HUMANA INC – 10-K – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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Executive Overview
General
Headquartered inLouisville, Kentucky ,Humana is a leading health care company that offers a wide range of insurance products and health and wellness services that incorporate an integrated approach to lifelong well-being. By leveraging the strengths of our core businesses, we believe that we can better explore opportunities for existing and emerging adjacencies in health care that can further enhance wellness opportunities for the millions of people across the nation with whom we have relationships. Our industry relies on two key statistics to measure performance. The benefit ratio, which is computed by taking total benefits expense as a percentage of premiums revenue, represents a statistic used to measure underwriting profitability. The operating cost ratio, which is computed by taking total operating costs as a percentage of total revenue less investment income, represents a statistic used to measure administrative spending efficiency.
Business Segments
We manage our business with three reportable segments: Retail,Employer Group , and Health and Well-Being Services. In addition, the Other Businesses category includes businesses that are not individually reportable because they do not meet the quantitative thresholds required by generally accepted accounting principles. These segments are based on a combination of the type of health plan customer and adjacent businesses centered on well-being solutions for our health plans and other customers, as described below. These segment groupings are consistent with information used by our Chief Executive Officer to assess performance and allocate resources. The Retail segment consists ofMedicare and commercial fully-insured medical and specialty health insurance benefits, including dental, vision, and other supplemental health and financial protection products, marketed directly to individuals.The Employer Group segment consists ofMedicare and commercial fully-insured medical and specialty health insurance benefits, including dental, vision, and other supplemental health and financial protection products, as well as administrative services only products marketed to employer groups. The Health and Well-Being Services segment includes services offered to our health plan members as well as to third parties that promote health and wellness, including provider services, pharmacy, integrated wellness, and home care services. The Other Businesses category consists of our military services, primarily ourTRICARE South Region contract,Medicaid , and closed-block long-term care businesses as well as our contract with CMS to administer the Limited Income Newly Eligible Transition program, or the LI-NET program. The results of each segment are measured by income before income taxes. Transactions between reportable segments consist of sales of services rendered by our Health and Well-Being Services segment, primarily pharmacy, behavioral health, and provider services, to ourRetail and Employer Group customers. Intersegment sales and expenses are recorded at fair value and eliminated in consolidation. Members served by our segments often utilize the same provider networks, enabling us in some instances to obtain more favorable contract terms with providers. Our segments also share indirect costs and assets. As a result, the profitability of each segment is interdependent. We allocate most operating expenses to our segments. Assets and certain corporate income and expenses are not allocated to the segments, including the portion of investment income not supporting segment operations, interest expense on corporate debt, and certain other corporate expenses. These items are managed at the corporate level. These corporate amounts are reported separately from our reportable segments and included with intersegment eliminations. 41
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Seasonality
One of the product offerings of our Retail segment isMedicare stand-alone prescription drug plans, or PDPs, under theMedicare Part D program. These plans provide varying degrees of coverage. Our quarterly Retail segment earnings and operating cash flows are impacted by theMedicare Part D benefit design and changes in the composition of our membership. TheMedicare Part D benefit design results in coverage that varies as a member's cumulative out-of-pocket costs pass through successive stages of a member's plan period which begins annually onJanuary 1 for renewals. These plan designs generally result in us sharing a greater portion of the responsibility for total prescription drug costs in the early stages and less in the latter stages. As a result, the PDP benefit ratio generally decreases as the year progresses. In addition, the number of low-income senior members as well as year-over-year changes in the mix of membership in our stand-alone PDP products affects the quarterly benefit ratio pattern.
Our
2012 Highlights Consolidated
• Our 2012 results reflect the continued implementation of our strategy to
offer our members affordable health care combined with a positive consumer
experience in growing markets. At the core of this strategy is our
integrated care delivery model, which unites quality care, high member
engagement, and sophisticated data analytics. Our approach to primary,
physician-directed care for our members aims to provide quality care that
is consistent, integrated, cost-effective, and member-focused. The model
is designed to improve health outcomes and affordability for individuals
and for the health system as a whole, while offering our members a simple,
seamless healthcare experience. We believe this strategy is positioning us
for continued sustainable growth in both membership and earnings. AtDecember 31, 2012 , approximately 511,700 members, or 26.5%, of our individualMedicare Advantage membership were in risk arrangements under our integrated care delivery model. We expect that number to grow in 2013. • During 2012, we issued$1 billion of senior notes, repurchased 6.25 million shares in open market transactions for$460 million , and
declared dividends to stockholders of
amount of$166 million .
• Our results for the year ended
impacted by a higher benefit ratio. The consolidated benefit ratio
increased 160 basis points to 83.7% for the year ended
compared to 82.1% for the year ended
primarily was due to an increase in the Retail segment benefit ratio
primarily associated with our individual
discussed in our Retail segment highlights that follow. • Comparisons to our 2012 consolidated benefit ratio and operating cost ratio are impacted by the transition to the newTRICARE South Region contract onApril 1, 2012 , which is accounted for similar to an administrative services fee only agreement as described in our Other
Businesses highlights that follow. Our previous contract was accounted for
similar to our fully-insured products.
• As more fully described herein under the section titled "Benefits Expense
Recognition" actuarial standards require the use of assumptions based on
moderately adverse experience, which generally results in favorable
reserve development, or reserves that are considered redundant. We
experienced favorable medical claims reserve development related to prior
fiscal years of$257 million in 2012,$372 million in 2011, and$434 million in 2010. Year-over-year comparisons of the benefit ratio were
negatively impacted by the
medical claims reserve development from 2011 to 2012. 42
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Table of Contents Retail Segment
• On
changes for 2014
payment policies. We believe the Advance Notice indicates a
mid-single-digit decline in the benchmark payment rates from CMS for 2014.
This excludes the impact of the industry premium tax, county rebasing, and
risk factor recalibration, which are anticipated to be discussed in the
final rate notice. However, the Advance Notice is subject to comment, and
the final rates will not be published until
analyzing all operational avenues available to address these preliminary
rates and the related impact on our ability to grow both our
membership and our earnings for 2014. We are committed to providing
quality care and service to our members through the
program. We will be drawing upon our program expertise to comment on the
impact of these preliminary rate changes upon beneficiaries as we provide
comments to CMS. Nonetheless, there can be no assurance that we will be
able to successfully execute operational and strategic initiatives with
respect to changes in the
these strategies may result in a material adverse effect on our results of
operations, financial position, and cash flows.
• As discussed in the detailed Retail segment results of operations
discussion that follows, we experienced a significant increase in the benefit ratio in the Retail segment, with the segment's benefit ratio
increasing 290 basis points to 84.1% for the year ended
The increase primarily was due to a planned increase in the target benefit
ratio associated with positioning for Health Insurance Reform Legislation
funding changes and minimum benefit ratio requirements and a higher
individual
than the assumptions used in our 2012Medicare bids.
• Individual Medicare Advantage membership of 1,927,600 at
increased 287,300 members, or 17.5%, from 1,640,300 at
primarily due to the 2012 enrollment season, as well as age-in enrollment
throughout the year. We acquired approximately 62,600 members with
As discussed below, we divested approximately 12,600 members acquired with
Arcadian effective
the
Advantage membership of approximately 2,011,000 increased more than 83,000
members, or approximately 4%, from
membership additions for the 2013 enrollment season and the Arcadian
related divestitures discussed below. In addition, we significantly
expanded ourHealth Maintenance Organization , or HMO, offerings in 2013, which we believe allow our integrated care delivery model to work more
effectively for our members than any other plan option. The percentage of
individual
2013 enrollment period reached approximately 48%. • IndividualMedicare stand-alone PDP membership of 2,985,600 at
enrollment season, particularly for our national stand-alone Medicare Part
D prescription drug plan co-branded with Wal-Mart Stores, Inc., or the
Humana-Walmart plan, supplemented by dual-eligible and age-in enrollments
throughout the year.
membership grew to approximately 3,113,000, increasing approximately
127,000 members, or 4%, from
additions for the 2013 enrollment season. 43
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• Effective
serving members in 15 U.S. states, increasing our
approximately 62,600 members and expanding our
future growth opportunities. To obtain antitrust approval in connection
with the Arcadian acquisition, we entered into a consent agreement with theUnited States Department of Justice that required divestiture of overlappingMedicare Advantage health plan business in eight areas withinArizona ,Arkansas ,Louisiana ,Oklahoma , andTexas . Accordingly, we divested 12,600 members effectiveJanuary 1, 2013 .
• During 2012, we were successful in our bids for
federal
and
serve the
alliance agreement. Employer Group Segment • Fully-insured groupMedicare Advantage membership of 370,800 atDecember 31, 2012 increased 80,200 members, or 27.6%, from 290,600 atDecember 31, 2011 primarily due to theJanuary 2012 addition of a new large group retiree account.
Health and Well-Being Services Segment
• On
Metropolitan, a
medical care for
primarily inFlorida . We paid$11.25 per share in cash to acquire all of the outstanding shares of Metropolitan and repaid all outstanding debt of
Metropolitan for a transaction value of
expenses.
OnOctober 29, 2012 , we acquired a noncontrolling equity interest inMCCI Holdings, LLC , or MCCI, a privately held MSO headquartered inMiami, Florida that coordinates medical care forMedicare Advantage andMedicaid beneficiaries primarily inFlorida andTexas . The Metropolitan and MCCI transactions are expected to provide us with components of a successful integrated care delivery model that has demonstrated scalability to new markets. A substantial portion of the revenues for both Metropolitan and MCCI are derived from services provided to Humana Medicare Advantage members under capitation contracts with our health plans. In addition, Metropolitan and MCCI provide services toMedicare Advantage andMedicaid members under capitation contracts with third party health plans. Under these capitation agreements withHumana and third party health plans, Metropolitan and MCCI assume financial risk associated with theseMedicare Advantage andMedicaid members. • OnJuly 6, 2012 , we acquiredSeniorBridge Family Companies, Inc. , or
SeniorBridge, a chronic-care provider of in-home care for seniors, expanding our existing clinical and home health capabilities and strengthening our offerings for members with complex chronic-care needs. Other Businesses
• On
Region contract that the
Activity, or TMA, awarded to us on
Region contract, which expires
renewals on
option. The TMA has notified us of its intent to exercise its option to
extend the
account for revenues under the new contract net of estimated health care
costs similar to an administrative services fee only agreement. Our
previous contract was accounted for similar to our fully-insured products.
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• Year-over-year comparisons within Other Businesses are impacted by the
transition to the new
including a change in profitability under the new contract in connection
with our bid strategy, benefits expense of approximately$46 million incurred related to the settlement of litigation associated with our military services business during 2012, and benefits expense of$29 million for reserve strengthening associated with our closed-block of long-term care policies during 2012 as discussed in Note 17 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data.
Health Insurance Reform
The Patient Protection and Affordable Care Act and The Health Care and Education Reconciliation Act of 2010 (which we collectively refer to as the Health Insurance Reform Legislation) enacted significant reforms to various aspects of the U.S. health insurance industry. While regulations and interpretive guidance on some provisions of the Health Insurance Reform Legislation have been issued to date by theDepartment of Health and Human Services, or HHS, theDepartment of Labor , theTreasury Department , and theNational Association of Insurance Commissioners , there are many provisions of the legislation that will require additional guidance and clarification in the form of regulations and interpretations in order to fully understand the impacts of the legislation on our overall business, which we expect to occur over the next several years.
Implementation dates of the Health Insurance Reform Legislation began in
• Many changes are already effective and have been implemented by the
Company, including: elimination of pre-existing condition limits for
enrollees under age 19, elimination of certain annual and lifetime caps on
the dollar value of benefits, expansion of dependent coverage to include
adult children until age 26, a requirement to provide coverage for
prescribed preventive services without cost to members, new claim appeal
requirements, and the establishment of an interim high risk program for
those unable to obtain coverage due to a pre-existing condition or health
status. • EffectiveJanuary 1, 2011 , minimum benefit ratios were mandated for all
commercial fully-insured medical plans in the large group (85%), small group (80%), and individual (80%) markets, with annual rebates to policyholders if the actual benefit ratios, calculated in a manner prescribed by HHS, do not meet these minimums. We began accruing for
rebates in 2011, based on the manner prescribed by HHS, with initial
rebate payments made in
calculated from financial statements prepared in accordance with
accounting principles generally accepted in
or GAAP, differ from the benefit ratios calculated as prescribed by HHS
under the Health Insurance Reform Legislation. The more noteworthy
differences include the fact that the benefit ratio calculations
prescribed by HHS are calculated separately by state and legal entity;
independently for individual, small group, and large group fully-insured
products; reflect actuarial adjustments where the membership levels are
not large enough to create credible size; exclude some of our health
insurance products; include taxes and fees as reductions of premium; treat
changes in reserves differently than GAAP; and classify rebate amounts as
additions to incurred claims as opposed to adjustments to premiums for GAAP reporting.
