationseffect of Ochsner since April 1, 2004,expensing stock awards under the datemodified retrospective application method of its acquisition.SFAS 123R.

ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

Not applicable.

 

ITEM 9A.CONTROLS AND PROCEDURES

Management’s Responsibility for Financial Statements and Other Information

We are responsible for the preparation and integrity of the consolidated financial statements appearing in our Annual Report. The consolidated financial statements were prepared in conformity with accounting principles generally accepted in the United States and include amounts based on our estimates and judgments. All other financial information in this report has been presented on a basis consistent with the information included in the financial statements.

Our control environment is the foundation for our system of internal control over financial reporting and is embodied in our Business Ethics Policy. It sets the tone of our organization and includes factors such as integrity and ethical values. Our internal control over financial reporting is supported by formal policies and procedures which are reviewed, modified and improved as changes occur in business conditions and operations.

The Audit Committee of the Board of Directors, which is composed solely of independent outside directors, meets periodically with members of management, the internal auditors and our independent registered public accounting firm to review and discuss internal controls over financial reporting and accounting and financial reporting matters. Our independent registered public accounting firm and internal auditors report to the Audit Committee and accordingly have full and free access to the Audit Committee at any time.

Evaluation of Disclosure Controls and Procedures

We have established disclosure controls and procedures to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to members of senior management and the Board of Directors.

Based on our evaluation as of December 31, 2005,2006, we as the principal executive officer, the principal financial officer and the principal accounting officer of the Company have concluded that the Company’s disclosure controls and procedures (as defined in the Securities Exchange Act of 1934) are effective to ensure that the information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as specified in Securities and Exchange Commission rules and forms.

Management’s Report on Internal Control Over Financial Reporting

We are responsible for establishing and maintaining effective internal control over financial reporting as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate or that the degree of compliance with the policies or procedures may deteriorate.

We assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005.2006. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) inInternal Control—Integrated Framework. Based on our assessment, we determined that, as of December 31, 2005,2006, the Company’s internal control over financial reporting was effective based on those criteria.

Our assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005,2006, has been audited by PricewaterhouseCoopers, LLP, our independent registered public accounting firm who also audited the Company’s consolidated financial statements included in our Annual Report on Form 10-K, as stated in their report which appears on page 94.93.

Michael B. McCallister

President and Chief Executive Officer

James H. Bloem

Senior Vice President and Chief Financial Officer

Steven E. McCulley

Vice President and Controller, Principal Accounting Officer

 

ITEM 9B.OTHER INFORMATION

None.

PART III

 

ITEM 10.DIRECTORS, AND EXECUTIVE OFFICERS OF THE REGISTRANTAND CORPORATE GOVERNANCE

Directors

The information required by this Item is herein incorporated by reference from our Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on April 27, 200626, 2007 appearing under the caption “Election of Directors” and “Section 16(a) Beneficial Ownership Reporting Compliance” of such Proxy Statement.

Executive Officers

Set forth below are names and ages of all of our current executive officers as of MarchFebruary 1, 2006,2007, their positions, and the date first elected an officer:

 

Name

Age

Position

First
Elected

Officer

Michael B. McCallister

53President and Chief Executive Officer09/89(1)

James E. Murray

52Chief Operating Officer08/90(2)

John M. Bertko

56Vice President—Chief Actuary03/00(3)

James H. Bloem

55Senior Vice President—Chief Financial Officer and Treasurer02/01(4)

Bruce J. Goodman

64Senior Vice President—Chief Service and Information Officer04/99(5)

Bonita C. Hathcock

57Senior Vice President—Chief Human Resources Officer05/99(6)

Arthur P. Hipwell

57Senior Vice President—General Counsel08/90(7)

Thomas J. Liston

44Senior Vice President—Strategy and Corporate Development01/97(8)

Jonathan T. Lord, M.D.  

51Senior Vice President—Chief Innovation Officer04/00(9)

Heidi S. Margulis

52Senior Vice President—Government Relations12/95(10)

Steven E. McCulley

44Vice President & Controller (Principal Accounting Officer)08/04(11)

Steven O. Moya

56Senior Vice President—Chief Marketing Officer01/01(12)
Name  Age  Position  First
Elected
Officer
 

Michael B. McCallister

  54  President and Chief Executive Officer  09/89(1)

James E. Murray

  53  Chief Operating Officer  08/90(2)

John M. Bertko

  57  Vice President—Chief Actuary  03/00(3)

James H. Bloem

  56  Senior Vice President—Chief Financial Officer and Treasurer  02/01(4)

Bruce J. Goodman

  65  Senior Vice President—Chief Service and Information Officer  04/99(5)

Bonita C. Hathcock

  58  Senior Vice President—Chief Human Resources Officer  05/99(6)

Arthur P. Hipwell

  58  Senior Vice President—General Counsel  08/90(7)

Thomas J. Liston

  45  Senior Vice President—Strategy and Corporate Development  01/97(8)

Jonathan T. Lord, M.D.  

