HUMANA INC – 10-K – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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Executive Overview

General

  Headquartered in Louisville, Kentucky, Humana is a leading health care company that offers a wide range of insurance products and health and wellness services that incorporate an integrated approach to lifelong well-being. By leveraging the strengths of our core businesses, we believe that we can better explore opportunities for existing and emerging adjacencies in health care that can further enhance wellness opportunities for the millions of people across the nation with whom we have relationships.  Our industry relies on two key statistics to measure performance. The benefit ratio, which is computed by taking total benefit expenses as a percentage of premiums revenue, represents a statistic used to measure underwriting profitability. The operating cost ratio, which is computed by taking total operating costs as a percentage of total revenue less investment income, represents a statistic used to measure administrative spending efficiency.  

2011 Business Segment Realignment

  During the first quarter of 2011, we realigned our business segments to reflect our evolving business model. As a result, we reassessed and changed our operating and reportable segments in the first quarter of 2011 to reflect management's view of the business and to align our external financial reporting with our new operating and internal financial reporting model. Historical segment information has been retrospectively adjusted to reflect the effect of this change. Our new reportable segments and the basis for determining those segments are discussed below.  Business Segments  We currently manage our business with three reportable segments: Retail, Employer Group, and Health and Well-Being Services. In addition, we include businesses that are not individually reportable because they do not meet the quantitative thresholds required by generally accepted accounting principles in an Other Businesses category. These segments are based on a combination of the type of health plan customer and adjacent businesses centered on well-being solutions for our health plans and other customers, as described below. These segment groupings are consistent with information used by our Chief Executive Officer to assess performance and allocate resources.  The Retail segment consists of Medicare and commercial fully-insured medical and specialty health insurance benefits, including dental, vision, and other supplemental health and financial protection products, marketed directly to individuals. The Employer Group segment consists of Medicare and commercial fully-insured medical and specialty health insurance benefits, including dental, vision, and other supplemental health and financial protection products, as well as administrative services only products marketed to employer groups. The Health and Well-Being Services segment includes services offered to our health plan members as well as to third parties that promote health and wellness, including primary care, pharmacy, integrated wellness, and home care services. The Other Businesses category consists of our Military services, primarily our TRICARE South Region contract, Medicaid, and closed-block long-term care businesses as well as our contract with CMS to administer the LI-NET program.  The results of each segment are measured by income before income taxes. Transactions between reportable segments consist of sales of services rendered by our Health and Well-Being Services segment, primarily pharmacy and behavioral health services, to our Retail and Employer Group customers. Intersegment sales and expenses are recorded at fair value and eliminated in consolidation. Members served by our segments often                                           41 

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  utilize the same provider networks, enabling us in some instances to obtain more favorable contract terms with providers. Our segments also share indirect costs and assets. As a result, the profitability of each segment is interdependent. We allocate most operating expenses to our segments. Assets and certain corporate income and expenses are not allocated to the segments, including the portion of investment income not supporting segment operations, interest expense on corporate debt, and certain other corporate expenses. These items are managed at the corporate level. These corporate amounts are reported separately from our reportable segments and included with intersegment eliminations.  

Seasonality

  Our Retail segment offers Medicare stand-alone prescription drug plans, or PDPs, under the Medicare Part D program. These plans provide varying degrees of coverage. Our quarterly Retail segment earnings and operating cash flows are impacted by the Medicare Part D benefit design and changes in the composition of our membership. The Medicare Part D benefit design results in coverage that varies as a member's cumulative out-of-pocket costs pass through successive stages of a member's plan period which begins annually on January 1 for renewals. These plan designs generally result in us sharing a greater portion of the responsibility for total prescription drug costs in the early stages and less in the latter stages. As a result, the PDP benefit ratio generally decreases as the year progresses. In addition, the number of low-income senior members as well as year-over-year changes in the mix of membership in our stand-alone PDP products affects the quarterly benefit ratio pattern.  

Our Employer Group segment also experiences seasonality in the benefit ratio pattern. However, the effect is opposite of the Retail segment, with the Employer Group's benefit ratio increasing as fully-insured members progress through their annual deductible and maximum out-of-pocket expenses.