•
and in 2012, additional cuts to
take effect (with plan payment benchmarks ultimately ranging from 95% in
high-cost areas to 115% in low-cost areas of
rates), with changes being phased-in over two to six years, depending on
the level of payment reduction in a county. In addition, beginning in 2011
the gap in coverage forMedicare Part D prescription drug coverage is incrementally closing.
• Beginning in 2014, the Health Insurance Reform Legislation requires: all
individual and group health plans to guarantee issuance and renew coverage
without pre-existing condition exclusions or health-status rating
adjustments; the elimination of annual limits on coverage on certain
plans; the 45
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establishment of federally facilitated or state-based exchanges for individuals and small employers (with up to 100 employees) coupled with programs designed to spread risk among insurers; the introduction of plan
designs based on set actuarial values; the establishment of a minimum
benefit ratio of 85% for
assessments, including an annual premium-based assessment and a three-year
assessment levied on the insurance industry is
increasing annual amounts thereafter, growing to
is not deductible for income tax purposes, which will significantly
increase our effective income tax rate in 2014.
of Insurance Commissioners, or NAIC, is continuing discussions regarding
the accounting for the insurance industry premium-based assessment and may
require accrual and associated subsidiary funding consideration for the
first two years of the assessment in 2014 followed by annual accruals
thereafter. The NAIC guidance is contradictory to final GAAP guidance
issued by the FASB inJuly 2011 , which requires annual accrual of the insurance industry premium-based assessment in the year in which it is payable. The Health Insurance Reform Legislation also specifies benefit design guidelines, limits rating and pricing practices, encourages additional competition (including potential incentives for new market entrants) and expands eligibility forMedicaid programs. In addition, the law will increase federal oversight of health plan premium rates and could adversely affect our ability to appropriately adjust health plan premiums on a timely basis. Financing for these reforms will come, in part, from material additional fees and taxes on us and other health plans and individuals beginning in 2014, as well as reductions in certain levels of payments to us and other health plans underMedicare as described herein. In addition, certain provisions in the Health Insurance Reform Legislation tieMedicare Advantage premiums to the achievement of certain quality performance measures (Star Ratings). Beginning in 2012,Medicare Advantage plans with an overall Star Rating of three or more stars (out of five) were eligible for a quality bonus in their basic premium rates. Initially quality bonuses were limited to the few plans that achieved four or more stars as an overall rating, but CMS has expanded the quality bonus to three Star plans for a three year period through 2014. Star Ratings issued by CMS inOctober 2012 indicated that 99% of ourMedicare Advantage members are now in plans that will qualify for quality bonus payments in 2014, up from 98% in 2013. Further, the percentage of ourMedicare Advantage members in plans with an overall Star Rating of four or more stars, including one five star plan, increased to 40%. Plans that earn an overall Star Rating of five are immediately eligible to enroll members year round. Beginning in 2015, plans must have a Star Rating of four or higher to qualify for bonus money. Notwithstanding successful historical efforts to improve our Star Ratings and other quality measures for 2012 and 2013 and the continuation of such efforts, there can be no assurances that we will be successful in maintaining or improving our Star Ratings in future years. Accordingly, our plans may not be eligible for full level quality bonuses, which could adversely affect the benefits such plans can offer, reduce membership, and/or reduce profit margins. As discussed above, implementing regulations and related interpretive guidance continue to be issued on several significant provisions of theHealth Insurance Reform Legislation.Congress may also withhold the funding necessary to implement the Health Insurance Reform Legislation, or may attempt to replace the legislation with amended provisions. Given the breadth of possible changes and the uncertainties of interpretation, implementation, and timing of these changes, which we expect to occur over the next several years, the Health Insurance Reform Legislation will change the way we do business, potentially impacting our pricing, benefit design, product mix, geographic mix, and distribution channels. In particular, implementing regulations and related guidance are forthcoming on various aspects of the minimum benefit ratio requirement's applicability toMedicare , including aggregation, credibility thresholds, and its application to prescription drug plans. The response of other companies to the Health Insurance Reform Legislation and adjustments to their offerings, if any, could cause meaningful disruption in the local health care markets. It is reasonably possible that the Health Insurance Reform Legislation and related regulations, as well as future legislative changes, in the aggregate may have a material adverse effect on our results of operations, including restricting revenue, enrollment and premium growth in certain products and market segments, restricting our 46
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ability to expand into new markets, increasing our medical and operating costs, lowering ourMedicare payment rates and increasing our expenses associated with the non-deductible federal premium tax and other assessments; our financial position, including our ability to maintain the value of our goodwill; and our cash flows. If the new non-deductible federal premium tax and other assessments, including a three-year commercial reinsurance fee, were imposed as enacted, and if we are unable to adjust our business model to address these new taxes and assessments, such as through the reduction of our operating costs or adjustments to premium pricing or benefit design, there can be no assurance that the non-deductible federal premium tax and other assessments would not have a material adverse effect on our results of operations, financial position, and cash flows. 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, including the primary factors that accounted for those changes. Transactions between reportable segments consist of sales of services rendered by our Health and Well-Being Services segment, primarily pharmacy, behavioral health, and provider services, to ourRetail and Employer Group customers and are described in Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. 47
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Comparison of Results of Operations for 2012 and 2011
Certain financial data on a consolidated basis and for our segments was as follows for the years ended
Consolidated Change 2012 2011 Dollars Percentage (dollars in millions, except per common share results) Revenues: Premiums: Retail $ 24,550 $ 21,402 $ 3,148 14.7 % Employer Group 10,138 8,877 1,261 14.2 % Other Businesses 2,321 4,827 (2,506 ) (51.9 )% Total premiums 37,009 35,106 1,903 5.4 % Services: Retail 24 16 8 50.0 % Employer Group 358 356 2 0.6 % Health and Well-Being Services 1,036 903 133 14.7 % Other Businesses 308 85 223 262.4 % Total services 1,726 1,360 366 26.9 % Investment income 391 366 25 6.8 % Total revenues 39,126 36,832 2,294 6.2 % Operating expenses: Benefits 30,985 28,823 2,162 7.5 % Operating costs 5,830 5,395 435 8.1 % Depreciation and amortization 295 270 25 9.3 % Total operating expenses 37,110 34,488 2,622 7.6 % Income from operations 2,016 2,344 (328 ) (14.0 )% Interest expense 105 109 (4 ) (3.7 )% Income before income taxes 1,911 2,235 (324 ) (14.5 )% Provision for income taxes 689 816 (127 ) (15.6 )% Net income $ 1,222 $ 1,419 $ (197 ) (13.9 )% Diluted earnings per common share $ 7.47 $ 8.46 $ (0.99 ) (11.7 )% Benefit ratio (a) 83.7 % 82.1 % 1.6 % Operating cost ratio (b) 15.1 % 14.8 % 0.3 % Effective tax rate 36.1 % 36.5 % (0.4 )%
(a) Represents total benefits expense as a percentage of premiums revenue.
(b) Represents total operating costs as a percentage of total revenues less
investment income. Summary Net income was$1.2 billion , or$7.47 per diluted common share, in 2012 compared to$1.4 billion , or$8.46 per diluted common share, in 2011 primarily due to lower operating results in the Retail segment, partially offset by improved operating performance in the Health and Well-Being Services segment. During 2012, we experienced a significant increase in the Retail segment benefit ratio primarily associated with our individual 48
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Medicare Advantage products primarily due to a planned increase in the target benefit ratio associated with positioning for Health Insurance Reform Legislation funding changes and minimum benefit ratio requirements and a higher benefit ratio experienced on new membership than the assumptions used in our 2012Medicare bids. Our diluted earnings per common share for 2012 included$0.18 per diluted common share for benefits expense related to the settlement of a litigation matter associated with our military services business, as well as$0.11 per diluted common share for benefits expense associated with reserve strengthening associated with our closed block of long-term care policies in our Other Businesses as discussed in Note 17 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data.
Premiums Revenue
Consolidated premiums increased$1.9 billion , or 5.4%, from 2011 to$37.0 billion for 2012 primarily due to increases in bothRetail and Employer Group segment premiums mainly driven by higher average individual and groupMedicare Advantage membership, partially offset by lower premiums for our Other Businesses due to the transition to the newTRICARE South Region contract. As discussed previously, onApril 1, 2012 , we began delivering services under the newTRICARE South Region contract that the TMA awarded to us onFebruary 25, 2011 . We account for revenues under the new contract net of estimated healthcare costs similar to an administrative services fee only agreement, and as such there are no premiums recognized under the new contract. Our previous contract was accounted for similar to our fully-insured products and as such we recognized premiums under the previous contract. Average membership is calculated by summing the ending membership for each month in a period and dividing the result by the number of months in a period. Premiums revenue reflects changes in membership and 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.
Services Revenue
Consolidated services revenue increased$366 million , or 26.9%, from 2011 to$1.7 billion for 2012, primarily due to an increase in service revenue for our Other Businesses due to the transition to the newTRICARE South Region contract onApril 1, 2012 , and an increase in services revenue in our Health and Well-Being Services segment from growth in our Concentra operations and the acquisition of SeniorBridge onJuly 6, 2012 .
Investment Income
Investment income totaled$391 million for 2012, an increase of$25 million from 2011, primarily reflecting net capital gains realized in 2012 as a result of ordinary portfolio management during the year.
Benefits Expense
Consolidated benefits expense was$31.0 billion for 2012, an increase of$2.2 billion , or 7.5%, from 2011 primarily due to a year-over-year increase inRetail and Employer Group segment benefits expense in 2012, primarily driven by an increase in the average number ofMedicare members, partially offset by a decrease in benefits expense for Other Businesses primarily due to the transition to the new administrative services onlyTRICARE South Region contract onApril 1, 2012 . We do not record benefits expense under the new contract. Our previous contract was accounted for similar to our fully-insured products and as such we recorded benefits expense under the previous contract. Retail segment benefits expense increased$3.3 billion , or 18.8%, from 2011 to 2012 andEmployer Group segment benefits expense increased$1.2 billion , or 16.5%, from 2011 to 2012. We experienced favorable medical claims reserve development related to prior fiscal years of$257 million in 2012 and$372 million in 2011. The consolidated benefit ratio for 2012 was 83.7%, increasing 160 basis points from the 2011 benefit ratio of 82.1%, primarily driven by increases in both theRetail and Employer Group segments benefit ratios as 49
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described further in our segment results discussion that follows. The$115 million decline in favorable prior-period medical claims reserve development from 2011 to 2012 negatively impacted year-over-year comparisons of the benefit ratio. Year-over-year comparisons of the consolidated benefit ratio were favorably impacted by 20 basis points due to the continued growth of our Health & Well-Being Services segment and the related savings realized on a consolidated basis from providing these services directly to our members at fair market value rather than through a third party.
Operating Costs
Our segments incur both direct and shared indirect operating costs. We allocate the indirect costs shared by the segments primarily as a function of revenues. As a result, the profitability of each segment is interdependent.
Consolidated operating costs increased
The consolidated operating cost ratio for 2012 was 15.1%, increasing 30 basis points from the 2011 operating cost ratio of 14.8% as the negative impact of the newTRICARE South Region contract being accounted for as an administrative services fee only arrangement was partially offset by improved operating leverage.
Depreciation and Amortization
Depreciation and amortization for 2012 totaled$295 million , an increase of$25 million , or 9.3%, from 2011, primarily reflecting depreciation and amortization expense associated with the acquisitions of Anvita in the fourth quarter of 2011, Arcadian in the first quarter of 2012, SeniorBridge in the third quarter of 2012, and other health and wellness businesses during 2012.
Interest Expense
Interest expense was$105 million for 2012, compared to$109 million for 2011, a decrease of$4 million , or 3.7%. InMarch 2012 , we repaid$36 million of junior subordinated debt that carried a higher interest rate than our senior notes. InDecember 2012 , we issued$600 million of 3.15% senior notes dueDecember 1, 2022 and$400 million of 4.625% senior notes dueDecember 1, 2042 .
