Prepared by R.R. Donnelley Financial -- Form 10-K405
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
 
þ    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2001
 
OR
 
¨    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from              to             
 
Commission file number 1-5975
 
HUMANA INC.
(Exact name of registrant as specified in its charter)
 
Delaware
 
61-0647538
(State of incorporation)
 
(I.R.S. Employer Identification Number)
500 West Main Street
   
Louisville, Kentucky
 
40202
(Address of principal executive offices)
 
(Zip Code)
 
Registrant’s telephone number, including area code: (502) 580-1000
 
Securities registered pursuant to Section 12(b) of the Act:
 
Title of each class

 
Name of exchange on which registered

Common stock, $0.16 2/3 par value
 
New York Stock Exchange
7 1/4% Senior Notes, due August 2006
 
 
Securities registered pursuant to Section 12(g) of the Act:
None
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past  90 days.
 
YES  þ                        NO  ¨
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of the Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in the Registrant’s definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ
 
The aggregate market value of voting stock held by non-affiliates of the Registrant as of March 20, 2002 was $2,050,333,615 calculated using the average price on such date of $12.97. The number of shares outstanding of the Registrant’s Common Stock as of March 20, 2002 was 168,866,651.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Part III incorporates herein by reference portions of the Registrant’s Proxy Statement filed pursuant to Regulation 14A covering the Annual Meeting of Stockholders scheduled to be held May 16, 2002.
 


HUMANA INC.
INDEX TO ANNUAL REPORT ON FORM 10-K
For the Fiscal Year Ended December 31, 2001
 
         
Page

Part I
Item 1.
     
2
Item 2.
     
15
Item 3.
     
15
Item 4.
     
18
Part II
Item 5.
     
19
Item 6.
     
20
Item 7.
     
21
Item 7a.
     
51
Item 8.
     
52
Item 9.
     
79
Part III
Item 10.
     
80
Item 11.
     
82
Item 12.
     
82
Item 13.
     
82
Part IV
Item 14.
     
83
       
86


PART I
 
ITEM 1.    BUSINESS
 
General
 
Headquartered in Louisville, Kentucky, Humana Inc. referred to throughout this document as “we,” “us,” “our,” the “Company” or “Humana,” is one of the nation’s largest publicly traded health benefits companies, based on our 2001 revenues of $10.2 billion. We offer coordinated health insurance coverage and related services through a variety of traditional and Internet-based plans for employer groups and government-sponsored programs. As of December 31, 2001, we had approximately 6.4 million members in our medical insurance programs, as well as approximately 2.3 million members in our specialty products programs. We have approximately 400,000 contracts with physicians, hospitals, dentists and other providers to provide health care to our members. In 2001, over 70% of our premiums and administrative services fees were derived from members located in Florida, Illinois, Texas, Kentucky, and Ohio.
 
We are a Delaware corporation, and were organized in 1964. Our principal executive offices are located at 500 West Main Street, Louisville, Kentucky 40202, and the telephone number at that address is (502) 580-1000. This Annual Report on Form 10-K contains both historical and forward-looking information. See the CAUTIONARY STATEMENTS section in Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations for a description of a number of factors that could adversely affect our results.
 
Business Segments
 
During the first quarter of 2001, we realigned our management to better reflect our focus on the consumer. As part of this management realignment, we redefined our business into two segments, Commercial and Government. The Commercial segment consists of members enrolled in products marketed to employer groups and individuals, and includes three lines of business: fully insured medical, administrative services only, or ASO, and specialty. The Government segment consists of members enrolled in government-sponsored plans, and includes three lines of business: Medicare+Choice, Medicaid, and TRICARE. Results of each segment are measured by income before income taxes. We allocate all selling, general and administrative expenses, investment and other income, and interest expense, but not assets, to our segments. Members served by our two segments generally utilize the same medical provider networks, enabling us to obtain more favorable contract terms with providers. Our segments also share overhead costs and assets. As a result, the profitability of each segment is interdependent.
 
Strategy
 
We recently concluded a two-year process of divesting those products and markets that either lacked the prospect for long-term profitability or no longer fit our strategic focus. During 2000 and 2001, we completed transactions to divest our workers’ compensation business and our Medicaid businesses in north Florida, Milwaukee, Wisconsin, and Austin, Houston and San Antonio, Texas. We also exited numerous counties in our Medicare+Choice business, reinsured with third parties substantially all of our Medicare supplement business, and discontinued aspects of our product line focusing on small group commercial business in 17 states.
 
Our core strategy currently focuses on growth. The cornerstone of our commercial growth strategy is the offering of innovative products which are supported by technology and service excellence. During the past two years, we developed an expansive range of consumer-directed products and developed industry-leading electronic self-service capabilities. Within the Commercial segment during 2001, we experienced membership declines primarily as a result of exercising a rigorous pricing discipline in small group accounts located in geographic markets that are not considered key to our long-term growth strategy. Although we will continue to

2


employ pricing discipline, we anticipate growth in our commercial membership during 2002 as a result of this consumer-directed approach and our commitment to provide excellent customer service.
 
Within our Government segment, we acquired 1.2 million eligible TRICARE members on May 31, 2001. TRICARE is the U.S. Department of Defense’s health benefits program for military dependents and retirees. Humana has been the TRICARE contractor for Regions 3 and 4 since 1996. The 1.2 million additional TRICARE members, from Regions 2 and 5, brought total Humana TRICARE membership to 2.7 million members, making us the leading national contractor for this program. Additionally, during 2001, a new government program, called TRICARE for Life, became effective allowing beneficiaries to continue in the TRICARE program even after becoming eligible for Medicare. Under the TRICARE for Life program, we provide administrative services only, for a fee, while the Department of Defense retains the risk of financing the costs of benefits. As of December 31, 2001, TRICARE ASO membership was 0.9 million of the total 2.7 million TRICARE members, including 0.6 million members in Regions 2 and 5 acquired in 2001.
 
Our Products
 
The following table presents our segment membership, premiums and ASO fees by product for the year ended December 31, 2001:
 
    
Medical Membership

  
Specialty Membership

  
Premiums

  
ASO Fees

  
Total Premiums and ASO Fees

  
Percent of Total Premiums and ASO Fees

 
Commercial:
                                     
Fully insured
  
2,301,300
  
—  
  
$
4,941,888
  
$
—  
  
$
4,941,888
  
49.1
%
Administrative services only
  
592,500
  
—  
  
 
—  
  
 
84,204
  
 
84,204
  
0.8
%
Specialty
  
—  
  
2,262,000
  
 
304,714
  
 
—  
  
 
304,714
  
3.0
%
    
  
  

  

  

  

Total Commercial
  
2,893,800
  
2,262,000
  
 
5,246,602
  
 
84,204
  
 
5,330,806
  
52.9
%
    
  
  

  

  

  

Government:
                                     
Medicare+Choice
  
393,900
  
—  
  
 
2,909,478
  
 
—  
  
 
2,909,478
  
28.9
%
Medicaid
  
490,800
  
—  
  
 
441,324
  
 
—  
  
 
441,324
  
4.4
%
TRICARE
  
1,714,600
  
—  
  
 
1,341,557
  
 
—  
  
 
1,341,557
  
13.3
%
TRICARE ASO
  
942,700
  
—  
  
 
—  
  
 
52,886
  
 
52,886
  
0.5
%
    
  
  

  

  

  

Total Government
  
3,542,000
  
—  
  
 
4,692,359
  
 
52,886
  
 
4,745,245
  
47.1
%
    
  
  

  

  

  

Total
  
6,435,800
  
—  
  
$
9,938,961
  
$
137,090
  
$
10,076,051
  
100.0
%
    
  
  

  

  

  

 
Our Products Marketed to Commercial Segment Members
 
New Generation of Products
 
We recently developed a range of consumer-directed products that we believe will be a solution for employers to the ongoing increases in medical cost inflation. These products include an array of choices for employees and incorporate electronic technologies and on-line tools for both employers and employees. These products combine the offering of traditional HMO, PPO and indemnity plans with newly designed products which incorporate benefit designs that more directly engage the individual consumers in product and cost decisions. They also include an innovative four-tier pharmacy benefit, which allows members access to virtually any medication at different copayment levels. This array of plan designs is offered to employers and their employees at varying levels of copayments, deductibles, coinsurance, benefit levels and price. These products are being sold as both fully insured and ASO (or self-funded) options to employers. Below is a summary description of our traditional HMO, PPO and ASO products.

3


 
HMO
 
Our HMO products provide prepaid health insurance coverage to our members through a network of independent primary care physicians, specialty physicians and other health care providers who contract with the HMO to furnish such services. Primary care physicians generally include internists, family practitioners and pediatricians. Generally, the member’s primary care physician must approve access to certain specialty physicians and other health care providers. These other health care providers include, among others, hospitals, nursing homes, home health agencies, pharmacies, mental health and substance abuse centers, diagnostic centers, optometrists, outpatient surgery centers, dentists, urgent care centers and durable medical equipment suppliers. Because the primary care physician must generally approve access to these other health care providers, the HMO product is the most restrictive form of managed care.
 
An HMO member, typically through the member’s employer, pays a monthly fee, which generally covers, with some copayments, health care services received from or approved by the member’s primary care physician. For the year ended December 31, 2001, commercial HMO premium revenues totaled approximately $2.2 billion, or 21.5% of our total premiums and ASO fees.
 
PPO
 
Our PPO products include some elements of managed health care; however, they typically include more cost-shifting to the member, through copayments and annual deductibles. PPOs are also similar to traditional health insurance because they provide a member with more freedom to choose a physician or other health care provider. In a PPO, the member is encouraged, through financial incentives, to use participating health care providers, which have contracted with the PPO to provide services at favorable rates. In the event a member chooses not to use a participating health care provider, the member may be required to pay a greater portion of the provider’s fees. For the year ended December 31, 2001, commercial PPO premium revenues totaled approximately $2.7 billion, or 27.6% of our total premiums and ASO fees.
 
Administrative Services Only
 
We offer an administrative services only, or ASO, product to those who self-insure their employee health plans. Administrative services generally include the processing of claims, offering access to our provider networks and clinical programs, and responding to customer services inquiries from members of self-funded employers. These products may include all of the same benefit and product design characteristics of our fully insured PPO and HMO products described above, however, under ASO contracts, self-funded employers retain the risk of financing the cost of health benefits. For the year ended December 31, 2001, commercial administrative services fees totaled $84.2 million, or 0.8% of our total premiums and ASO fees.
 
Specialty Products
 
We also offer various specialty products including dental, group life and short-term disability. At December 31, 2001, we had approximately 2.3 million specialty members. For the year ended December 31, 2001, specialty product premium revenues were approximately $304.7 million, or 3.0% of our total premiums and ASO fees.
 
Our Products Marketed to Government Segment Members
 
Medicare+Choice Product
 
Medicare is a federal program that provides persons age 65 and over and some disabled persons certain hospital and medical insurance benefits, which include hospitalization benefits for up to 90 days per incident of illness plus a lifetime reserve aggregating 60 days. Each Medicare-eligible individual is entitled to receive inpatient hospital care, known as Part A care, without the payment of any premium, but is required to pay a

4


premium to the federal government, which is adjusted annually, to be eligible for physician care and other services, known as Part B care.
 
We contract with the federal government’s Centers for Medicare and Medicaid Services, or CMS, under the Medicare+Choice program, to provide health insurance coverage in exchange for a fixed monthly payment per member for Medicare-eligible individuals residing in the geographic areas in which our HMOs operate. Individuals who elect to participate in Medicare+Choice programs receive additional benefits not covered by Medicare and are relieved of the obligation to pay some or all of the deductible or coinsurance amounts but are generally required to use exclusively the services provided by the HMO (subject to nominal copayments and coinsurance) and are required to pay a Part B premium to the Medicare program.
 
The Medicare+Choice product involves a contract between an HMO and CMS, pursuant to which CMS makes a fixed monthly payment to the HMO on behalf of each Medicare-eligible individual that chooses to enroll for coverage in the HMO. The fixed monthly payment, payable on the first day of a month, is determined by formula established by federal law. We sometimes receive the fixed monthly payment early due to a weekend or holiday falling on the first day of a month. We also collect additional member premiums from our members in certain of our markets. The member’s right to terminate coverage is limited by CMS during the first six months of 2002, and members are locked-in to their existing coverage on July 1, 2002 until January 1, 2003. Starting in 2003, the member’s right to terminate coverage is limited during the first three months of the year, and members are locked-in to their existing coverage from April 1st until the following January 1st.
 
At December 31, 2001, we provided health insurance coverage under CMS contracts to approximately 393,900 Medicare+Choice members for which we received premium revenues of approximately $2.9 billion, or 28.9% of our total premiums and ASO fees for 2001. One such CMS contract covered approximately 232,500 members in Florida and accounted for premium revenues of approximately $1.7 billion, which represented 58.7% of our Medicare+Choice premium revenues, or 16.9% of our total premiums and ASO fees for 2001.
 
Our Medicare+Choice contracts with the federal government are renewed for a one-year term each December 31 unless terminated 90 days prior thereto. Increased funding beginning March 1, 2001 specific to the Medicare, Medicaid and State Children’s Health Insurance Benefits Improvement and Protection Act, or BIPA, is being used to provide additional funding under contracts with our providers and to lower member premiums in certain markets. Our 2002 average rate of statutory increase under the Medicare+Choice contracts, including the March 1, 2001 BIPA increase, is approximately 5.0%. Over the last five years, annual increases have ranged from as low as the January 1998 increase of 1.8% to as high as 5.0% in January 2002, with an average of approximately 2.6%. On January 1, 2001, we ceased providing our Medicare+Choice product in 45 counties, affecting approximately 54,000 members, and again on January 1, 2002, we exited our Medicare+Choice product in 5 counties in the Kentucky market, affecting approximately 14,000 members and DuPage County, Illinois, affecting approximately 8,000 members. These county exits were the result, in part, of lower CMS reimbursement rates. We are working with CMS to develop other alternative offerings. For example, we are participating in a Medicare+Choice private fee-for-service pilot program in DuPage County, Illinois covering approximately 2,000 members.
 
Medicaid Product
 
Medicaid is a federal program that is state-operated to facilitate the delivery of health care services to low-income residents. Each state that chooses to do so develops, through a state specific regulatory agency, a Medicaid managed care initiative that must be approved by CMS. CMS requires that Medicaid managed care plans meet federal standards and cost no more than the amount that would have been spent on a comparable fee-for-service basis. States currently either use a formal proposal process in which they review many bidders before selecting one or award individual contracts to qualified bidders which apply for entry to the program. In either case, the contractual relationship with a state is generally for a one-year period. Under these contracts, we receive a fixed monthly payment from a government agency for which we are required to provide health insurance

5


coverage to enrolled members. Due to the increased emphasis on state health care reform and budgetary constraints, more states are utilizing a managed care product in their Medicaid programs.
 
Our Medicaid contracts in Puerto Rico, Florida and Illinois generally are annual contracts. The two contracts with the Health Insurance Administration in Puerto Rico expire on June 30, 2002, unless extended. Both parties have agreed to use good faith efforts to extend the latest contract for a period of no less than 12 months covering no fewer beneficiaries than the current contract. We believe that at the end of the current contract period this contract will be renewed. Since June 2000, we have sold a number of our Medicaid businesses to various other insurance providers, which has resulted in a reduction of over 164,000 members in our Medicaid products. For the year ended December 31, 2001, premium revenues from our Medicaid products totaled $441.3 million, or 4.4% of our total premiums and ASO fees. At December 31, 2001, we had approximately 428,200 Medicaid members in Puerto Rico, and 62,600 Medicaid members in Florida and Illinois.
 
TRICARE
 
TRICARE provides health insurance coverage to the dependents of active duty military personnel and to retired military personnel and their dependents. In November 1995, the United States Department of Defense awarded us our first TRICARE contract covering approximately 1.1 million eligible beneficiaries in Florida, Georgia, South Carolina, Mississippi, Alabama, Tennessee and Eastern Louisiana. On July 1, 1996, we began providing health insurance coverage to these approximately 1.1 million eligible beneficiaries. Effective July 1, 2001, this TRICARE contract for Regions 3 and 4 was renewed for up to two additional years subject to annual renewal at the option of the Department of Defense.
 
On May 31, 2001, we acquired for $43.5 million the outstanding shares of common stock of a newly formed Anthem Alliance Health Insurance Company subsidiary responsible for administering TRICARE benefits to approximately 1.2 million eligible members in Illinois, Indiana, Kentucky, Michigan, a portion of Missouri, North Carolina, Ohio, Tennessee, Virginia, Wisconsin and West Virginia. The Department of Defense has notified us of its intent to renew the TRICARE contract for Regions 2 and 5 through April 30, 2003.
 
Three health benefit options are available to TRICARE beneficiaries. In addition to a traditional indemnity option, participants may enroll in an HMO-like plan with a point-of-service option or take advantage of reduced copayments by using a network of preferred providers. We have subcontracted with third parties to provide various administration and specialty services under the contracts. For the year ended December 31, 2001, TRICARE premium revenues were approximately $1.3 billion, or 13.3% of our total premiums and ASO fees.
 
At December 31, 2001, we had 942,700 TRICARE ASO members for which the Department of Defense retains the risk of financing the cost of their health benefits. We obtained these members from our recent acquisition of Regions 2 and 5, and from two new government programs that allow senior members to continue in the TRICARE program even after becoming Medicare eligible, which is normally age 65. The first of these programs, called TRICARE Senior Pharmacy, became effective April 1, 2001. Under this new government administrative services program, senior TRICARE members received certain pharmacy benefits not covered under Medicare. On October 1, 2001, the TRICARE For Life program became effective, and expanded coverage to include medical benefits as well. For the year ended December 31, 2001, TRICARE administrative services fees totaled $52.9 million, or 0.5% of our total premiums and ASO fees.

6


 
The following table summarizes our medical membership at December 31, 2001, by market and product:
 
    
Commercial

  
Government

  
Percent of Total

 
    
HMO

  
PPO

  
ASO

  
Medicare +Choice

  
Medicaid

  
TRICARE

  
Total

  
    
(in thousands)
 
Florida
  
142.6
  
70.9
  
9.4
  
232.5
  
46.2
  
402.8
  
904.4
  
14.1
%
Illinois
  
297.2
  
227.5
  
111.4
  
81.7
  
16.4
  
58.4
  
792.6
  
12.3
 
Texas
  
198.4
  
253.0
  
20.7
  
27.0
  
—  
  
—  
  
499.1
  
7.8
 
Puerto Rico
  
17.0
  
38.8
  
4.4
  
—  
  
428.2
  
—  
  
488.4
  
7.6
 
Ohio
  
187.9
  
76.8
  
64.4
  
—  
  
—  
  
66.0
  
395.1
  
6.1
 
Wisconsin
  
66.6
  
36.6
  
234.7
  
—  
  
—  
  
27.2
  
365.1
  
5.7
 
Kentucky
  
101.6
  
165.4
  
36.5
  
12.3
  
—  
  
38.4
  
354.2
  
5.5
 
Georgia
  
21.7
  
46.9
  
2.8
  
—  
  
—  
  
265.5
  
336.9
  
5.2
 
North Carolina
  
—  
  
24.4
  
3.4
  
—  
  
—  
  
184.6
  
212.4
  
3.3
 
Tennessee
  
—  
  
37.9
  
15.9
  
—  
  
—  
  
90.7
  
144.5
  
2.2
 
South Carolina
  
—  
  
9.0
  
0.7
  
—  
  
—  
  
129.9
  
139.6
  
2.2
 
Virginia
  
—  
  
—  
  
0.4
  
—  
  
—  
  
132.2
  
132.6
  
2.0
 
Arizona
  
28.1
  
40.8
  
37.0
  
21.2
  
—  
  
—  
  
127.1
  
2.0
 
Indiana
  
—  
  
31.3
  
28.1
  
—  
  
—  
  
45.3
  
104.7
  
1.6
 
Missouri/Kansas
  
43.7
  
12.2
  
12.2
  
19.2
  
—  
  
14.3
  
101.6
  
1.6
 
Alabama
  
—  
  
—  
  
0.2
  
—  
  
—  
  
98.3
  
98.5
  
1.5
 
Mississippi
  
—  
  
3.8
  
0.3
  
—  
  
—  
  
73.8
  
77.9
  
1.2
 
Michigan
  
—  
  
25.2
  
4.3
  
—  
  
—  
  
45.9
  
75.4
  
1.2
 
Colorado
  
—  
  
56.0
  
0.1
  
—  
  
—  
  
—  
  
56.1
  
0.9
 
TRICARE ASO
  
—  
  
  —  
  
—  
  
—  
  
—  
  
942.7
  
942.7
  
14.6
 
Others
  
—  
  
40.0
  
5.6
  
—  
  
—  
  
41.3
  
86.9
  
1.4
 
    
  
  
  
  
  
  
  

Totals
  
1,104.8
  
1,196.5
  
592.5
  
393.9
  
490.8
  
2,657.3
  
6,435.8
  
100.0
%
    
  
  
  
  
  
  
  

 
Provider Arrangements
 
We provide our members with access to health care services through our networks of health care providers with whom we have contracted, including hospitals and other independent facilities such as outpatient surgery centers, primary care physicians, specialist physicians, dentists and providers of ancillary health care services and facilities. We have approximately 400,000 contracts with health care providers participating in our networks, which consists of approximately 296,000 physicians, 3,700 hospitals, and 103,200 ancillary providers and dentists. These ancillary services and facilities include ambulance services, medical equipment services, home health agencies, mental health providers, rehabilitation facilities, nursing homes, optical services and pharmacies. Our membership base and the ability to influence where our members seek care generally enable us to obtain contractual discounts with providers.
 
We typically contract with hospitals on either a per diem rate, which is an all-inclusive rate per day, or a case rate, which is an all-inclusive rate per admission, for inpatient hospital services. Outpatient hospital services are generally contracted at a flat rate by type of service or at a discounted charge. These contracts are typically multi-year agreements with rates that are adjusted for inflation annually based on the consumer price index or other nationally recognized inflation index. Outpatient surgery centers and other ancillary providers are typically contracted at flat rates per service provided or are reimbursed based upon a nationally recognized fee schedule such as the Medicare+Choice fee schedule.
 
Our contracts with physicians typically are automatically renewed each year, unless either party gives written notice to the other party of their intent to terminate the arrangement. Most of the physicians in our PPO networks and some of our physicians in our HMO networks are reimbursed based upon a fixed fee schedule,

7


which typically provides for reimbursement based upon a percentage of the standard Medicare allowable fee schedule. Many physicians, usually primary care physicians, participating in our HMO networks are reimbursed a fixed monthly amount per member, known as a capitation payment, for directly providing health care services to these members.
 