  52  Senior Vice President—Chief Innovation Officer  04/00(9)

Heidi S. Margulis

  53  Senior Vice President—Government Relations  12/95(10)

Steven E. McCulley

  45  Vice President & Controller (Principal Accounting Officer)  08/04(11)

Steven O. Moya

  57  Senior Vice President—Chief Marketing Officer  01/01(12)

(1)Mr. McCallister was elected President, Chief Executive Officer and a member of the Board of Directors in February 2000. Prior to that, Mr. McCallister served as Senior Vice President—Health System Management from January 1998 to February 2000. Mr. McCallister joined the Company in June 1974.
(2)Mr. Murray currently serves as Chief Operating Officer, having held this position since February 2006. Prior to that, Mr. Murray held the position of Chief Operating Officer—Market and Business Segment Operations from September 2002 to February 2006, Chief Operating Officer—Service Operations from February 2001 to September 2002, and Chief Operating Officer—Health Plan Division and Interim Chief Financial Officer from February 2000 to February 2001. Mr. Murray joined the Company in October 1989.
(3)Mr. Bertko currently serves as Vice President—Chief Actuary and joined the Company in October 1999 as Vice President—Actuarial Consulting.
(4)Mr. Bloem currently serves as Senior Vice President, Chief Financial Officer and Treasurer, having held this position since July 2002. Prior to that, Mr. Bloem served as Senior Vice President and Chief Financial Officer from February 2001, when he joined the company, through July 2002.
(5)Mr. Goodman currently serves as Senior Vice President and Chief Service and Information Officer having held this position since September 2002. Mr. Goodman joined the Company in April 1999 as Senior Vice President and Chief Information Officer.
(6)Ms. Hathcock currently serves as Senior Vice President and Chief Human Resources Officer having held this position since May 1999 when she joined the Company.
(7)Mr. Hipwell currently serves as Senior Vice President and General Counsel having held this position since September 1999. Mr. Hipwell joined the Company in 1979.
(8)Mr. Liston currently serves as Senior Vice President—Strategy & Corporate Development having held this position since July 2000. Mr. Liston joined the Company in 1995.

(9)Dr. Lord currently serves as Senior Vice President and Chief Innovation Officer having held this position since September 2002. Prior to that, he served as Senior Vice President and Chief Clinical Strategy and Innovation Officer from February 2001 to September 2002. Dr. Lord joined the Company in April 2000 as Senior Vice President and Chief Medical Officer.
(10)Ms. Margulis currently serves as Senior Vice President—Government Relations having held this position since January 2000. Prior to that, she served as Vice President—Government Affairs from May 1996 to January 2000. Ms. Margulis joined the Company in November 1985.
(11)Mr. McCulley currently serves as Vice President & Controller (Principal Accounting Officer) having held this position since August 2004. Prior to that, he served as Vice President & Controller from January 2001 to August 2004, Vice President and Chief Financial Officer of Market Operations from May 2000 to January 2001. Mr. McCulley joined the company in 1990.
(12)Mr. Moya currently serves as Senior Vice President and Chief Marketing Officer having held this position since January 2001.

Executive officers are elected annually by the Company’s Board of Directors and serve until their successors are elected or until resignation or removal. There are no family relationships among any of the executive officers of the Company.

Section 16(a) Beneficial Ownership Reporting Compliance

The information required by this Item is herein incorporated by reference from our Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on April 26, 2007 appearing under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” of such Proxy Statement.

Code of Ethics for Chief Executive Officer and Senior Financial Officers

The Company has adopted a Code of Ethics for the Chief Executive Officer and Senior Financial Officers, violations of which should be reported to the Audit Committee. The code may be viewed on our web site at www.humana.com. Any amendment to or waiver of the application of the Code of Ethics for the Chief Executive Officer and Senior Financial Officers will be promptly disclosed on the Company’s web site at www.humana.com.

Code of Business Conduct and Ethics

Since 1995, the Company has operated under an omnibus Code of Ethics and Business Conduct, known as the Humana Inc. Principles of Business Ethics, which includes provisions ranging from restrictions on gifts to conflicts of interest. All employees and directors are required to annually affirm in writing their acceptance of the code. The Humana Inc. Principles of Business Ethics was adopted by our Board of Directors in February 2004 as the document to comply with the New York Stock Exchange Corporate Governance Standard 303A.10. The Humana Inc. Principles of Business Ethics is available at our web site www.humana.com and upon a written request addressed to Humana Inc. Corporate Secretary at 500 West Main Street, 27th Floor, Louisville, Kentucky 40202. Any waiver of the application of the Humana Inc. Principles of Business Ethics to directors or executive officers must be made by the Board of Directors and will be promptly disclosed on our web site at www.humana.com.

Corporate Governance Items

We have made available free of charge on or through the Investor Relations section of our Internet web site (http:(http://www.humana.com)www.humana.com) our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Proxy Statements, and all of our other reports, and, if applicable, amendments to those reports filed or furnished pursuant to Section 13(a) of the Exchange Act, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Also available on our Internet web site is information about our Board of

Directors, including a determination of independence for each member, the various committees of our Board of Directors, the charters of these committees, the name(s) of the Directors designated as a financial expert under rules and regulations promulgated by the SEC, the process for designating a lead director to act at executive sessions of the non-management Directors, the pre-approval process of non-audit services provided by our independent accountants, the process by which stockholders can communicate with Directors, the process by which stockholders can make Director nominations, the Company’s Corporate Governance guidelines,Guidelines, the Humana Principles of Business Ethics, and the Code of Ethics for the Chief Executive Officer and Senior Financial Officers. Any waivers or amendments for Directors or Executive Officers to the Principles of Business Ethics and the Code of Ethics for the Chief Executive Officer and Senior Financial Officers will be promptly displayed on our web site. The Company will provide any of these documents in print without charge to any stockholder who makes a written request to: Corporate Secretary, Humana Inc., 500 West Main Street, 27th floor, Louisville, Kentucky 40202. Additional information about these items can be found in, and is incorporated by reference to, the Company’s Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on April 27, 2006.26, 2007.