Income Taxes
Our effective tax rate during 2012 was 36.1% compared to the effective tax rate of 36.5% in 2011. See Note 10 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. Retail Segment Change 2012 2011 Members Percentage Membership: Medical membership: Individual Medicare Advantage 1,927,600 1,640,300 287,300 17.5 % Individual Medicare stand-alone PDP 2,985,600 2,540,400 445,200 17.5 % Total individual Medicare 4,913,200 4,180,700 732,500 17.5 % Individual commercial 521,400 493,200 28,200 5.7 % Total individual medical members 5,434,600 4,673,900 760,700 16.3 % Individual specialty membership (a) 948,700 782,500 166,200 21.2 % 50
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(a) Specialty products include dental, vision, and other supplemental health and
financial protection products. Members included in these products may not be
unique to each product since members have the ability to enroll in multiple products. Change 2012 2011 Dollars Percentage (in millions) Premiums and Services Revenue: Premiums: Individual Medicare Advantage $ 20,788 $ 18,100 $ 2,688 14.9 % Individual Medicare stand-alone PDP 2,587 2,317 270 11.7 % Total individual Medicare 23,375 20,417 2,958 14.5 % Individual commercial 1,004 861 143 16.6 % Individual specialty 171 124 47 37.9 % Total premiums 24,550 21,402 3,148 14.7 % Services 24 16 8 50.0 %
Total premiums and services revenue
14.7 % Income before income taxes $ 1,162 $ 1,587 $ (425 ) (26.8 )% Benefit ratio 84.1 % 81.2 % 2.9 % Operating cost ratio 11.0 % 11.2 % (0.2 )% Pretax Results
• Retail segment pretax income was
million, or 26.8%, from$1.6 billion in 2011, primarily driven by a year-over-year increase in the benefit ratio partially offset by improvement in the operating cost ratio as described below. Enrollment
• Individual Medicare Advantage membership increased 287,300 members, or
17.5%, from
2012 enrollment season, as well as age-in enrollment throughout the year.
We acquired approximately 62,600 members with Arcadian effective March 31,
2012. As discussed previously, we divested approximately 12,600 members
acquired with Arcadian effective
agreement with theUnited States Department of Justice . • IndividualMedicare stand-alone PDP membership increased 445,200 members,
or 17.5%, from
higher gross sales during the 2012 enrollment season, particularly for our
Humana-Walmart plan offering, supplemented by dual-eligible and age-in
enrollments throughout the year. • Individual specialty membership increased 166,200, or 21.2%, from
membership in dental offerings.
Premiums revenue
• Retail segment premiums increased
2012 primarily due to a 17.6% increase in average individual Medicare
Advantage membership. Individual
decreased approximately 2% in 2012 compared to 2011, primarily driven by a
higher percentage of members that aged-in that generally carry a lower risk score than other members and accordingly a lower premium per member as well as lower per member premiums for members 51
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acquired in connection with the Arcadian acquisition effectiveMarch 31, 2012 . IndividualMedicare stand-alone PDP premiums revenue increased$270 million , or 11.7%, in 2012 compared to 2011 primarily due to a 20.0% increase in average individual PDP membership, partially offset by a decrease in individualMedicare stand-alone PDP per member premiums. This was primarily a result of sales of our Humana-Walmart plan that we began offering for the 2011 plan year. Benefits expense
• The Retail segment benefit ratio increased 290 basis points from 81.2% in
2011 to 84.1% in 2012. During 2012, we experienced a significant increase
in the benefit ratio for our individual
primarily due to a planned increase in the target benefit ratio associated
with positioning for Health Insurance Reform Legislation funding changes
and minimum benefit ratio requirements, a higher benefit ratio experienced
on new membership than the assumptions used in our 2012
increased outpatient utilization for both new and existing members. In
addition, year-over-year comparisons of the benefit ratio were negatively
impacted by lower favorable prior-period medical claims reserve
development in 2012 than in 2011 and a year-over-year increase in
clinicians and other health care quality expenditures given our continuing
growth in membership. The Retail segment's pretax income for 2012 included
the beneficial effect of
claims reserve development versus
prior-period medical claims reserve development decreased the Retail segment benefit ratio by approximately 80 basis points in 2012 versus approximately 110 basis points in 2011. Operating costs
• The Retail segment operating cost ratio of 11.0% for 2012 decreased 20
basis points from 11.2% for 2011 primarily due to scale efficiencies
associated with servicing higher year-over-year membership together with
our continued focus on operating cost efficiencies, partially offset by
higher year-over-year clinical, provider, and technological infrastructure spending. Employer Group Segment Change 2012 2011 Members Percentage Membership: Medical membership: Fully-insured commercial group 1,211,800 1,180,200 31,600 2.7 % ASO 1,237,700 1,292,300 (54,600 ) (4.2 )% Group Medicare Advantage 370,800 290,600 80,200 27.6 % Medicare Advantage ASO 27,700 27,600 100 0.4 %
Total group
25.2 % Group Medicare stand-alone PDP 4,400 4,200 200 4.8 % Total group Medicare 402,900 322,400 80,500 25.0 % Total group medical members 2,852,400 2,794,900 57,500 2.1 %
Group specialty membership (a) 7,136,200 6,532,600 603,600
9.2 %
(a) Specialty products include dental, vision, and other supplemental health and
financial protection products. Members included in these products may not be
unique to each product since members have the ability to enroll in multiple
products. 52
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Table of Contents Change 2012 2011 Dollars Percentage (in millions)
Premiums and Services Revenue:
Premiums:
Fully-insured commercial group
4.5 % Group Medicare Advantage 4,064 3,152 912
28.9 %
Group Medicare stand-alone PDP 8 8 0 0.0 % Total group Medicare 4,072 3,160 912 28.9 % Group specialty 1,070 935 135 14.4 % Total premiums 10,138 8,877 1,261 14.2 % Services 358 356 2 0.6 %
Total premiums and services revenue
13.7 % Income before income taxes $ 253 $ 242 $ 11 4.5 % Benefit ratio 84.1 % 82.4 % 1.7 % Operating cost ratio 16.1 % 17.8 % (1.7 )% Pretax Results
•
ratio partially offset by an increase in the benefit ratio as described
below. Enrollment
• Fully-insured commercial group medical membership increased 31,600
members, or 2.7%, from
due to growth in small group membership partially offset by declines in
large group business. Approximately 59% of our fully-insured commercial
group medical membership was in small group accounts at
compared to 56% atDecember 31, 2011 . • Fully-insured groupMedicare Advantage membership increased 80,200
members, or 27.6%, from
due to the
• Group ASO commercial medical membership decreased 54,600 members, or 4.2%,
from
pricing discipline in a highly competitive environment for self-funded
accounts. • Group specialty membership increased 603,600 members, or 9.2%, fromDecember 31, 2011 toDecember 31, 2012 primarily due to increased cross-selling of our specialty products to our medical membership and growth in stand-alone specialty product sales. Premiums revenue
•
2011 to
In addition, 2012 included the beneficial effect of approximately $25
million associated with revising estimates regarding calculations of 2011
premium rebates payable associated with minimum benefit ratios required
under the Health Insurance Reform Legislation. This change in estimate was
the run out of claims during 2012. 53
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Table of Contents Benefits expense
•
basis points from 82.4% in 2011 primarily due to higher membership in our groupMedicare Advantage products which generally carry a higher benefit
ratio than our fully-insured commercial group products. In addition,
year-over-year comparisons of the benefit ratio were negatively impacted
by lower favorable prior-period medical claims reserve development in 2012
than in 2011. These increases were partially offset by the beneficial
effect on the benefit ratio in 2012 of a reduction in prior-year premium
rebate estimates discussed above. Fully-insured group
members represented 13.0% of totalEmployer Group segment medical membership atDecember 31, 2012 compared to 10.4% atDecember 31, 2011 .The Employer Group segment's pretax income for 2012 included the beneficial effect of$48 million in favorable prior-period medical claims reserve development versus$114 million in 2011. This favorable
prior-period medical claims reserve development decreased the Employer
Group segment benefit ratio by approximately 50 basis points in 2012 versus approximately 130 basis points in 2011. Operating costs
•
170 basis points from 17.8% for 2011 primarily reflecting growth in our
group
cost ratio than our fully-insured commercial group products and continued
savings as a result of our operating cost reduction initiatives.
Health and Well-Being Services Segment
Change 2012 2011 Dollars Percentage (in millions) Revenues: Services: Provider services $ 967 $ 880 $ 87 9.9 % Home care services 40 0 40 100.0 % Pharmacy solutions 16 11 5 45.5 % Integrated wellness services 13 12 1 8.3 % Total services revenues 1,036 903 133 14.7 % Intersegment revenues: Pharmacy solutions 11,352 9,886 1,466 14.8 % Provider services 214 185 29 15.7 % Integrated wellness services 219 175 44 25.1 % Home care services 167 84 83 98.8 % Total intersegment revenues 11,952 10,330 1,622 15.7 %
Total services and intersegment revenues
$ 1,755 15.6 % Income before income taxes $ 486 $ 353 $ 133 37.7 % Operating cost ratio 95.5 % 96.1 % (0.6 )% Pretax results
• Health and Well-Being Services segment pretax income increased $133
million, or 37.7%, from 2011 to
growth in our pharmacy solutions business, including higher utilization of
our mail-order pharmacy by our members. 54
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Table of Contents Script Volume
• Script volumes for the
increased to approximately 238 million in 2012, up approximately 15.5%
versus scripts of approximately 206 million in 2011. The year-over-year
increase primarily reflects growth associated with higher average medical
membership together with an increase in mail order penetration for our Retail segment medical membership in 2012 than in 2011. Services revenue
• Provider services revenue increased
in 2012 primarily due to growth in our Concentra operations and the acquisition of SeniorBridge inJuly 2012 . Intersegment revenues
• Intersegment revenues increased
billion for 2012 primarily due to growth in our pharmacy solutions
business, including our mail-order pharmacy, as it serves our growing
membership, particularly
Operating costs
• The Health and Well-Being Services segment operating cost ratio improved
60 basis points from 2011 to 95.5% for 2012 reflecting scale efficiencies
associated with growth in our pharmacy solutions business, including
higher script volumes in our mail-order pharmacy business.
Other Businesses
Pretax loss for our Other Businesses of$19 million for 2012 compared to pretax income of$84 million for 2011. The year-over-year decline primarily reflects the combined effect of costs in connection with a litigation settlement associated with our military services business in 2012, reserve strengthening for our closed block of long-term care policies in 2012, and a change in profitability under the newTRICARE South Region contract in connection with our bid strategy. 55
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Comparison of Results of Operations for 2011 and 2010
Certain financial data on a consolidated basis and for our segments was as follows for the years ended
Consolidated Change 2011 2010 Dollars Percentage (dollars in millions, except per common share results) Revenues: Premiums: Retail $ 21,402 $ 19,052 $ 2,350 12.3 % Employer Group 8,877 9,080 (203 ) (2.2 )% Other Businesses 4,827 4,580 247 5.4 % Total premiums 35,106 32,712 2,394 7.3 % Services: Retail 16 11 5 45.5 % Employer Group 356 395 (39 ) (9.9 )% Health and Well-Being Services 903 34 869 nm Other Businesses 85 115 (30 ) (26.1 )% Total services 1,360 555 805 145.0 % Investment income 366 329 37 11.2 % Total revenues 36,832 33,596 3,236 9.6 % Operating expenses: Benefits 28,823 27,117 1,706 6.3 % Operating costs 5,395 4,380 1,015 23.2 % Depreciation and amortization 270 245 25 10.2 % Total operating expenses 34,488 31,742 2,746 8.7 % Income from operations 2,344 1,854 490 26.4 % Interest expense 109 105 4 3.8 % Income before income taxes 2,235 1,749 486 27.8 % Provision for income taxes 816 650 166 25.5 % Net income $ 1,419 $ 1,099 $ 320 29.1 % Diluted earnings per common share $ 8.46 $ 6.47 $ 1.99 30.8 % Benefit ratio (a) 82.1 % 82.9 % (0.8 )% Operating cost ratio (b) 14.8 % 13.2 % 1.6 % Effective tax rate 36.5 % 37.2 % (0.7 )%
(a) Represents total benefits expense as a percentage of premiums revenue.
(b) Represents total operating costs as a percentage of total revenues less
investment income. nm - not meaningful Summary Net income was$1.4 billion , or$8.46 per diluted common share, in 2011 compared to$1.1 billion , or$6.47 per diluted common share, in 2010 primarily due to improved operating performance in the Retail and Health and Well-Being Services segments and the negative impact of certain charges described below on 2010 results that did not recur in 2011. Share repurchase activity also contributed to the year-over-year increase in diluted 56
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earnings per common share. Net income for 2010 included the negative impact of a$147 million ($0.55 per diluted common share) write-down of deferred acquisition costs associated with our individual commercial medical policies in our Retail Segment, and a net charge of$139 million ($0.52 per diluted common share) for reserve strengthening associated with our closed block of long-term care policies in our Other Businesses as discussed in Note 17 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data.
Premiums Revenue
Consolidated premiums increased$2.4 billion , or 7.3%, from 2010 to$35.1 billion for 2011, primarily due to an increase in Retail segment premiums, partially offset by a decline inEmployer Group segment premiums. The increase in Retail segment premiums primarily resulted from higher average individualMedicare Advantage membership. The decrease inEmployer Group segment premiums primarily resulted from lower average fully-insured commercial group medical membership. Services Revenue Consolidated services revenue increased$805 million , or 145.0%, from 2010 to$1.4 billion for 2011, primarily due to an increase in provider services revenue in our Health and Well-Being Services segment, primarily as a result of the acquisition of Concentra onDecember 21, 2010 .