Under other types of capitation arrangements, the providers are paid a monthly capitation payment per member both for directly providing health care services to members and arranging for services by other providers. Accordingly, they assume financial risk for all or some portion of the cost of health care services for their membership, which may include the costs for specialist physicians, hospitals and prescription drugs. Primary care physicians under these types of arrangements typically have stop loss coverage so that a physician’s financial risk for any single member is limited to a maximum amount on an annual basis. We remain financially responsible for health care services to our members in the event our providers fail to provide such services. Some physicians may have arrangements under which they can earn bonuses when certain target goals relating to the provisions of patient care are met.
 
We use a variety of techniques to provide access to effective and efficient use of health care services for our members. These techniques include the coordination of care for our members, product and benefit designs, hospital inpatient management systems, or HIMS, and enrolling members into our disease management programs. The focal point for health care services in many of our Medicare+Choice and HMO networks is the primary care physician who, under contract, provides services, and controls utilization of appropriate services, by directing or approving hospitalization and referrals to specialists and other providers. Our HIMS programs use specially trained physicians to effectively manage the entire range of an HMO members’ medical care during a hospital admission and to effectively coordinate the members’ discharge and post-discharge care. We have a variety of disease management programs related to specific medical conditions such as congestive heart failure, coronary artery disease, prenatal and premature infant care, asthma related illness, end stage renal disease, diabetes and breast cancer screening. We also focus on certain rare conditions where disease management techniques benefit members in a more cost effective manner.
 
Quality Assessment
 
Our quality assessment program consists of several internal programs such as those that credential providers and those designed to meet the audit standards of federal and state agencies and external accreditation standards. We also offer quality and outcome measurement and improvement programs such as the Health Plan Employer Data Information Sets, or HEDIS, which is used by employers, government purchasers and the National Committee for Quality Assurance, or NCQA, to evaluate HMOs based on various criteria, including effectiveness of care and member satisfaction.
 
Physicians participating in our HMO networks must satisfy specific criteria, including licensing, hospital admission privileges, patient access, office standards, after-hours coverage and many other factors. Participating hospitals must also meet accreditation criteria established by CMS and/or the Joint Commission on Accreditation of Healthcare Organizations, or JCAHO.
 
Participating HMO physicians are recredentialed regularly. Recredentialing of primary care physicians includes verification of their medical license; review of their malpractice liability claims history; review of their board certification, if applicable; and review of any quality complaints, member appeals and grievances regarding the physicians. Committees, composed of a peer group of physicians, review participating primary care physicians being considered for credentialing and recredentialing.
 
We request accreditation for certain of our HMO plans from NCQA and the American Accreditation Healthcare Commission/Utilization Review Accreditation Commission, or AAHC/URAC. Accreditation or external review by an approved organization is mandatory in the states of Florida and Kansas for licensure as an HMO. Accreditation specific to the utilization review process is also required in the state of Georgia for licensure as an HMO or PPO.

8


 
NCQA performs reviews of standards for quality improvement, credentialing, utilization management, preventative health, member rights and responsibilities and medical records. Humana continues to maintain accreditation in select markets through NCQA. Six markets maintain commendable NCQA accredited status for all HMO product lines: Humana Health Plan, Inc. in Chicago, Illinois; Humana Health Plan, Inc. in Kansas City, Missouri; Humana Health Plan of Ohio, Inc. in Cincinnati, Ohio; Humana Medical Plan, Inc. in south Florida, north Florida, and central Florida. Humana Medical Plan, Inc. in Tampa Bay has received commendable accreditation for its commercial product line and has received accredited status for its Medicare+Choice product line.
 
AAHC/URAC performs reviews of standards for utilization management, and for health plan standards in quality management, credentialing, rights and responsibilities, and network management. Seven markets have achieved URAC health plan accreditation for all HMO product lines: Humana Medical Plan, Inc. in north Florida, south Florida, central Florida (Daytona, Tampa and Orlando), Humana Health Plan of Ohio, Inc. in Cincinnati, Ohio, and Humana Health Plan, Inc. in Kentucky. The Kansas City market has just completed their URAC Health Plan survey with a recommendation for a full accreditation for all HMO product lines. The Atlanta market has URAC utilization management accreditation for HMO and PPO product lines. AAHC/URAC utilization management accreditation was received for Humana Military Healthcare Services, Inc., which administers the TRICARE program and for the Green Bay service center.
 
Some of our HMO entities are unaccredited, because we sought accreditation only where regulatory requirements were in place, such as in Florida, which requires accreditation for HMO licensing, or in market areas where commercial groups use it as a variable in choosing carriers. As the requirements of accreditation have become less focused on factors under our control and more focused on other factors such as provider behavior, we have concluded that these programs do not add value for our customers. We are piloting ISO 9000 certification as an alternative to accreditation. ISO is the international standards organization, which has developed an international commercial set of certifications as to quality and process, called ISO 9000.
 
Sales and Marketing
 
Individuals become members of our commercial HMOs and PPOs through their employer or other groups which typically offer employees or members a selection of health insurance products, pay for all or part of the premiums and make payroll deductions for any premiums payable by the employees. We attempt to become an employer’s or group’s exclusive source of health insurance benefits by offering a variety of HMO, PPO and specialty products that provide cost-effective quality healthcare coverage consistent with the needs and expectations of the employees or members.
 
We use various methods to market our commercial, Medicare+Choice and Medicaid products, including television, radio, the Internet, telemarketing and mailings. At December 31, 2001, we used approximately 46,000 licensed independent brokers and agents and approximately 430 licensed employees to sell our commercial products. Many of our employer group customers are represented by insurance brokers and consultants who assist these groups in the design and purchase of health care products. We generally pay brokers a commission based on premiums, with commissions varying by market and premium volume.
 
At December 31, 2001, we employed approximately 530 sales representatives, who are each paid a salary and/or per member commission, to market our Medicare+Choice and Medicaid products. We also employed approximately 240 telemarketing representatives who assisted in the marketing of Medicare+Choice and Medicaid products by making appointments for sales representatives with prospective members.
 
Risk Management
 
Through the use of internally developed underwriting criteria, we determine the risk we are willing to assume and the amount of premium to charge for our commercial products. In most instances, employer and other groups must meet our underwriting standards in order to qualify to contract with us for coverage. Small

9


group reform laws in some states have imposed regulations which provide for guaranteed issue of certain health insurance products and prescribe certain limitations on the variation in rates charged based upon assessment of health conditions.
 
Underwriting techniques are not employed in connection with Medicare+Choice products because CMS regulations require us to accept all eligible Medicare applicants regardless of their health or prior medical history. We also are not permitted to employ underwriting criteria for the Medicaid product, but rather we follow CMS and state requirements. In addition, with respect to our TRICARE business, we do not employ any underwriting techniques because we must accept all eligible beneficiaries who choose to participate.
 
Competition
 
The managed health care industry is highly competitive and contracts for the sale of commercial products are generally bid or renewed annually. Our competitors vary by local market and include other publicly traded managed care companies, national insurance companies and other HMOs and PPOs, including HMOs and PPOs owned by Blue Cross/Blue Shield plans. Many of our competitors have larger memberships and/or greater financial resources than our health plans in the markets in which we compete. Our ability to sell our products and to retain customers is, or may be, influenced by such factors as benefits, pricing, contract terms, number and quality of participating physicians and other managed health care providers, utilization review, claims processing, administrative efficiency, relationships with agents, quality of customer service and accreditation results.
 
Government Regulation
 
Government regulation of health care products and services is a changing area of law that varies from jurisdiction to jurisdiction. Regulatory agencies generally have broad discretion to issue regulations and interpret and enforce laws and rules. Changes in applicable laws and regulations are continually being considered, and the interpretation of existing laws and rules also may change periodically. These regulatory revisions could affect our operations and financial results. Also, it may become increasingly difficult to control medical costs if federal and state bodies continue to consider and enact significant and sometimes onerous managed care laws and regulations.
 
Enforcement of health care fraud and abuse laws has become a top priority for the nation’s law enforcement entities. The funding of such law enforcement efforts has increased dramatically in the past few years and is expected to continue. The focus of these efforts has been directed at participants in federal government health care programs such as Medicare, Medicaid and FEHBP. We participate extensively in these programs and have enhanced our regulatory compliance efforts for these programs. The programs are subject to very technical rules. When combined with law enforcement intolerance for any level of noncompliance, these rules mean that compliance efforts in this area continue to be challenging.
 
We are subject to various governmental audits, investigations and enforcement actions. These include possible government actions relating to ERISA, FEHBP, federal and state fraud and abuse laws, and other laws relating to Medicare, including adjusted community rating development, special payment status, payments for emergency room visits, and various other areas. Adjusted community rating development is the government-defined rating formula used to justify the Medicare HMO or Medicare+Choice benefits we offer individuals eligible for Medicare benefits based on a particular community and certain other factors. Special payment status refers to Medicare+Choice members who are institutionalized, Medicaid-eligible, or have contracted end-stage renal disease. The Medicare+Choice plan receives a higher payment for members who qualify for one or more of these statuses. We are currently involved in various government investigations, audits and reviews, some of which are under ERISA, and the authority of state departments of insurance. On May 31, 2000, we entered into a five-year Corporate Integrity Agreement with the Office of the Inspector General for the Department of Health and Human Services as part of a settlement of a Medicare overpayment issue arising from an audit by the Office

10


of the Inspector General. Although any of the pending government actions could result in assessment of damages, civil or criminal fines or penalties, or other sanctions against us, including exclusion from participation in government programs, we do not believe the results of any of these actions, individually or in the aggregate, will have a material adverse effect on our financial position, results of operations or cash flows.
 
Of our eight licensed and active HMO subsidiaries as of March 1, 2002, five are qualified under the Federal Health Maintenance Organization Act of 1973, as amended. To obtain federal qualification, an HMO must meet certain requirements, including conformance with benefit, rating and financial reporting standards. In certain markets, and for certain products, we operate HMOs that are not federally qualified because this provides greater flexibility with respect to product design and pricing than is possible for federally qualified HMOs.
 
As of March 1, 2002, Humana Medical Plan, Inc., Humana Health Plan of Texas, Inc., and Humana Health Plan, Inc. each hold CMS contracts under the Medicare+Choice program to sell Medicare HMO products in a total of seven states. In addition, Humana Insurance Company holds a CMS contract under the Medicare+Choice program to sell a private fee-for-service product in DuPage County, Illinois.
 
CMS conducts audits of HMOs qualified under its Medicare+Choice program at least biannually and may perform other reviews more frequently to determine compliance with federal regulations and contractual obligations. These audits include review of the HMOs’ administration and management, including management information and data collection systems, fiscal stability, utilization management and physician incentive arrangements, health services delivery, quality assurance, marketing, enrollment and disenrollment activity, claims processing, and complaint systems.
 
CMS regulations require submission of quarterly and annual financial statements. In addition, CMS requires certain disclosures to CMS and to Medicare beneficiaries concerning operations of a health plan qualified under the Medicare+Choice program. CMS’s rules require disclosure to members upon request of information concerning financial arrangements and incentive plans between an HMO and physicians in the HMOs’ networks. These rules also require certain levels of stop-loss coverage to protect contracted physicians against major losses relating to patient care, depending on the amount of financial risk they assume. The reporting of certain health care data contained in HEDIS is another important CMS disclosure requirement.
 
Our Medicaid products are regulated by the applicable state agency in the state in which we sell a Medicaid product and by the Health Insurance Administration in Puerto Rico, in conformance with federal approval of the applicable state plan, and are subject to periodic reviews by these agencies. The reviews are similar in nature to those performed by CMS.
 
Laws in each of the states and the Commonwealth of Puerto Rico in which we operate our HMOs, PPOs and other health insurance-related services regulate our operations, including the scope of benefits, rate formulas, delivery systems, utilization review procedures, quality assurance, complaint systems, enrollment requirements, claim payments, marketing and advertising. The HMO, PPO and other health insurance-related products we offer are sold under licenses issued by the applicable insurance regulators. Under state laws, our HMOs and health insurance companies are audited by state departments of insurance for financial and contractual compliance, and our HMOs are audited for compliance with health services standards by respective state departments of health. Most states’ laws require such audits to be performed at least once every three years.
 
Our licensed subsidiaries are subject to regulation under state insurance holding company and Commonwealth of Puerto Rico regulations. These regulations generally require, among other things, prior approval and/or notice of certain material transactions, including dividend payments, intercompany agreements and the filing of various financial and operational reports.
 
Certain of our subsidiaries operate in states that regulate the payment of dividends to Humana Inc., our parent company, require minimum levels of equity, and limit investments to approved securities. The amount of dividends that may be paid to Humana Inc. by these subsidiaries, without prior approval by state regulatory

11


authorities, is limited based on the entity’s level of statutory income and statutory capital and surplus. In most states, prior notification is provided before paying a dividend that does not require approval.
 
At December 31, 2001, our regulated health insurance subsidiaries, other than our federally regulated TRICARE subsidiaries, maintained aggregate statutory capital and surplus of $1,079.9 million. Each of these subsidiaries was in compliance with applicable statutory requirements, which aggregated $521.9 million in total. Although the minimum required levels of equity are largely based on premium volume, product mix and the quality of assets held, minimum requirements can vary significantly at the state level. Certain states rely on risk-based capital requirements, or RBC, to define the required levels of equity. RBC is a model developed by the National Association of Insurance Commissioners to monitor an entity’s solvency. This calculation indicates recommended minimum levels of required capital and surplus and signals regulatory measures should actual surplus fall below these recommended levels. Some states are in the process of phasing in these RBC requirements over a number of years. If RBC were fully implemented by all states at December 31, 2001, each of our subsidiaries would be in compliance and we would have $494.4 million of aggregate capital and surplus above the minimum level required under RBC.
 
Our management works proactively to ensure compliance with all governmental laws and regulations affecting our business.
 
Health Care Reform
 
There continue to be diverse legislative and regulatory initiatives at both the federal and state levels to address aspects of the nation’s health care system.
 
Federal
 
In 2000, Congress passed BIPA, amending certain provisions of the Balanced Budget Act of 1997, and certain provisions of the Medicare, Medicaid and State Children’s Health Insurance Program Balanced Budget Refinement Act of 1999. The Balanced Budget Act changed the way health plans are compensated for Medicare members by eliminating over five years amounts paid for graduate medical education, increasing the blend of national cost factors applied in determining local reimbursement rates over a six-year phase-in period and directing CMS to implement a risk adjusted mechanism on its monthly member payment to Medicare plans over the same period. These changes have had the effect of reducing reimbursement in high cost metropolitan areas with a large number of teaching hospitals. Congress has subsequently lengthened this timetable to allow the risk adjusted mechanism to be fully implemented by 2007. BIPA, among other things, enacted modest increases to the payment formula for Medicare+Choice plans. While we believe that these increases and modifications restore some Medicare+Choice reimbursement, pending legislative and regulatory initiatives could cause us to again consider increasing enrollee out-of-pocket costs, modifying benefits or exiting markets. On January 1, 2001, we exited our Medicare product in 45 counties, affecting approximately 54,000 members, and again on January 1, 2002, we exited our Medicare product in 5 counties in the Kentucky market, affecting approximately 14,000 members and DuPage County, Illinois affecting approximately 8,000 members. These county exits were the result, in part, of lower CMS reimbursement rates. We are working with CMS to develop other alternative offerings. For example, we are participating in a Medicare+Choice private fee-for-service pilot program in DuPage County, Illinois covering approximately 2,000 members.
 
Other federal laws which govern our business and which significantly affect our operations include, among others, the Newborn’s and Mothers’ Health Protection Act of 1996. This Act generally prohibits group health plans and health insurance issuers from restricting benefits for a mother’s or newborn child’s hospital stay in connection with childbirth to less than 48 hours for a normal delivery and to less than 96 hours for a cesarean section.
 
On November 21, 2000, the Department of Labor published its final regulation on claims review procedures under the Employee Retirement Security Act of 1974, or ERISA. The claims procedure regulation applies to all

12


employee benefit plans governed by ERISA, whether benefits are provided through insurance products or are self-funded. As a result, the new claims review regulation impacts nearly all employer and union-sponsored health and disability plans, except church and government plans. Similar to legislation recently passed by many states, the new ERISA claims procedures impose shorter and more detailed procedures for processing and reviewing claims and appeals. According to the Department of Labor, however, its ERISA claims regulation does not preempt state insurance and utilization review laws that impose different procedures or time lines, unless complying with the state law would make compliance with the new ERISA regulation impossible. Unlike its state counterparts, the ERISA claims rule does not provide for independent external review to decide disputed medical questions. Instead, the federal regulation will generally make it easier for claimants to avoid state-mandated internal and external review processes and to file suit in federal court. Because the processes and timelines established by the new ERISA claims rules are similar to existing state requirements, although different in many of their particulars, it is difficult to estimate the cost of bringing the Company’s claims procedures into compliance. Pending outcome of litigation currently pending before the U. S. Supreme Court, it is also difficult to predict the impact that the new ERISA rules will have on state external review laws. The United States Supreme Court has a number of cases before it addressing the preemptive effect of ERISA on state laws, and may issue important decisions on these cases during 2002. The new ERISA claims rules generally become effective July 1, 2002 or the first day of the first plan year beginning after July 1, 2002, whichever is later. In any case, health plans must comply with the new rules with respect to all claims filed on or after January 1, 2003. Although the cost of complying with these regulations is likely to be significant, we cannot predict the ultimate impact on our business or results of operations in future periods.
 
The Health Insurance Portability and Accountability Act of 1996, or HIPAA, includes administrative provisions directed at simplifying electronic data interchange through standardizing transactions, establishing uniform health care provider, payor and employer identifiers and seeking protections for confidentiality and security of patient data. Under the new HIPAA standard transactions and code sets rules, we must make significant systems enhancements and invest in new technical solutions. The standard transactions and code sets rules compliance date may be extended by any covered entity until October 17, 2003 by submitting a request to the Secretary of Health and Human Services by October 16, 2002. We intend to file for the extension. Under the new HIPAA privacy rules, we must comply with a variety of requirements concerning the use and disclosure of individuals’ protected health information, establish rigorous internal procedures to protect health information and enter into business associate contracts with those companies to whom protected health information is disclosed. Violations of these rules will subject us to significant penalties. Compliance with HIPAA regulations requires significant systems enhancements, training and administrative effort. The final rules do not provide for complete federal preemption of state laws, but rather preempt all inconsistent state laws unless the state law is more stringent. HIPAA could also expose us to additional liability for violations by our business associates.
 
Further in 1999, Congress passed the Financial Services Modernization Act, or Gramm Leach Bliley Act, that includes provisions related to privacy standards for personal information to be implemented by both the federal government and the states. This law became effective in July 2001. Many states are currently enacting laws or regulations to implement the federal law. We intend to comply with such provisions.
 
There are several other legislative proposals under consideration that include, among other things, a Patient Bill of Rights, expansion of a patient’s right to sue and mandatory external review of health plan coverage decisions. Under some versions of these bills, our exposure to large jury verdicts could be increased.
 
In addition, Congress is evaluating proposals to expand tax credits to provide health insurance for low-income families or expansion of governmental programs to permit enrollment at lower costs. Other proposals include establishing additional protections for personal health information, collective bargaining rights for independent physicians, proposals to reduce the number of medical errors by health care providers and systems of care, and various state and/or federal purchasing pools to allow individuals and small employers to purchase health insurance. Also, Congress is evaluating proposals to expand Medicare benefits to cover prescription drugs for Medicare-eligible seniors or to introduce a pharmacy discount card. Many of these proposals may require

13


additional administrative costs to ensure compliance and we are currently assessing their cost and impact on premiums for the future.
 
State
 
A number of states continue to enact some form of managed care reform. Three of these states in which we conduct business, including Arizona, Georgia and Texas, have passed health plan liability laws. To date, no significant increase in litigation has arisen as a result; however, management is unable to predict future activity under these laws. Issues relating to managed care consumer protection standards, including increased plan information disclosure, expedited appeals and grievance procedures, third party review of certain medical decisions, health plan liability, access to specialists, physician collective bargaining rights and confidentiality of medical records continue to be under discussion. Further, proposals that place restrictions on the selection and termination of participating health care providers also are receiving review.
 
Another area receiving increased focus in 2002 is the time in which various laws require the payment of health care claims. Many states already have legislation in place covering payment of claims within a specific number of days. However, due to provider groups advocating for laws or regulations establishing even stricter standards, procedures and penalties, we expect additional regulatory scrutiny and supplemental legislation with respect to claims payment practices. The provider-sponsored bills are characterized by stiff penalties for late payment, including high interest rates payable to providers and costly fines levied by state insurance departments and attorneys general. This legislation and possible future regulation and oversight could expose our Company to additional liability and penalties.
 
We are unable to predict how existing federal or state laws and regulations may be changed or interpreted, what additional laws or regulations affecting our businesses may be enacted or proposed, when and which of the proposed laws will be adopted or what effect any such new laws and regulations will have on our financial position, results of operations or cash flows.
 
Other
 
Captive Insurance Company
 
We insure substantially all professional liability risks through a wholly owned subsidiary. Independent actuaries determine the annual premiums paid to this subsidiary. Our subsidiary reinsures levels of coverage for losses in excess of our retained limits with unrelated insurance carriers. In 2002, we increased the retention limits with respect to our wholly owned captive insurance subsidiary as a result of substantially higher insurance rates.
 
Centralized Management Services
 
We provide centralized management services to each health plan from our headquarters and service centers. These services include management information systems, product administration, financing, personnel, development, accounting, legal advice, public relations, marketing, insurance, purchasing, risk management, actuarial, underwriting and claims processing.
 
Employees
 
As of December 31, 2001, we had approximately 14,500 employees, including approximately 40 employees covered by collective bargaining agreements. We have not experienced any work stoppages and believe we have good relations with our employees.

14


 
ITEM 2.    PROPERTIES
 
We own our principal executive office, which is located in the Humana Building, 500 West Main Street, Louisville, Kentucky 40202. In addition, we own buildings in Louisville, Kentucky, San Antonio, Texas, Green Bay, Wisconsin and Jacksonville, Florida, and lease facilities in Madison, Wisconsin, all of which are used for customer service and claims processing. Our Louisville and Green Bay facilities also perform enrollment processing and other corporate functions.
 