Material Changes to the Procedures by which Security Holders May Recommend Nominees to the Registrant’s Board Of Directors

The information required by this Item is herein incorporated by reference from our Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on April 26, 2007 appearing under the caption “Majority Vote Policy” of such Proxy Statement.

Audit Committee Financial Expert

The information required by this Item is herein incorporated by reference from our Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on April 27, 200626, 2007 appearing under the caption “Corporate Governance-Audit Committee” of such Proxy Statement.

Audit Committee Composition and Independence

The information required by this Item is herein incorporated by reference from our Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on April 27, 200626, 2007 appearing under the caption “Corporate Governance-Committee Composition” of such Proxy Statement.

Code of Ethics for Chief Executive Officer and Senior Financial Officers

The Company has adopted a Code of Ethics for the Chief Executive Officer and Senior Financial Officers, violations of which should be reported to the Audit Committee. The code may be viewed on our web site at www.humana.com.Any amendment to or waiver of the application of the Code of Ethics for the Chief Executive Officer and Senior Financial Officers will be promptly disclosed on the Company’s web site at www.humana.com.

Code of Business Conduct and Ethics

Since 1995, the Company has operated under an omnibus Code of Ethics and Business Conduct, known as the Humana Inc. Principles of Business Ethics, which includes provisions ranging from restrictions on gifts to conflicts of interest. All employees and directors are required to annually affirm in writing their acceptance of the code. The Humana Inc. Principles of Business Ethics was adopted by our Board of Directors in February 2004 as the document to comply with the New York Stock Exchange Corporate Governance Standard 303A.10. The Humana Inc. Principles of Business Ethics are available at our web site www.humana.com and upon a written request addressed to Humana Inc. Corporate Secretary at 500 West Main Street, 27th Floor, Louisville, Kentucky 40202. Any waiver of the application of the Humana Inc. Principles of Business Ethics to directors or executive officers must be made by the Board of Directors and will be promptly disclosed on our web site at www.humana.com.

Committee Charters

Charters governing the Audit Committee, Executive Committee, Investment Committee, Nominating & Governance Committee, Organization & Compensation Committee, and Science and Technology Committee of the Board of Directors are available on our web site at www.humana.com and are also available upon a written request addressed to Humana Inc. Corporate Secretary at 500 West Main Street, 27th Floor, Louisville, Kentucky 40202.

Corporate Governance Guidelines

The Board of Directors has adopted Corporate Governance Guidelines, which are intended to comply with the requirements of Section 303A.09 of the NYSE Listed Company Manual. The code was attached as Appendix A to our Proxy Statement for the Annual Meeting of Stockholders held on April 22, 2004 and is incorporated by reference herein. The Corporate Governance Guidelines may be viewed on our web site at www.humana.com and are also available upon a written request addressed to Humana Inc. Corporate Secretary at 500 West Main Street, 27th Floor, Louisville, Kentucky 40202.

Certifications

Our CEO and CFO have signed the certifications required by Sections 302 and 906 of the Sarbanes-Oxley Act. These certifications are filed as Exhibits to this Annual Report on Form 10-K. Additionally, our CEO has signed the certificate as to compliance with the Corporate Governance Listing Standards adopted by the New York Stock Exchange as of December 31, 20042005 and will sign the certificate as to such compliance as of December 31, 2005.2006.

 

ITEM 11.EXECUTIVE COMPENSATION

Additional information required by this Item is incorporated herein by reference from our Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on April 27, 200626, 2007 appearing under the captioncaptions “Compensation Committee Interlocks and Insider Participation,” “Director Compensation,” “Compensation Discussion and Analysis,” “Organization & Compensation Committee Report,” and “Executive Compensation of the Company” of such Proxy Statement.

ITEM 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by this Item is herein incorporated by reference from our Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on April 27, 200626, 2007 appearing under the captioncaptions “Security Ownership of Certain Beneficial Owners of Company Common Stock” and “Equity Compensation Plan Information” of such Proxy Statement.

 

ITEM 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information required by this Item is herein incorporated by reference from our Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on April 27, 200626, 2007 appearing under the captioncaptions “Certain Transactions with Management and Others” and “Independent Directors” of such Proxy Statement.

 

ITEM 14.PRINCIPAL ACCOUNTANTACCOUNTING FEES AND SERVICES

The information required by this Item is herein incorporated by reference from our Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on April 27, 200626, 2007 appearing under the caption “Audit Committee Report” of such Proxy Statement.

Audit Committee Pre-approval Policies and Procedures

The information required by this Item is herein incorporated by reference from our Proxy Statement for the Annual Meeting of Stockholders scheduled to be held on April 27, 2006 appearing under the caption “Audit Committee” and under the caption “Audit Committee Report” of such Proxy Statement.

PART IV

 

ITEM 15.EXHIBITS, AND FINANCIAL STATEMENT SCHEDULES

The financial statements, financial statement scheduleschedules and exhibits set forth below are filed as part of this report.

 

(1)Financial Statements—The response to this portion of Item 15 is submitted as Item 8 of Part II of this report.