Investment Income
Investment income totaled
Benefits Expense
Consolidated benefits expense was$28.8 billion for 2011, an increase of <money>$1.7 billion, or 6.3%, from 2010. The increases were primarily due to a$1.8 billion , or 11.3%, year-over-year increase in Retail segment benefits expense in 2011, primarily driven by an increase in the average number ofMedicare members, partially offset by a decline inEmployer Group segment benefits expense. We experienced favorable medical claims reserve development related to prior fiscal years of$372 million in 2011 and$434 million in 2010. The consolidated benefit ratio for 2011 was 82.1%, declining 80 basis points from the 2010 benefit ratio of 82.9%, primarily driven by a decline in the Retail segment benefit ratio and a net charge for reserve strengthening associated with our closed block of long-term care policies in our Other Businesses in 2010 that did not recur in 2011. Year-over-year comparisons of the benefit ratio were negatively impacted by the$62 million decline in favorable prior-period medical claims reserve development from 2010 to 2011.
Operating Costs
Our segments incur both direct and shared indirect operating costs. We allocate the indirect costs shared by the segments primarily as a function of revenues. As a result, the profitability of each segment is interdependent. Consolidated operating costs increased$1.0 billion , or 23.2%, during 2011 compared to 2010, primarily due to an increase in operating costs in our Health and Well-Being Segment as a result of the acquisition of Concentra onDecember 21, 2010 , as well as an increase in operating costs in our Retail segment as a result of increased expenses associated with servicing higher averageMedicare Advantage membership. Operating costs for 2010 include$147 million for the write-down of deferred acquisition costs associated with our individual commercial medical policies in our Retail Segment. 57
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The consolidated operating cost ratio for 2011 was 14.8%, increasing 160 basis points from the 2010 operating cost ratio of 13.2%. The$147 million write-down of deferred acquisition costs in 2010 increased the operating cost ratio 50 basis points for 2010. Excluding the impact of the write-down of deferred acquisition costs in 2010, the increase primarily reflects the greater percentage of our revenues derived from Concentra, acquiredDecember 21, 2010 , in our Health and Well-Being Services segment, which carries a higher operating cost ratio on external revenues than our other segments, as well as an increase in theRetail and Employer Group segment operating cost ratios.
Depreciation and Amortization
Depreciation and amortization for 2011 totaled$270 million , an increase of$25 million , or 10.2%, from 2010, primarily reflecting depreciation and amortization expense associated with our Concentra operations, acquired onDecember 21, 2010 .
Interest Expense
Interest expense was
Income Taxes
Our effective tax rate during 2011 was 36.5% compared to the effective tax rate of 37.2% in 2010. The higher tax rate for 2010 primarily was due to the cumulative adjustment associated with estimating the retrospective aspect of new limitations on the deductibility of annual compensation in excess of$500,000 per employee as mandated by the Health Insurance Reform Legislation. See Note 10 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. Retail Segment Change 2011 2010 Members Percentage Membership: Medical membership: Individual Medicare Advantage 1,640,300 1,460,700 179,600 12.3 %
Individual
870,100 52.1 % Total individual Medicare 4,180,700 3,131,000 1,049,700 33.5 % Individual commercial 493,200 411,200 82,000 19.9 %
Total individual medical members 4,673,900 3,542,200
1,131,700 31.9 % Individual specialty membership (a) 782,500 510,000 272,500 53.4 %
(a) Specialty products include dental, vision, and other supplemental health and
financial protection products. Members included in these products may not be
unique to each product since members have the ability to enroll in multiple
products. 58
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Table of Contents Change 2011 2010 Dollars Percentage (in millions)
Premiums and Services Revenue:
Premiums:
Individual
11.3 % Individual Medicare stand-alone PDP 2,317 1,959 358 18.3 % Total individual Medicare 20,417 18,224 2,193 12.0 % Individual commercial 861 746 115 15.4 % Individual specialty 124 82 42 51.2 % Total premiums 21,402 19,052 2,350 12.3 % Services 16 11 5 45.5 %
Total premiums and services revenue
12.4 % Income before income taxes $ 1,587 $ 1,289 $ 298 23.1 % Benefit ratio 81.2 % 82.0 % (0.8 )% Operating cost ratio 11.2 % 11.1 % 0.1 % Pretax Results
• Retail segment pretax income was
million, or 23.1%, from
average individual
partially offset by a higher operating cost ratio, discussed below. Pretax
income for 2010 included the negative impact of a
of deferred acquisition costs associated with our individual commercial
medical policies. Enrollment
• Individual Medicare Advantage membership increased 179,600 members, or
12.3%, from
enrollment season as well as age-in enrollment throughout the year.
Individual
approximately 12,100 members acquired with an acquisition effective
December 30, 2011 . • IndividualMedicare stand-alone PDP membership increased 870,100 members,
or 52.1%, from
higher gross sales year-over-year, particularly due to our Humana-Walmart
plan that we began offering for the 2011 plan year, supplemented by dual
eligible and age-in enrollments throughout the year. • Individual specialty membership increased 272,500, or 53.4%, from
in dental offerings.
Premiums revenue
• Retail segment premiums increased
2011 primarily due to a 10.3% increase in average individual Medicare
Advantage membership. Individual
increased
to a 41.9% increase in average individual PDP membership, partially offset
by a decrease in individual
This was primarily a result of sales of our Humana-Walmart plan that we
began offering for the 2011 plan year.
Benefits expense
• The Retail segment benefit ratio decreased 80 basis points from 82.0% in
2010 to 81.2% in 2011. The decline primarily reflects a lower Medicare
Advantage benefit ratio due to lower cost trends arising out of our cost-reduction and outcome-enhancing strategies, including care coordination and care 59
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management, as well as a significant increase in our individual
stand-alone PDP membership in 2011 that carries a lower benefit ratio,
partially offset by lower favorable prior-period medical claims reserve
development in 2011 than in 2010. The Retail segment's pretax income for 2011 included the beneficial effect of$245 million in favorable prior-period medical claims reserve development versus$343 million in 2010. This favorable prior-period medical claims reserve development decreased the Retail segment benefit ratio by approximately 110 basis points in 2011 versus approximately 180 basis points in 2010. Operating costs
• The Retail segment operating cost ratio of 11.2% for 2011 increased 10
basis points from 11.1% for 2010. The
acquisition costs in 2010 increased the operating cost ratio 80 basis
points in 2010. Excluding the impact of the write-down of deferred
acquisition costs, the increase in the operating cost ratio year-over-year
primarily reflects increased expenses associated with theMedicare sales season for 2012 offerings which began a month earlier than in the prior
year and staffing necessary to service anticipated
additions. Further, a higher percentage of membership in individual
ratio, in light of the Humana-Walmart plan, first offered in 2011, which
carries a higher operating cost ratio than otherMedicare products. Employer Group Segment Change 2011 2010 Members Percentage Membership: Medical membership: Fully-insured commercial group 1,180,200 1,252,200 (72,000 ) (5.7 )% ASO 1,292,300 1,453,600 (161,300 ) (11.1 )% Group Medicare Advantage 290,600 273,100 17,500 6.4 % Medicare Advantage ASO 27,600 28,200 (600 ) (2.1 )% Total group Medicare Advantage 318,200 301,300 16,900 5.6 % Group Medicare stand-alone PDP 4,200 2,400 1,800 75.0 % Total group Medicare 322,400 303,700 18,700 6.2 % Total group medical members 2,794,900 3,009,500 (214,600 ) (7.1 )%
Group specialty membership (a) 6,532,600 6,517,500
15,100 0.2 %
(a) Specialty products include dental, vision, and other supplemental health and
financial protection products. Members included in these products may not be
unique to each product since members have the ability to enroll in multiple
products. 60
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Table of Contents Change 2011 2010 Dollars Percentage (in millions) Premiums and Services Revenue: Premiums: Fully-insured commercial group $ 4,782 $ 5,169 $ (387 ) (7.5 )% Group Medicare Advantage 3,152 3,021 131 4.3 % Group Medicare stand-alone PDP 8 5 3 60.0 % Total group Medicare 3,160 3,026 134 4.4 % Group specialty 935 885 50 5.6 % Total premiums 8,877 9,080 (203 ) (2.2 )% Services 356 395 (39 ) (9.9 )%
Total premiums and services revenue
(2.6 )% Income before income taxes $ 242 $ 288 $ (46 ) (16.0 )% Benefit ratio 82.4 % 82.4 % 0.0 % Operating cost ratio 17.8 % 17.5 % 0.3 % Pretax Results
•
required under the Health Insurance Reform Legislation which became
effective in 2011. Enrollment
• Fully-insured commercial group medical membership decreased 72,000
members, or 5.7%, from
due to continued pricing discipline in a highly competitive environment
for large group business partially offset by small group business membership gains.
• Group ASO commercial medical membership decreased 161,300 members, or
11.1%, fromDecember 31, 2010 toDecember 31, 2011 primarily due to continued pricing discipline in a highly competitive environment for self-funded accounts. Premiums revenue
•
2010 to
group medical membership year-over-year and rebates associated with minimum benefit ratios required under the Health Insurance Reform Legislation which became effective in 2011, partially offset by an increase in groupMedicare Advantage membership. Rebates result in the recognition of lower premiums revenue, as amounts are set aside for payments to commercial customers during the following year. Benefits expense
•
from 2010 due to offsetting factors. Factors increasing the 2011 ratio
compared to the 2010 ratio include growth in our group
products which generally carry a higher benefit ratio than our fully-insured commercial group products and the effect of rebates accrued in 2011 associated with the minimum benefit ratios required under the Health Insurance Reform Legislation. Factors decreasing the 2011 ratio compared to the 2010 ratio include the beneficial effect of higher favorable prior-period medical claims reserve development in 2011 versus 2010 and lower utilization of benefits in our commercial group 61
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products in 2011. Fully-insured group
represented 10.4% of total
Group segment's pretax income for 2011 included the beneficial effect of
versus
reserve development decreased the
approximately 130 basis points in 2011 versus approximately 80 basis
points in 2010. Operating costs
•
increased 30 basis points from 17.5% for 2010 primarily reflecting the
impact of lower premiums revenue due to the minimum benefit ratio
regulatory requirements which became effective in 2011.
Health and Well-Being Services Segment
Change 2011 2010 Dollars Percentage (in millions) Revenues: Services: Provider services $ 880 $ 21 $ 859 nm Integrated wellness services 12 13 (1 ) (7.7 )% Pharmacy solutions 11 0 11 100.0 % Total services revenues 903 34 869 nm Intersegment revenues: Pharmacy solutions 9,886 8,410 1,476 17.6 % Provider services 185 170 15 8.8 % Integrated wellness services 175 167 8 4.8 % Home care services 84 39 45 115.4 % Total intersegment revenues 10,330 8,786 1,544 17.6 % Total services and intersegment revenues $ 11,233 $ 8,820 $ 2,413 27.4 % Income before income taxes $ 353 $ 219 $ 134 61.2 % Operating cost ratio 96.1 % 97.2 % (1.1 )% nm - not meaningful Pretax results
• Health and Well-Being Services segment pretax income increased $134
million, or 61.2%, from 2010 to
growth in our pharmacy solutions business together with the addition of
the Concentra business, acquired on
Services revenue
• Provider services revenue increased
in 2011 primarily due to the acquisition of Concentra onDecember 21, 2010 . Intersegment revenues
• Intersegment revenues increased
billion for 2011 primarily due to growth in our pharmacy solutions
business as it serves our growing membership, particularlyMedicare stand-alone PDP. 62
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Table of Contents Operating costs
• The Health and Well-Being Services segment operating cost ratio decreased
110 basis points from 2010 to 96.1% for 2011 reflecting scale efficiencies
associated with growth in our pharmacy solutions business together with the addition of our acquired Concentra operations which carry a lower operating cost ratio than other lines of business in this segment.
Other Businesses
Pretax income for our Other Businesses of$84 million for 2011 compared to pretax losses of$2 million for 2010. Pretax losses for 2010 include the impact of a net charge of$139 million associated with reserve strengthening for our closed block of long-term care policies. Excluding this charge, the year-over-year decline primarily reflects a decrease in pretax income associated with our contract with CMS to administer the LI-NET program.