We also own or lease medical centers ranging in size from approximately 1,500 to 80,000 square feet. We no longer operate most of these medical centers but, rather, lease them to their provider operators. Our administrative market offices are generally leased, with square footage ranging from approximately 700 to 89,000. The following table lists the location of properties we owned or leased at December 31, 2001:
 
    
Medical
Centers

    
Administrative Offices

    
    
Owned

    
Leased

    
Owned

  
Leased

  
Total

Florida
  
6
    
71
    
1
  
26
  
104
Puerto Rico
  
    
    
  
9
  
9
Illinois
  
5
    
6
    
  
14
  
25
Texas
  
4
    
2
    
3
  
7
  
16
Kentucky
  
6
    
2
    
4
  
7
  
19
Wisconsin
  
    
    
1
  
9
  
10
Ohio
  
    
    
  
11
  
11
Missouri/Kansas
  
3
    
3
    
  
2
  
8
Others
  
1
    
1
    
1
  
69
  
72
    
    
    
  
  
Total
  
25
    
85
    
10
  
154
  
274
    
    
    
  
  
 
I TEM 3.    LEGAL PROCEEDINGS
 
Securities Litigation
 
Six purported class action complaints were filed in 1999 in the United States District Court for the Western District of Kentucky at Louisville by purported stockholders of the Company against the Company and certain of its current and former directors and officers. The complaints contained the same or substantially similar allegations; namely, that the Company and the individual defendants knowingly or recklessly made false or misleading statements in press releases and public filings concerning the Company’s financial condition, primarily with respect to the impact of negotiations over renewal of the Company’s contract with HCA-The Healthcare Company, formerly Columbia/HCA Healthcare Corporation, which took effect April 1, 1999. The complaints allege violations of Section 10(b) of the Securities Exchange Act of 1934 (the “1934 Act”) and SEC Rule 10b-5 and Section 20(a) of the 1934 Act. They seek certification of a class of stockholders who purchased shares of Humana common stock starting either (in four complaints) in late October 1998 or (in two complaints) on February 9, 1999, and ending (in all complaints) on April 8, 1999. Plaintiffs moved for consolidation of the actions, now styled In Re Humana Inc. Securities Litigation, and filed a consolidated Complaint. On April 28, 2000, the defendants filed a motion requesting dismissal of the Consolidated Complaint. On November 7, 2000, the United States District Court for the Western District of Kentucky issued a Memorandum Opinion and Order dismissing the action. On November 30, 2000, the plaintiffs filed a notice of appeal to the Court of Appeals for the Sixth Circuit. Oral argument is scheduled for June 11, 2002. The Company believes the above allegations are without merit and intends to continue to pursue defense of the action.
 
In late 1997, three purported class action complaints were filed in the United States District Court for the Southern District of Florida by former stockholders of Physician Corporation of America, or PCA, and certain of its former directors and officers. We acquired PCA by a merger that became effective on September 8, 1997. The

15


three actions were consolidated into a single action entitled In re Physician Corporation of America Securities Litigation. The consolidated complaint alleges that PCA and the individual defendants knowingly or recklessly made false and misleading statements in press releases and public filings with respect to the financial and regulatory difficulties of PCA’s workers’ compensation business. On May 5, 1999, plaintiffs moved for certification of the purported class, and on August 25, 2000, the defendants moved for summary judgment. On January 31, 2001, defendants were granted leave to file a third-party complaint for declaratory judgment on insurance coverage. The defendants seek a determination that the defense costs and liability, if any, resulting from the class action defense are covered by an insurance policy issued by one insurer and, in the alternative, declaring that there is coverage under policies issued by two other insurers. Defendants have moved for summary judgment on the third-party complaint, and the third-party defendants have moved to dismiss or stay the third-party complaint. On March 6, 2002, the Court, while not dismissing the matter, ordered mediation of the insurance coverage issue in accordance with the requirements of one of the insurance contracts.
 
Managed Care Industry Class Action Litigation
 
We are involved in several purported class action lawsuits that are part of a wave of generally similar actions that target the health care payor industry and particularly target managed care companies. As a result of action by the Judicial Panel on Multi District Litigation, most of the cases against us, as well as similar cases against other companies in the industry, have been consolidated in the United States District Court for the Southern District of Florida, or the Court, and are now styled In re Managed Care Litigation. The cases include separate suits against us and five other managed care companies that purport to have been brought on behalf of members, which are referred to as the subscriber track cases, and a single action against us and seven other companies that purports to have been brought on behalf of providers, which is referred to as the provider track case.
 
In the subscriber track cases, the plaintiffs seek a recovery under RICO for all persons who are or were subscribers at any time during the four-year period prior to the filing of the complaints. Plaintiffs also seek to represent a subclass of policyholders who purchased insurance through their employers’ health benefit plans governed by ERISA, and who are or were subscribers at any time during the six-year period prior to the filing of the complaints. The complaints allege, among other things, that we intentionally concealed from members certain information concerning the way in which we conduct business, including the methods by which we pay providers. The plaintiffs do not allege that any of the purported practices resulted in denial of any claim for a particular benefit, but instead, claim that we provided the purported class with health insurance benefits of lesser value than promised. The complaints also allege an industry-wide conspiracy to engage in the various alleged improper practices. The plaintiffs seek certification of a class consisting of all members of our medical plans, excluding Medicare and Medicaid plans, for the period from 1990 to 1999. We filed our opposition to the motion for class certification on November 15, 2000. A hearing on the class certification issue was conducted on July 24, 2001. No ruling has been issued on that issue.
 
On February 20, 2002, the Court issued its ruling on the defendants’ motions to dismiss the Second Consolidated Amended Complaint (the “Amended Complaint”). The Amended Complaint was filed on June 29, 2001, after the Court dismissed most of the claims in the original complaints, but granted leave to refile. In its February 20, 2002, ruling, the Court dismissed the RICO claims of ten of the sixteen named plaintiffs, including three of the four involving us, on the ground that the McCarran-Ferguson Act prohibited their claims because they interfered with the state regulatory processes in the states in which they resided (Florida, New Jersey, California and Virginia). With respect to ERISA, the Court dismissed the misrepresentation claims of current members, finding that they have adequate remedies under the law and failed to exhaust administrative remedies. Claims for former members were not dismissed. The Court also refused to dismiss claims by all members for breach of fiduciary duty arising from alleged interference with the doctor-patient relationship by the use of so-called “gag clauses” that assertedly prohibited doctors from freely communicating with members. On March 1, 2002, we and other defendants requested that the Court allow us to ask the United States Court of Appeals for the Eleventh Circuit to review the Court’s refusal to follow the decision by the Court of Appeals for the Third Circuit

16


in Maio v. Aetna that would have resulted in dismissal of the RICO claims. On March 4, 2002, the defendants filed a Motion for Partial Reconsideration of the February 20, 2002 Dismissal order.
 
In the provider track case, the plaintiffs assert that we and other defendants improperly (i) paid providers’ claims and (ii) “downcoded” their claims by paying lesser amounts than they submitted. The complaint alleges, among other things, multiple violations under RICO as well as various breaches of contract and violations of regulations governing the timeliness of claim payments. We moved to dismiss the provider track complaint on September 8, 2000, and the other defendants filed similar motions thereafter. On March 2, 2001, the Court dismissed certain of the plaintiffs’ claims pursuant to the defendants’ several motions to dismiss. However, the Court allowed the plaintiffs to attempt to correct the deficiencies in their complaint with an amended pleading with respect to all of the allegations except the claim under the federal Medicare regulations, which was dismissed with prejudice. The Court also left undisturbed the plaintiffs’ claims for breach of contract. On March 26, 2001, the plaintiffs filed their amended complaint which, among other things, added four state or county medical associations as additional plaintiffs. Two of those, the Denton County Medical Society and the Texas Medical Association, purport to bring their actions against us, as well as against several other defendant companies. The Medical Association of Georgia and the California Medical Association purport to bring their actions against various other defendant companies. The associations seek injunctive relief only. The Florida Medical Association has also announced its intent to join the action. The defendants filed a motion to dismiss the amended complaint on April 30, 2001. On October 27, 2000, the plaintiffs filed a motion for class certification. We filed our opposition to that motion on November 17, 2000. Oral argument on the motion for class certification was conducted May 7, 2001. No ruling has been issued.
 
Some defendants filed appeals to the United States Court of Appeals for the Eleventh Circuit from a ruling by the district court that refused to enforce several arbitration clauses in the provider agreements with the defendants in certain respects. On March 14, 2002, the Court of Appeals upheld the district court’s rulings on the arbitration issues.
 
We intend to continue to defend these actions vigorously.
 
Chipps v. Humana Health Insurance Company of Florida, Inc.
 
On January 4, 2000, a jury in Palm Beach County, Florida, rendered an approximately $80 million verdict against us in a case arising from removal of an insured from a special case management program. The award included approximately $78.5 million of punitive damages, $1 million of damages for emotional distress and $29,000 of damages for contractual benefits. On September 19, 2001, the Court of Appeals overturned the verdict, citing numerous errors by the trial court, and remanded for a new trial. The plaintiff filed a Motion for Rehearing EnBanc with the Court of Appeals on October 3, 2001. The Court of Appeals modified its ruling somewhat, but affirmed its reversal of the verdict. The case subsequently was settled in the first quarter of 2002 for approximately $2.2 million. This settlement was fully reserved at December 31, 2001.
 
Government Audits and Other Litigation and Proceedings
 
In July 2000, the Office of the Florida Attorney General initiated an investigation, apparently relating to some of the same matters that are involved in the purported class action lawsuits described above. While the Attorney General has filed no action against us, he has indicated that he may do so in the future. On September 21, 2001, the Texas Attorney General initiated a similar investigation. These investigations are ongoing, and we have cooperated with the regulators in both states.
 
In addition, our business practices are subject to review by various state insurance and health care regulatory authorities and federal regulatory authorities. Recently, there has been increased scrutiny by these regulators of the managed health care companies’ business practices, including claims payment practices and utilization management. We have been and continue to be subject to such reviews. Some of these could require changes in some of our practices and could also result in fines or other sanctions.

17


 
We also are involved in other lawsuits that arise in the ordinary course of our business operations, including claims of medical malpractice, bad faith, failure to properly pay claims, nonacceptance or termination of providers, failure to disclose network discounts and various provider arrangements, challenges to subrogation practices, and claims relating to performance of contractual obligations to providers and others. Recent court decisions and pending state and federal legislative activity may increase our exposure for any of these types of claims.
 
Personal injury claims and claims for extracontractual damages arising from medical benefit denials are covered by insurance from our wholly owned captive insurance subsidiary and excess carriers, except to the extent that claimants seek punitive damages, which may not be covered by insurance in certain states in which insurance coverage for punitive damages is not permitted. In addition, insurance coverage for all or certain forms of liability may become unavailable or prohibitively expensive in the future. In 2002, we increased the retention limits with respect to our wholly owned captive insurance subsidiary as a result of substantially higher insurance rates.
 
We do not believe that any pending or threatened legal actions against us or audits by agencies will have a material adverse effect on our financial position, results of operations, or cash flows. However, the likelihood or outcome of current or future suits, like the purported class action lawsuits described above, cannot be accurately predicted with certainty. In addition, the increased litigation which has accompanied the recent negative publicity and public perception of our industry adds to this uncertainty. Therefore, such legal actions could have a material adverse effect on our financial position, results of operations and cash flows.
 
ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
Not applicable.

18


PART II
 
ITEM 5.    MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
Our common stock trades on the New York Stock Exchange under the symbol HUM. The following table shows the range of high and low closing sales prices as reported on the New York Stock Exchange Composite Tape for each quarter in the years ended December 31, 2001 and 2000:
 
    
High

    
Low

Year Ended December 31, 2001
               
First quarter
  
$
14.94
    
$
9.84
Second quarter
  
$
10.71
    
$
8.58
Third quarter
  
$
12.19
    
$
9.30
Fourth quarter
  
$
12.89
    
$
10.22
Year Ended December 31, 2000
               
First quarter
  
$
9.25
    
$
6.13
Second quarter
  
$
8.69
    
$
4.75
Third quarter
  
$
10.75
    
$
5.25
Fourth quarter
  
$
15.38
    
$
10.50
 
As of March 20, 2002, there were approximately 7,200 holders of record of our common stock.
 
Since February 1993, we have not declared or paid any cash dividends on our common stock. We do not presently intend to pay dividends, and will retain our earnings for future operations and growth of our businesses.

19


 
ITEM 6.    SELECTED FINANCIAL DATA
 
    
2001

    
2000

    
1999 (a)

    
1998 (b)

    
1997 (c)

 
    
(in thousands, except per share results, membership and ratios)
 
Summary of Operations
                                            
Revenues:
                                            
Premiums
  
$
9,938,961
 
  
$
10,394,631
 
  
$
9,958,582
 
  
$
9,597,749
 
  
$
7,880,314
 
Administrative services fees
  
 
137,090
 
  
 
86,298
 
  
 
97,940
 
  
 
84,546
 
  
 
68,868
 
Investment and other income
  
 
118,835
 
  
 
115,021
 
  
 
155,013
 
  
 
183,885
 
  
 
155,715
 
    


  


  


  


  


Total revenues
  
 
10,194,886
 
  
 
10,595,950
 
  
 
10,211,535
 
  
 
9,866,180
 
  
 
8,104,897
 
    


  


  


  


  


Operating expenses:
                                            
Medical
  
 
8,279,844
 
  
 
8,781,998
 
  
 
8,533,090
 
  
 
8,040,951
 
  
 
6,521,866
 
Selling, general and administrative
  
 
1,545,129
 
  
 
1,524,799
 
  
 
1,466,181
 
  
 
1,413,329
 
  
 
1,185,610
 
Depreciation and amortization
  
 
161,531
 
  
 
146,548
 
  
 
123,858
 
  
 
127,662
 
  
 
107,675
 
Asset impairments and other charges
  
 
—  
 
  
 
—  
 
  
 
459,852
 
  
 
34,183
 
  
 
—  
 
    


  


  


  


  


Total operating expenses
  
 
9,986,504
 
  
 
10,453,345
 
  
 
10,582,981
 
  
 
9,616,125
 
  
 
7,815,151
 
    


  


  


  


  


Income (loss) from operations
  
 
208,382
 
  
 
142,605
 
  
 
(371,446
)
  
 
250,055
 
  
 
289,746
 
Interest expense
  
 
25,302
 
  
 
28,615
 
  
 
33,393
 
  
 
46,972
 
  
 
19,617
 
    


  


  


  


  


Income (loss) before income taxes
  
 
183,080
 
  
 
113,990
 
  
 
(404,839
)
  
 
203,083
 
  
 
270,129
 
Provision (benefit) for income taxes
  
 
65,909
 
  
 
23,938
 
  
 
(22,419
)
  
 
74,126
 
  
 
96,657
 
    


  


  


  


  


Net income (loss)
  
$
117,171
 
  
$
90,052
 
  
$
(382,420
)
  
$
128,957
 
  
$
173,472
 
    


  


  


  


  


Basic earnings (loss) per common share
  
$
0.71
 
  
$
0.54
 
  
$
(2.28
)
  
$
0.77
 
  
$
1.06
 
    


  


  


  


  


Diluted earnings (loss) per common share
  
$
0.70
 
  
$
0.54
 
  
$
(2.28
)
  
$
0.77
 
  
$
1.05
 
    


  


  


  


  


Financial Position
                                            
Cash and investments
  
$
2,321,336
 
  
$
2,306,148
 
  
$
2,778,546
 
  
$
2,843,423
 
  
$
2,828,264
 
Total assets
  
 
4,403,638
 
  
 
4,306,978
 
  
 
4,899,845
 
  
 
5,495,605
 
  
 
5,600,444
 
Medical and other expenses payable
  
 
1,086,386
 
  
 
1,181,027
 
  
 
1,756,227
 
  
 
1,908,175
 
  
 
2,074,934
 
Debt
  
 
578,489
 
  
 
599,952
 
  
 
686,213
 
  
 
822,977
 
  
 
889,195
 
Stockholders’ equity
  
 
1,507,949
 
  
 
1,360,421
 
  
 
1,268,009
 
  
 
1,688,363
 
  
 
1,501,315
 
Operating Data
                                            
Medical expense ratio
  
 
83.3
%
  
 
84.5
%
  
 
85.7
%
  
 
83.8
%
  
 
82.8
%
SG&A expense ratio
  
 
15.3
%
  
 
14.5
%
  
 
14.6
%
  
 
14.6
%
  
 
14.9
%
Medical Membership by Segment
                                            
Commercial:
                                            
Fully insured
  
 
2,301,300
 
  
 
2,545,800
 
  
 
3,083,600
 
  
 
3,261,500
 
  
 
3,258,600
 
Administrative services only
  
 
592,500
 
  
 
612,800
 
  
 
648,000
 
  
 
646,200
 
  
 
651,200
 
Medicare supplement
  
 
—  
 
  
 
—  
 
  
 
44,500
 
  
 
56,600
 
  
 
68,800
 
    


  


  


  


  


Total Commercial
  
 
2,893,800
 
  
 
3,158,600
 
  
 
3,776,100
 
  
 
3,964,300
 
  
 
3,978,600
 
    


  


  


  


  


Government:
                                            
Medicare+Choice
  
 
393,900
 
  
 
494,200
 
  
 
488,500
 
  
 
502,000
 
  
 
480,800
 
Medicaid
  
 
490,800
 
  
 
575,600
 
  
 
616,600
 
  
 
643,800
 
  
 
635,200
 
TRICARE
  
 
1,714,600
 
  
 
1,070,300
 
  
 
1,058,000
 
  
 
1,085,700
 
  
 
1,112,200
 
TRICARE ASO
  
 
942,700
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
  
 
—  
 
    


  


  


  


  


Total Government
  
 
3,542,000
 
  
 
2,140,100
 
  
 
2,163,100
 
  
 
2,231,500
 
  
 
2,228,200
 
    


  


  


  


  


Total Medical Membership
  
 
6,435,800
 
  
 
5,298,700
 
  
 
5,939,200
 
  
 
6,195,800
 
  
 
6,206,800
 
    


  


  


  


  


Commercial Specialty Membership
                                            
Dental
  
 
1,690,700
 
  
 
1,665,900
 
  
 
1,628,200
 
  
 
1,375,500
 
  
 
936,400
 
Other
  
 
571,300
 
  
 
678,900
 
  
 
1,333,100
 
  
 
1,257,800
 
  
 
1,504,200
 
    


  


  


  


  


Total specialty membership
  
 
2,262,000
 
  
 
2,344,800
 
  
 
2,961,300
 
  
 
2,633,300
 
  
 
2,440,600
 
    


  


  


  


  



(a)
 
Includes charges of $584.8 million pretax ($499.3 million after tax, or $2.97 per diluted share) primarily related to goodwill impairment, losses on non-core asset sales, professional liability reserve strengthening, premium deficiency and medical reserve strengthening.
 
(b)
 
Includes charges of $132.4 million pretax ($84.1 million after tax, or $0.50 per diluted share) primarily related to the costs of certain market exits and product discontinuances, asset impairments, premium deficiency and a one-time non-officer employee incentive.
 
(c)
 
Includes the operations of the following entities since the dates we acquired them: Health Direct, Inc., February 28, 1997; Physician Corporation of America, September 8, 1997; and ChoiceCare Corporation, October 17, 1997.

20


 
ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The consolidated financial statements of Humana Inc. in this document present the Company’s financial position, results of operations and cash flows, and should be read in conjunction with the following discussion and analysis. References to “we,” “us,” “our,” “Company,” and “Humana” mean Humana Inc. and its subsidiaries. This discussion includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. When used in this filing and in future filings with the Securities and Exchange Commission, in our press releases, investor presentations, and in oral statements made by or with the approval of one of our executive officers, the words or phrases like “expects,” “anticipates,” “intends,” “likely will result,” “estimates,” “projects” or variations of such words and similar expressions are intended to identify such forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions, including, among other things, information set forth in the “Cautionary Statements” section of this document. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this document might not occur. There may also be other risks that we are unable to predict at this time. Any of these risks and uncertainties may cause actual results to differ materially from the results discussed in the forward-looking statements.
 
Introduction
 
Headquartered in Louisville, Kentucky, Humana Inc. is one of the nation’s largest publicly traded health benefits companies, based on our 2001 revenues of $10.2 billion. We offer coordinated health insurance coverage and related services through a variety of traditional and Internet-based plans for employer groups, and government-sponsored programs. As of December 31, 2001, we had approximately 6.4 million members in our medical insurance programs, as well as approximately 2.3 million members in our specialty products programs. We have approximately 400,000 contracts with physicians, hospitals, dentists and other providers to provide health care to our members. In 2001, over 70% of our premiums and administrative services fees were derived from members located in Florida, Illinois, Texas, Kentucky, and Ohio.
 
During the first quarter of 2001, we realigned our management to better reflect our focus on the consumer. As part of this management realignment, we redefined our business into two segments, Commercial and Government. The Commercial segment consists of members enrolled in products marketed to employer groups and individuals, and includes three lines of business: fully insured medical, administrative services only, or ASO, and specialty. The Government segment consists of members enrolled in government-sponsored plans, and includes three lines of business: Medicare+Choice, Medicaid, and TRICARE. Results of each segment are measured by income before income taxes. We allocate all selling, general and administrative expenses, investment and other income, and interest expense, but not assets, to our segments. Members served by our two segments generally utilize the same medical provider networks, enabling us to obtain more favorable contract terms with providers. Our segments also share overhead costs and assets. As a result, the profitability of each segment is interdependent.
 
We recently concluded a two-year process of divesting those products and markets that either lacked the prospect for long-term profitability or no longer fit our strategic focus. During 2000 and 2001, we completed transactions to divest our workers’ compensation business and our Medicaid businesses in north Florida, Milwaukee, Wisconsin, and Austin, Houston and San Antonio, Texas. We also exited numerous counties in our Medicare+Choice business, reinsured with third parties substantially all of our Medicare supplement business, and discontinued aspects of our product line focusing on small group commercial business in 17 states.
 
Our core strategy currently focuses on growth. The cornerstone of our commercial growth strategy is the offering of innovative products which are supported by technology and service excellence. During the past two years, we developed an expansive range of consumer-directed products and developed industry-leading electronic self-service capabilities. Within the Commercial segment during 2001, we experienced membership

21


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

declines primarily as a result of exercising a rigorous pricing discipline in small group accounts located in geographic markets that are not considered key to our long-term growth strategy. Although we will continue to employ pricing discipline, we anticipate growth in our commercial membership during 2002 as a result of this consumer-directed approach and our commitment to provide excellent customer service.
 
Within our Government segment, we acquired 1.2 million eligible TRICARE members on May 31, 2001. TRICARE is the U.S. Department of Defense’s health benefits program for military dependents and retirees. Humana has been the TRICARE contractor for Regions 3 and 4 since 1996. The 1.2 million additional TRICARE members, from Regions 2 and 5, brought total Humana TRICARE membership to 2.7 million members, making us the leading national contractor for this program. Additionally, during 2001, a new government program, called TRICARE for Life, became effective allowing beneficiaries to continue in the TRICARE program even after becoming eligible for Medicare. Under the TRICARE for Life program, we provide administrative services only, for a fee, while the Department of Defense retains the risk of financing the costs of benefits. As of December 31, 2001, TRICARE ASO membership was 0.9 million of the total 2.7 million TRICARE members, including 0.6 million members in Regions 2 and 5 acquired in 2001.
 