(2)The following Consolidated Financial Statement Schedules are included herein:

Schedule I Parent Company Financial Information

Schedule II Valuation and Qualifying Accounts

All other schedules have been omitted because they are not applicable.

  (3)Schedule I Parent Company Financial Information
Exhibits:

Schedule II Valuation and Qualifying Accounts
All other schedules have been omitted because they are not applicable.
(3)Exhibits:
3(a)  Restated Certificate of Incorporation filed with the Secretary of State of Delaware on November 9, 1989, as restated to incorporate the amendment of January 9, 1992, and the correction of March 23, 1992. Exhibit 4(i) to the Company’s Post-Effective Amendment No.1 to the Registration Statement on Form S-8 (Reg. No. 33-49305) filed February 2, 1994, is incorporated by reference herein.
  (b)  By-laws, as amended. Exhibit 3(b) to the Company’s Annual Reportamended, on Form 10-K for the fiscal year ended December 31, 1997, is incorporated by reference herein.January 4, 2007, filed herewith.
   4(a)  Indenture dated as of August 2001 covering the Company’s 7 1/4% Senior Notes due 2006. Exhibit 4.1 to Registration Statement No. 333-63384 is incorporated by reference herein.
    (b)  4(a)  Indenture dated August 5, 2003 covering the Company’s Senior Debt Securities. Exhibit 4.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003, is incorporated by reference herein.
    (c)    (b)  First Supplemental Indenture dated August 5, 2003 covering the Company’s 6.30% Senior Notes due 2018. Exhibit 4.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003, is incorporated by reference herein.
  (c)Second Supplemental Indenture dated May 31, 2006 covering the Company’s 6.450% Senior Notes due 2016. Exhibit 4.1 to the Company’s 8-K filed on May 31, 2006, is incorporated by reference herein.
  (d)Indenture dated March 30, 2006 by and between the Company and The Bank of New York Trust Company, N.A., as trustee. Exhibit 4.2 to the Company’s Form S-3 filed on March 31, 2006, is incorporated by reference herein.
  (e)  There are no instruments defining the rights of holders with respect to long-term debt in excess of 10 percent of the total assets of the Company on a consolidated basis. Other long-term indebtedness of the Company is described herein in Note 910 to Consolidated Financial Statements. The Company agrees to furnish copies of all such instruments defining the rights of the holders of such indebtedness not otherwise filed as an Exhibit to the Form 10-K to the Commission upon request.
10(a)*1989 Stock Option Plan for Employees. Exhibit A to the Company’s Proxy Statement covering the Annual Meeting of Stockholders held on January 11, 1990, is incorporated by reference herein.
    (b)*Amendment No. 1 to the 1989 Stock Option Plan for Employees. Annex B to the Company’s Proxy Statement covering the Annual Meeting of Stockholders held on February 18, 1993, is incorporated by reference herein.
    (c)*Amendment No. 2 to the 1989 Stock Option Plan for Employees. Exhibit 10(e) to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1993, is incorporated by reference herein.
    (d)10(a)*  1989 Stock Option Plan for Non-Employee Directors. Exhibit B to the Company’s Proxy Statement covering the Annual Meeting of Stockholders held on January 11, 1990, is incorporated by reference herein.

10(e)    (b)*  Amendment No. 1 to the 1989 Stock Option Plan for Non-Employee Directors. Annex C to the Company’s Proxy Statement covering the Annual Meeting of Stockholders held on February 18, 1993, is incorporated by reference herein.
    (f)    (c)*  Amendment No. 2 to the 1989 Stock Option Plan for Non-Employee Directors. Exhibit 10(h) to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1993, is incorporated by reference herein.

    (g)10(d)*  1989 Stock Option Plan for Non-Employee Directors, as amended and restated in 1998. Exhibit A to the Company’s Proxy Statement covering the Annual Meeting of Stockholders held on May 14, 1998, is incorporated by reference herein.
    (h)    (e)*  1996 Stock Incentive Plan for Employees. Annex A to the Company’s Proxy Statement covering the Annual Meeting of Stockholders held on May 9, 1996, is incorporated by reference herein.
    (i)    (f)*  1996 Stock Incentive Plan for Employees as amended in 1998. Exhibit C to the Company’s Proxy Statement covering the Annual Meeting of Stockholders held on May 14, 1998, is incorporated by reference herein.
    (j)    (g)*  Humana Inc. Non-Qualified Stock Option Plan for Employees. Exhibit 99 to the Company’s Form S-8 Registration Statement No. 333-86801 filed on September 9, 1999, is incorporated by reference herein.
    (k)    (h)*  Form of Company’s Stock Option Agreement under the 1996 Stock Incentive Plan for Employees (Non-Qualified Stock Options). Exhibit 10(a) to the Company’s Form 8-K filed on August 26, 2004, is incorporated by reference herein.
    (l)    (i)*  Form of Company’s Stock Option Agreement under the 1996 Stock Incentive Plan for Employees (Incentive Stock Options). Exhibit 10(b) to the Company’s Form 8-K filed on August 26, 2004, is incorporated by reference herein.
    (m)    (j)*  Form of Company’s Stock Option Agreement under the 2003 Stock Incentive Plan (Non-Qualified Stock Options). Exhibit 10(c) to the Company’s Form 8-K filed on August 26, 2004, is incorporated by reference herein.
    (n)    (k)*  Form of Company’s Stock Option Agreement under the 2003 Stock Incentive Plan (Incentive Stock Options). Exhibit 10(d) to the Company’s Form 8-K filed on August 26, 2004, is incorporated by reference herein.
    (o)    (l)*  Humana Inc. Amended and Restated 2003 Stock Incentive Plan. Appendix BA to the Company’s Proxy Statement covering the Annual Meeting of Stockholders held on May 15, 2003,April 27, 2006, is incorporated by reference herein.
    (p)   (m)*  Humana Inc. 2003 Executive Management Incentive Compensation Plan. Appendix C to the Company’s Proxy Statement covering the Annual Meeting of Stockholders held on May 15, 2003, is incorporated by reference herein.
    (q)    (n)*  Restated agreement providing for termination benefits in the event of a change of control. Exhibit 10(m) to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1997, is incorporated by reference herein.
    (r)    (o)*  Employment Agreement—Michael B. McCallister. Exhibit 10 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2000, is incorporated by reference herein.
    (s)    (p)*  Trust under Humana Inc. Deferred Compensation Plans. Exhibit 10(p) to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1999, is incorporated by reference herein.