Liquidity
Our primary sources of cash include receipts of premiums, services revenue, and investment and other income, as well as proceeds from the sale or maturity of our investment securities and borrowings. Our primary uses of cash include disbursements for claims payments, operating costs, interest on borrowings, taxes, purchases of investment securities, acquisitions, capital expenditures, repayments on borrowings, dividends, and share repurchases. Because premiums generally are collected in advance of claim payments by a period of up to several months, our business normally should produce positive cash flows during periods of increasing premiums and enrollment. Conversely, cash flows would be negatively impacted during periods of decreasing premiums and enrollment. From period to period, our cash flows may also be affected by the timing of working capital items. 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 and seek approval before paying dividends from the subsidiaries to the parent. Cash and cash equivalents decreased to$1.3 billion atDecember 31, 2012 from$1.4 billion atDecember 31, 2011 . The change in cash and cash equivalents for the years endedDecember 31, 2012 , 2011 and 2010 is summarized as follows: 2012 2011 2010 (in millions)
Net cash provided by operating activities
Net cash used in investing activities (1,965 ) (1,358
) (1,811 )
Net cash used in financing activities (29 ) (1,017
) (371 )
(Decrease) increase in cash and cash equivalents $ (71 ) $ (296 )
The change in operating cash flows over the three year period primarily results from the corresponding change in earnings, enrollment activity, and changes in working capital items as discussed below. Cash flows were positively impacted byMedicare enrollment gains in 2012, 2011, and 2010 because premiums generally are collected in advance of claim payments by a period of up to several months. 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 payments of benefits expense. We illustrate these changes with the following summaries of receivables and benefits payable. 63
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The detail of total net receivables was as follows atDecember 31, 2012 , 2011 and 2010: Change 2012 2011 2010 2012 2011 2010 (in millions) Medicare $ 422 $ 336 $ 216 $ 86 $ 120 $ (22 ) Commercial and other 346 315 368 31 (53 ) 185 Military services 59 468 427 (409 ) 41 (26 ) Allowance for doubtful accounts (94 ) (85 ) (52 ) (9 ) (33 ) (1 ) Total net receivables $ 733 $ 1,034 $ 959 (301 ) 75 136 Reconciliation to cash flow statement: Provision for doubtful accounts 26 31 19 Receivables from acquisition
(51 ) 0 (109 )
Change in receivables per cash flow statement resulting in cash from operations $ (326 ) $ 106 $ 46Medicare receivables are impacted by revenue growth associated with growth in individual and groupMedicare membership and the timing of accruals and related collections associated with the CMS risk-adjustment model. Military services receivables atDecember 31, 2011 andDecember 31, 2010 primarily consisted of estimated claims owed from the federal government for health care services provided to beneficiaries and underwriting fees under our previousTRICARE South Region contract that expired onMarch 31, 2012 . The claim reimbursement component of military services base receivables is generally collected over a three to four month period. The timing of claim reimbursements resulted in the$41 million increase in base receivables for 2011 as compared to 2010 and the$26 million decrease in base receivables for 2010 as compared to 2009. The$409 million decrease in military services receivables fromDecember 31, 2011 toDecember 31, 2012 primarily resulted from the transition to our newTRICARE South Region contract which we account for similar to an administrative services fee only agreement. As such, beginningApril 1, 2012 , payments of the federal government's claims and related reimbursements for the newTRICARE South Region contract are classified with receipts (withdrawals) from contract deposits as a financing item in our consolidated statements of cash flows. Military services receivables atDecember 31, 2012 primarily consist of administrative services only fees owed from the federal government for administrative services provided under our newTRICARE South Region contract. Commercial and other receivables for 2012, 2011, and 2010 include$166 million ,$144 million , and$109 million , respectively, of patient services receivables acquired with the acquisition of Concentra inDecember 2010 . In addition, the allowance for doubtful accounts increased$33 million from 2010 to 2011. The increase in Concentra receivables in 2010 and the related allowance in 2011 result from the requirement to record acquired balances at fair value at the acquisition date. Excluding the receivables acquired with Concentra, commercial and other receivables reflect the timing of reimbursements from thePuerto Rico Health Insurance Administration for ourMedicaid business. 64
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The detail of benefits payable was as follows atDecember 31, 2012 , 2011 and 2010: Change 2012 2011 2010 2012 2011 2010 (in millions) IBNR (1) $ 2,552 $ 2,056 $ 2,051 $ 496 $ 5 $ 148 Reported claims in process (2) 315 376 137 (61 ) 239 (221 ) Military services benefits payable (3) 4 339 255 (335 ) 84 (24 ) Other benefits payable (4) 908 983
1,026 (75 ) (43 ) 344
Total benefits payable $ 3,779 $ 3,754 $
3,469 25 285 247
Payables from acquisition
(66 ) (29 ) 0
Change in benefits payable per cash flow statement resulting in cash from operations $ (41 ) $ 256 $ 247
(1) IBNR represents an estimate of benefits 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) 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, as
well as amounts owed to our pharmacy benefit administrator which fluctuate
due to bi-weekly payments and the month-end cutoff.
(3) Military services benefits payable primarily represents the run-out of the
claims liability associated with our previous
that expired on
by the federal government is included in the military services receivable in
the receivables table that follows.
(4) Other benefits payable include amounts owed to providers under capitated and
risk sharing arrangements.
The increase in benefits payable in 2012 primarily was due to an increase in IBNR, primarily as a result ofMedicare Advantage membership growth, partially offset by a$335 million decrease in the military services benefits payable due to the run-out of claims under the previousTRICARE South Region contract that expired onMarch 31, 2012 , a decrease in amounts owed to providers under capitated and risk sharing arrangements, and a decrease in the amounts due to our pharmacy benefit administrator which fluctuate due to month-end cutoff. Under the newTRICARE South Region contract effectiveApril 1, 2012 , the federal government retains the risk of the cost of health benefits and related benefit obligation as further described in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. The increase in benefits payable in 2011 primarily was due to an increase in processed but unpaid claims, including amounts due to our pharmacy benefit administrator, which fluctuate due to month-end cutoff, and an increase in military services benefits payable. The increase in benefits payable in 2010 primarily was due to an increase in amounts owed to providers under capitated and risk sharing arrangements as well as an increase in IBNR, both primarily as a result ofMedicare Advantage membership growth, partially offset by a decrease in the amount of processed but unpaid claims, including pharmacy claims, which fluctuate due to the month-end cutoff. In addition to the timing of receipts for premiums and services fees and payments of benefits expense, other working capital items impacting operating cash flows primarily resulted from the timing of payments for theMedicare Part D risk corridor provisions of our contracts with CMS, changes in the timing of the collection of pharmacy rebates, and the timing of payments for premium rebates associated with minimum benefit ratios required under the Health Insurance Reform Legislation. 65
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Cash consideration paid for acquisitions, net of cash acquired, of
We reinvested a portion of our operating cash flows in investment securities, primarily investment-grade fixed income securities, totaling$320 million in 2012,$796 million in 2011, and$756 million in 2010. Our ongoing capital expenditures primarily relate to our information technology initiatives, support of services in our provider services operations including medical and administrative facility improvements necessary for activities such as the provision of care to members, claims processing, billing and collections, wellness solutions, care coordination, regulatory compliance and customer service. Total capital expenditures, excluding acquisitions, were$410 million in 2012,$346 million in 2011, and$222 million in 2010, with 2012 and 2011 reflecting increased spending associated with growth in our provider services and pharmacy businesses in our Health and Well-Being Services segment. Excluding acquisitions, we expect total capital expenditures in 2013 in a range of approximately$425 million to $450 million .
InDecember 2012 , we issued$600 million of 3.15% senior notes dueDecember 1, 2022 and$400 million of 4.625% senior notes dueDecember 1, 2042 . Our net proceeds, reduced for the discount and cost of the offering, were$990 million . We used the proceeds from the offering primarily to finance the acquisition of Metropolitan, including the retirement of Metropolitan's indebtedness, and to pay related fees and expenses.
In
Receipts from CMS associated withMedicare Part D claim subsidies for which we do not assume risk were$341 million less than claims payments during 2012,$378 million less than claim payments during 2011, and$237 million less than claims payments during 2010. Under our new administrative services onlyTRICARE South Region contract that beganApril 1, 2012 , health care cost payments for which we do not assume risk exceeded reimbursements from the federal government by$56 million in 2012. See Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for further description. We repurchased 6.25 million shares for$460 million in 2012, 6.8 million shares for$492 million in 2011, and 1.99 million shares for$100 million in 2010 under share repurchase plans authorized by the Board of Directors. We also acquired common shares in connection with employee stock plans for an aggregate cost of$58 million in 2012,$49 million in 2011, and$8 million in 2010.
During 2012, we paid dividends to stockholders of
The remainder of the cash used in or provided by financing activities in 2012, 2011, and 2010 primarily resulted from proceeds from stock option exercises and the change in book overdraft.Future Sources and Uses of Liquidity
Dividends
InApril 2011 , our Board of Directors approved the initiation of a quarterly cash dividend policy. Declaration and payment of future dividends is at the discretion of our Board of Directors, and may be adjusted as business or market conditions change. 66
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The following table provides details of dividend payments in 2011 and 2012:
Record Payment Amount Total Date Date per Share Amount (in millions) 2011 payments 6/30/2011 7/28/2011 $0.25 $41 9/30/2011 10/28/2011 $0.25 $41 2012 payments 12/30/2011 1/31/2012 $0.25 $41 3/30/2012 4/27/2012 $0.25 $41 6/29/2012 7/27/2012 $0.26 $42 9/28/2012 10/26/2012 $0.26 $41 InOctober 2012 , the Board of Directors declared a cash dividend of$0.26 per share that was paid onJanuary 25, 2013 , for an aggregate amount of$42 million , to stockholders of record as of the close of business onDecember 31, 2012 .
Stock Repurchase Authorization
InApril 2012 , the Board of Directors replaced its previously approved share repurchase authorization of up to$1 billion (of which$461 million remained unused) with the current authorization for repurchases of up to$1 billion of our common shares exclusive of shares repurchased in connection with employee stock plans. The current authorization will expireJune 30, 2014 . Under this share repurchase authorization, shares may be purchased from time to time at prevailing prices in the open market, by block purchases, or in privately-negotiated transactions, subject to certain regulatory restrictions on volume, pricing, and timing. As ofFebruary 1, 2013 , the remaining authorized amount under the current authorization totaled$640 million .
Senior Notes
InDecember 2012 , we issued$600 million of 3.15% senior notes dueDecember 1, 2022 and$400 million of 4.625% senior notes dueDecember 1, 2042 . Our net proceeds, reduced for the discount and cost of the offering, were$990 million . We used the proceeds from the offering primarily to finance the acquisition of Metropolitan, including the retirement of Metropolitan's indebtedness, and to pay related fees and expenses. We previously issued$500 million of 6.45% senior notes dueJune 1, 2016 ,$500 million of 7.20% senior notes dueJune 15, 2018 ,$300 million of 6.30% senior notes dueAugust 1, 2018 , and$250 million of 8.15% senior notes dueJune 15, 2038 . The 7.20% and 8.15% senior notes are subject to an interest rate adjustment if the debt ratings assigned to the notes are downgraded (or subsequently upgraded). In addition, our 7.20%, 8.15%, 3.15%, and 4.625% senior notes contain a change of control provision that may require us to purchase the notes under certain circumstances. All six series of our senior notes, which are unsecured, may be redeemed at our option at any time at 100% of the principal amount plus accrued interest and a specified make-whole amount. Our senior notes are more fully discussed in Note 11 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data.