Critical Accounting Policies and Estimates
 
The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements and accompanying notes, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements and accompanying notes requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an on-going basis, we evaluate our estimates and those critical accounting policies related primarily to revenue and medical cost recognition. These estimates are based on knowledge of current events and anticipated future events, and accordingly, actual results may ultimately differ from those estimates. We believe the following critical accounting policies, among others, affect the more significant judgments and estimates used in the preparation of our consolidated financial statements.
 
Revenue Recognition
 
We generally establish one-year commercial membership contracts with employer groups, subject to cancellation by the employer group’s written notice. Our TRICARE contracts with the federal government and various state Medicaid programs are generally multi-year contracts. Our Medicare+Choice contracts with the federal government renew annually. We bill and collect premium remittances from employer groups and some individual Medicare+Choice members monthly. We receive monthly premiums from the federal government and various states according to government specified reimbursement rates and various contractual terms.
 
Premium revenues are recognized as income in the period members are entitled to receive services, and are net of estimated uncollectible amounts and retroactive membership adjustments. Retroactive membership adjustments result from enrollment changes not yet processed, or not reported by an employer group or the government. We routinely monitor these trends, as well as prevailing and anticipated economic conditions, and any required adjustments are reflected in current operations. Premiums and operating expenses may also include adjustments attributable to our TRICARE contracts, which generally reflect variation in healthcare experience and change orders for services not originally specified in the contracts. Our TRICARE contracts are subject to adjustments resulting from negotiations with the federal government. Revenues and corresponding expenses for these adjustments generally are recognized when a settlement becomes known and the collectibility reasonably assured.
 
Administrative services fees are earned as services are performed. Administrative services generally include the processing of claims, offering access to our provider networks and clinical programs, and responding to customer services inquiries from members of self-funded employers. Under ASO contracts, self-funded employers and, for TRICARE ASO, the Department of Defense, retain the risk of financing the cost of health benefits.

22


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
Premiums receivable are shown net of an allowance for estimated uncollectible accounts and retroactive membership adjustments based on historical trends. Premiums received prior to the period members are entitled to receive services are recorded as unearned premium revenues.
 
Medical Cost Recognition
 
Medical costs include claim payments, capitation payments, allocations of certain centralized expenses and various other costs incurred to provide health insurance coverage to members, as well as estimates of future payments to hospitals and others for medical care provided prior to the balance sheet date. Capitation payments represent monthly contractual fees disbursed to primary care physicians and other providers who are responsible for providing medical care to members. We estimate the costs of our future medical claims and other expense payments using actuarial methods and assumptions based upon claim payment patterns, medical cost inflation, historical developments such as claim inventory levels and claim receipt patterns, and other relevant factors, and record medical claims reserves for future payments. We continually review estimates of future payments relating to medical claims costs for services incurred in the current and prior periods and make necessary adjustments to our reserves.
 
We reassess the profitability of our contracts for providing health insurance coverage to our members when current operating results or forecasts indicate probable future losses. We establish a premium deficiency liability in current operations to the extent that the sum of a market’s expected future medical costs, claim adjustment expenses, and maintenance costs exceeds related future premiums under contract. Anticipated investment income is not considered for purposes of computing the premium deficiency. Losses recognized as a premium deficiency result in a beneficial effect in subsequent periods as operating losses under these contracts are charged to the liability previously established. At December 31, 2001, there were no premium deficiency liabilities. Because the majority of our member contracts renew annually, we do not anticipate recording a premium deficiency liability, except when unanticipated adverse events or changes in circumstances indicate otherwise.
 
Medical cost inflation, among other items, may significantly impact our estimate of medical costs. Medical cost inflationary trends today are substantially higher than other segments of the economy and are increasing at an accelerating rate. In the early 1990’s employer-driven migration to HMO enrollment was popular and resulted in several years of very low medical cost trends. Today, there are very few economic forces existing to mitigate increases in the utilization of hospital and physician services, prescription drugs and new medical technologies, and the inflationary trend on the cost per unit for each of these expense components. Other factors which could contribute to fluctuations in cost trends are government mandated benefits or other regulatory changes, catastrophes and epidemics.
 
We believe our medical and other expenses payable are adequate to cover future claims payments required. However, a relatively small variance between our estimates of medical cost trends and actual trends could have a material impact, either favorable or unfavorable, on the adequacy of our medical claims reserves and our overall financial position. For example, a 10 basis point change in the estimate of our medical and other expenses payable at December 31, 2001, which represents 38% of total liabilities, would require an adjustment of $10.9 million in a future period in which the revision in the estimate becomes known. A 100 basis point change in estimated medical expense trends would have changed annual pretax results of our Commercial segment by $43.6 million and our Government segment by $39.2 million in 2001.
 
Recent Transactions
 
Acquisitions
 
On May 31, 2001, we acquired the outstanding shares of common stock of a newly-formed Anthem Health Insurance Company subsidiary responsible for administering TRICARE benefits in Regions 2 and 5 for $43.5 million in cash, net of direct transaction costs.

23


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
During 2000, we acquired a Houston-based health plan, two operating shell entities for future business initiatives, and a hospital in-patient management services firm for $76.3 million in cash, net of direct transaction costs.
 
On June 1, 1999, we reached an agreement with FPA Medical Management, Inc., or FPA, FPA’s lenders and a federal bankruptcy court under which we acquired the operations of 50 medical centers from FPA for approximately $14.8 million in cash, net of direct transaction costs. We subsequently transferred operating responsibility for all acquired FPA medical centers under long-term provider agreements.
 
We accounted for each of these acquisitions under the purchase method of accounting and accordingly, our consolidated results of operations include the results of the acquired businesses from the date of acquisition. For each acquisition, we allocated the purchase price to net tangible and identifiable intangible assets based upon their fair values. Any remaining value not assigned to net tangible or identifiable intangible assets was then allocated to goodwill. Identifiable intangible assets primarily relate to government, subscriber and provider contracts and the cost of the acquired licenses. Goodwill and identifiable intangible assets recorded in connection with the acquisitions were $44.8 million in 2001, $52.1 million in 2000, and $16.5 million in 1999. The identifiable intangible assets are being amortized over periods ranging from 2 to 20 years, with a weighted average life of 5.7 years, while goodwill is being amortized over periods ranging from 6 to 20 years, with a weighted average life of 17.0 years. Unaudited pro forma results of operations information have not been presented because the effects, individually or in the aggregate, of these acquisitions were not significant to our results of operations or financial position.
 
Effective January 1, 2000, we adopted a 20-year amortization period from the date of acquisition for goodwill previously amortized over 40 years. As further discussed in the “Recently Issued Accounting Pronouncements” section of this document, we ceased amortizing goodwill subject to an annual impairment test upon adopting Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, effective January 1, 2002.
 
Divestitures
 
During 2000, we completed transactions to divest our workers’ compensation, north Florida Medicaid and Medicare supplement businesses. We estimated and recorded a $117.2 million loss in 1999 related to these divestitures. There was no change in the estimated loss during 2000. Divested assets, consisting primarily of investment securities and reinsurance recoverables, totaled $651.9 million. Divested liabilities, consisting primarily of workers’ compensation and other reserves, totaled $437.6 million. Cash proceeds were $97.1 million, net of direct transaction costs for 2000. Revenue and pretax results associated with these businesses for the years ended December 31, 2000, and 1999 were as follows:
 
    
For the year ended December 31,

 
    
2000

      
1999

 
    
(in thousands)
 
Revenues
  
$
102,939
 
    
$
218,090
 
Pretax results
  
$
(8,359
)
    
$
(12,889
)
 
Recently Issued Accounting Pronouncements
 
In June 2001, the Financial Accounting Standards Board, or FASB, issued Statement No. 141, Business Combinations, or Statement 141, and Statement No. 142, Goodwill and Other Intangible Assets, or Statement 142.
 
Statement 141 requires that all business combinations initiated after June 30, 2001 be accounted for using the purchase method. Use of the pooling-of-interest method is no longer permitted.

24


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
Statement 142 requires that goodwill no longer be amortized to earnings, but instead be reviewed at least annually for impairment using a two-step process. The first step is a screen for potential impairment, and the second step measures the amount of impairment, if any. Impairment losses that arise from completing a transitional impairment test during 2002 are to be reported as the cumulative effect of a change in accounting principle at the beginning of the year. Subsequent impairments, if any, would be classified as an operating expense. Statement 142 also specifies the types of acquired intangible assets that are required to be recognized and reported separately from goodwill.
 
At December 31, 2001, goodwill and identifiable intangible assets represented 19% of total assets and 55% of total stockholders’ equity. In 2001, amortization expense was $55.1 million for goodwill and $13.5 million for identifiable intangible assets. Effective January 1, 2002, we ceased amortizing goodwill upon adopting Statement 142. Statement 142 requires completion of the first step of the transitional impairment test by June 30, 2002. Completion of the second step, if necessary, is required as soon as possible upon completing the first step but no later than December 31, 2002. We are currently in the process of completing the transitional impairment test. This test requires fair value measurements. We expect to use a discounted cash flow analysis and other valuation methodologies which utilize many assumptions and estimates in determining an impairment loss including assumptions and estimates related to future earnings. Until we complete our analysis, no assurances can be given that we will or will not have an impairment.
 
In October 2001, the FASB issued Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, or Statement 144. Statement 144 develops a single accounting model for long-lived assets to be disposed of by sale, and addresses significant implementation issues related to previous guidance. Statement 144 requires that long-lived assets to be disposed of by sale be measured at the lower of their carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations. Statement 144 also broadens the reporting of discontinued operations by potentially qualifying more disposal transactions for discontinued operations reporting. Generally, the provisions of Statement 144 are to be applied prospectively beginning on January 1, 2002.
 
Other
 
No related party transactions had a material effect on our financial position, results of operations, or cash flows. Certain immaterial related party transactions are discussed in our Proxy Statement for the Annual Meeting to be held May 16, 2002—see “Certain Transactions with Management and Others.”

25


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
Comparison of Results of Operations for 2001 and 2000
 
The following table presents certain financial data for our two segments for the years ended December 31, 2001 and 2000:
 
    
For the year ended December 31,

 
    
2001

      
2000

 
    
(in thousands, except ratios)
 
Premium revenues:
                   
Fully insured
  
$
4,941,888
 
    
$
5,263,602
 
Specialty
  
 
304,714
 
    
 
291,315
 
    


    


Total Commercial
  
 
5,246,602
 
    
 
5,554,917
 
    


    


Medicare+Choice
  
 
2,909,478
 
    
 
3,286,351
 
TRICARE
  
 
1,341,557
 
    
 
892,375
 
Medicaid
  
 
441,324
 
    
 
660,988
 
    


    


Total Government
  
 
4,692,359
 
    
 
4,839,714
 
    


    


Total
  
$
9,938,961
 
    
$
10,394,631
 
    


    


Administrative services fees:
                   
Commercial
  
$
84,204
 
    
$
86,298
 
Government
  
 
52,886
 
    
 
—  
 
    


    


Total
  
$
137,090
 
    
$
86,298
 
    


    


Medical expense ratios:
                   
Commercial
  
 
83.1
%
    
 
83.6
%
Government
  
 
83.6
%
    
 
85.5
%
    


    


Total
  
 
83.3
%
    
 
84.5
%
    


    


SG&A expense ratios:
                   
Commercial
  
 
17.6
%
    
 
17.2
%
Government
  
 
12.8
%
    
 
11.5
%
    


    


Total
  
 
15.3
%
    
 
14.5
%
    


    


Income (loss) before income taxes:
                   
Commercial
  
$
(2,013
)
    
$
(7,954
)
Government
  
 
185,093
 
    
 
121,944
 
    


    


Total
  
$
183,080
 
    
$
113,990
 
    


    


 
The following table presents our medical membership at December 31, 2001 and 2000:
 
    
December 31,

  
Change

 
    
2001

  
2000

  
Members

    
Percentage

 
Commercial segment medical members:
                       
Fully insured
  
2,301,300
  
2,545,800
  
(244,500
)
  
(9.6
)%
ASO
  
592,500
  
612,800
  
(20,300
)
  
(3.3
)%
    
  
  

  

Total Commercial
  
2,893,800
  
3,158,600
  
(264,800
)
  
(8.4
)%
    
  
  

  

Government segment medical members:
                       
Medicare+Choice
  
393,900
  
494,200
  
(100,300
)
  
(20.3
)%
Medicaid
  
490,800
  
575,600
  
(84,800
)
  
(14.7
)%
TRICARE
  
1,714,600
  
1,070,300
  
644,300
 
  
60.2
%
TRICARE ASO
  
942,700
  
—  
  
942,700
 
  
100.0
%
    
  
  

  

Total Government
  
3,542,000
  
2,140,100
  
1,401,900
 
  
65.5
%
    
  
  

  

Total medical membership
  
6,435,800
  
5,298,700
  
1,137,100
 
  
21.5
%
    
  
  

  

26


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
Overview
 
Net income was $117.2 million, or $0.70 per diluted share in 2001, compared to net income of $90.1 million, or $0.54 per diluted share in 2000. This increase in earnings occurred despite an increase in our effective income tax rate from 21% in 2000 to 36% in 2001. The earnings increase resulted primarily from significant Medicare+Choice benefit reductions, improvements in determining appropriate premiums for our fully insured commercial medical membership (a process we refer to as pricing discipline) and divestitures of those products and markets that either lacked the prospect for long-term profitability or no longer fit our strategic focus.
 
Premium Revenues and Medical Membership
 
Premium revenues decreased 4.4% to $9.9 billion for 2001, compared to $10.4 billion for 2000. This decrease was due to medical membership reductions from exiting numerous markets and products, partially offset by higher premium revenues from our TRICARE acquisition on May 31, 2001, and premium yields in our commercial and Medicare+Choice products. Premium yield represents the percentage increase in the average premium per member over the comparable period in the prior year. Items impacting premium yield include changes in premium rates, changes in government reimbursement rates, changes in the geographic mix of membership, and changes in the mix of benefit plans selected by our membership.
 
Commercial segment premium revenues decreased 5.6% to $5.2 billion for 2001, compared to $5.6 billion for 2000. This decrease was due to membership reductions partially offset by premium yields on our fully insured commercial business. Our fully insured commercial medical membership decreased 9.6% or 244,500 members, to 2,301,300 at December 31, 2001 compared to 2,545,800 at December 31, 2000, as we continued to focus on opportunities that satisfy our pricing criteria, and exit non-core businesses.
 
Government segment premium revenues decreased 3.0% to $4.7 billion for 2001, compared to $4.8 billion for 2000. This decrease was primarily attributable to reductions in our Medicare+Choice and Medicaid membership partially offset by higher Medicare+Choice premium yield in 2001, and higher premium revenues from our TRICARE acquisition on May 31, 2001. Medicare+Choice membership was 393,900 at December 31, 2001 compared to 494,200 at December 31, 2000, a decline of 100,300 members, or 20.3%. This decline in membership primarily was attributable to the exits from 45 Medicare counties on January 1, 2001. Medicaid membership was 490,800 at December 31, 2001 compared to 575,600 at December 31, 2000, a decline of 84,800 members. This decline resulted primarily from the divestiture of our north Florida, Milwaukee, Wisconsin, and Austin, San Antonio and Houston, Texas Medicaid businesses. For 2001, TRICARE premiums were $1.3 billion compared to $892.4 million for 2000, an increase of $449.2 million. Fully insured TRICARE membership increased by 644,300 members, or 60.2%, to 1,714,600 at December 31, 2001 compared to 1,070,300 at December 31, 2000 due to the TRICARE Regions 2 and 5 acquisition on May 31, 2001. This acquisition increased TRICARE fully insured medical members by approximately 648,000 members.
 
For the Commercial segment, we are expecting net growth in medical membership for 2002. However, we are anticipating that the most significant gains in Commercial membership will occur in the first quarter of 2002, since that is when most of our large group customers renew their contracts with us, and most prospective large group customers select new health benefit carriers. For our Government segment, we are expecting our Medicare+Choice membership to decline to approximately 365,000 members at the end of the first quarter of 2002, due to our exit of 5 counties on January 1, 2002, where we served approximately 14,000 members as well as the attrition of some members selecting other plans in various markets as a result of new January 1, 2002 benefit designs.
 

27


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

Administrative Services Fees
 
Administrative services fees for 2001 were $137.1 million, an increase of $50.8 million from $86.3 million for 2000. This increase primarily was due to the TRICARE Regions 2 and 5 acquisition, and servicing medical and pharmacy benefits in an administrative capacity under the new TRICARE program for seniors, called TRICARE for Life.
 
Investment and Other Income
 
Investment and other income totaled $118.8 million in 2001, an increase of $3.8 million from $115.0 million in 2000. The increased investment and other income resulted from higher average invested balances partially offset by lower interest rates.
 
Medical Expense
 
Total medical expenses as a percentage of premium revenues, or medical expense ratio, for 2001 was 83.3%, decreasing 120 basis points from 84.5% for 2000. The improvement in the medical expense ratio primarily was due to significant benefit reductions in our Medicare+Choice product effective January 1, 2001, continued discipline in commercial pricing, and the exit of numerous higher cost markets and products during 2000.
 
The Commercial segment medical expense ratio for 2001 was 83.1%, decreasing 50 basis points from 83.6% for 2000. Our improving Commercial medical expense ratio results primarily from exercising pricing discipline in our fully insured accounts.
 
The Government segment medical expense ratio for 2001 was 83.6%, decreasing 190 basis points from 85.5% for 2000. This improvement primarily resulted from exiting 45 non-core counties in our Medicare+Choice business with higher medical expense ratios on January 1, 2001, coupled with significant benefit design changes which also became effective on that date.
 
SG&A Expense
 
Total selling, general and administrative, or SG&A, expenses as a percentage of premium revenues and administrative services fees, or SG&A expense ratio, for 2001 was 15.3%, increasing 80 basis points from 14.5% for 2000. Similar increases occurred in the SG&A expense ratios of our Commercial and Government segments as indicated in the preceding table. These increases resulted from an increase in the mix of ASO membership, primarily from the TRICARE acquisition, and planned spending on infrastructure and technology initiatives. For 2002, we are expecting the SG&A ratio to be in the 15% to 16% range as the percentage of revenues we derive from administrative services fees increases throughout the year.
 
Depreciation and amortization was $161.5 million in 2001, an increase of $15.0 million, or 10.2%, from $146.5 million in 2000. This increase was the result of increased capital expenditures primarily related to our technology initiatives and the TRICARE acquisition on May 31, 2001.
 
Interest Expense
 
Interest expense was $25.3 million in 2001, a decrease of $3.3 million from $28.6 million in 2000. This decline was attributable to the impact from lower interest rates that were offset by higher daily average outstanding borrowings. A greater proportion of total debt outstanding during 2001 resulted from borrowings

28


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

under our credit agreement, and later in the year under the 5-year senior notes issued in August 2001. These borrowings have longer maturities than borrowings under our commercial paper program, resulting in higher daily average outstanding borrowings in 2001 compared to 2000. As a result of this changing debt mix, daily cash in excess of our funding requirements was invested, causing higher average invested balances described above.
 
Income Taxes
 
Our effective tax rate in 2001 was approximately 36% compared to a 21% effective tax rate in 2000. The lower effective tax rate in 2000 was the result of recognizing the benefit of capital loss carryforwards resulting from the sale of our workers’ compensation business.
 
Comparison of Results of Operations for 2000 and 1999
 
In order to enhance comparability as well as to provide a baseline against which historical and prospective periods can be measured, the following discussion comparing results for the year ended December 31, 2000 and 1999, excludes the 1999 charges described below, but does include in our 1999 financial results, the beneficial effect from losses charged to premium deficiency liabilities. There were no adjustments to the results for 2000.
 
1999 Asset Impairments and Operational Charges
 
The following table presents the components of the asset impairments and operational charges and their respective classifications in the 1999 Consolidated Statement of Operations:
 
    
Medical

  
Selling, General and Administrative

  
Asset Impairments and Other

  
Total

    
(in thousands)
Premium deficiency
  
$
50,000
  
$
—  
  
$
—  
  
$
50,000
Reserve strengthening
  
 
35,000
  
 
—  
  
 
—  
  
 
35,000
Provider costs
  
 
5,000
  
 
—  
  
 
—  
  
 
5,000
Long-lived asset impairment
  
 
—  
  
 
—  
  
 
342,607
  
 
342,607
Losses on non-core asset sales
  
 
—  
  
 
—  
  
 
117,245
  
 
117,245
Professional liability reserve strengthening and other costs
  
 
—  
  
 
34,926
  
 
—  
  
 
34,926
    

  

  

  

Total asset impairments and operational charges
  
$
90,000
  
$
34,926
  
$
459,852
  
$
584,778
    

  

  

  

 
Premium Deficiency, Reserve Strengthening and Provider Costs
 
As a result of an assessment of the profitability of our contracts for providing health insurance coverage to our members in certain markets, we recorded a provision for probable future losses, or premium deficiency, of $50.0 million during the first quarter of 1999. Ineffective provider risk-sharing contracts and the impact of the March 31, 1999 HCA—The Healthcare Company, formerly Columbia/HCA Healthcare Corporation, or HCA, hospital agreement in Florida on current and projected future medical costs contributed to the premium deficiency. The beneficial effect from losses charged to the premium deficiency liability in 1999 was $50.0 million.
 
Prior period adverse claims development primarily in our PPO and Medicare products initially identified during an analysis of February and March 1999 medical claims resulted in the $35.0 million reserve strengthening. In addition, we paid HCA $5.0 million to settle certain contractual issues associated with the March 31, 1999 hospital agreement in Florida.

29


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
Long-Lived Asset Impairment
 
Historical and current period operating losses in certain of our markets prompted a review during the fourth quarter of 1999 for the possible impairment of long-lived assets. This review indicated that estimated future undiscounted cash flows were insufficient to recover the carrying value of long-lived assets, primarily goodwill, associated with our Austin, Dallas and Milwaukee markets. Accordingly, we adjusted the carrying value of these long-lived assets to their estimated fair value resulting in a non-cash impairment charge of $342.6 million. Estimated fair value was based on discounted cash flows.
 
The long-lived assets associated with the Austin and Dallas markets primarily resulted from our 1997 acquisition of Physician Corporation of America, or PCA. Operating losses in Austin and Dallas were related to the deterioration of risk-sharing arrangements with providers and the failure to effectively convert the PCA operating model and computer platform to ours. The long-lived assets associated with the Milwaukee market primarily resulted from our 1994 acquisition of CareNetwork, Inc. Operating losses in the Milwaukee market were the result of competitor pricing strategies resulting in lower premium levels to large employer groups as well as market dynamics dominated by limited provider groups causing higher than expected medical costs.
 