 2011 Highlights  Consolidated   

• Our strategy and commitment to the Medicare programs have led to

          significant growth as discussed in our Retail segment discussion below.          •   As more fully described herein under the section titled "Benefit Expense

Recognition" actuarial standards require the use of assumptions based on

moderately adverse experience, which generally results in favorable

         reserve development, or reserves that are considered redundant. When we          recognize a release of the redundancy, we disclose the amount that is not

in the ordinary course of business. We experienced favorable prior-period

medical claims reserve development not in the ordinary course of business,

primarily in our Retail and Employer Group segments, of approximately $205

million in the aggregate, or $0.77 per diluted common share, for the year

ended December 31, 2011 as compared to $231 million in the aggregate, or

$0.86 per diluted common share, for the year ended December 31, 2010. Any

discussion of favorable prior-period medical claims reserve development in

         our results of operation discussion that follows refers to amounts that          were not in the ordinary course of business.    

     •   In April 2011, our Board of Directors approved the initiation of a 

quarterly cash dividend policy and we subsequently declared cash dividends

         of $0.25 per share to stockholders of record on each of June 30, 2011,          September 30, 2011, and December 30, 2011.    

• In addition, in April 2011, the Board of Directors replaced its previously

approved share repurchase authorization of up to $250 million with a new

authorization for repurchases of up to $1 billion. The new authorization

will expire June 30, 2013. As of February 6, 2012, the remaining

          authorized amount under the new authorization totaled $561 million.          •   Comparisons to 2010 are impacted by the $147 million write-down of

deferred acquisition costs associated with our individual commercial

         medical policies during the year ended December 31, 2010                                            42 

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as well as the net charge of $139 million due to reserve strengthening for

       our closed block of long-term care policies as discussed more fully in        Note 17 to the consolidated financial statements included in Item 8. -        Financial Statements and Supplementary Data.   Retail Segment    

• On February 17, 2012, CMS issued its Advance Notice for methodological

changes for 2013 Medicare Advantage capitation rates and Part C and Part D

payment policies. We believe the Advance Notice indicates our payment

rates from CMS will remain relatively unchanged from those for 2012, with

the exception of the impact of any automatic rate reductions that would

occur as a result of the Budget Control Act of 2011. These potential

automatic rate reductions were not addressed in the Advance notice, but we

believe they would be primarily passed through as provider payment

reductions from us. (For additional information, please refer to the risk

factor entitled, "As a government contractor, we are exposed to risks that

         may materially affect our business or our willingness or ability to          participate in government health care programs.") However, the Advance

Notice is subject to comment, and the final rates will not be published

until the first Monday in April 2012. Nevertheless, we believe we can

effectively design Medicare Advantage products based upon this level of

rate increase while continuing to remain competitive compared to both the

combination of original Medicare with a supplement policy as well as other

Medicare Advantage competitors within our industry. In addition, we will

continue to pursue our cost-reduction and outcome-enhancing strategies,

including care coordination and disease management, which we believe will

mitigate the adverse effects of the rates on our Medicare Advantage

members. Nonetheless, there can be no assurance that we will be able to

successfully execute operational and strategic initiatives with respect to

         changes in the Medicare Advantage program. Failure to execute these          strategies may result in a material adverse effect on our results of          operations, financial position, and cash flows.    

• Individual Medicare Advantage membership of 1,640,300 at December 31, 2011

increased 179,600 members, or 12.3%, from 1,460,700 at December 31, 2010

primarily due to a successful enrollment season associated with the 2011

plan year. January 2012 individual Medicare Advantage membership of

approximately 1,813,000 increased nearly 173,000 members, or approximately

11%, from December 31, 2011, reflecting another successful enrollment

         season.          •   Individual Medicare stand-alone PDP membership of 2,540,400 at

December 31, 2011 increased 870,100 members, or 52.1%, from 1,670,300 at

December 31, 2010 primarily due to sales of our new lowest premium

national stand-alone Medicare Part D prescription drug plan co-branded

with Wal-Mart Stores, Inc., the Humana Walmart-Preferred Rx Plan, that we

began offering for the 2011 plan year. January 2012 individual Medicare

stand-alone PDP membership grew to approximately 2,825,000, increasing

nearly 285,000 members, or approximately 11%, from December 31, 2011, also

         reflecting another successful selling season for the co-branded Humana          Walmart-Preferred Rx Plan.    

• Comparisons to 2010 within the Retail segment are impacted by the $147

million write-down of deferred acquisition costs associated with our

individual commercial medical policies during the year ended December 31,

         2010 as discussed above.          •   On December 6, 2011, we acquired Anvita, Inc., or Anvita, a San

Diego-based health care analytics company. The Anvita acquisition provides

scalable analytics solutions that produce clinical insights which we

believe will enhance our ability to improve the quality and lower the cost

          of health care for our members and customers.          •   Effective December 30, 2011, we acquired the California-based Medicare

Advantage HMO MD Care, Inc., or MD Care. This acquisition expanded our          Medicare footprint in California and grew our Medicare enrollment by          approximately 12,100 members.    