Credit Agreement
Our 5-year$1.0 billion unsecured revolving agreement expires inNovember 2016 . Under the credit agreement, at our option, we can borrow on either a competitive advance basis or a revolving credit basis. The revolving credit portion bears interest at either LIBOR plus a spread or the base rate plus a spread. The LIBOR spread, currently 120 basis points, varies depending on our credit ratings ranging from 87.5 to 147.5 basis points. We also pay an annual facility fee regardless of utilization. This facility fee, currently 17.5 basis points, may fluctuate between 12.5 and 27.5 basis points, depending upon our credit ratings. 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 based on LIBOR, at our option. 67
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The terms of the credit agreement include standard provisions related to conditions of borrowing, including a customary material adverse effect clause which could limit our ability to borrow additional funds. In addition, the credit agreement contains customary restrictive and financial covenants as well as customary events of default, including financial covenants regarding the maintenance of a minimum level of net worth of$6.6 billion atDecember 31, 2012 and a maximum leverage ratio of 3.0:1. We are in compliance with the financial covenants, with actual net worth of$8.8 billion and actual leverage ratio of 1.1:1, as measured in accordance with the credit agreement as ofDecember 31, 2012 . In addition, the credit agreement includes an uncommitted$250 million incremental loan facility. AtDecember 31, 2012 , we had no borrowings outstanding under the credit agreement. We have outstanding letters of credit of$5 million secured under the credit agreement. No amounts have been drawn on these letters of credit. Accordingly, as ofDecember 31, 2012 , we had$995 million of remaining borrowing capacity under the credit agreement, none of which would be restricted by our financial covenant compliance requirement. We have other customary, arms-length relationships, including financial advisory and banking, with some parties to the credit agreement. Other Long-Term Borrowings
In
Liquidity Requirements
We believe our cash balances, investment securities, operating cash flows, and funds available under our credit agreement or from other public or private financing sources, taken together, provide adequate resources to fund ongoing operating and regulatory requirements, acquisitions, future expansion opportunities, and capital expenditures for at least the next twelve months, as well as to refinance or repay debt, and repurchase shares. 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 atDecember 31, 2012 was BBB according to Standard & Poor's Rating Services, or S&P, and Baa3 according toMoody's Investors Services, Inc. , or Moody's. A downgrade by S&P to BB+ or by Moody's to Ba1 triggers an interest rate increase of 25 basis points with respect to$750 million of our senior notes. Successive one notch downgrades increase the interest rate an additional 25 basis points, or annual interest expense by$2 million , up to a maximum 100 basis points, or annual interest expense by$8 million . In addition, we operate as a holding company in a highly regulated industry.Humana Inc. , our parent company, is dependent upon dividends and administrative expense reimbursements from our subsidiaries, most of which are subject to regulatory restrictions. We continue to maintain significant levels of aggregate excess statutory capital and surplus in our state-regulated operating subsidiaries. Cash, cash equivalents, and short-term investments at the parent company were$346 million atDecember 31, 2012 and$494 million atDecember 31, 2011 . Our subsidiaries paid dividends to the parent of$1.2 billion in 2012,$1.1 billion in 2011, and$747 million in 2010. Refer to our parent company financial statements and accompanying notes in Schedule I - Parent Company Financial Information. As described in Item 7. - Management's Discussion and Analysis of Financial Condition and Results of Operations under the section titled "Health Insurance Reform," the NAIC is continuing discussions regarding the accounting for the insurance industry premium-based assessment required by the Health Insurance Reform Legislation and may require accrual and associated subsidiary funding consideration for the first two years of the assessment in 2014 followed by annual accruals thereafter. The NAIC guidance is contradictory to final GAAP guidance issued by the FASB inJuly 2011 , which requires annual accrual of the insurance industry premium-based assessment in the year in which it is payable. 68
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Regulatory Requirements
Certain of our subsidiaries operate in states that regulate the payment of dividends, loans, or other cash transfers toHumana 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 toHumana Inc. by these subsidiaries, without prior approval by state regulatory authorities, or ordinary dividends, 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. Actual dividends paid may vary due to consideration of excess statutory capital and surplus and expected future surplus requirements related to, for example, premium volume and product mix. Although minimum required levels of equity are largely based on premium volume, product mix, and the quality of assets held, minimum requirements vary significantly at the state level. Our state regulated subsidiaries had aggregate statutory capital and surplus of approximately$5.1 billion and$4.7 billion as ofDecember 31, 2012 and 2011, respectively, which exceeded aggregate minimum regulatory requirements. ExcludingPuerto Rico subsidiaries, the amount of ordinary dividends that may be paid to our parent company in 2013 is approximately$911 million in the aggregate. This compares to ordinary dividends that were able to be paid in 2012 of approximately$860 million . We expect the amount of dividends to be paid to our parent company in 2013 to approximate the amount of ordinary dividends.
Contractual Obligations
We are contractually obligated to make payments for years subsequent to
Payments Due by Period Less than More than Total 1 Year 1-3 Years 3-5 Years 5 Years (in millions) Debt $ 2,550 $ 0 $ 0 $ 500 $ 2,050 Interest (1) 1,694 146 293 243 1,012 Operating leases (2) 852 212 326 192 122 Purchase obligations (3) 262 124 109 13 16 Future policy benefits payable and other long-term liabilities (4) 2,209 65 269 238 1,637 Total $ 7,567 $ 547 $ 997 $ 1,186 $ 4,837
(1) Interest includes the estimated contractual interest payments under our debt
agreements.
(2) We lease facilities, computer hardware, and other furniture and equipment
under long-term operating leases that are noncancelable and expire on various
dates through 2025. 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 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 15 to the consolidated financial statements included in
Item 8. - Financial Statements and Supplementary Data.
(3) Purchase 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.
(4) Includes future policy benefits payable ceded to third parties through 100%
coinsurance agreements as more fully described in Note 18 to the consolidated
financial statements included in Item 8. - Financial Statements and
Supplementary Data. We expect the assuming reinsurance carriers to fund these
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and reflected these amounts as reinsurance recoverables included in other
long-term assets on our consolidated balance sheet. Amounts payable in less
than one year are included in trade accounts payable and accrued expenses in
the consolidated balance sheet.
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 special purpose entities, or SPEs, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As ofDecember 31, 2012 , we were not involved in any SPE transactions.
Guarantees and Indemnifications
Through indemnity agreements approved by the state regulatory authorities, certain of our regulated subsidiaries generally are guaranteed byHumana 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 military services subsidiaries. In the ordinary course of business, we enter into contractual arrangements under which we may agree to indemnify a third party to such arrangement from any losses incurred relating to the services they perform on behalf of us, or for losses arising from certain events as defined within the particular contract, which may include, for example, litigation or claims relating to past performance. Such indemnification obligations may not be subject to maximum loss clauses. Historically, payments made related to these indemnifications have been immaterial. Government Contracts OurMedicare products, which accounted for approximately 72% of our total premiums and services revenue for the year endedDecember 31, 2012 , primarily consisted of products covered under theMedicare Advantage andMedicare Part D Prescription Drug Plan contracts with the federal government. These contracts are renewed generally for a calendar year term unless CMS notifies us of its decision not to renew byAugust 1 of the calendar year in which the contract would end, or we notify CMS of our decision not to renew by the first Monday in June of the calendar year in which the contract would end. All material contracts betweenHumana and CMS relating to ourMedicare products have been renewed for 2013, and all of our product offerings filed with CMS for 2013 have been approved. CMS uses a risk-adjustment model which apportions premiums paid toMedicare Advantage plans according to health severity. The risk-adjustment model pays more for enrollees with predictably higher costs. Under this model, rates paid toMedicare Advantage plans are based on actuarially determined bids, which include a process whereby our prospective payments are based on a comparison of our beneficiaries' risk scores, derived from medical diagnoses, to those enrolled in the government's originalMedicare program. Under the risk-adjustment methodology, allMedicare Advantage plans must collect and submit the necessary diagnosis code information from hospital inpatient, hospital outpatient, and physician providers to CMS within prescribed deadlines. The CMS risk-adjustment model uses the diagnosis data to calculate the risk-adjusted premium payment toMedicare Advantage plans, which CMS adjusts for coding pattern differences between the health plans and the government fee-for-service program. We generally rely on providers, including certain providers in our network who are our employees, to code their claim submissions with appropriate diagnoses, which we send to CMS as the basis for our payment received from CMS under the actuarial risk-adjustment model. We also rely on these providers to document appropriately all medical data, including the diagnosis data submitted with claims. 70
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CMS is continuing to perform audits of various companies' selectedMedicare Advantage contracts related to this risk adjustment diagnosis data. We refer to these audits as Risk-Adjustment Data Validation Audits, or RADV audits. RADV audits review medical records in an attempt to validate provider medical record documentation and coding practices which influence the calculation of premium payments toMedicare Advantage plans. OnFebruary 24, 2012 , CMS released a "Notice of Final Payment Error Calculation Methodology for Part C Medicare Advantage Risk Adjustment Data Validation (RADV) Contract-Level Audits." The payment error calculation methodology provides that, in calculating the economic impact of audit results for aMedicare Advantage contract, if any, the results of the audit sample will be extrapolated to the entireMedicare Advantage contract based upon a comparison to "benchmark" audit data in the government fee-for-service program. This comparison to the government program benchmark audit is necessary to determine the economic impact, if any, of audit results because the government program data set, including any attendant errors that are present in that data set, provides the basis forMedicare Advantage plans risk adjustment to payment rates. CMS already makes other adjustments to payment rates based on a comparison of coding pattern differences betweenMedicare Advantage plans and the government fee-for-service program data (such as for frequency of coding for certain diagnoses inMedicare Advantage plan data versus the government program data set). The final methodology, including the first application of extrapolated audit results to determine audit settlements, is expected to be applied to the next round of RADV contract level audits to be conducted on 2011 premium payments. SelectedMedicare Advantage contracts will be notified of an audit at some point after the close of the final reconciliation for the payment year being audited. The final reconciliation occurs in August of the calendar year following the payment year. Estimated audit settlements are recorded as a reduction of premiums revenue in our consolidated statements of income, based upon available information. During 2012, we completed internal contract level audits of certain contracts based on the RADV audit methodology prescribed by CMS. Included in these internal contract level audits was an audit of our Private Fee-For-Service business which we used to represent a proxy of the benchmark audit data in the government fee-for-service program which has not yet been released. We based our accrual of estimated audit settlements for contract years 2011 (the first year that application of extrapolated audit results is applicable) and 2012 on the results of these internal contract level audits. Estimates derived from these results were not material to our results of operations, financial position, or cash flows. However, as indicated, we are awaiting additional guidance from CMS regarding the benchmark audit data in the government fee-for-service program and the identification of our specificMedicare Advantage contracts that will be selected for audit. Accordingly, we cannot determine whether such audits will have a material adverse effect on our results of operations, financial position, or cash flows. AtDecember 31, 2012 , our military services business, which accounted for approximately 3% of our total premiums and services revenue for the year endedDecember 31, 2012 , primarily consisted of theTRICARE South Region contract. OnApril 1, 2012 , we began delivering services under the newTRICARE South Region contract that the TMA awarded to us onFebruary 25, 2011 . The new 5-yearSouth Region contract, which expiresMarch 31, 2017 , is subject to annual renewals onApril 1 of each year during its term at the government's option. The TMA has notified us of its intent to exercise its option to extend theTRICARE South Region contract throughMarch 31, 2014 . OurMedicaid business, which accounted for approximately 3% of our total premiums and services revenue for the year endedDecember 31, 2012 , primarily consists of contracts inPuerto Rico andFlorida , with the vast majority inPuerto Rico . EffectiveOctober 1, 2010 , as amended inMay 2011 , thePuerto Rico Health Insurance Administration , or PRHIA, awarded us contracts for the East, Southeast, and Southwest regions for a three-year term throughJune 30, 2013 . 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 71
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increases in premium payments to us, may have a material adverse effect on our results of operations, financial position, 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 inthe 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 benefits expense 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.
Benefits Expense Recognition
Benefits expense is recognized in the period in which services are provided and includes an estimate of the cost of services which have been incurred but not yet reported, or IBNR. IBNR represents a substantial portion of our benefits payable as follows: December 31, Percentage December 31, Percentage 2012 of Total 2011 of Total (dollars in millions) IBNR $ 2,552 67.5 % $ 2,056 54.8 % Reported claims in process 315 8.3 % 376 10.0 % Other benefits payable 908 24.1 % 983 26.2 % Benefits payable, excluding military services 3,775 99.9 % 3,415 91.0 % Military services benefits payable 4 0.1 % 339 9.0 % Total benefits payable $ 3,779 100.0 % $ 3,754 100.0 % Military services benefits payable primarily relates to our previousTRICARE South Region contract that expired onMarch 31, 2012 and primarily consists of our estimate of incurred healthcare services provided to beneficiaries which were in turn reimbursed by the federal government as further described in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. This amount was generally offset by a corresponding receivable due from the federal government, as more fully-described in Item 7. - Management's Discussion and Analysis of Financial Condition and Results of Operations under the section titled "Cash Flow from Operating Activities." Under the newTRICARE South Region contract effectiveApril 1, 2012 , the federal government retains the risk of the cost of health benefits and related benefit obligation as further described in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. 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. 72
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We develop our estimate for IBNR using actuarial methodologies and assumptions, primarily based upon historical claim 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, changes in member cost sharing, changes in medical management processes, 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 recoveries of overpayments, receipt cycle times, claim inventory levels, outsourcing, system conversions, and processing disruptions due to weather or other events affect views regarding the reasonable choice of completion factors. Claim payments to providers for services rendered are often net of overpayment recoveries for claims paid previously, as contractually allowed. Claim overpayment recoveries can result from many different factors, including retroactive enrollment activity, audits of provider billings and/or payment errors. Changes in patterns of claim overpayment recoveries can be unpredictable and result in completion factor volatility, as they often impact older dates of service. 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 several years. If claims are submitted or processed on a faster (slower) pace than prior periods, the actual claim may be more (less) complete than originally estimated using our completion factors, which may result in reserves that are higher (lower) than required. 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, new higher priced technologies and medical procedures, and new prescription drugs and therapies, 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, the tort liability system, increases in medical services capacity, direct to consumer advertising for prescription drugs and medical services, an aging population, lifestyle changes including diet and smoking, 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. 73
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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 generally 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 onDecember 31, 2012 data: Completion Factor (a): Claims Trend Factor (b): Factor Decrease in Factor Decrease in Change (c) Benefits Payable Change (c) Benefits Payable (dollars in millions) 1.60% $(309) (4.75%) $(321) 1.20% $(232) (4.25%) $(288) 0.80% $(155) (3.50%) $(237) 0.60% $(116) (3.00%) $(203) 0.40% $ (77) (2.50%) $(169) 0.20% $ (39) (2.00%) $(135) 0.10% $ (19) (1.50%) $(101)
(a) Reflects estimated potential changes in benefits payable at
caused by changes in completion factors for incurred months prior to the most
recent three months.