In conjunction with our 1999 goodwill impairment, we also reviewed the estimated life assigned to goodwill. Effective January 1, 2000, we adopted a 20-year amortization period from the date of acquisition for goodwill previously amortized over 40 years.
 
Losses on Non-Core Asset Sales
 
Between December 30, 1999 and February 4, 2000, we entered into definitive agreements to sell our workers’ compensation, Medicare supplement and north Florida Medicaid businesses. Since the carrying value of the net assets of these businesses exceeded the estimated fair value, we recorded a $117.2 million loss in 1999. The estimated fair value was established based upon definitive sale agreements, net of direct transaction costs. During the first half of 2000, we completed the divestiture of these businesses. There was no change in the estimated loss during 2000.
 
Professional Liability Reserve Strengthening and Other Costs
 
We insure substantially all professional liability risks through a wholly owned captive insurance subsidiary, or the Subsidiary. The Subsidiary recorded an additional $24.9 million expense during the fourth quarter of 1999 primarily related to expected claim and legal costs.
 
Additionally, other expenses of $10.0 million were recorded during the fourth quarter of 1999 related to a claim payment dispute with a contracted provider and government audits.

30


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
The following table reconciles the 1999 results reported in the consolidated statement of operations, or reported results, to the results contained in the following discussion, or adjusted results:
 
    
1999
Reported Results

    
1999 Excluded Charges (a)

    
1999 Adjusted Results

    
(in thousands, except per share results)
Consolidated Statement of Operations caption items that
are adjusted:
                        
Operating expenses:
                        
Medical
  
$
8,533,090
 
  
$
(90,000
)
  
$
8,443,090
Selling, general and administrative
  
 
1,466,181
 
  
 
(34,926
)
  
 
1,431,255
Depreciation and amortization
  
 
123,858
 
  
 
—  
 
  
 
123,858
Asset impairments and other charges
  
 
459,852
 
  
 
(459,852
)
  
 
—  
    


  


  

Total operating expenses
  
 
10,582,981
 
  
 
(584,778
)
  
 
9,998,203
(Loss) income from operations
  
 
(371,446
)
  
 
584,778
 
  
 
213,332
(Loss) income before income taxes
  
 
(404,839
)
  
 
584,778
 
  
 
179,939
Net (loss) income
  
$
(382,420
)
  
$
499,338
 
  
$
116,918
Basic (loss) earnings per common share
  
$
(2.28
)
  
$
2.97
 
  
$
0.69
Diluted (loss) earnings per common share
  
$
(2.28
)
  
$
2.97
 
  
$
0.69
 
    
1999 Reported Ratios

      
Ratio Effect of Excluded Charges (a)

    
1999 Adjusted Ratios

 
Medical expense ratios:
                      
Commercial
  
84.9
%
    
(1.0
)%
  
83.9
%
Government
  
86.7
%
    
(0.7
)%
  
86.0
%
    

    

  

Total
  
85.7
%
    
(0.9
)%
  
84.8
%
    

    

  

SG&A expense ratios:
                      
Commercial
  
17.4
%
    
(0.3
)%
  
17.1
%
Government
  
10.9
%
    
(0.3
)%
  
10.6
%
    

    

  

Total
  
14.6
%
    
(0.4
)%
  
14.2
%
    

    

  


(a)
 
Reflects the previously discussed medical expenses of $90.0 million, SG&A expenses of $34.9 million and asset impairments and other charges of $459.9 million.

31


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
The following table presents certain financial data for our two segments for the years ended December 31, 2000 and 1999:
 
    
For the year ended December 31,

 
    
2000

    
1999 (a)

 
    
(in thousands, except ratios)
 
Premium revenues:
                 
Fully insured
  
$
5,263,602
 
  
$
5,290,651
 
Specialty
  
 
291,315
 
  
 
277,200
 
    


  


Total Commercial
  
 
5,554,917
 
  
 
5,567,851
 
    


  


Medicare+Choice
  
 
3,286,351
 
  
 
2,920,829
 
TRICARE
  
 
892,375
 
  
 
866,882
 
Medicaid
  
 
660,988
 
  
 
603,020
 
    


  


Total Government
  
 
4,839,714
 
  
 
4,390,731
 
    


  


Total
  
$
10,394,631
 
  
$
9,958,582
 
    


  


Administrative services fees:
                 
Commercial
  
$
86,298
 
  
$
97,940
 
Government
  
 
—  
 
  
 
—  
 
    


  


Total
  
$
86,298
 
  
$
97,940
 
    


  


Medical expense ratios:
                 
Commercial
  
 
83.6
%
  
 
83.9
%
Government
  
 
85.5
%
  
 
86.0
%
    


  


Total
  
 
84.5
%
  
 
84.8
%
    


  


SG&A expense ratios:
                 
Commercial
  
 
17.2
%
  
 
17.1
%
Government
  
 
11.5
%
  
 
10.6
%
    


  


Total
  
 
14.5
%
  
 
14.2
%
    


  


Income (loss) before income taxes:
                 
Commercial
  
$
(7,954
)
  
$
35,850
 
Government
  
 
121,944
 
  
 
144,089
 
    


  


Total
  
$
113,990
 
  
$
179,939
 
    


  



(a)
 
Excludes the previously discussed medical expenses of $90.0 million, SG&A expenses of $34.9 million, and asset impairments and other charges of $459.9 million.
 
The following table presents our medical membership at December 31, 2000 and 1999:
 
    
December 31,

  
Change

 
    
2000

  
1999

  
Members

    
Percentage

 
Commercial segment medical members:
                       
Fully insured
  
2,545,800
  
3,083,600
  
(537,800
)
  
(17.4
)%
ASO
  
612,800
  
648,000
  
(35,200
)
  
(5.4
)%
Medicare supplement
  
—  
  
44,500
  
(44,500
)
  
100.0
 %
    
  
  

  

Total Commercial
  
3,158,600
  
3,776,100
  
(617,500
)
  
(16.4
)%
    
  
  

  

Government segment medical members:
                       
Medicare+Choice
  
494,200
  
488,500
  
5,700
 
  
1.2
 %
Medicaid
  
575,600
  
616,600
  
(41,000
)
  
(6.6
)%
TRICARE
  
1,070,300
  
1,058,000
  
12,300
 
  
1.2
 %
    
  
  

  

Total Government
  
2,140,100
  
2,163,100
  
(23,000
)
  
(1.1
)%
    
  
  

  

Total medical membership
  
5,298,700
  
5,939,200
  
(640,500
)
  
(10.8
)%
    
  
  

  

32


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
Overview
 
Net income was $90.1 million, or $0.54 per diluted share in 2000, compared to adjusted net income of $116.9 million, or $0.69 per diluted share in 1999. This decrease in earnings occurred despite a decrease in our effective income tax rate from 35% in 1999 to 21% in 2000. The earnings decline resulted primarily from favorable adjustments recorded during 1999, including premium deficiency and workers’ compensation reserve adjustments and a gain from the sale of a tangible asset.
 
Premium Revenues and Medical Membership
 
Premium revenues increased 4.4% to $10.4 billion for 2000 compared to $10.0 billion for 1999. Higher premium revenues resulted primarily from strong premium yields partially offset by a decline in commercial membership. Due to the impact the premium increases had on fully insured commercial medical member retention, total medical membership declined 640,500, or 10.8%, to 5,298,700.
 
Commercial segment premium revenues were $5.6 billion in both 2000 and 1999, as membership reductions in 2000 offset significantly higher premium yields. Fully insured commercial medical premium yield of 12.5% in 2000 increased from 7.4% in 1999, reflecting improved pricing. The improved pricing during 2000 resulted primarily from higher renewal rates as well as accelerated rate increases in Colorado and Texas where higher than expected medical cost trends had been experienced. Fully insured commercial medical membership fell 17.4% to 2,545,800 during 2000. The decrease in the number of members was caused primarily by our pricing actions, the termination of a large unprofitable account in Texas, and the exit of the small group product in 17 states.
 
Government segment premium revenues increased 10.2% to $4.8 billion in 2000 compared to $4.4 billion in 1999. Medicare+Choice premiums increased 12.5% to $3.3 billion in 2000 due to higher premium yields and increased membership. Medicare+Choice premium yield increased to 6.1% during 2000 from the implementation of additional member premiums for many Medicare+Choice members and a higher proportion of members in markets with higher Centers for Medicare and Medicaid Services, or CMS, reimbursement rates. Medicare+Choice membership increased 5,700 members, or 1.2%, despite the exit from 29 non-core counties in our Medicare+Choice business on January 1, 2000. Total Government segment membership declined as a result of a transaction in 2000 to divest the north Florida Medicaid business.
 
Administrative Services Fees
 
Administrative services fees in 2000 were $86.3 million, a decrease of $11.6 million from $97.9 million in 1999. This decrease was primarily due to the sale of our workers’ compensation business in 1999.
 
Investment and Other Income
 
Investment and other income totaled $115.0 million in 2000, compared to $155.0 million in 1999, a decline of $40 million. This decrease resulted from a lower average invested balance caused primarily by the sale of the workers’ compensation business, lower realized investment gains and a non-recurring $11.5 million gain in 1999 from the sale of a tangible asset.
 
Medical Expense
 
Medical expense as a percentage of premium revenues, or medical expense ratio, for 2000 was 84.5%, improving 30 basis points compared to an adjusted medical expense ratio of 84.8% for 1999. The 1999 ratio includes the beneficial effect of losses charged to premium deficiency liabilities and favorable workers’

33


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

compensation liability adjustments recorded in 1999 but not recorded in 2000. Improving fully insured commercial medical claims experience from lower pharmacy cost trends and the reduction of higher cost, non-core membership was partially offset by higher Medicare+Choice utilization in the 45 Medicare counties we exited on January 1, 2001. Fully insured commercial medical pharmacy cost trends improved in 1999 primarily as a result of the conversion of members to a three-tier pharmacy benefit plan.
 
The Commercial segment medical expense ratio was 83.6% in 2000 compared to an adjusted medical expense ratio of 83.9% in 1999. This 30 basis point improvement resulted from declining pharmacy cost trends, corrective pricing related to higher cost, open access products and the reduction of higher cost, non-core membership. We reduced higher cost, non-core membership when we terminated a large unprofitable account in Texas, exited our small group product in 17 unprofitable states and reinsured substantially all of our Medicare supplement business. Fully insured commercial medical pharmacy cost trends improved in 1999, from the conversion of members to a three-tier pharmacy benefit plan. Partially offsetting the improvement in the medical expense ratio were the beneficial effect from losses charged to premium deficiency liabilities and favorable workers’ compensation liability adjustments recorded in 1999 but not in 2000.
 
The Government segment medical expense ratio decreased 50 basis points to 85.5% from 86.0% in 1999. This decrease resulted primarily from divesting higher cost, non-core Medicaid membership in north Florida, and improving TRICARE results partially offset by higher than expected utilization in the 45 Medicare counties we exited on January 1, 2001.
 
SG&A Expense
 
Total selling, general and administrative, or SG&A, expense as a percentage of premium revenues and administrative services fees, or SG&A expense ratio, increased 30 basis points to 14.5% in 2000 from an adjusted ratio of 14.2% in 1999. Contributing to this increase were planned investments in infrastructure and technology initiatives and a lower ratio of members to employees.
 
Depreciation and amortization was $146.5 million in 2000, an increase of $22.6 million from $123.9 million in 1999. This increase was primarily the result of the change to a 20-year life for goodwill previously amortized over 40 years.
 
Interest Expense
 
Interest expense totaled $28.6 million in 2000, compared to $33.4 million in 1999. This $4.8 million decline was primarily the result of lower average outstanding borrowings during 2000 compared to 1999 as we used a portion of the proceeds from the sale of the workers’ compensation business to reduce debt.
 
Income Taxes
 
Our effective tax rate in 2000 was approximately 21% compared to an adjusted 35% effective tax rate in 1999. The lower effective tax rate in 2000 was primarily the result of recognizing the benefit of capital loss carryforwards resulting from the sale of our workers’ compensation business.
 
Liquidity
 
Our operating cash flows were $149.0 million in 2001, compared to operating cash flows of $40.4 million in 2000, an increase of $108.6 million. This increase primarily was attributable to higher net income in 2001 compared to 2000 and a reduction in workers’ compensation claims payments from the sale of this business on March 31, 2000.

34


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
Our operating cash flows were impacted by a decline in medical and other expenses payable of $179.5 million in 2001 and $195.9 million in 2000. This decline was principally a result of two actions: reductions in membership levels and reductions in claim inventories on-hand. Reductions in membership levels were attributable to our strategy of exiting certain products and markets that either lacked the prospect for long-term profitability or no longer fit our strategic focus. Reductions of claim inventories on-hand are a direct result of our focused effort to attain service and operational excellence. We implemented many new technologies and substantial process improvements in our customer service centers to improve claim processing speed and administrative efficiency.
 
The following table presents the impact these two actions had on the medical and other expenses payable for the years ended December 31, 2001 and 2000:
 
    
For the year ended December 31,

 
    
2001

    
2000

 
    
(in thousands)
 
                   
Reductions in IBNR due to membership decline (a)
  
$
(109,752
)
  
$
(106,863
)
Reductions in claim inventories on-hand
  
 
(131,959
)
  
 
(55,955
)
All other, net (b)
  
 
62,172
 
  
 
(33,073
)
    


  


The total change in medical and other expenses payable as shown on the consolidated cash flow statement
  
$
(179,539
)
  
$
(195,891
)
    


  



(a)
 
The largest component of medical and other expenses payable represents the liability established for those services incurred during the current period but for which the claim invoice had not yet been received as of the balance sheet date. This liability is commonly known as IBNR (incurred but not reported). This liability will increase or decrease with corresponding membership levels.
(b)
 
All other, net items consist primarily of changes in provider balances from risk-sharing arrangements due to the timing of settlements with providers.
 
The following table presents the approximate number of claims on-hand and their estimated aggregate valuation. Claims on hand represent the number of provider requests for reimbursement that have been received but not yet processed and paid.
 
    
Number of Claims
On-hand

  
Estimated Valuation

         
(in thousands)
December 31, 2001
  
518,100
  
$
125,448
December 31, 2000
  
1,157,900
  
$
257,407
December 31, 1999
  
1,398,300
  
$
313,362
 
In addition to membership and claim inventory reductions, we accelerated the claim submission cycle time during 2001 by increasing electronic connectivity with providers which increased the percentage of claims received electronically. Other items which may significantly impact medical claims and other expenses payable are primarily the timing of a bi-weekly reimbursement to our pharmacy benefits management vendor, the timing of periodic settlements with providers, medical cost inflation and our mix of membership between products.
 
Our provision for doubtful accounts of $4.0 million in 2001 declined from $10.9 million in 2000 and $12.6 million in 1999. Our allowance for doubtful accounts of $38.5 million at December 31, 2001 likewise declined

35


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

from $42.0 million at December 31, 2000. This decline resulted from a reduction in past due accounts and improved collections, primarily attributable to a new billing system and related process improvements implemented since the first quarter of 2000. The timing of TRICARE collections increased premiums receivable, net of the effects of the acquisition.
 
Debt
 
The following table presents our short-term, long-term and total debt outstanding at December 31, 2001 and 2000:
 
    
December 31,

    
2001

  
2000

    
(in thousands)
Short-term debt:
             
Credit agreements
  
$
—  
  
$
520,000
Conduit commercial paper financing program
  
 
263,000
  
 
—  
Commercial paper program
  
 
—  
  
 
79,952
    

  

Total short-term debt
  
 
263,000
  
 
599,952
    

  

Long-term debt:
             
Senior notes
  
$
309,789
  
$
—  
Other long-term borrowings
  
 
5,700
  
 
—  
    

  

Total long-term debt
  
 
315,489
  
 
—  
    

  

Total debt
  
$
578,489
  
$
599,952
    

  

 
Senior Notes
 
On August 7, 2001, we issued $300 million 7¼% senior, unsecured notes due August 1, 2006 at 99.759% for proceeds of $299.3 million. The proceeds from this offering were used to repay a portion of the amounts outstanding under our credit facility that existed at that time.
 
In order to hedge the risk of changes in the fair value of our $300 million 7¼% senior notes attributable to fluctuations in interest rates, we entered into interest rate swap agreements. Interest rate swap agreements, which are considered derivatives, are contracts that exchange interest payments on a specified principal amount, or notional amount, for a specified period. Our interest rate swap agreements exchange the 7¼% fixed interest rate under our senior notes for a variable interest rate, which was 3.56% at December 31, 2001. The $300 million swap agreements mature on August 1, 2006, and have the same critical terms as our senior notes. Changes in the fair value of the 7¼% senior notes and the swap agreements due to changing interest rates are assumed to offset each other completely, resulting in no impact to earnings from any hedge ineffectiveness.
 
Our swap agreements are recognized in our consolidated balance sheet at fair value with an equal and offsetting adjustment to the carrying value of our senior notes. The fair value of our swap agreements are estimated based on quoted market prices of comparable agreements and reflects the amounts we would receive (or pay) to terminate the agreements at the reporting date. At December 31, 2001, the $10.5 million fair value of our swap agreements is included in other long-term assets. Likewise, the carrying value of our senior notes has been increased $10.5 million to its fair value. The counterparties to our swap agreements are major financial institutions with which we also have other financial relationships.

36


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
Credit Agreements
 
On October 11, 2001, we replaced our existing credit agreement with two new unsecured revolving credit agreements consisting of a $265 million, 4-year revolving credit agreement and a $265 million, 364-day revolving credit agreement with a one-year term out option. Under these new agreements, at our option, we can borrow on either a competitive advance basis or a revolving credit basis. The revolving credit portion of both the 4-year and 364-day agreements bear interest at either a fixed rate or floating rate based on LIBOR plus a spread. The spread, which varies depending on our credit ratings, ranges from 80 to 125 basis points for our 4-year agreement, and 85 to 137.5 basis points for our 364-day agreement. We also pay an annual facility fee regardless of utilization. This facility fee, currently 25 basis points, may fluctuate between 15 and 50 basis points, depending upon our credit ratings. The competitive advance portion of any borrowings under either the 4-year or 364-day revolving credit agreements will bear interest at market rates prevailing at the time of borrowing on either a fixed rate or a floating rate basis, at our option.
 
These credit agreements contain customary restrictive and financial covenants as well as customary events of defaults, including financial covenants regarding the maintenance of net worth, and minimum interest coverage and maximum leverage ratios. The terms of each of these credit agreements also include standard provisions related to conditions of borrowing, including a customary material adverse effect clause which could limit our ability to borrow. We have not experienced a material adverse effect and we know of no circumstances or events which would be reasonably likely to result in a material adverse effect. We do not believe the material adverse effect clause poses a material funding risk to Humana in the future. The minimum net worth requirement was $1,091.2 million at December 31, 2001 and increases by 50% of consolidated net income each quarter. The minimum interest coverage ratio is generally calculated by dividing interest expense into earnings before interest and tax expense, or EBIT. The maximum leverage ratio is generally calculated by dividing debt into earnings before interest, taxes, depreciation and amortization expense, or EBITDA. EBIT and EBITDA used to calculate compliance with these financial covenants is based upon four consecutive quarters. The current minimum interest coverage ratio of 3.0, increases to 3.5 effective December 31, 2002, and to 4.0 effective December 31, 2003. The current maximum leverage ratio of 3.0 declines to 2.75 effective December 31, 2002, and to 2.5 effective December 31, 2003. We were in compliance with all covenants at December 31, 2001, including the more restrictive future minimum interest coverage and maximum leverage requirements.
 
Commercial Paper Programs
 
We maintain and issue short-term debt securities under a commercial paper program. The program is backed by our credit agreements described above. Aggregate borrowing under both the credit agreement and commercial paper program cannot exceed $530 million. Since the fourth quarter of 2000, reduced direct access to the commercial paper market has resulted in fewer borrowings under this program. As part of our 2001 refinancing, we increased our indirect access to the commercial paper market through our conduit commercial paper financing program. Under this program, a third party issues commercial paper and loans the proceeds of those issuances to us so that the interest and principal payments on the loans match those on the underlying commercial paper. The $265 million, 364-day revolving credit agreement supports the conduit commercial paper financing program of up to $265 million. The weighted average interest rate on our conduit commercial paper borrowings was 2.51% at December 31, 2001. The carrying value of these borrowings approximates fair value as the interest rate on the borrowings varies at market rates.
 
Other Borrowings and Letters of Credit
 
Other borrowings of $5.7 million at December 31, 2001 represent low-interest financing for the renovation of a building payable in various installments beginning, generally, in 2003 through 2011. Issued and undrawn

37


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

letters of credit total $25.4 million at December 31, 2001. These letters of credit were issued primarily to support obligations of our wholly owned captive insurance subsidiary related to our professional liability risks. These letters of credit renew automatically on an annual basis unless the beneficiary is otherwise notified. Over the past 5 years, we have not had to fund any letters of credit.
 
Operating Leases
 
We lease facilities, computer hardware, and other equipment under long-term operating leases that are noncancelable and expire on various dates through 2017. Future annual minimum payments due subsequent to December 31, 2001 under all of our noncancelable operating leases in excess of one year are as follows:
 
      
(in thousands)

2002
    
$
72,596
2003
    
 
58,572
2004
    
 
44,453
2005
    
 
35,268
2006
    
 
26,103
Thereafter
    
 
66,252
      

Total minimum lease payments
    
 
303,244
Less: minimum sublease rental payments
    
 
85,302
      

Net minimum lease payments
    
$
217,942
      

 
Certain 5-year airplane operating leases included above provide for a residual value guarantee of no more than $13.1 million on December 29, 2004, the end of the lease term. We have the right to exercise a purchase option with respect to the leased equipment or the equipment can be sold to a third party. If the fair value of the airplanes, which was $20.3 million at lease inception, falls between a range of $5.0 million and $18.1 million at the end of the lease term, we would be obligated to pay the difference between $18.1 million and the fair value at the end of the lease term up to a maximum payment of $13.1 million. A $3.5 million gain in connection with the 1999 sale/leaseback transaction is being deferred until the residual value guarantee is resolved at the end of the lease term. The estimated fair market value at December 31, 2001 of the airplanes exceeds the residual value guarantee, therefore, we have not accrued for any loss.
 