10(t)    (q)*  The Humana Inc. Deferred Compensation Plan for Non-Employee Directors. Exhibit 10(s) to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003, is incorporated by reference herein.
    (u)    (r)*  Severance policy. Exhibit 10 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1999, is incorporated by reference herein.
    (v)    (s)*  Humana Officers’ Target Retirement Plan, as amended. Exhibit 10(p) to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1997, is incorporated by reference herein.

    (w)  10(t)*  Summary of Changes to Humana Inc. Retirement Plans, as amended. Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003, is incorporated by reference herein.
    (x)    (u)*  Humana Supplemental Executive Retirement and Savings Plan, as amended and restated on December 31, 2003. Exhibit 10(w) to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003, is incorporated by reference herein.
    (y)    (v)*  Letter agreement with Company officers concerning health insurance availability. Exhibit 10(mm) to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 1994, is incorporated by reference herein.
    (z)    (w)*  Executive Long-Term Disability Program. Exhibit 10(a) to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2004, is incorporated by reference herein.
    (aa)

      (x)*

  Indemnity Agreement. Appendix B to the Company’s Proxy Statement covering the Annual Meeting of Stockholders held on January 8, 1987, is incorporated by reference herein.
    (bb)

      (y)*

  Form of Company’s Restricted Stock Agreement under the 1996 Stock Incentive Plan. Exhibit 10(cc) to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004, is incorporated by reference herein.
    (cc)

      (z)*

  Form of Company’s Restricted Stock Agreement under the 2003 Stock Incentive Plan. Exhibit 10(dd) to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004, is incorporated by reference herein.
    (dd)

    (aa)*

  Summary of the Company’s Financial Planning Program for eight executive officers. Current Report on Form 8-K dated December 15, 2005, is incorporated by reference herein.
    (ee)

    (bb)*

  Form of Combined Option and Restricted Stock Agreement with Restrictive Covenants filed herewith.
    (ff) Five-Year Credit Agreement.under the 2003 Stock Incentive Plan. Exhibit 10(b)10(ee) to the Company’s QuarterlyAnnual Report on Form 10-Q10-K for the quarterfiscal year ended September 30, 2004,December 31, 2005, is incorporated by reference herein.
    (gg) 

    (cc)

Five-Year Credit Agreement. Exhibit 10 to the Company’s 8-K filed on July 14, 2006, is incorporated by reference herein.

    (dd)

  Agreement between the United States Department of Defense and Humana Military Healthcare Services, Inc., a wholly owned subsidiary of the Company dated as September 1, 2003. Exhibit 10(gg) to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004, is incorporated by reference herein.
    (hh) 

    (ee)

  Form of CMS Coordinated Care Plan Agreement. Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005, is incorporated by reference herein.

10(ii)         

     (ff)

  Form of CMS Private Fee for Service Agreement. Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005, is incorporated by reference herein.
    (jj)       

    (gg)

  Addendum to Agreement Providing for the Operation of a Medicare Voluntary Prescription Drug Plan. Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005, is incorporated by reference herein.
    (kk)      

    (hh)

  Addendum to Agreement Providing for the Operation of an Employer/Union-only Group Medicare Advantage Prescription Drug Plan. Exhibit 10.4 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005, is incorporated by reference herein.

    (ll)        

 10(ii)

  Addendum to Agreement Providing for the Operation of an Employer/Union-only Group Medicare Advantage-Only Plan. Exhibit 10.5 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005, is incorporated by reference herein.
    (mm)    

     (jj)

  Addendum to Agreement Providing for the Operation of a Medicare Advantage Regional Coordinated Care Plan. Exhibit 10.6 to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2005, is incorporated by reference herein.
    (nn)      

    (kk)

  Explanatory Note regarding Medicare Prescription Drug Plan Contracts between Humana and CMS, filed herewith.CMS. Exhibit 10(nn) to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005, is incorporated by reference herein.

     (jj)

Underwriting Agreement dated May 25, 2006 among the Company, Citigroup Global Markets Inc. and Wachovia Capital Markets, LLC as representatives of the several Underwriters. Exhibit 1.1 to the Company’s 8-K filed on May 26, 2006, is incorporated by reference herein.

12

  Computation of ratio of earnings to fixed charges, filed herewith.