(b) Reflects estimated potential changes in benefits payable at
caused by changes in annualized claims trend used for the estimation of per
member per month incurred claims for the most recent three months.
(c) The factor change indicated represents the percentage point change.
The following table provides a historical perspective regarding the accrual and payment of our benefits payable, excluding military services. Components of the total incurred claims for each year include amounts accrued for current year estimated benefits expense as well as adjustments to prior year estimated accruals. 2012 2011 2010 (in millions) Balances at January 1 $ 3,415 $ 3,214 $ 2,943 Acquisitions 66 29 0 Incurred related to: Current year 30,198 25,834 24,226 Prior years (257 ) (372 ) (434 ) Total incurred 29,941 25,462 23,792 Paid related to: Current year (26,738 ) (22,742 ) (21,309 ) Prior years (2,909 ) (2,548 ) (2,212 ) Total paid (29,647 ) (25,290 ) (23,521 ) Balances at December 31 $ 3,775 $ 3,415 $ 3,214 74
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The following table summarizes the changes in estimate for incurred claims related to prior years attributable to our key assumptions. As previously described, our key assumptions consist of trend and completion factors estimated using an assumption of moderately adverse conditions. The amounts below represent the difference between our original estimates and the actual benefits expense ultimately incurred as determined from subsequent claim payments. Favorable Development by Changes in Key Assumptions 2012 2011 2010 Factor Factor Factor Amount Change (a) Amount Change (a) Amount Change (a) (dollars in millions) Trend factors $ (138 ) (2.4 )% $ (189 ) (3.8 )% $ (213 ) (4.7 )% Completion factors (119 ) 0.7 % (183 ) 1.2 % (221 ) 1.6 % Total $ (257 ) $ (372 ) $ (434 )
(a) The factor change indicated represents the percentage point change.
As 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 development, or reserves that are considered redundant. There was favorable medical claims reserve development related to prior fiscal years of$257 million in 2012,$372 million in 2011, and$434 million in 2010. The table below details our favorable medical claims reserve development related to prior fiscal years by segment for 2012, 2011, and 2010. Favorable Medical Claims Reserve Development Change 2012 2011 2010 2012 2011 (in millions) Retail Segment $ (192 ) $ (245 ) $ (343 ) $ (53 ) $ (98 ) Employer Group Segment (48 ) (114 ) (73 ) (66 ) 41 Other Businesses (17 ) (13 ) (18 ) 4 (5 ) Total $ (257 ) $ (372 ) $ (434 ) $ (115 ) $ (62 ) The favorable medical claims reserve development for 2012, 2011, and 2010 primarily reflects the consistent application of trend and completion factors estimated using an assumption of moderately adverse conditions. In addition, the favorable medical claims reserve development for 2011 and 2010 reflect improvements in the claims processing environment and, to a lesser extent, better than originally estimated utilization. The improvements in the claims processing environment benefited all lines of business during 2011 and 2010, but were more significant during 2010, particularly in our Medicare Private Fee-For-Service line of business. As a result of these improvements, during 2011 and 2010 we experienced a significant increase in claim overpayment recoveries for claims incurred in prior years, primarily as a result of increased audits of provider billings, as well as system enhancements that improved the claim recovery functionality. In addition, in 2010, a shortening of the cycle time associated with provider claim submissions was a contributing factor. We believe we have consistently applied our methodology in determining our best estimate for benefits payable. We continually adjust our historical trend and completion factor experience with our knowledge of recent events that may impact current trends and completion factors when establishing our reserves. Because our reserving practice is to consistently recognize the actuarial best point estimate using an assumption of moderately adverse conditions as required by actuarial standards, there is a reasonable possibility that variances between actual trend and completion factors and those assumed in ourDecember 31, 2012 estimates would fall towards the middle of the ranges previously presented in our sensitivity table. 75
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Benefits expense associated with military services and provisions associated with future policy benefits excluded from the previous table was as follows for the years endedDecember 31, 2012 , 2011 and 2010: 2012 2011 2010 (in millions) Military services $ 908 $ 3,247 $ 3,059 Future policy benefits 136 114 266 Total $ 1,044 $ 3,361 $ 3,325 The declines in military services benefits payable and benefits expense in 2012 relate to the transition to the newTRICARE South Region contract onApril 1, 2012 , which is accounted for as an administrative services only contract as more fully described in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Our previousTRICARE contract that expired onMarch 31, 2012 contained provisions where we shared the risk with the federal government for the cost of health benefits. Therefore, the impact on our income from operations from changes in estimate forTRICARE benefits payable was reduced substantially by the federal government's share of the risk. The net change in income from operations as determined retrospectively, after giving consideration to claim development occurring in the current period, was an increase of approximately$2 million for 2011 and a decrease of approximately$14 million for 2010. Future policy benefits payable of$1.9 billion and$1.7 billion atDecember 31, 2012 and 2011, respectively, represent liabilities for long-duration insurance policies including long-term care, life insurance, annuities, and certain health and other supplemental policies sold to individuals for which some of the premium received in the earlier years is intended to pay anticipated benefits to be incurred in future years. These reserves are recognized on a net level premium method based on interest rates, mortality, morbidity, withdrawal and maintenance expense assumptions from published actuarial tables, modified based upon actual experience. The assumptions used to determine the liability for future policy benefits are established and locked in at the time each contract is acquired and would only change if our expected future experience deteriorated to the point that the level of the liability, together with the present value of future gross premiums, are not adequate to provide for future expected policy benefits. Future policy benefits payable include$1.1 billion atDecember 31, 2012 and$938 million atDecember 31, 2011 associated with a closed block of long-term care policies acquired in connection with theNovember 30, 2007 KMG acquisition. These amounts include$119 million atDecember 31, 2012 and$47 million atDecember 31, 2011 associated with amounts charged to accumulated other comprehensive income for an additional liability that would exist on our closed-block of long-term care policies if unrealized gains on the sale of the investments backing such products had been realized and the proceeds reinvested at then current yields. Amounts charged to accumulated other comprehensive income are net of applicable deferred taxes. During 2012, we recorded a change in estimate associated with future policy benefits payable for our long-term care block resulting in additional benefits expense of$29 million and a corresponding increase in future policy benefits payable. This change in estimate was based on current claim experience demonstrating an increase in the length of the time policyholders already in payment status remained in such status. Future policy benefits payable was increased to cover future payments to policyholders currently in payment status. Long-term care policies provide for long-duration coverage and, therefore, our actual experience will emerge many years after assumptions have been established. The risk of a deviation of the actual interest rates, morbidity rates, and mortality rates from those assumed in our reserves are particularly significant to our closed block of long-term care policies. We monitor the loss experience of these long-term care policies and, when necessary, apply for premium rate increases through a regulatory filing and approval process in the jurisdictions in which such products were sold. To the extent premium rate increases and/or loss experience vary from our acquisition date assumptions, future adjustments to reserves could be required. During 2010, certain states 76
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approved premium rate increases for a large portion of our long-term care block that were significantly below our acquisition date assumptions. Based on these actions by the states, combined with lower interest rates and higher actual expenses as compared to acquisition date assumptions, we determined that our existing future policy benefits payable, together with the present value of future gross premiums, associated with our long-term care policies were not adequate to provide for future policy benefits under these policies; therefore we unlocked and modified our assumptions based on current expectations. Accordingly, during 2010 we recorded$139 million of additional benefits expense, with a corresponding increase in future policy benefits payable of$170 million partially offset by a related reinsurance recoverable of$31 million included in other long-term assets. In addition, future policy benefits payable include amounts of$220 million atDecember 31, 2012 and of$224 million atDecember 31, 2011 which are subject to 100% coinsurance agreements as more fully described in Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data, and as such are offset by a related reinsurance recoverable included in other long-term assets.
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. OurMedicare contracts with CMS renew annually. Our military services contracts with the federal government and our contracts with various stateMedicaid programs generally are multi-year contracts subject to annual renewal provisions. Our commercial contracts establish rates on a per employee basis for each month of coverage based on the type of coverage purchased (single to family coverage options). OurMedicare andMedicaid contracts also establish monthly rates per member. However, ourMedicare contracts also have additional provisions as outlined in the following separate section. Premiums revenue and administrative services only, or 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, and beginningJanuary 1, 2011 , for estimated rebates to policyholders under the minimum benefit ratios required under the Health Insurance Reform Legislation. We estimate these policyholder rebates by projecting calendar year minimum benefit ratios for the individual, small group, and large group markets, as defined by the Health Insurance Reform Legislation using a methodology prescribed by theDepartment of Health and Human Services, separately by state and legal entity. Estimated calendar year rebates recognized ratably during the year are revised each period to reflect current experience. Enrollment changes not yet processed or not yet reported by an employer group or the government, also known as retroactive membership adjustments, are estimated based on available data and historical trends. We routinely monitor the collectibility of specific accounts, the aging of receivables, historical retroactivity trends, estimated rebates, as well as prevailing and anticipated economic conditions, and reflect any required adjustments in the current period's revenue. We bill and collect premium remittances from employer groups and members in ourMedicare and other individual products monthly. We receive monthly premiums from the federal government and various states according to government specified payment rates and various contractual terms. Changes in revenues from CMS for ourMedicare products resulting from the periodic changes in risk-adjustment scores derived from medical diagnoses for our membership are recognized when the amounts become determinable and the collectibility is reasonably assured.
Medicare Part D Provisions
We cover prescription drug benefits in accordance withMedicare 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 premiums revenue for providing this insurance coverage ratably over the term of our annual contract. Our CMS payment is subject to 77
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risk sharing through theMedicare Part D risk corridor provisions. In addition, receipts for reinsurance and low-income cost subsidies as well as receipts for certain discounts on brand name prescription drugs in the coverage gap represent payments for 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 premiums revenue 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 timing of expected settlement. The estimate of the settlement associated with risk corridor provisions requires us to consider factors that may not be certain at period end, including member eligibility and risk adjustment score differences with CMS as well as pharmacy rebates from manufacturers. These factors have an offsetting effect on changes in the risk corridor estimate. In 2012, we paid$131 million and inJanuary 2013 we paid$158 million related to our reconciliation with CMS regarding the 2011Medicare Part D risk corridor provisions compared to our estimate of$286 million atDecember 31, 2011 . In 2011, we paid$380 million related to our reconciliation with CMS regarding the 2010Medicare Part D risk corridor provisions compared to our estimate of$345 million atDecember 31, 2010 . The net liability associated with the 2012 risk corridor estimate, which will be settled in 2013, was$194 million atDecember 31, 2012 . Reinsurance and low-income cost subsidies represent funding from CMS in connection with theMedicare Part D program for which we assume no risk. Reinsurance subsidies represent funding from CMS for its portion of prescription drug costs which exceed the member's out-of-pocket threshold, or the catastrophic coverage level. Low-income cost subsidies represent funding 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. Beginning in 2011, the Health Reform Legislation mandates consumer discounts of 50% on brand name prescription drugs for Part D plan participants in the coverage gap. These discounts are funded by CMS and pharmaceutical manufacturers while we administer the application of these funds. We account for these subsidies and discounts as a deposit in our consolidated balance sheets and as a financing activity in our consolidated statements of cash flows. We do not recognize premiums revenue or benefits expense for these subsidies or discounts. 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$3.5 billion and gross financing withdrawals were$3.8 billion during 2012. CMS subsidy and brand name prescription drug discount activity recorded to the consolidated balance sheets atDecember 31, 2012 was$635 million to other current assets and$77 million to trade accounts payable and accrued expenses.
Settlement of the reinsurance and low-income cost subsidies as well as the brand name prescription drug discounts and risk corridor payment is based on a reconciliation made approximately 9 months after the close of each calendar year. We continue to revise our estimates with respect to the risk corridor provisions based on subsequent period pharmacy claims data.