Other Liquidity Factors
 
Our investment grade credit rating at December 31, 2001 was Baa3 according to Moody’s Investors Services, Inc., or Moody’s and BBB, according to Standard & Poor’s Corporation, or S&P. A downgrade to Ba2 or lower by Moody’s and BB or lower by S&P would give the counterparty of one of our interest rate swap agreements with a $100 million notional amount, the right, but not the obligation, to cancel the interest rate swap agreement. If cancelled, we would pay or receive an amount based on the fair market value of the swap agreement. Assuming this swap agreement had been cancelled on December 31, 2001, we would have received $3.5 million. Other than the swap agreement, adverse changes in our credit ratings will not create, increase, or accelerate any liabilities. Adverse changes in our credit rating will increase the rate of interest we pay and may impact the amount of credit available to us in the future.
 
We do not have any unconsolidated special purpose entities and, other than the leases described above, we do not have any material off-balance sheet arrangements.

38


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
Regulatory Requirements
 
Certain of our subsidiaries operate in states that regulate the payment of dividends to Humana Inc., our parent company, require minimum levels of equity, and limit investments to approved securities. The amount of dividends that may be paid to Humana Inc. by these subsidiaries, without prior approval by state regulatory authorities, is limited based on the entity’s level of statutory income and statutory capital and surplus. In most states, prior notification is provided before paying a dividend that does not require approval.
 
At December 31, 2001, our regulated health insurance subsidiaries, other than our federally regulated TRICARE subsidiaries, maintained aggregate statutory capital and surplus of $1,079.9 million. Each of these subsidiaries was in compliance with applicable statutory requirements, which aggregated $521.9 million in total. Although the minimum required levels of equity are largely based on premium volume, product mix and the quality of assets held, minimum requirements can vary significantly at the state level. Certain states rely on risk-based capital requirements, or RBC, to define the required levels of equity. RBC is a model developed by the National Association of Insurance Commissioners to monitor an entity’s solvency. This calculation indicates recommended minimum levels of required capital and surplus and signals regulatory measures should actual surplus fall below these recommended levels. Some states are in the process of phasing in these RBC requirements over a number of years. If RBC were fully implemented by all states at December 31, 2001, each of our subsidiaries would be in compliance and we would have $494.4 million of aggregate capital and surplus above the minimum level required under RBC.
 
Stock Repurchase Plan
 
In 2000, our Board of Directors authorized the repurchase of up to five million of our common shares. In 2001, we repurchased 187,500 shares of our common stock for approximately $1.9 million. Under this authorization, as of December 31, 2001, we have repurchased a total of approximately 3.6 million of our common shares for an aggregate purchase price of $28.3 million, at an average cost of $7.82 per share.
 
We believe that funds from future operating cash flows and funds available under our credit agreements and commercial paper program are sufficient to meet future liquidity needs. We also believe these sources of funds are adequate to allow us to fund selected expansion opportunities, as well as to fund capital requirements.
 
Market Risk-Sensitive Financial Instruments and Positions
 
The level of our pretax earnings is subject to risk due to changes in investment income from our fixed income portfolio which is partially offset by both our debt position and the short-term duration of the fixed income investment portfolio.
 
We evaluated the impact on our investment income and debt expense resulting from a hypothetical change in interest rates of 100, 200 and 300 basis points over the next twelve-month period, as reflected in the following table. In the past ten years, annual changes in commercial paper or LIBOR rates have exceeded 300 basis points twice, have changed between 200 and 300 basis points once and have changed between 100 and 200 basis points three times. The modeling technique used to calculate the pro forma net change considered the cash flows related

39


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

to fixed income investments and debt, which are subject to interest rate changes during a prospective twelve- month period. LIBOR was 1.88% at December 31, 2001. Our model assumed the maximum possible reduction in LIBOR could not exceed 188 basis points.
 
    
Increase (decrease) in
pretax earnings given an interest rate decrease of X basis points

    
Increase (decrease) in
pretax earnings given an interest rate increase of X basis points

 
    
(300)

    
(200)

    
(100)

    
100

    
200

    
300

 
    
(in thousands)
 
2001
                                                     
Fixed income portfolio
  
$
(15,216
)
  
$
(11,578
)
  
$
(5,496
)
  
$
5,528
 
  
$
11,102
 
  
$
16,655
 
Debt
  
 
7,238
 
  
 
7,238
 
  
 
3,822
 
  
 
(3,822
)
  
 
(7,645
)
  
 
(11,467
)
    


  


  


  


  


  


Total
  
$
(7,978
)
  
$
(4,340
)
  
$
(1,674
)
  
$
1,706
 
  
$
3,457
 
  
$
5,188
 
    


  


  


  


  


  


2000
                                                     
Fixed income portfolio
  
$
(15,087
)
  
$
(10,098
)
  
$
(5,062
)
  
$
5,098
 
  
$
10,258
 
  
$
15,444
 
Debt
  
 
12,975
 
  
 
8,650
 
  
 
4,325
 
  
 
(4,325
)
  
 
(8,650
)
  
 
(12,975
)
    


  


  


  


  


  


Total
  
$
(2,112
)
  
$
(1,448
)
  
$
(737
)
  
$
773
 
  
$
1,608
 
  
$
2,469
 
    


  


  


  


  


  


 
The following table presents the hypothetical change in fair market values of the common marketable equity securities we held at December 31, 2001 and 2000, which are sensitive to changes in stock market values. These common marketable equity securities are held for purposes other than trading.
 
    
Decrease in valuation
of security given an X% decrease in each
equity security’s value

    
Fair Value at Dec. 31,

  
Increase in valuation
of security given an X% decrease in each equity security’s value

    
(30%)

    
(20%)

    
(10%)

       
10%

  
20%

  
30%

    
(in thousands)
2001
                                                      
Common marketable equity securities
  
$
(4,830
)
  
$
(3,220
)
  
$
(1,610
)
  
$
16,101
  
$
1,610
  
$
3,220
  
$
4,830
    


  


  


  

  

  

  

2000
                                                      
Common marketable equity securities
  
$
(6,920
)
  
$
(4,614
)
  
$
(2,307
)
  
$
23,068
  
$
2,307
  
$
4,614
  
$
6,920
    


  


  


  

  

  

  

 
Annual changes in equity valuations (based upon the Standard & Poor’s 500 stock index) over the past 10 years which were in excess of 30% occurred four times, between 20% and 30% occurred three times and between 10% and 20% also occurred three times.
 
Capital Resources
 
Our ongoing capital expenditures relate primarily to our technology initiatives and administrative facilities necessary for activities such as claims processing, billing and collections, medical utilization review and customer service. Total capital expenditures, excluding acquisitions, were $115.0 million in 2001, $135.1 million in 2000, and $88.9 million in 1999. Excluding acquisitions, we expect our total capital expenditures in 2002 will be approximately $115 million, most of which will be used for our technology initiatives and expansion and improvement of administrative facilities.

40


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
Government Contracts
 
Our operations are regulated by various state and federal government agencies. Actuarially determined premium rate increases for commercial products generally are approved by the respective state insurance commissioners, while increases in premiums for Medicaid and Medicare+Choice products are established by various state governments and CMS. Premium rates under our TRICARE contract with the United States Department of Defense for Regions 3 and 4 is adjusted every 12 months, and for Regions 2 and 5, every three months, to reflect inflation, changes in the workload volumes of military medical facilities and contract modifications.
 
Our Medicare+Choice contracts with the federal government are renewed for a one-year term each December 31 unless terminated 90 days prior thereto. Increased funding beginning March 1, 2001 specific to the Medicare, Medicaid and State Children’s Health Insurance Benefits Improvement and Protection Act, or BIPA, is being used to provide additional funding under contracts with our providers and to lower member premiums in certain markets. Our 2002 average rate of statutory increase under the Medicare+Choice contracts, including the March 1, 2001 BIPA increase, is approximately 5.0%. Over the last five years, annual increases have ranged from as low as the January 1998 increase of 1.8% to as high as 5.0% in January 2002, with an average of approximately 2.6%. Legislative proposals are being considered which may revise the Medicare+Choice program’s current support of the use of managed health care for Medicare+Choice beneficiaries and future reimbursement rates. We are unable to predict the outcome of these proposals or the impact they may have on our financial position, results of operations, or cash flows.
 
Effective July 1, 2001, our TRICARE contract for Regions 3 and 4 was renewed for up to two additional years subject to annual renewal at the option of the Department of Defense. The Department of Defense has notified us of its intent to renew the TRICARE contract for Regions 2 and 5 that we acquired from Anthem through April 30, 2003.
 
Our Medicaid contracts in Puerto Rico, Florida and Illinois generally are annual contracts. The two contracts with the Health Insurance Administration in Puerto Rico expire on June 30, 2002, unless extended. Both parties have agreed to use good faith efforts to extend for a period of no less than 12 months covering no fewer beneficiaries than the current contracts. We believe that at the end of the current contract period this contract will be renewed.
 
The loss of any of these government contracts or significant changes in these programs as a result of legislative action, including reductions in premium payments to us, or increases in member benefits without corresponding increases in premium payments to us, may have a material adverse effect on our financial position, results of operations, and cash flows.
 
Legal Proceedings
 
Securities Litigation
 
Six purported class action complaints were filed in 1999 in the United States District Court for the Western District of Kentucky at Louisville by purported stockholders of the Company against the Company and certain of its current and former directors and officers. The complaints contained the same or substantially similar allegations; namely, that the Company and the individual defendants knowingly or recklessly made false or misleading statements in press releases and public filings concerning the Company’s financial condition, primarily with respect to the impact of negotiations over renewal of the Company’s contract with HCA-The Healthcare Company, formerly Columbia/HCA Healthcare Corporation, which took effect April 1, 1999. The

41


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

complaints allege violations of Section 10(b) of the Securities Exchange Act of 1934 (the “1934 Act”) and SEC Rule 10b-5 and Section 20(a) of the 1934 Act. They seek certification of a class of stockholders who purchased shares of Humana common stock starting either (in four complaints) in late October 1998 or (in two complaints) on February 9, 1999, and ending (in all complaints) on April 8, 1999. Plaintiffs moved for consolidation of the actions, now styled In Re Humana Inc. Securities Litigation, and filed a consolidated Complaint. On April 28, 2000, the defendants filed a motion requesting dismissal of the Consolidated Complaint. On November 7, 2000, the United States District Court for the Western District of Kentucky issued a Memorandum Opinion and Order dismissing the action. On November 30, 2000, the plaintiffs filed a notice of appeal to the Court of Appeals for the Sixth Circuit. Oral argument is scheduled for June 11, 2002. The Company believes the above allegations are without merit and intends to continue to pursue defense of the action.
 
In late 1997, three purported class action complaints were filed in the United States District Court for the Southern District of Florida by former stockholders of Physician Corporation of America, or PCA, and certain of its former directors and officers. We acquired PCA by a merger that became effective on September 8, 1997. The three actions were consolidated into a single action entitled In re Physician Corporation of America Securities Litigation. The consolidated complaint alleges that PCA and the individual defendants knowingly or recklessly made false and misleading statements in press releases and public filings with respect to the financial and regulatory difficulties of PCA’s workers’ compensation business. On May 5, 1999, plaintiffs moved for certification of the purported class, and on August 25, 2000, the defendants moved for summary judgment. On January 31, 2001, defendants were granted leave to file a third-party complaint for declaratory judgment on insurance coverage. The defendants seek a determination that the defense costs and liability, if any, resulting from the class action defense are covered by an insurance policy issued by one insurer and, in the alternative, declaring that there is coverage under policies issued by two other insurers. Defendants have moved for summary judgment on the third-party complaint, and the third-party defendants have moved to dismiss or stay the third-party complaint. On March 6, 2002, the Court, while not dismissing the matter, ordered mediation of the insurance coverage issue in accordance with the requirements of one of the insurance contracts.
 
Managed Care Industry Class Action Litigation
 
We are involved in several purported class action lawsuits that are part of a wave of generally similar actions that target the health care payor industry and particularly target managed care companies. As a result of action by the Judicial Panel on Multi District Litigation, most of the cases against us, as well as similar cases against other companies in the industry, have been consolidated in the United States District Court for the Southern District of Florida, or the Court, and are now styled In re Managed Care Litigation. The cases include separate suits against us and five other managed care companies that purport to have been brought on behalf of members, which are referred to as the subscriber track cases, and a single action against us and seven other companies that purports to have been brought on behalf of providers, which is referred to as the provider track case.
 
In the subscriber track cases, the plaintiffs seek a recovery under RICO for all persons who are or were subscribers at any time during the four-year period prior to the filing of the complaints. Plaintiffs also seek to represent a subclass of policyholders who purchased insurance through their employers’ health benefit plans governed by ERISA, and who are or were subscribers at any time during the six-year period prior to the filing of the complaints. The complaints allege, among other things, that we intentionally concealed from members certain information concerning the way in which we conduct business, including the methods by which we pay providers. The plaintiffs do not allege that any of the purported practices resulted in denial of any claim for a particular benefit, but instead, claim that we provided the purported class with health insurance benefits of lesser value than promised. The complaints also allege an industry-wide conspiracy to engage in the various alleged improper practices. The plaintiffs seek certification of a class consisting of all members of our medical plans,

42


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

excluding Medicare and Medicaid plans, for the period from 1990 to 1999. We filed our opposition to the motion for class certification on November 15, 2000. A hearing on the class certification issue was conducted on July 24, 2001. No ruling has been issued on that issue.
 
On February 20, 2002, the Court issued its ruling on the defendants’ motions to dismiss the Second Consolidated Amended Complaint (the “Amended Complaint”). The Amended Complaint was filed on June 29, 2001, after the Court dismissed most of the claims in the original complaints, but granted leave to refile. In its February 20, 2002, ruling, the Court dismissed the RICO claims of ten of the sixteen named plaintiffs, including three of the four involving us, on the ground that the McCarran-Ferguson Act prohibited their claims because they interfered with the state regulatory processes in the states in which they resided (Florida, New Jersey, California and Virginia). With respect to ERISA, the Court dismissed the misrepresentation claims of current members, finding that they have adequate remedies under the law and failed to exhaust administrative remedies. Claims for former members were not dismissed. The Court also refused to dismiss claims by all members for breach of fiduciary duty arising from alleged interference with the doctor-patient relationship by the use of so-called “gag clauses” that assertedly prohibited doctors from freely communicating with members. On March 1, 2002, we and other defendants requested that the Court allow us to ask the United States Court of Appeals for the Eleventh Circuit to review the Court’s refusal to follow the decision by the Court of Appeals for the Third Circuit in Maio v. Aetna that would have resulted in dismissal of the RICO claims. On March 4, 2002, the defendants filed a Motion for Partial Reconsideration of the February 20, 2002, Dismissal Order.
 
In the provider track case, the plaintiffs assert that we and other defendants improperly (i) paid providers’ claims and (ii) “downcoded” their claims by paying lesser amounts than they submitted. The complaint alleges, among other things, multiple violations under RICO as well as various breaches of contract and violations of regulations governing the timeliness of claim payments. We moved to dismiss the provider track complaint on September 8, 2000, and the other defendants filed similar motions thereafter. On March 2, 2001, the Court dismissed certain of the plaintiffs’ claims pursuant to the defendants’ several motions to dismiss. However, the Court allowed the plaintiffs to attempt to correct the deficiencies in their complaint with an amended pleading with respect to all of the allegations except the claim under the federal Medicare regulations, which was dismissed with prejudice. The Court also left undisturbed the plaintiffs’ claims for breach of contract. On March 26, 2001, the plaintiffs filed their amended complaint which, among other things, added four state or county medical associations as additional plaintiffs. Two of those, the Denton County Medical Society and the Texas Medical Association, purport to bring their actions against us, as well as against several other defendant companies. The Medical Association of Georgia and the California Medical Association purport to bring their actions against various other defendant companies. The associations seek injunctive relief only. The Florida Medical Association has also announced its intent to join the action. The defendants filed a motion to dismiss the amended complaint on April 30, 2001. On October 27, 2000, the plaintiffs filed a motion for class certification. We filed our opposition to that motion on November 17, 2000. Oral argument on the motion for class certification was conducted May 7, 2001. No ruling has been issued.
 
Some defendants filed appeals to the United States Court of Appeals for the Eleventh Circuit from a ruling by the district court that refused to enforce several arbitration clauses in the provider agreements with the defendants in certain respects. On March 14, 2002, the Court of Appeals upheld the district court’s rulings on the arbitration issues.
 
We intend to continue to defend these actions vigorously.
 
Chipps v. Humana Health Insurance Company of Florida, Inc.
 
On January 4, 2000, a jury in Palm Beach County, Florida, rendered an approximately $80 million verdict against us in a case arising from removal of an insured from a special case management program. The award

43


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

included approximately $78.5 million of punitive damages, $1 million of damages for emotional distress and $29,000 of damages for contractual benefits. On September 19, 2001, the Court of Appeals overturned the verdict, citing numerous errors by the trial court, and remanded for a new trial. The plaintiff filed a Motion for Rehearing EnBanc with the Court of Appeals on October 3, 2001. The Court of Appeals modified its ruling somewhat, but affirmed its reversal of the verdict. The case subsequently was settled in the first quarter of 2002 for approximately $2.2 million. This settlement was fully reserved at December 31, 2001.
 
Government Audits and Other Litigation and Proceedings
 
In July 2000, the Office of the Florida Attorney General initiated an investigation, apparently relating to some of the same matters that are involved in the purported class action lawsuits described above. While the Attorney General has filed no action against us, he has indicated that he may do so in the future. On September 21, 2001, the Texas Attorney General initiated a similar investigation. These investigations are ongoing, and we have cooperated with the regulators in both states.
 
In addition, our business practices are subject to review by various state insurance and health care regulatory authorities and federal regulatory authorities. Recently, there has been increased scrutiny by these regulators of the managed health care companies’ business practices, including claims payment practices and utilization management. We have been and continue to be subject to such reviews. Some of these could require changes in some of our practices and could also result in fines or other sanctions.
 
We also are involved in other lawsuits that arise in the ordinary course of our business operations, including claims of medical malpractice, bad faith, failure to properly pay claims, nonacceptance or termination of providers, failure to disclose network discounts and various provider arrangements, challenges to subrogation practices, and claims relating to performance of contractual obligations to providers and others. Recent court decisions and pending state and federal legislative activity may increase our exposure for any of these types of claims.
 
Personal injury claims and claims for extracontractual damages arising from medical benefit denials are covered by insurance from our wholly owned captive insurance subsidiary and excess carriers, except to the extent that claimants seek punitive damages, which may not be covered by insurance in certain states in which insurance coverage for punitive damages is not permitted. In addition, insurance coverage for all or certain forms of liability may become unavailable or prohibitively expensive in the future. In 2002, we increased the retention limits with respect to our wholly owned captive insurance subsidiary as a result of substantially higher insurance rates.
 
We do not believe that any pending or threatened legal actions against us or audits by agencies will have a material adverse effect on our financial position, results of operations, or cash flows. However, the likelihood or outcome of current or future suits, like the purported class action lawsuits described above, cannot be accurately predicted with certainty. In addition, the increased litigation which has accompanied the recent negative publicity and public perception of our industry adds to this uncertainty. Therefore, such legal actions could have a material adverse effect on our financial position, results of operations and cash flows.
 
Cautionary Statements
 
This document includes both historical and forward-looking statements. The forward-looking statements are made within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. We intend such forward-looking statements to be covered by the safe harbor provisions

44


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995, and we are including this statement for purposes of complying with these safe harbor provisions. We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions, including, among other things, the information discussed below. In making these statements, we are not undertaking to address or update each factor in future filings or communications regarding our business or results. Our business is complicated, highly regulated and competitive with many different factors affecting results.
 
If the premiums we charge are insufficient to cover the cost of health care services delivered to our members, or if our reserves are inadequate, our profitability could decline.
 
We use a significant portion of our revenues to pay the costs of health care services delivered to our members. These costs include claims payments, capitation payments, allocations of certain centralized expenses and various other costs incurred to provide health insurance coverage to our members, as well as estimates of future payments to hospitals and others for medical care provided to our members. Generally, premiums in the health care business are fixed for one-year periods. Accordingly, costs we incur in excess of our medical cost projections generally are not recovered in the contract year through higher premiums. We estimate the costs of our future medical claims and other expenses using actuarial methods and assumptions based upon claim payment patterns, medical inflation, historical developments such as claim inventory levels and claim receipt patterns, and other relevant factors, and record medical claims reserves for future payments. We continually review estimates of future payments relating to medical claims costs for services incurred in the current and prior periods and make necessary adjustments to our reserves. However, competition, government regulations and other factors may and often do cause actual health care costs to exceed what was estimated and reflected in premiums.
 
These factors may include:
 
 
 
increased use of services, including prescription drugs;
 
 
increased cost of individual services;
 
 
catastrophes or epidemics;
 
 
the introduction of new or costly treatments, including new technologies;
 
 
medical cost inflation;
 
 
new government mandated benefits or other regulatory changes; and
 
 
increased use of health care, including doctors’ office visits and prescriptions resulting from terrorists’ attacks and subsequent terrorists threats, including bioterrorism.
 
Failure to adequately price our products or develop sufficient reserves may result in a material adverse effect on our financial position, results of operations and cash flows.
 
If we fail to manage prescription drug costs successfully, our financial results could suffer.
 
In general, prescription drug costs have been rising over the past few years. These increases are due to the introduction of new drugs costing significantly more than existing drugs, direct consumer advertising by the pharmaceutical industry that creates consumer demand for particular brand-name drugs, and members seeking medications to address lifestyle changes. In order to control prescription drug costs, we introduced Rx4, our four-tiered copayment benefit design for prescription drugs. We cannot assure that these efforts will be successful in controlling costs. Failure to control these costs could have a material adverse effect on our financial position, results of operations and cash flows.

45


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
If competitive pressures restrict or lower the premiums we receive, our financial results could suffer.
 
In addition to the challenge of controlling health care costs, we face competitive pressure to contain premium prices. The managed health care industry is highly competitive and contracts for the sale of commercial products are generally bid upon or renewed annually. Many of our competitors are more established in the health care industry and have a larger market share and greater financial resources than we do in certain markets. In addition, other companies may enter our markets in the future. While health plans compete on the basis of many factors, including service and the quality and depth of provider networks, we expect that price will continue to be a significant basis of competition. Failure to compete effectively in our markets could have a material adverse effect on our financial position, results of operations and cash flows.
 
We are involved in various legal actions, which, if resolved unfavorably to us, could result in substantial monetary damages.
 
We are a party to a variety of legal actions that affect our business, such as employment and employment discrimination-related suits, employee benefit claims, breach of contract actions, tort claims, and shareholder suits, including securities fraud.
 
A number of purported class action lawsuits have been filed against us and some of our competitors in the health benefits business. The suits are purported class actions on behalf of all of our managed care members and network providers for alleged breaches of federal statutes, including Employee Retirement Income Security Act, as amended, or ERISA, and Racketeer Influenced and Corrupt Organizations Act, or RICO.
 