14

  Code of Conduct for Chief Executive Officer & Senior Financial Officers. Exhibit 14 to the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003, is incorporated by reference herein.

21

  List of subsidiaries, filed herewith.

23

  Consent of PricewaterhouseCoopers LLP, filed herewith.

31.1

  CEO certification pursuant to Rule 13a-14(a)/15d-14(a), filed herewith.

31.2

  CFO certification pursuant to Rule 13a-14(a)/15d-14(a), filed herewith.

32

  Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes—Oxley Act of 2002, filed herewith.


*Exhibits 10(a) through and including 10(ee)10(bb) are compensatory plans or management contracts.

Humana Inc.

SCHEDULE I—PARENT COMPANY FINANCIAL INFORMATION

CONDENSED BALANCE SHEETS

 

  December 31,   December 31, 
  2005 2004   2006 2005 
  (in thousands, except share
amounts)
   (in thousands, except share
amounts)
 
ASSETS     

Current assets:

      

Cash and cash equivalents

  $169,206  $242,868   $319,340  $169,206 

Investment securities

   250,399   196,420    105,024   250,399 

Receivable from operating subsidiaries

   197,172   115,813    330,891   197,172 

Securities lending collateral

   1,983   7,991    1,081   1,983 

Other current assets

   87,833   67,696    325,002   87,833 
              

Total current assets

   706,593   630,788    1,081,338   706,593 

Property and equipment, net

   352,013   292,523    407,345   352,013 

Investments in subsidiaries

   3,159,349   2,530,458    4,117,757   3,159,349 

Notes receivable from operating subsidiaries

   7,000   17,000    —     7,000 

Other

   58,320   75,087    44,278   58,320 
              

Total assets

  $4,283,275  $3,545,856   $5,650,718  $4,283,275 
              
LIABILITIES AND STOCKHOLDERS’ EQUITY     

Current liabilities:

      

Payable to operating subsidiaries

  $568,313  $400,960   $902,463  $568,313 

Current portion of notes payable to operating subsidiaries

   27,600   27,600    27,600   27,600 

Book overdraft

   46,847   53,526    56,153   46,847 

Other current liabilities

   230,947   211,595    254,205   230,947 

Securities lending payable

   1,983   7,991    1,081   1,983 

Current portion of long-term debt

   301,254   —      —     301,254 
              

Total current liabilities

   1,176,944   701,672    1,241,502   1,176,944 

Long-term debt

   513,790   636,696    1,269,100   513,790 

Notes payable to operating subsidiaries

   18,000   18,000    18,000   18,000 

Other

   100,436   99,364    68,230   65,667 
              

Total liabilities

   1,809,170   1,455,732    2,596,832   1,774,401 
              

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; 179,062,807 shares issued in 2005, and 176,044,649 shares issued in 2004

   29,843   29,340 

Treasury stock, at cost, 15,846,384 shares in 2005, and 15,778,088 shares in 2004

   (203,364)  (201,000)

Common stock, $0.16 2/3 par; 300,000,000 shares authorized; 182,947,691 shares issued in 2006, and 179,062,807 shares issued in 2005

   30,491   29,843 

Treasury stock, at cost, 16,314,151 shares in 2006, and 15,846,384 shares in 2005

   (229,575)  (203,364)

Other stockholders’ equity

   2,647,626   2,261,784    3,252,970   2,682,395 
              

Total stockholders’ equity

   2,474,105   2,090,124    3,053,886   2,508,874 
              

Total liabilities and stockholders’ equity

  $4,283,275  $3,545,856   $5,650,718  $4,283,275 
              

See accompanying notes to the parent company financial statements.

Humana Inc.

SCHEDULE I—PARENT COMPANY FINANCIAL INFORMATION

CONDENSED STATEMENTS OF OPERATIONS

 

  For the year ended December 31,  For the year ended December 31, 
  2005 2004 2003  2006  2005 2004 
  (in thousands)  (in thousands) 

Revenues:

         

Management fees charged to operating subsidiaries

  $581,362  $502,833  $458,373  $798,472  $581,362  $502,833 

Investment income and other income, net

   23,657   18,312   19,883   91,109   23,657   18,312 
                   
   605,019   521,145   478,256   889,581   605,019   521,145 

Expenses:

         

Selling, general and administrative

   486,900   412,761   357,041   676,613   499,787   423,614 

Depreciation

   81,634   87,597   82,478   96,215   81,634   87,597 

Interest

   40,935   24,857   21,229   63,587   40,935   24,857 
                   
   609,469   525,215   460,748   836,415   622,356   536,068 
                   

(Loss) income before income taxes and equity in net earnings of subsidiaries

   (4,450)  (4,070)  17,508

(Benefit) provision for income taxes

   (37,093)  (14,075)  10,944

Income (loss) before income taxes and equity in net earnings of subsidiaries

   53,166   (17,337)  (14,923)

Provision (benefit) for income taxes

   25,181   (44,174)  (20,482)
                   

Income before equity in net earnings of subsidiaries

   32,643   10,005   6,564   27,985   26,837   5,559 

Equity in net earnings of subsidiaries

   275,840   270,007   222,370   459,438   269,893   264,388 
                   

Net income

  $308,483  $280,012  $228,934  $487,423  $296,730  $269,947 
                   

See accompanying notes to the parent company financial statements.

Humana Inc.