Medicare Risk-Adjustment Provisions
CMS utilizes a risk-adjustment model which apportions premiums paid toMedicare Advantage plans according to health severity. The risk-adjustment model pays more for enrollees with predictably higher costs. Under the risk-adjustment methodology, allMedicare Advantage plans must collect and submit the necessary 78
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diagnosis code information from hospital inpatient, hospital outpatient, and physician providers to CMS within prescribed deadlines. The CMS risk-adjustment model uses this diagnosis data to calculate the risk-adjusted premium payment toMedicare Advantage plans. Rates paid toMedicare Advantage plans are established under an actuarial bid model, including a process that bases our payments on a comparison of our beneficiaries' risk scores, derived from medical diagnoses, to those enrolled in the government's originalMedicare program. We generally rely on providers, including certain providers in our network who are our employees, to code their claim submissions with appropriate diagnoses, which we send to CMS as the basis for our payment received from CMS under the actuarial risk-adjustment model. We also rely on providers to appropriately document all medical data, including the diagnosis data submitted with claims. We estimate risk-adjustment revenues based on medical diagnoses for our membership. The risk-adjustment model is more fully described in Item 1. - Business under the section titled "Individual Medicare."
Military services
In 2012, revenues derived from our military services business represented approximately 3% of total premiums and services revenue. Military services premiums and services revenue primarily is derived from ourTRICARE South Region contract with theDepartment of Defense , or DoD. OnApril 1, 2012 , we began delivering services under a newTRICARE South Region contract with the DoD. Under the new contract, we provide administrative services, including offering access to our provider networks and clinical programs, claim processing, customer service, enrollment, and other services, while the federal government retains all of the risk of the cost of health benefits. Under the terms of the newTRICARE South Region contract, we do not record premiums revenue or benefits expense in our consolidated statements of income related to these health care costs and related reimbursements. Instead, we account for revenues under the new contract net of estimated health care costs similar to an administrative services fee only agreement. The new contract includes fixed administrative services fees and incentive fees and penalties. Administrative services fees are recognized as services are performed. OurTRICARE members are served by both in-network and out-of-network providers in accordance with the new contract. We pay health care costs related to these services to the providers and are subsequently reimbursed by the DoD for such payments. We account for the payments associated with these health care costs and the related reimbursements under deposit accounting in our consolidated balance sheets and as a financing activity under receipts (withdrawals) from contract deposits in our consolidated statements of cash flows. For the first nine months of the new contract,April 1, 2012 toDecember 31, 2012 , health care cost payments were$2.1 billion , exceeding reimbursements of$2.0 billion by$56 million . Our previousTRICARE South Region contract that expired onMarch 31, 2012 provided a financial interest in the underlying health care cost; therefore, we reported revenues on a gross basis. We shared the risk with the federal government for the cost of health benefits incurred under our previous contract, earning more revenue or incurring additional cost based on the variance of actual health care costs from an annually negotiated target health care cost as described below.TRICARE revenues consisted 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 were in turn reimbursed by the federal government; and (3) administrative services fees related to claim processing, customer service, enrollment, and other services. We recognized the insurance premium as revenue ratably over the period coverage was provided. Health care services reimbursements were recognized as revenue in the period health services were provided. Administrative services fees were recognized as revenue in the period services were performed. As indicated above, our previousTRICARE South Region contained provisions where we shared the risk with the federal government for the cost of health benefits. Annually, we negotiated a target health care cost amount, or target cost, with the federal government and determined an underwriting fee. Any variance from the target cost was shared. We earned more revenue or incurred additional costs based on the variance of actual health care costs versus the negotiated target cost. We received 20% for any cost underrun, subject to a ceiling 79
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that limited the underwriting profit to 10% of the target cost. We paid 20% for any cost overrun, subject to a floor that limited the underwriting loss to negative 4% of the target cost. A final settlement occurred 12 to 18 months after the end of each contract year to which it applied. We deferred the recognition of any revenues for favorable contingent underwriting fee adjustments related to cost underruns until the amount was determinable and the collectibility was reasonably assured. We estimated and recognized unfavorable contingent underwriting fee adjustments related to cost overruns currently in operations as an increase in benefits expense. The military services contracts contain 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.
Patient Services
Patient services revenue associated with provider services in our Health and Well-Being Services segment primarily related to Concentra, acquiredDecember 21, 2010 . Patient services revenue includes (1) workers' compensation injury care and related services and (2) other healthcare services related to employer needs or statutory requirements. Patient services revenues are recognized in the period services are provided to the customer when the sales price is fixed or determinable, and are net of contractual allowances. The provider reimbursement methods for workers' compensation injury care and related services vary on a state-by-state basis. Most states have fee schedules pursuant to which all healthcare providers are uniformly reimbursed. The fee schedules are determined by each state and generally prescribe the maximum amounts that may be reimbursed for a designated procedure. In the states without fee schedules, healthcare providers are reimbursed based on usual, customary, and reasonable fees charged in the particular state in which the services are provided. We include billings for services in revenue net of allowance for estimated differences between list prices and allowable fee schedule rates or amounts allowed as usual, customary and reasonable, as applicable. Revenue for other healthcare services is recognized on a fee-for-service basis at estimated collectible amounts at the time services are rendered. Our fees are determined in advance for each type of service performed.
Investment securities totaled
December 31 , Percentage
2012 of Total 2011 of Total (dollars in
millions)
U.S. Treasury and other U.S. government corporations and agencies: U.S. Treasury and agency obligations $ 618 6.3 % $ 725 7.7 % Mortgage-backed securities 1,603 16.3 % 1,784 18.9 % Tax-exempt municipal securities 3,071 31.2 % 2,856 30.2 % Mortgage-backed securities: Residential 34 0.3 % 44 0.4 % Commercial 659 6.7 % 381 4.0 % Asset-backed securities 68 0.7 % 83 0.9 % Corporate debt securities 3,794 38.5 % 3,580 37.9 % Total debt securities $ 9,847 100.0 % $ 9,453 100.0 % 80
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Approximately 94% of our debt securities were investment-grade quality, with a weighted average credit rating of AA- by S&P atDecember 31, 2012 . Most of the debt securities that were below investment-grade were rated BB, the higher end of the below investment-grade rating scale. Our investment policy limits investments in a single issuer and requires diversification among various asset types. Tax-exempt municipal securities included pre-refunded bonds of$311 million atDecember 31, 2012 and$332 million atDecember 31, 2011 . These pre-refunded bonds were secured by an escrow fund consisting of U.S. government obligations sufficient to pay off all amounts outstanding at maturity. The ratings of these pre-refunded bonds generally assume the rating of the government obligations at the time the fund is established. Tax-exempt municipal securities that were not pre-refunded were diversified among general obligation bonds of U.S. states and local municipalities as well as special revenue bonds. General obligation bonds, which are backed by the taxing power and full faith of the issuer, accounted for$1.1 billion of these municipals in the portfolio. Special revenue bonds, issued by a municipality to finance a specific public works project such as utilities, water and sewer, transportation, or education, and supported by the revenues of that project, accounted for$1.7 billion of these municipals. Our general obligation bonds are diversified across the U.S. with no individual state exceeding 11%. In addition, certain monoline insurers guarantee the timely repayment of bond principal and interest when a bond issuer defaults and generally provide credit enhancement for bond issues related to our tax-exempt municipal securities. We have no direct exposure to these monoline insurers. We owned$627 million and$634 million atDecember 31, 2012 and 2011, respectively, of tax-exempt securities guaranteed by monoline insurers. The equivalent weighted average S&P credit rating of these tax-exempt securities without the guarantee from the monoline insurer was AA-. Our direct exposure to subprime mortgage lending is limited to investment in residential mortgage-backed securities and asset-backed securities backed by home equity loans. The fair value of securities backed by Alt-A and subprime loans was$2 million atDecember 31, 2012 and$3 million atDecember 31, 2011 . There are no collateralized debt obligations or structured investment vehicles in our investment portfolio.
The percentage of corporate securities associated with the financial services industry was 22.8% at
Gross unrealized losses and fair values aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position were as follows atDecember 31, 2012 : Less than 12 months 12 months or more Total Gross Gross Gross Fair Unrealized Fair Unrealized Fair Unrealized Value Losses Value Losses Value Losses (in millions)December 31, 2012 U.S. Treasury and other U.S. government corporations and agencies: U.S. Treasury and agency obligations $ 56 $ 0 $
2 $ 0
38 0 25 (1 ) 63 (1 ) Tax-exempt municipal securities 233 (3 ) 27 (1 ) 260 (4 ) Mortgage-backed securities: Residential 0 0 4 (1 ) 4 (1 ) Commercial 94 0 0 0 94 0 Asset-backed securities 2 0 4 0 6 0 Corporate debt securities 104 (2 ) 4 0 108 (2 ) Total debt securities $ 527 $ (5 ) $ 66 $ (3 ) $ 593 $ (8 ) Under the other-than-temporary impairment model for debt securities held, we recognize an impairment loss in income in an amount equal to the full difference between the amortized cost basis and the fair value when we 81
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have the intent to sell the debt security or it is more likely than not we will be required to sell the debt security before recovery of our amortized cost basis. However, if we do not intend to sell the debt security, we evaluate the expected cash flows to be received as compared to amortized cost and determine if a credit loss has occurred. In the event of a credit loss, only the amount of the impairment associated with the credit loss is recognized currently in income with the remainder of the loss recognized in other comprehensive income. When we do not intend to sell a security in an unrealized loss position, potential other-than-temporary impairment is considered using a variety of factors, including the length of time and extent to which the fair value has been less than cost; adverse conditions specifically related to the industry, geographic area or financial condition of the issuer or underlying collateral of a security; payment structure of the security; changes in credit rating of the security by the rating agencies; the volatility of the fair value changes; and changes in fair value of the security after the balance sheet date. For debt securities, we take into account expectations of relevant market and economic data. For example, with respect to mortgage and asset-backed securities, such data includes underlying loan level data and structural features such as seniority and other forms of credit enhancements. A decline in fair value is considered other-than-temporary when we do not expect to recover the entire amortized cost basis of the security. We estimate the amount of the credit loss component of a debt security as the difference between the amortized cost and the present value of the expected cash flows of the security. The present value is determined using the best estimate of future cash flows discounted at the implicit interest rate at the date of purchase. 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. There is a continuing risk that declines in fair value may occur and additional material realized losses from sales or other-than-temporary impairments may be recorded in future periods. The recoverability of our non-agency residential and commercial mortgage-backed securities is supported by factors such as seniority, underlying collateral characteristics and credit enhancements. These residential and commercial mortgage-backed securities atDecember 31, 2012 primarily were composed of senior tranches having high credit support, with over 99% of the collateral consisting of prime loans. The weighted average credit rating of all commercial mortgage-backed securities was AA+ atDecember 31, 2012 .
Several European countries, including
All issuers of securities we own that were trading at an unrealized loss atDecember 31, 2012 remain current on all contractual payments. After taking into account these and other factors previously described, we believe these unrealized losses primarily were caused by an increase in market interest rates and tighter liquidity conditions in the current markets than when the securities were purchased. AtDecember 31, 2012 , we did not intend to sell the securities with an unrealized loss position in accumulated other comprehensive income, and it is not likely that we will be required to sell these securities before recovery of their amortized cost basis. As a result, we believe that the securities with an unrealized loss were not other-than-temporarily impaired atDecember 31, 2012 .
There were no material other-than-temporary impairments in 2012, 2011, or 2010.
Goodwill and Long-lived Assets
AtDecember 31, 2012 , goodwill and other long-lived assets represented 28% of total assets and 62% of total stockholders' equity, compared to 23% and 51%, respectively, atDecember 31, 2011 . 82
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We are required to 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 either is our operating segments or one level below the operating segments, referred to as a component, which comprise our reportable segments. A component is considered a reporting unit if the component constitutes a business for which discrete financial information is available that is regularly reviewed by management. We are required to aggregate the components of an operating segment into one reporting unit if they have similar economic characteristics. Goodwill is assigned to the reporting unit that is expected to benefit from a specific acquisition. We use 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. Our strategy, long-range business plan, and annual planning process support our goodwill impairment tests. These tests are performed, at a minimum, annually in the fourth quarter, and are based on an evaluation of future discounted cash flows. We rely on this discounted cash flow analysis to determine fair value. However outcomes from the discounted cash flow analysis are compared to other market approach valuation methodologies for reasonableness. We use discount rates that correspond to a market-based weighted-average cost of capital and terminal growth rates that correspond to long-term growth prospects, consistent with the long-term inflation rate. Key assumptions in our cash flow projections, including changes in membership, premium yields, medical and operating 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, including the impact of the ultimate outcome of theHealth Insurance Reform Legislation, 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. The fair value of our reporting units with significant goodwill exceeded carrying amounts by a substantial margin. A 100 basis point increase in the discount rate would not have a significant impact on the amount of margin for any of our reporting units with significant goodwill.
Beginning with 2012, we are allowed to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. We did not elect to use the qualitative approach in 2012.
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 material impairment losses in the last three years.
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Contract OK’d for 19 Penn Township police officers [Tribune-Review, Greensburg, Pa.]
RENAISSANCERE HOLDINGS LTD – 10-K – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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