In addition, because of the nature of the health care business, we are subject to a variety of legal actions relating to our business operations, including the design, management and offering of products and services. These include and could include in the future:
 
 
 
claims relating to the denial of health care benefits;
 
 
medical malpractice actions;
 
 
allegations of anti-competitive and unfair business activities;
 
 
provider disputes over compensation and termination of provider contracts;
 
 
disputes related to self-funded business, including actions alleging claim administration errors;
 
 
claims related to the failure to disclose certain business practices; and
 
 
claims relating to customer audits and contract performance.
 
In some cases, substantial non-economic or punitive damages, or treble damages, may be sought. While we currently have insurance coverage for some of these potential liabilities, other potential liabilities may not be covered by insurance, insurers may dispute coverage, or the amount of insurance may not be enough to cover the damages awarded.
 
In addition, certain types of damages, such as punitive damages, may not be covered by insurance, particularly in those jurisdictions in which coverage of punitive damages is prohibited. Insurance coverage for all or some forms of liability may become unavailable or prohibitively expensive in the future.
 
A description of material legal actions in which we are currently involved is included under “Legal Proceedings.” We cannot predict the outcome of these suits with certainty, and we are incurring expenses in the defense of these matters. In addition, recent court decisions and legislative activity may increase our exposure for any of these types of claims. Therefore, these legal actions could have a material adverse effect on our financial position, results of operations, and cash flows.

46


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
Increased litigation and negative publicity could increase our cost of doing business.
 
The managed care industry continues to receive significant negative publicity and has been the subject of large jury awards that have affected or reflected public perception of the industry. This publicity and perception have been accompanied by increased litigation, legislative activity, regulation and governmental review of industry practices. These factors may adversely affect our ability to market our products or services, may require us to change our products or services, and may increase the regulatory burdens under which we operate. Any combination of these factors could further increase our cost of doing business and adversely affect our financial position, results of operations and cash flows.
 
If we fail to effectively implement our operational and strategic initiatives, our business could be materially adversely affected.
 
Our future performance depends in large part upon our management team’s ability to execute our strategy to position the company for the future. This strategy involves, among other things, the introduction of new products and benefit designs, the successful implementation of our e-business initiatives and the selection and adoption of new technologies. We believe we have experienced, capable management and technical staff who are capable of implementing this strategy. However, the market for management and technical staff in the health care industry is competitive. Loss of key employees could adversely affect the implementation of our initiatives. There can be no assurance that we will be able to successfully implement our operational and strategic initiatives that are intended to position the company for future growth. Failure to implement this strategy may result in a material adverse effect on our financial position, results of operations and cash flows.
 
Our industry is currently subject to substantial government regulation, which, along with possible increased governmental regulation or legislative reform, increases our costs of doing business and could adversely affect our profitability.
 
The health care industry in general, and HMOs and PPOs in particular, are subject to substantial federal and state government regulation, including:
 
 
 
regulation relating to minimum net worth;
 
 
licensing requirements;
 
 
approval of policy language and benefits;
 
 
mandated benefits and processes;
 
 
provider compensation arrangements;
 
 
member disclosure;
 
 
premium rates; and
 
 
periodic examinations by state and federal agencies.
 
State regulations require our HMO and insurance subsidiaries to maintain minimum net worth requirements and restrict certain investment activities. Additionally, those regulations restrict the ability of our subsidiaries to make dividend payments, loans, loan repayments or other payments to us.
 
In recent years, significant federal and state legislation affecting our business has been enacted. State and federal governmental authorities are continually considering changes to laws and regulations applicable to us and are currently considering regulations relating to:
 
 
 
patients’ rights;
 
 
mandatory benefits and products, such as a Medicare pharmacy benefit;
 
 
defining medical necessity;

47


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
 
health insurance access;
 
 
provider compensation and contract terms;
 
 
health plan liability to members who fail to receive appropriate care;
 
 
disclosure and composition of physician networks;
 
 
physicians’ ability to collectively negotiate contract terms with carriers, including fees;
 
 
rules tightening time periods in which claims must be paid; and
 
 
mental health parity.
 
All of these proposals could apply to us.
 
There can be no assurance that we will be able to continue to obtain or maintain required governmental approvals or licenses or that legislative or regulatory changes will not have a material adverse effect on our business. Delays in obtaining or failure to obtain or maintain required approvals, or moratoria imposed by regulatory authorities, could adversely affect our revenue or the number of our members, increase costs or adversely affect our ability to bring new products to market as forecasted.
 
The National Association of Insurance Commissioners, or NAIC, has adopted risk-based capital requirements, also known as RBC, which is subject to state-by-state adoption and to the extent implemented, sets minimum capitalization requirements for insurance and HMO companies. The NAIC recommendations for life insurance companies were adopted in all states and the prescribed calculation for HMOs has been adopted in most states in which we operate. The HMO rules may increase the minimum capital required for some of our subsidiaries. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity” above.
 
Congress is considering significant changes to Medicare, including a pharmacy benefit requirement. In 2002, President Bush announced a revised prescription drug discount plan for Medicare-eligible seniors and Congress is continuing to examine the proposal. We are unable to determine what effect, if any, the prescription drug discount plan will have on our products or our operating results.
 
Congress is also considering proposals relating to health care reform, including a comprehensive package of requirements for managed care plans called the Patient Bill of Rights, or PBOR, legislation. During the summer of 2001, the House and Senate both passed versions of PBOR legislation that must now be reconciled. Due to the tragic events of September 11, 2001, enactment of PBOR legislation is being delayed. The reconciliation of the Senate and House bills may be further complicated since 2002 is an election year. If PBOR legislation becomes law, it could expose us to significant increased costs and additional litigation risks. Although we could attempt to mitigate our ultimate exposure from these costs through increases in premiums or changes in benefits, there can be no assurance that we will be able to mitigate or cover the costs stemming from any PBOR legislation or the other costs incurred in connection with complying with any PBOR or similar legislation.
 
The Health Insurance Portability and Accountability Act of 1996, or HIPAA, includes administrative provisions directed at simplifying electronic data interchange through standardizing transactions, establishing uniform health care provider, payor and employer identifiers and seeking protections for confidentiality and security of patient data. Under the new HIPAA standard transactions and code sets rules, we must make significant systems enhancements and invest in new technical solutions. The standard transactions and code sets rules compliance date may be extended by any covered entity until October 17, 2003 by submitting a request to the Secretary of Health and Human Services by October 16, 2002. We intend to file for the extension. Under the new HIPAA privacy rules, we must comply with a variety of requirements concerning the use and disclosure of individuals’ protected health information, establish rigorous internal procedures to protect health information and

48


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

enter into business associate contracts with those companies to whom protected health information is disclosed. Violations of these rules will subject us to significant penalties. Compliance with HIPAA regulations requires significant systems enhancements, training and administrative effort. The final rules do not provide for complete federal preemption of state laws, but rather preempt all inconsistent state laws unless the state law is more stringent. HIPAA could also expose us to additional liability for violations by our business associates.
 
Another area receiving increased focus in 2002 is the time in which various laws require the payment of health care claims. Many states already have legislation in place covering payment of claims within a specific number of days. However, due to provider groups advocating for laws or regulations establishing even stricter standards, procedures and penalties, we expect additional regulatory scrutiny and supplemental legislation with respect to claims payment practices. The provider-sponsored bills are characterized by stiff penalties for late payment, including high interest rates payable to providers and costly fines levied by state insurance departments and attorneys general. This legislation and possible future regulation and oversight could expose our Company to additional liability and penalties.
 
On November 21, 2000, the Department of Labor published its final regulation on claims review procedures under the Employee Retirement Security Act of 1974, or ERISA. The claims procedure regulation applies to all employee benefit plans governed by ERISA, whether benefits are provided through insurance products or are self-funded. As a result, the new claims review regulation impacts nearly all employer and union-sponsored health and disability plans, except church and government plans. Similar to legislation recently passed by many states, the new ERISA claims procedures impose shorter and more detailed procedures for processing and reviewing claims and appeals. According to the Department of Labor, however, its ERISA claims regulation does not preempt state insurance and utilization review laws that impose different procedures or time lines, unless complying with the state law would make compliance with the new ERISA regulation impossible. Unlike its state counterparts, the ERISA claims rule does not provide for independent external review to decide disputed medical questions. Instead, the federal regulation will generally make it easier for claimants to avoid state-mandated internal and external review processes and to file suit in federal court. Because the processes and timelines established by the new ERISA claims rules are similar to existing state requirements, although different in many of their particulars, it is difficult to estimate the cost of bringing the Company’s claims procedures into compliance. Pending outcome of litigation currently pending before the U. S. Supreme Court, it is also difficult to predict the impact that the new ERISA rules will have on state external review laws. The United States Supreme Court has a number of cases before it addressing the preemptive effect of ERISA on state laws, and may issue important decisions on these cases in 2002. The new ERISA claims rules generally become effective July 1, 2002 or the first day of the first plan year beginning after July 1, 2002, whichever is later. In any case, health plans must comply with the new rules with respect to all claims filed on or after January 1, 2003.
 
We are also subject to various governmental audits and investigations. These can include audits and investigations by state attorneys general, CMS, the Office of the Inspector General of Health and Human Services, the Office of Personnel Management, the Department of Justice and state Departments of Insurance and Departments of Health. These activities could result in the loss of licensure or the right to participate in various programs, or the imposition of fines, penalties and other sanctions. In addition, disclosure of any adverse investigation or audit results or sanctions could negatively affect our reputation in various markets and make it more difficult for us to sell our products and services.

49


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

 
As a government contractor, we are exposed to additional risks that could adversely affect our business or our willingness to participate in government health care programs.
 
A significant portion of our revenues relates to federal, state and local government health care coverage programs, including the Medicare+Choice, Medicaid and TRICARE programs. These programs involve various risks, including:
 
 
 
the possibility of reduced or insufficient government reimbursement in the future;
 
 
higher comparative medical costs;
 
 
government regulatory and reporting requirements;
 
 
higher marketing and advertising costs per member as a result of marketing to individuals as opposed to groups;
 
 
state budget constraints;
 
 
the possibility that we will not be able to extend or renew any of the contracts relating to these programs. These contracts also are generally subject to frequent change, including changes which may reduce the number of persons enrolled or eligible to enroll, reduce the revenue we receive or increase our administrative or health care costs under those programs. In the event government reimbursement were to decline from projected amounts, our failure to reduce the health care costs associated with these programs could have a material adverse effect on our business. Changes to these government programs in the future may also affect our ability or willingness to participate in these programs. The loss of these contracts or significant changes in these programs as a result of legislative action, including reductions in payments or increases in benefits without corresponding increases in payments, may have a material adverse effect on our financial condition, results of operations and cash flows; and
 
 
in addition at December 31, 2001, under one of our CMS contracts, we provided health insurance coverage to approximately 232,500 members in Florida. This contract accounted for approximately 16.9% of our total premiums and ASO fees for 2001. The termination of this contract would likely have a material adverse effect upon our financial condition, results of operations, and cash flows.
 
If we fail to maintain satisfactory relationships with the providers of care to our members, our business could be adversely affected.
 
We contract with physicians, hospitals and other providers to deliver health care to our members. Our products encourage or require our customers to use these contracted providers. These providers may share medical cost risk with us or have financial incentives to deliver quality medical services in a cost-effective manner.
 
In any particular market, providers could refuse to contract with us, demand higher payments, or take other actions that could result in higher health care costs for us, less desirable products for customers and members, or difficulty meeting regulatory or accreditation requirements. In some markets, certain providers, particularly hospitals, physician/hospital organizations or multi-specialty physician groups, may have significant market positions and negotiating power. In addition, physician or practice management companies, which aggregate physician practices for administrative efficiency and marketing leverage, may, in some cases, compete directly with us. If these providers refuse to contract with us, use their market position to negotiate favorable contracts, or place us at a competitive disadvantage, our ability to market products or to be profitable in those areas could be adversely affected.
 
In some situations, we have contracts with individual or groups of primary care physicians for an actuarially determined, fixed, per-member-per-month fee under which physicians are paid a fixed amount to provide all required medical services to our members. The inability of providers to properly manage costs under these arrangements can result in the financial instability of such providers and the termination of their relationship with us. In addition, payment or other disputes between the primary care provider and specialists with whom it

50


Management’s Discussion and Analysis of
Financial Condition and Results of Operations—(Continued)

contracts can result in a disruption in the provision of services to our members or a reduction in the services available. A primary care provider’s financial instability or failure to pay other providers for services rendered could lead that provider to demand payment from us, even though we have made our regular fixed payments to the primary provider. There can be no assurance that providers with whom we contract will properly manage the costs of services, maintain financial solvency or avoid disputes with other providers, the failure of any of which could have an adverse effect on the provision of services to our members and our operations.
 
ITEM 7a.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
The information required by this Item appears in Management’s Discussion and Analysis of Financial Condition and Results of Operations — Item 7 herein, under the caption “Market Risk-Sensitive Financial Instruments and Positions.”

51


 
ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
Humana Inc.
 
CONSOLIDATED BALANCE SHEETS
 
    
December 31,

 
    
2001

      
2000

 
    
(in thousands, except share amounts)
 
ASSETS
                   
Current assets:
                   
Cash and cash equivalents
  
$
651,420
 
    
$
657,562
 
Investment securities
  
 
1,389,596
 
    
 
1,408,522
 
Premiums receivable, less allowance for doubtful accounts
    of $38,539 in 2001, and $42,005 in 2000
  
 
322,064
 
    
 
205,260
 
Deferred income taxes
  
 
64,221
 
    
 
67,205
 
Other
  
 
195,637
 
    
 
195,517
 
    


    


Total current assets
  
 
2,622,938
 
    
 
2,534,066
 
    


    


Property and equipment, net
  
 
461,761
 
    
 
434,620
 
Other assets:
                   
Long-term investment securities
  
 
280,320
 
    
 
240,064
 
Goodwill
  
 
776,874
 
    
 
789,541
 
Deferred income taxes
  
 
36,582
 
    
 
102,767
 
Other
  
 
225,163
 
    
 
205,920
 
    


    


Total other assets
  
 
1,318,939
 
    
 
1,338,292
 
    


    


Total assets
  
$
4,403,638
 
    
$
4,306,978
 
    


    


LIABILITIES AND STOCKHOLDERS’ EQUITY
                   
Current liabilities:
                   
Medical and other expenses payable
  
$
1,086,386
 
    
$
1,181,027
 
Trade accounts payable and accrued expenses
  
 
479,996
 
    
 
428,556
 
Book overdraft
  
 
152,757
 
    
 
148,563
 
Unearned premium revenues
  
 
325,040
 
    
 
333,305
 
Short-term debt
  
 
263,000
 
    
 
599,952
 
    


    


Total current liabilities
  
 
2,307,179
 
    
 
2,691,403
 
Long-term debt
  
 
315,489
 
    
 
—  
 
Professional liability risks
  
 
241,431
 
    
 
219,768
 
Other long-term liabilities
  
 
31,590
 
    
 
35,386
 
    


    


Total liabilities
  
 
2,895,689
 
    
 
2,946,557
 
    


    


Commitments and contingencies
                   
Stockholders’ equity:
                   
Preferred stock, $1 par; 10,000,000 shares authorized; none issued
  
 
—  
 
    
 
—  
 
Common stock, $0.16 2/3 par; 300,000,000 shares authorized; 170,692,520 shares issued in 2001, and 170,889,142 shares issued in 2000
  
 
28,449
 
    
 
28,482
 
Capital in excess of par value
  
 
922,439
 
    
 
922,621
 
Retained earnings
  
 
578,122
 
    
 
460,951
 
Accumulated other comprehensive income (loss)
  
 
11,670
 
    
 
(8,509
)
Unearned restricted stock compensation
  
 
(17,882
)
    
 
(29,177
)
Treasury stock, at cost, 1,880,619 shares in 2001, and
    1,823,348 shares in 2000
  
 
(14,849
)
    
 
(13,947
)
    


    


Total stockholders’ equity
  
 
1,507,949
 
    
 
1,360,421
 
    


    


Total liabilities and stockholders’ equity
  
$
4,403,638
 
    
$
4,306,978
 
    


    


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

52


 
Humana Inc.  
 
CONSOLIDATED STATEMENTS OF OPERATIONS
 
    
For the year ended December 31,

 
    
2001

  
2000

  
1999

 
    
(in thousands, except per share results)
 
Revenues:
                      
Premiums
  
$
9,938,961
  
$
10,394,631
  
$
9,958,582
 
Administrative services fees
  
 
137,090
  
 
86,298
  
 
97,940
 
Investment and other income
  
 
118,835
  
 
115,021
  
 
155,013
 
    

  

  


Total revenues
  
 
10,194,886
  
 
10,595,950
  
 
10,211,535
 
    

  

  


Operating expenses:
                      
Medical
  
 
8,279,844
  
 
8,781,998
  
 
8,533,090
 
Selling, general and administrative
  
 
1,545,129
  
 
1,524,799
  
 
1,466,181
 
Depreciation and amortization
  
 
161,531
  
 
146,548
  
 
123,858
 
Asset impairments and other charges
  
 
—  
  
 
—  
  
 
459,852
 
    

  

  


Total operating expenses
  
 
9,986,504
  
 
10,453,345
  
 
10,582,981
 
    

  

  


Income (loss) from operations
  
 
208,382
  
 
142,605
  
 
(371,446
)
Interest expense
  
 
25,302
  
 
28,615
  
 
33,393
 
    

  

  


Income (loss) before income taxes
  
 
183,080
  
 
113,990
  
 
(404,839
)
Provision (benefit) for income taxes
  
 
65,909
  
 
23,938
  
 
(22,419
)
    

  

  


Net income (loss)
  
$
117,171
  
$
90,052
  
$
(382,420
)
    

  

  


Basic earnings (loss) per common share
  
$
0.71
  
$
0.54
  
$
(2.28
)
    

  

  


Diluted earnings (loss) per common share
  
$
0.70
  
$
0.54
  
$
(2.28
)
    

  

  


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

53


 
Humana Inc.  
 
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
 
   
Common Stock

   
Capital in Excess of Par Value

          
Accumulated Other
Comprehensive Income (Loss)

    
Unearned Restricted Stock Compensation

         
Total Stockolders’ Equity

 
   
Issued
Shares

   
Amount

     
Retained
Earnings

         
Treasury Stock

   
   
(in thousands)
 
Balances, January 1, 1999
 
167,540
 
 
$
27,923
 
 
$
902,711
 
 
$
753,798
 
  
$
12,771
 
  
$
(8,814
)
 
$
—  
 
 
$
1,688,389
 
Comprehensive loss:
                                                               
Net loss
 
—  
 
 
 
—  
 
 
 
—  
 
 
 
(382,420
)
  
 
—  
 
  
 
—  
 
 
 
—  
 
 
 
(382,420
)
Other comprehensive loss:
                                                               
Net unrealized investment losses, net of $26,269 tax
 
—  
 
 
 
—  
 
 
 
—  
 
 
 
—  
 
  
 
(41,261
)
  
 
—  
 
 
 
—  
 
 
 
(41,261
)
                                                           


Comprehensive loss
                                                         
 
(423,681
)
Restricted stock grants (forfeitures), net
 
(43
)
 
 
(7
)
 
 
(910
)
 
 
—  
 
  
 
—  
 
  
 
(150
)
 
 
—  
 
 
 
(1,067
)
Restricted stock amortization
 
—  
 
 
 
—  
 
 
 
—  
 
 
 
—  
 
  
 
—  
 
  
 
3,104
 
 
 
—  
 
 
 
3,104
 
Restricted stock market value adjustment
 
—  
 
 
 
—  
 
 
 
(4,350
)
 
 
—  
 
  
 
—  
 
  
 
4,350
 
 
 
—  
 
 
 
—  
 
Stock option exercises
 
112
 
 
 
19
 
 
 
859
 
 
 
—  
 
  
 
—  
 
  
 
—  
 
 
 
—  
 
 
 
878
 
Stock option tax benefit
 
—  
 
 
 
—  
 
 
 
388
 
 
 
—  
 
  
 
—  
 
  
 
—  
 
 
 
—  
 
 
 
388
 
   

 


 


 


  


  


 


 


Balances, December 31, 1999
 
167,609
 
 
 
27,935
 
 
 
898,698
 
 
 
371,378
 
  
 
(28,490
)
  
 
(1,510
)
 
 
—  
 
 
 
1,268,011
 
Comprehensive income:
                                                               
Net income
 
—  
 
 
 
—  
 
 
 
—  
 
 
 
90,052
 
  
 
—  
 
  
 
—  
 
 
 
—  
 
 
 
90,052
 
Other comprehensive income:
                                                               
Net unrealized investment gains, net of $12,721 tax
 
—  
 
 
 
—  
 
 
 
—  
 
 
 
—  
 
  
 
19,981
 
  
 
—  
 
 
 
—  
 
 
 
19,981
 
                                                           


Comprehensive income
                                                         
 
110,033
 
Common stock repurchases
 
—  
 
 
 
—  
 
 
 
—  
 
 
 
—  
 
  
 
—  
 
  
 
—  
 
 
 
(26,432
)
 
 
(26,432
)
Restricted stock grants (forfeitures), net
 
2,990
 
 
 
498
 
 
 
20,525
 
 
 
(479
)
  
 
—  
 
  
 
(33,029
)
 
 
12,485
 
 
 
—  
 
Restricted stock amortization
 
—  
 
 
 
—  
 
 
 
—  
 
 
 
—  
 
  
 
—  
 
  
 
7,069
 
 
 
—  
 
 
 
7,069
 
Restricted stock market value adjustment
 
—  
 
 
 
—  
 
 
 
1,707
 
 
 
—  
 
  
 
—  
 
  
 
(1,707
)
 
 
—  
 
 
 
—  
 
Stock option exercises
 
290
 
 
 
49
 
 
 
1,568
 
 
 
—  
 
  
 
—  
 
  
 
—  
 
 
 
—  
 
 
 
1,617
 
Stock option tax benefit
 
—  
 
 
 
—  
 
 
 
123
 
 
 
—  
 
  
 
—  
 
  
 
—  
 
 
 
—  
 
 
 
123
 
   

 


 


 


  


  


 


 


Balances, December 31, 2000
 
170,889
 
 
 
28,482
 
 
 
922,621
 
 
 
460,951
 
  
 
(8,509
)
  
 
(29,177
)
 
 
(13,947
)
 
 
1,360,421
 
Comprehensive income:
                                                               
Net income
 
—  
 
 
 
—  
 
 
 
—  
 
 
 
117,171
 
  
 
—  
 
  
 
—  
 
 
 
—  
 
 
 
117,171
 
Other comprehensive income:
                                                               