SCHEDULE I—PARENT COMPANY FINANCIAL INFORMATION

CONDENSED STATEMENTS OF CASH FLOWS

 

  For the year ended December 31,   For the year ended December 31, 
  2005 2004 2003   2006 2005 2004 
  (in thousands)   (in thousands) 

Net cash provided by operating activities

  $430,335  $266,775  $200,011   $330,722  $414,790  $263,027 

Cash flows from investing activities:

        

Acquisitions

   (498,948)  —     —      (2,810)  (498,948)  —   

Purchases of investment securities

   (200,048)  (989,757)  (388,138)   (119,753)  (200,048)  (989,757)

Proceeds from sale of investment securities

   193,391   812,796   244,442    264,439   193,391   812,796 

Maturities of investment securities

   22,041   56,740   65,393    29,005   22,041   56,740 

Purchases of property and equipment, net

   (141,124)  (98,953)  (90,765)   (147,719)  (141,124)  (98,953)

Capital contributions to operating subsidiaries

   (116,000)  (5,201)  (17,000)   (723,501)  (116,000)  (5,201)

Surplus note redemption from operating subsidiaries

   10,000   —     35,000    7,000   10,000   —   

Change in securities lending collateral

   6,008   (7,991)  —      902   6,008   (7,991)

Other

   —     (4,726)  70    29   —     (4,726)
                    

Net cash used in investing activities

   (724,680)  (237,092)  (150,998)   (692,408)  (724,680)  (237,092)
                    

Cash flows from financing activities:

        

Borrowings under credit agreement

   494,000   —     —      550,000   494,000   —   

Repayments under credit agreement

   (294,000)  —     —      (300,000)  (294,000)  —   

Net conduit commercial paper borrowings

   —     —     (265,000)

Proceeds from issuance of senior notes

   —     —     299,139    498,545   —     —   

Proceeds from swap exchange

   —     —     31,556 

Repayments of senior notes

   (300,000)  —     —   

Debt issue costs

   —     (1,954)  (3,331)   (5,980)  —     (1,954)

Change in book overdraft

   (6,679)  (77,422)  73,463    9,306   (6,679)  (77,422)

Change in securities lending payable

   (6,008)  7,991   —      (902)  (6,008)  7,991 

Repayment of notes issued to operating subsidiaries

   —     —     (31,500)

Common stock repurchases

   (2,364)  (67,024)  (44,147)   (26,211)  (2,364)  (67,024)

Tax benefit from stock-based compensation

   38,839   15,545   3,748 

Proceeds from stock option exercises and other

   35,734   29,918   25,475    48,223   35,734   29,918 
                    

Net cash provided by (used in) financing activities

   220,683   (108,491)  85,655    511,820   236,228   (104,743)
                    

(Decrease) increase in cash and cash equivalents

   (73,662)  (78,808)  134,668 

Increase (decrease) in cash and cash equivalents

   150,134   (73,662)  (78,808)

Cash and cash equivalents at beginning of year

   242,868   321,676   187,008    169,206   242,868   321,676 
                    

Cash and cash equivalents at end of year

  $169,206  $242,868  $321,676   $319,340  $169,206  $242,868 
                    

See accompanying notes to the parent company financial statements.

Humana Inc.

SCHEDULE I—PARENT COMPANY FINANCIAL INFORMATION

NOTES TO CONDENSED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

Parent company financial information has been derived from our consolidated financial statements and excludes the accounts of all operating subsidiaries. This information should be read in conjunction with our consolidated financial statements.

We adopted Statement of Financial Accounting Standards No. 123 (revised 2004),Share-Based Payment, or SFAS 123R, on January 1, 2006. We have adjusted prior period amounts to reflect the effect of expensing stock awards under the modified retrospective application method of SFAS 123R as discussed in Note 11 of the notes to consolidated financial statements in the Annual Report on Form 10-K.

2. TRANSACTIONS WITH SUBSIDIARIES

Management Fee

Through intercompany service agreements approved, if required, by state regulatory authorities, Humana Inc., our parent company, charges a management fee for reimbursement of certain centralized services provided to its subsidiaries including information systems, disbursement, investment and cash administration, marketing, legal, finance, and medical and executive management oversight.

Dividends

Cash dividends received from subsidiaries and included as a component of net cash provided by operating activities were $247.5 million in 2006, $236.0 million in 2005 and $126.0 million in 2004 and $131.0 million in 2003.2004.

Guarantee

Through indemnity agreements approved by state regulatory authorities, certain of our regulated subsidiaries generally are guaranteed by 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 has also guaranteed the obligations of our TRICARE subsidiaries.

Notes Receivables from Operating Subsidiaries

We funded certain subsidiaries with surplus note agreements. These notes are generally non-interest bearing and may not be entered into or repaid without the prior approval of the applicable Departments of Insurance.

Notes Payable to Operating Subsidiaries

We borrowed funds from certain subsidiaries with notes generally collateralized by real estate. These notes, which have various payment and maturity terms, bear interest ranging from 5.07%5.65% to 6.65% and are payable between 20062007 and 2009. We recorded interest expense of $2.6 million, $2.2 million $1.7 million and $3.9$1.7 million related to these notes for the years ended December 31, 2006, 2005 2004 and 2003,2004, respectively.

3. REGULATORY REQUIREMENTS

Certain of our subsidiaries operate in states that regulate the payment of dividends, loans, or other cash transfers to Humana Inc., our parent company, and require minimum levels of equity as well as limit investments

Humana Inc.

