HUM

Business Context and Reporting Period

Company: Humana Inc.
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2006
Overview: Humana is a major publicly traded health benefits company headquartered in Louisville, Kentucky. As of December 31, 2006, the company served approximately 11.3 million members in medical benefit programs and 1.9 million in specialty products. The business is managed through two segments: Government (Medicare, TRICARE, Medicaid) and Commercial (employer groups and individuals). In 2006, 67% of premiums and administrative services fees were derived from federal government contracts.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Total revenues increased 48.0% to $21.4 billion, driven primarily by a 93.6% surge in Government segment premiums. This was fueled by the introduction of stand-alone Medicare Part D prescription drug plans (adding 3.5 million members) and a 79.7% increase in Medicare Advantage membership.
• Profitability: Net income rose 64.3% to $487.4 million. The Government segment pretax income increased 62.3% to $513.8 million, while the Commercial segment pretax income jumped 188.0% to $248.2 million.
• Expense Ratios: The consolidated Medical Expense Ratio (MER) increased slightly by 80 basis points to 84.0%, largely due to the new Medicare Part D offerings. The SG&A expense ratio improved by 110 basis points to 14.3%, aided by the absence of 2005 litigation settlement costs.
• Debt Structure: Total debt increased to $1.27 billion. In 2006, the company issued $500 million of 6.45% senior notes due 2016 and replaced its $600 million credit facility with a $1.0 billion facility.

Guidance, Outlook, and Risks

• Outlook: Management expects the 2007 effective tax rate to range between 36% and 37%. Capital contributions to subsidiaries are expected to range from $325 million to $425 million in 2007 to meet regulatory requirements driven by premium growth.
• Medicare Part D Risk Corridor: The company recorded a net liability of $738.7 million at year-end related to the Medicare Part D risk corridor settlement, which is expected to be settled with CMS in mid-2007. This amount reflects favorable experience on allowable costs during the second half of 2006.
• Key Risks:
  • Government Contract Dependency: Approximately 70% of premiums come from government programs. Changes in CMS payment methodologies (risk adjustment models) or legislative actions could materially impact results.
  • Medical Cost Inflation: The company faces risks from rising medical costs, new technologies, and utilization trends that may exceed premium pricing.
  • Regulatory Environment: The company is subject to extensive federal and state regulations regarding licensing, rate setting, and benefit mandates.
  • Legal Proceedings: Ongoing litigation regarding claims practices, provider disputes, and the implementation of Medicare Part D could result in significant damages.

Investor Verification Checklist

• Part D Settlement Timing: Verify the actual cash flow impact and final settlement amount of the $738.7 million Medicare Part D risk corridor liability expected in mid-2007.
• Medical Expense Ratio Trends: Monitor the MER for the new Medicare stand-alone PDP offerings, which operated at a loss (116% MER) in 2006 due to specific product design, and assess if the re-design for 2007 improves profitability.
• Government Contract Renewals: Confirm the status of the TRICARE South Region contract (subject to annual renewal) and the Puerto Rico Medicaid contract extension negotiations.
• Capital Requirements: Track the actual capital contributions made to subsidiaries in 2007 against the projected $325-$425 million range to ensure compliance with state regulatory capital requirements.
• Commercial Segment Mix: Observe the shift in the Commercial segment from fully insured to Administrative Services Only (ASO) and individual products, noting the higher SG&A ratios associated with these lines.