Net unrealized investment gains, net of $12,847 tax
 
—  
 
 
 
—  
 
 
 
—  
 
 
 
—  
 
  
 
20,179
 
  
 
—  
 
 
 
—  
 
 
 
20,179
 
                                                           


Comprehensive income
                                                         
 
137,350
 
Common stock repurchases
 
—  
 
 
 
—  
 
 
 
—  
 
 
 
—  
 
  
 
—  
 
  
 
—  
 
 
 
(1,867
)
 
 
(1,867
)
Restricted stock grants (forfeitures), net
 
(433
)
 
 
(72
)
 
 
(1,699
)
 
 
—  
 
  
 
—  
 
  
 
815
 
 
 
956
 
 
 
—  
 
Restricted stock amortization
 
—  
 
 
 
—  
 
 
 
—  
 
 
 
—  
 
  
 
—  
 
  
 
9,492
 
 
 
—  
 
 
 
9,492
 
Restricted stock market value adjustment
 
—  
 
 
 
—  
 
 
 
(988
)
 
 
—  
 
  
 
—  
 
  
 
988
 
 
 
—  
 
 
 
—  
 
Stock option exercises
 
237
 
 
 
39
 
 
 
2,244
 
 
 
—  
 
  
 
—  
 
  
 
—  
 
 
 
9
 
 
 
2,292
 
Stock option tax benefit
 
—  
 
 
 
—  
 
 
 
261
 
 
 
—  
 
  
 
—  
 
  
 
—  
 
 
 
—  
 
 
 
261
 
   

 


 


 


  


  


 


 


Balances, December 31, 2001
 
170,693
 
 
$
28,449
 
 
$
922,439
 
 
$
578,122
 
  
$
11,670
 
  
$
(17,882
)
 
$
(14,849
)
 
$
1,507,949
 
   

 


 


 


  


  


 


 


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

54


 
Humana Inc.  
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
 
 
For the year ended December 31,

 
 
2001

 
2000

 
1999

 
 
(in thousands)
 
Cash flows from operating activities
           
Net income (loss)
$    117,171
 
$    90,052
 
$(382,420
)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
           
Depreciation and amortization
161,531
 
146,548
 
123,858
 
Amortization of restricted stock
9,492
 
7,069
 
3,104
 
Gain on sale of property and equipment, net
—  
 
(3,373
)
(11,652
)
Gain on sale of investment securities, net
(13,853
)
(6,615
)
(10,641
)
Provision for deferred income taxes
56,104
 
19,287
 
4,974
 
Provision for doubtful accounts
4,039
 
10,927
 
12,644
 
Payment of government audit settlement
(8,000
)
(14,526
)
—  
 
Asset impairments and other charges
—  
 
—  
 
459,852
 
Changes in operating assets and liabilities excluding the effects of acquisitions and divestitures:
           
        Premiums receivable
(22,836
)
(994
)
38,593
 
                Other assets
8,184
 
(8,234
)
53,940
 
Medical and other expenses payable
(179,539
)
(195,891
)
(22,949
)
Workers’ compensation liabilities
—  
 
(30,064
)
(150,245
)
Other liabilities
27,456
 
39,020
 
43,218
 
Unearned premium revenues
(13,397
)
(16,050
)
55,601
 
        Other
2,606
 
3,248
 
(142
)
 





Net cash provided by operating activities
148,958
 
40,404
 
217,735
 
 





Cash flows from investing activities
           
Acquisitions, net of cash and cash equivalents acquired
(29,359
)
(12,910
)
(14,810
)
Divestitures, net of cash and cash equivalents disposed
1,470
 
28,517
 
—  
 
Purchases of property and equipment
(114,971
)
(135,067
)
(88,930
)
Dispositions of property and equipment
—  
 
21,163
 
53,833
 
Purchases of investment securities
(1,874,482
)
(1,205,129
)
(796,026
)
Maturities of investment securities
626,369
 
543,062
 
391,440
 
Proceeds from sales of investment securities
1,272,166
 
582,339
 
472,272
 
 





Net cash (used in) provided by investing activities
(118,807
)
(178,025
)
17,779
 
 





Cash flows from financing activities
           
Revolving credit agreement (repayments) borrowings
(520,000
)
520,000
 
(93,000
)
Net conduit commercial paper borrowings
263,000
 
—  
 
—  
 
Net commercial paper repayments
(79,952
)
(606,261
)
(43,763
)
Proceeds from issuance of senior notes
299,277
 
—  
 
—  
 
Proceeds from other borrowings
5,700
 
—  
 
—  
 
Debt issue costs
(7,116
)
—  
 
—  
 
Change in book overdraft
4,194
 
(66,618
)
(19,243
)
Common stock repurchases
(1,867
)
(26,432
)
—  
 
Other
471
 
(3,793
)
(13,800
)
 





Net cash used in financing activities
(36,293
)
(183,104
)
(169,806
)
 





(Decrease) increase in cash and cash equivalents
(6,142
)
(320,725
)
65,708
 
Cash and cash equivalents at beginning of period
657,562
 
978,287
 
912,579
 
 





Cash and cash equivalents at end of period
$    651,420
 
$  657,562
 
$978,287
 
 





Supplemental cash flow disclosures:
           
Interest payments
$      23,663
 
$    25,190
 
$  33,187
 
Income tax payments (refunds), net
$      11,413
 
$   (35,182
)
$  (58,375
)
Details of businesses acquired in purchase transactions:
           
Fair value of assets acquired, net of cash acquired
$    154,684
 
$  125,816
 
$  20,157
 
Less: liabilities assumed
(125,325
)
(112,906
)
(5,347
)
 





Cash paid for acquired businesses, net of cash acquired
$      29,359
 
$    12,910
 
$  14,810
 
 





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

55


Humana Inc.  
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1. Reporting Entity
 
Nature of Operations
 
Headquartered in Louisville, Kentucky, Humana Inc. is one of the nation’s largest publicly traded health benefits companies, based on our 2001 revenues of $10.2 billion. References throughout this document to “we,” “us,” “our,” “Company,” and “Humana,” mean Humana Inc. and all entities we own. We offer coordinated health insurance coverage and related services through a variety of traditional and Internet-based plans for employer groups and government-sponsored programs. In 2001, over 70% of our premiums and administrative services fees resulted from members located in Florida, Illinois, Texas, Kentucky and Ohio. We derived approximately 44% of our premiums and administrative services fees from contracts with the federal government in 2001.
 
During the first quarter of 2001, we realigned our management to better reflect our focus on the consumer. As part of this management realignment, we redefined our business into two segments, Commercial and Government. The Commercial segment consists of members enrolled in products marketed to employer groups and individuals, and includes three lines of business: fully insured medical, administrative services only, or ASO, and specialty. The Government segment consists of members enrolled in government-sponsored plans, and includes three lines of business: Medicare+Choice, Medicaid, and TRICARE. Results of each segment are measured by income before income taxes. We allocate all selling, general and administrative expenses, investment and other income, and interest expense, but not assets, to our segments. Members served by our two segments generally utilize the same medical provider networks, enabling us to obtain more favorable contract terms with providers. Our segments also share overhead costs and assets. As a result, the profitability of each segment is interdependent.
 
2. Summary of Significant Accounting Policies
 
Basis of Presentation
 
Our financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America. Our consolidated financial statements include the accounts of Humana Inc., and its majority-owned subsidiaries. All significant intercompany balances and transactions have been eliminated. Certain reclassifications have been made to our prior years’ consolidated financial statements to conform with the current year presentation. These adjustments had no effect on previously reported consolidated net income (loss) or stockholders’ equity.
 
The preparation of financial statements in accordance with generally accepted accounting principles requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. These estimates are based on knowledge of current events and anticipated future events, and accordingly, actual results may ultimately differ materially from those estimates.
 
Cash and Cash Equivalents
 
Cash and cash equivalents include cash, time deposits, money market funds, commercial paper, and certain U.S. Government securities with an original maturity of three months or less. Carrying value approximates fair value due to the short-term maturity of the investments.
 
Investment Securities
 
Investment securities, which consist primarily of debt and equity securities, have been categorized as available for sale and, as a result, are stated at fair value based generally on quoted market prices. Investment

56


Humana Inc.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

securities available for current operations are classified as current assets. Investment securities available for our capital spending, professional liability, long-term insurance product requirements and strategic investments are classified as long-term assets. Unrealized holding gains and losses, net of applicable deferred taxes, are included as a component of stockholders’ equity until realized.
 
For the purpose of determining gross realized gains and losses, the cost of investment securities sold is based upon specific identification.
 
Premiums Receivable and Revenue Recognition
 
We generally establish one-year commercial membership contracts with employer groups, subject to cancellation by the employer group’s written notice. Our TRICARE contracts with the federal government and various state Medicaid programs are generally multi-year contracts. Our Medicare+Choice contracts with the federal government renew annually. We bill and collect premium remittances from employer groups and some individual Medicare+Choice members monthly. We receive monthly premiums from the federal government and various states according to government specified reimbursement rates and various contractual terms.
 
Premium revenues are recognized as income in the period members are entitled to receive services, and are net of estimated uncollectible amounts and retroactive membership adjustments. Retroactive membership adjustments result from enrollment changes not yet processed, or not reported by an employer group or the government. We routinely monitor these trends, as well as prevailing and anticipated economic conditions, and any required adjustments are reflected in current operations. Premiums and operating expenses may also include adjustments attributable to our TRICARE contracts, which generally reflect variation in healthcare experience and change orders for services not originally specified in the contracts. Our TRICARE contracts are subject to adjustments resulting from negotiations with the federal government. Revenues and corresponding expenses for these adjustments generally are recognized when a settlement becomes known and the collectibility reasonably assured.
 
Administrative services fees are earned as services are performed. Administrative services generally include the processing of claims, offering access to our provider networks and clinical programs, and responding to customer services inquiries from members of self-funded employers. Under ASO contracts, self-funded employers and, for TRICARE ASO, the Department of Defense, retain the risk of financing the cost of health benefits.
 
Premiums receivable are shown net of an allowance for estimated uncollectible accounts and retroactive membership adjustments based on historical trends. Premiums received prior to the period members are entitled to receive services are recorded as unearned premium revenues.
 
Long-Lived Assets
 
Property and equipment is carried at cost, and is comprised of the following at December 31, 2001 and 2000:
 
    
2001

    
2000

 
    
(in thousands)
 
Land
  
$
32,194
 
  
$
32,928
 
Buildings
  
 
320,839
 
  
 
319,481
 
Equipment and computer software
  
 
618,775
 
  
 
526,277
 
    


  


    
 
971,808
 
  
 
878,686
 
Accumulated depreciation
  
 
(510,047
)
  
 
(444,066
)
    


  


Property and equipment, net
  
$
461,761
 
  
$
434,620
 
    


  


57


Humana Inc.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 
We compute depreciation expense using the straight-line method over estimated useful lives ranging from 3 to 10 years for equipment, 3 to 7 years for computer software, and 20 to 40 years for buildings. Depreciation expense was $92.9 million in 2001, $84.3 million in 2000, and $78.5 million in 1999.
 
Goodwill represents the unamortized excess of cost over the fair value of net tangible and identifiable intangible assets acquired. Identifiable intangible assets, which are included in other long-term assets in the accompanying Consolidated Balance Sheets, primarily relate to government, subscriber and provider contracts and the cost of acquired licenses. We amortized goodwill and identifiable intangible assets on a straight-line method over their estimated useful lives over periods ranging from 6 to 20 years for goodwill, and 2 to 20 years for identifiable intangible assets.
 
We periodically review long-lived assets for impairment whenever adverse events or changes in circumstances indicate the carrying value of the asset may not be recoverable. Losses are recognized when the undiscounted future cash flows expected to result from the use of the asset and its eventual disposition are less than its carrying value. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. In addition, we periodically review the estimated lives of all long-lived assets for reasonableness. See Note 13 for a discussion related to our 1999 impairment and estimated life review.
 
Amortization expense for goodwill was $55.1 million in 2001, $51.9 million in 2000, and $33.8 million in 1999. Amortization expense for identifiable intangible assets was $13.5 million in 2001, $10.3 million in 2000, and $11.6 million in 1999. In conjunction with our 1999 goodwill impairment, we also reviewed the estimated life assigned to goodwill. Effective January 1, 2000, we adopted a 20-year amortization period from the date of acquisition for goodwill previously amortized over 40 years. As further discussed in the “Recently Issued Accounting Pronouncements” section of this Note, we ceased amortizing goodwill subject to an annual impairment test upon adopting Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, on January 1, 2002.
 
Medical and Other Expenses Payable and Medical Cost Recognition
 
Medical costs include claim payments, capitation payments, allocations of certain centralized expenses and various other costs incurred to provide health insurance coverage to members, as well as estimates of future payments to hospitals and others for medical care provided prior to the balance sheet date. Capitation payments represent monthly contractual fees disbursed to primary care physicians and other providers who are responsible for providing medical care to members. We estimate the costs of our future medical claims and other expense payments using actuarial methods and assumptions based upon claim payment patterns, medical cost inflation, historical developments such as claim inventory levels and claim receipt patterns, and other relevant factors, and record medical claims reserves for future payments. We continually review estimates of future payments relating to medical claims costs for services incurred in the current and prior periods and make necessary adjustments to our reserves.
 
We reassess the profitability of our contracts for providing health insurance coverage to our members when current operating results or forecasts indicate probable future losses. We establish a premium deficiency liability in current operations to the extent that the sum of a market’s expected future medical costs, claim adjustment expenses, and maintenance costs exceeds related future premiums under contract. Anticipated investment income is not considered for purposes of computing the premium deficiency. Losses recognized as a premium deficiency result in a beneficial effect in subsequent periods as operating losses under these contracts are charged to the liability previously established. At December 31, 2001, there were no premium deficiency liabilities. Because the majority of our member contracts renew annually, we do not anticipate recording a premium deficiency liability, except when unanticipated adverse events or changes in circumstances indicate otherwise.

58


Humana Inc.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 
We believe our medical and other expenses payable are adequate to cover future claims payments required. However, such estimates are based on knowledge of current events and anticipated future events. Therefore, the actual liability could differ from the amounts provided.
 
Book Overdraft
 
Under our cash management system, checks issued but not presented to banks frequently result in overdraft balances for accounting purposes and are classified as a current liability in the Consolidated Balance Sheets.
 
Income Taxes
 
We recognize an asset or liability for the deferred tax consequences of temporary differences between the tax bases of assets or liabilities and their reported amounts in the financial statements. These temporary differences will result in taxable or deductible amounts in future years when the reported amounts of the assets or liabilities are recovered or settled. We also recognize the future tax benefits such as net operating and capital loss carryforwards as deferred tax assets. A valuation allowance is provided against these deferred tax assets if it is more likely than not that some portion or all of the deferred tax assets will not be realized.
 
Professional Liability Risk
 
Professional liability risks include estimates for claims reported and outstanding, claims incurred but not reported (based on actuarial determinations using past experience, modified for current trends), and corresponding loss adjustment expenses incurred to adjudicate such claims. We continually review these estimated liabilities, and make necessary adjustments as warranted.
 
Stock Options
 
We account for our stock option plans under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations, and have adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, or Statement 123. No compensation expense has been recognized in connection with the granting of stock options to employees. See Note 7 for discussion of stock options and the disclosures required by Statement 123.
 
Earnings (Loss) Per Common Share
 
We compute basic earnings (loss) per common share on the basis of the weighted average number of unrestricted common shares outstanding. Diluted earnings (loss) per common share is computed on the basis of the weighted average number of unrestricted common shares outstanding plus the dilutive effect of outstanding employee stock options and restricted shares using the treasury stock method.
 
Recently Issued Accounting Pronouncements
 
In June 2001, the Financial Accounting Standards Board, or FASB, issued Statement No. 141, Business Combinations, or Statement 141, and Statement No. 142, Goodwill and Other Intangible Assets, or Statement 142.
 
Statement 141 requires that all business combinations initiated after June 30, 2001 be accounted for using the purchase method. Use of the pooling-of-interest method is no longer permitted.

59


Humana Inc.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 
Statement 142 requires that goodwill no longer be amortized to earnings, but instead be reviewed at least annually for impairment using a two-step process. The first step is a screen for potential impairment, and the second step measures the amount of impairment, if any. Impairment losses that arise from completing a transitional impairment test during 2002 are to be reported as the cumulative effect of a change in accounting principle at the beginning of the year. Subsequent impairments, if any, would be classified as an operating expense. Statement 142 also specifies the types of acquired intangible assets that are required to be recognized and reported separately from goodwill.
 
At December 31, 2001, goodwill and identifiable intangible assets represented 19% of total assets and 55% of total stockholders’ equity. In 2001, amortization expense was $55.1 million for goodwill and $13.5 million for identifiable intangible assets. Effective January 1, 2002, we ceased amortizing goodwill upon adopting Statement 142. Statement 142 requires completion of the first step of the transitional impairment test by June 30, 2002. Completion of the second step, if necessary, is required as soon as possible upon completing the first step but no later than December 31, 2002. We are currently in the process of completing the transitional impairment test. This test requires fair value measurements. We expect to use a discounted cash flow analysis and other valuation methodologies which utilize many assumptions and estimates in determining an impairment loss including assumptions and estimates related to future earnings. Until we complete our analysis, no assurances can be given that we will or will not have an impairment.
 
In October 2001, the FASB issued Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, or Statement 144. Statement 144 develops a single accounting model for long-lived assets to be disposed of by sale, and addresses significant implementation issues related to previous guidance. Statement 144 requires that long-lived assets to be disposed of by sale be measured at the lower of their carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations. Statement 144 also broadens the reporting of discontinued operations by potentially qualifying more disposal transactions for discontinued operations reporting. Generally, the provisions of Statement 144 are to be applied prospectively beginning on January 1, 2002.
 
3. Investment Securities
 
Investment securities classified as current assets at December 31, 2001 and 2000 included the following:
 
   
2001

 
2000

   
Amortized
Cost

  
Gross
Unrealized
Gains

 
Gross
Unrealized
Losses

   
Fair
Value

 
Amortized
Cost

  
Gross
Unrealized
Gains

 
Gross
Unrealized
Losses

   
Fair
Value

                  
(in thousands)
              
U.S. Government obligations
 
$
374,421
  
$
4,254
 
$
(2,249
)
 
$
376,426
 
$
139,960
  
$
1,231
 
$
(182
)
 
$
141,009
Tax exempt municipal securities
 
 
637,898
  
 
7,706
 
 
(2,354
)
 
 
643,250
 
 
810,940
  
 
5,018
 
 
(6,410
)
 
 
809,548
Corporate and other securities
 
 
266,931
  
 
2,594
 
 
(2,878
)
 
 
266,647
 
 
257,511
  
 
2,232
 
 
(3,557
)
 
 
256,186
Mortgage-backed securities
 
 
904
  
 
13
 
 
—  
 
 
 
917
 
 
28,169
  
 
916
 
 
(5
)
 
 
29,080
Redeemable preferred stocks
 
 
29,773
  
 
36
 
 
(1,597
)
 
 
28,212
 
 
61,125
  
 
16
 
 
(2,745
)
 
 
58,396
   

  

 


 

 

  

 


 

Debt securities
 
 
1,309,927
  
 
14,603
 
 
(9,078
)
 
 
1,315,452
 
 
1,297,705
  
 
9,413
 
 
(12,899
)
 
 
1,294,219
Equity securities
 
 
80,275
  
 
894
 
 
(7,025
)
 
 
74,144
 
 
123,803
  
 
1,280
 
 
(10,780
)
 
 
114,303
   

  

 


 

 

  

 


 

Investment securities
 
$
1,390,202
  
$
15,497
 
$
(16,103
)
 
$
1,389,596
 
$
1,421,508
  
$
10,693
 
$
(23,679
)
 
$
1,408,522
   

  

 


 

 

  

 


 

60


Humana Inc.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 
Investment securities classified as long-term assets at December 31, 2001 and 2000 included the following:
 
   
2001

 
2000

   
Amortized
Cost

  
Gross
Unrealized
Gains

  
Gross
Unrealized
Losses

   
Fair
Value

 
Amortized
Cost

  
Gross
Unrealized
Gains

  
Gross
Unrealized
Losses

   
Fair
Value

                   
(in thousands)
               
U.S. Government obligations
 
$
31,906
  
$
8
  
$
(218
)
 
$
31,696
 
$
—  
  
$
—  
  
$
—  
 
 
$
—  
Tax exempt municipal securities
 
 
65,877
  
 
727
  
 
(874
)
 
 
65,730
 
 
76,637
  
 
1,112
  
 
(629
)
 
 
77,120
Corporate and other securities
 
 
74,398
  
 
687
  
 
(1,416
)
 
 
73,669
 
 
76,250
  
 
356
  
 
(1,054
)
 
 
75,552
Mortgage-backed securities
 
 
22,449
  
 
—  
  
 
—  
 
 
 
22,449
 
 
25,771
  
 
—  
  
 
—  
 
 
 
25,771
Redeemable preferred stocks
 
 
48,387
  
 
22,001
  
 
(92
)
 
 
70,296
 
 
42,291
  
 
9
  
 
(54
)
 
 
42,246
   

  

  


 

 

  

  


 

Debt securities
 
 
243,017
  
 
23,423
  
 
(2,600
)
 
 
263,840
 
 
220,949
  
 
1,477
  
 
(1,737
)
 
 
220,689
Equity securities
 
 
16,565
  
 
11
  
 
(96
)
 
 
16,480
 
 
19,582
  
 
—  
  
 
(207
)
 
 
19,375
   

  

  


 

 

  

  


 

Long-term investment securities
 
$
259,582
  
$
23,434
  
$
(2,696
)
 
$
280,320
 
$
240,531
  
$
1,477
  
$
(1,944
)
 
$
240,064
   

  

  


 

 

  

  


 

 
The contractual maturities of debt securities available for sale at December 31, 2001, regardless of their balance sheet classification, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
    
Amortized Cost

  
Fair
Value

    
(in thousands)
Due within one year
  
$
89,415
  
$
88,748
Due after one year through five years
  
 
601,338
  
 
609,745
Due after five years through ten years
  
 
360,516
  
 
358,972
Due after ten years
  
 
501,675
  
 
521,827
    

  

Total debt securities
  
$
1,552,944
  
$
1,579,292
    

  

 
Gross realized investment gains were $25.1 million in 2001, $8.1 million in 2000, and $18.0 million in 1999. Gross realized investment losses were $11.2 million in 2001, $1.5 million in 2000, and $7.4 million in 1999.
 
4. Income Taxes
 
The provision (benefit) for income taxes consisted of the following:
 
    
For the year ended December 31,

 
    
2001

  
2000

  
1999

 
    
(in thousands)
 
Current provision (benefit):