SCHEDULE I—PARENT COMPANY FINANCIAL INFORMATION

NOTES TO CONDENSED FINANCIAL STATEMENTS—(Continued)

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.

Humana Inc.

SCHEDULE I—PARENT COMPANY FINANCIAL INFORMATION

NOTES TO CONDENSED FINANCIAL STATEMENTS—(Continued)

As of December 31, 2005,2006, we maintained aggregate statutory capital and surplus of $1,203.2$2,066.0 million in our state regulated subsidiaries. Each of these subsidiaries was in compliance with applicable statutory requirements which aggregated $722.2$1,430.3 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.

Most states rely on risk-based capital requirements, or RBC, to define thetheir required levels of equity.equity discussed above. RBC is a model developed by the National Association of Insurance Commissioners to monitor an entity’s solvency. This calculation indicates recommended minimum levels of required capital and surplus and signals regulatory measures should actual surplus fall below these recommended levels. If RBC were adopted by allthe remaining states and Puerto Rico at December 31, 2005, we2006, each of our subsidiaries would be required to fund $14.7 million in one of our Puerto Rico subsidiaries to meet all requirements. After this funding,substantial compliance and we would have $378.2$516.2 million of aggregate capital and surplus above any of the levels that require corrective action under RBC.RBC, or individual state requirements.

4. ACQUISITIONS

Refer to Note 3 of the notes to consolidated financial statements in the Annual Report on Form 10-K for a description of acquisitions.

5. INCOME TAXES

The decreasereduction in 2005 tax expense primarily related to the recognition of a $22.8 million contingent tax benefit and associated $3.1 million reversal of accrued interest resulting from the resolution of an uncertain tax position associated with the 2000 tax year during the first quarter of 2005 in connection with the expiration of the statute of limitations. Refer to Note 89 of the notes to consolidated financial statements in the Annual Report on Form 10-K for a description of income taxes.

Humana Inc.

SCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS

For the Years Ended December 31, 2006, 2005, 2004, and 20032004

(in thousands)

 

        Additions            Additions    
  Balance at
Beginning
of Period
  Acquired
Balances
  Charged
(Credited) to
Costs and
Expenses
 Charged to
Other
Accounts(1)
 Deductions
or
Write-offs
 Balance at
End of
Period
  Balance at
Beginning
of Period
  Acquired
Balances
  Charged
(Credited) to
Costs and
Expenses
 Charged to
Other
Accounts(1)
 Deductions
or
Write-offs
 Balance at
End of
Period

Allowance for loss on receivables:

                  

2006

  $32,557  $—    $20,901  $(717) $(7,152) $45,589

2005

  $34,506  $—    $4,566  $(1,027) $(5,488) $32,557   34,506   —     4,566   (1,027)  (5,488)  32,557

2004

   40,400   355   6,433   (1,338)  (11,344)  34,506   40,400   355   6,433   (1,338)  (11,344)  34,506

2003

   30,178   —     7,416   6,584   (3,778)  40,400

Deferred tax asset valuation allowance:

                  

2006

   —     —     —     —     —     —  

2005

   20,123   —     (5,198)  —     (14,925)  —     20,123   —     (5,198)  —     (14,925)  —  

2004

   26,978   —     (6,855)  —     —     20,123   26,978   —     (6,855)  —     —     20,123

2003

   36,470   —     (9,492)  —     —     26,978

(1)Represents changes in retroactive membership adjustments to premium revenues as more fully described in Note 2 to the consolidated financial statements.

SIGNATURES

Pursuant to the requirements of Sections 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized.

 

HUMANA INC.
By:   /s/    JAMES H. BLOEM        
 

James H. Bloem

Senior Vice President and

Chief Financial Officer

(Principal Financial Officer)

Date: March 3, 2006

 February 23, 2007

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the date indicated.

 

Signature

  

Title

 

Date

By:

/s/    JAMES H. BLOEM        

James H. Bloem

  

Senior Vice President and

Chief Financial Officer

(Principal (Principal Financial Officer)

 March 3, 2006February 23, 2007

/s/    STEVEN E. MCCULLEY        

Steven E. McCulley

  

Vice President and Controller

(Principal (Principal Accounting Officer)

 March 3, 2006February 23, 2007

/s/    DAVID A. JONES, JR.        

David A. Jones, Jr.

  Chairman of the Board March 3, 2006February 23, 2007

/s/    FRANK A. D’AMELIO        

Frank A. D’Amelio

  Director March 3, 2006February 23, 2007

/s/    W. ROY DUNBAR

W. Roy Dunbar

  Director March 3, 2006February 23, 2007

/s/    JOHN R. HALL        

John R. Hall

DirectorMarch 3, 2006

/s/    KURT J. HILZINGER        

Kurt J. Hilzinger

  Director March 3, 2006February 23, 2007

/s/    MICHAEL B. MCCALLISTER        

Michael B. McCallister

  

Director, President and Chief

Executive Officer

 March 3, 2006February 23 2007

/s/    JAMES J. O’BRIEN        

James J. O’Brien

DirectorFebruary 23, 2007

/s/    W. ANN REYNOLDS, PH.D.        

W. Ann Reynolds, Ph.D.

  Director March 3, 2006February 23, 2007

/s/    JAMES O. ROBBINS        

James O. Robbins

  Director March 3, 2006February 23, 2007

 

113112