• During the second half of 2011, we entered into a definitive agreement to

         acquire Arcadian Management Services, Inc., which serves Medicare          Advantage HMO members in 15 U.S. states,                                            43 

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offering us an opportunity to further expand our Medicare footprint and

grow our Medicare enrollment. The closing of this acquisition is subject

to regulatory approval.

Health and Well-Being Services Segment

• During the second half of 2011, we entered into a definitive agreement to

acquire SeniorBridge, a chronic-care provider providing in-home care for

         seniors that will expand our existing clinical and home health          capabilities and strengthen our offerings for members with complex          chronic-care needs. The closing of this acquisition is subject to          regulatory approval.    

• In 2011, we launched HumanaVitality, a joint venture with Discovery

Holdings Ltd., providing our members with access to a science-based,

actuarially driven wellness and loyalty program that features a wide range

of well-being tools and rewards that are customized to an individual's

          needs and wants.   Other Businesses   

• Comparisons to 2010 within Other Businesses are impacted by the net charge

         of $139 million due to reserve strengthening for our closed block of          long-term care policies during the year ended December 31, 2010 as          discussed above.          •   As more fully discussed in Note 15 to the consolidated financial 

statements included in Item 8. - Financial Statements and Supplementary

Data. On February 25, 2011, the Department of Defense TRICARE Management

         Activity, or TMA, awarded the new TRICARE South Region contract to us,          which we expect to take effect on April 1, 2012. The new 5-year South          Region contract, which expires March 31, 2017, is subject to annual

renewals on April 1 of each year during its term at the government's

          option.   Health Insurance Reform  In March 2010, the President signed into law The Patient Protection and Affordable Care Act and The Health Care and Education Reconciliation Act of 2010 (which we collectively refer to as the Health Insurance Reform Legislation) which enact significant reforms to various aspects of the U.S. health insurance industry. While regulations and interpretive guidance on some provisions of the Health Insurance Reform Legislation have been issued to date by the Department of Health and Human Services (HHS), the Department of Labor, the Treasury Department, and the National Association of Insurance Commissioners, there are many significant provisions of the legislation that will require additional guidance and clarification in the form of regulations and interpretations in order to fully understand the impacts of the legislation on our overall business, which we expect to occur over the next several years.  

Implementation dates of the Health Insurance Reform Legislation vary from September 23, 2010 to as late as 2018. The following outlines certain provisions of the Health Insurance Reform Legislation:

• Changes effective for plan years which began on or after September 23,

2010 included: elimination of pre-existing condition limits for enrollees

under age 19, elimination of certain annual and lifetime caps on the

dollar value of benefits, expansion of dependent coverage to include adult

children until age 26, a requirement to provide coverage for preventive

services without cost to members, new claim appeal requirements, and the

establishment of an interim high risk program for those unable to obtain

          coverage due to a pre-existing condition or health status.          •   Effective January 1, 2011, minimum benefit ratios were mandated for all

         commercial fully-insured medical plans in the large group (85%), small          group (80%), and individual (80%) markets, with annual rebates to          policyholders if the actual benefit ratios, calculated in a manner          prescribed by HHS, do not meet these minimums. Certain states were

approved to apply an individual threshold lower than the 80% requirement

temporarily to avoid market disruption. In 2011, we accrued for rebates,

         based on the                                            44 

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manner prescribed by HHS, with initial rebate payments to be made in

mid-2012. Our benefit ratios reported herein, calculated from financial

statements prepared in accordance with accounting principles generally

accepted in the United States of America, or GAAP, differ from the benefit

ratios calculated as prescribed by HHS under the Health Insurance Reform

Legislation. The more noteworthy differences include the fact that the

benefit ratio calculations prescribed by HHS are calculated separately by

state and legal entity; reflect actuarial adjustments where the membership

levels are not large enough to create credible size; exclude some of our

health insurance products; include taxes and fees as reductions of

premium; treat changes in reserves differently than GAAP; and classify

rebate amounts as additions to incurred claims as opposed to adjustments

       to premiums for GAAP reporting.    

• Medicare Advantage payment benchmarks for 2011 were frozen at 2010 levels

and beginning in 2012, additional cuts to Medicare Advantage plan payments

will begin to take effect (plans will receive a range of 95% in high-cost

areas to 115% in low-cost areas of Medicare fee-for-service rates), with

changes being phased-in over two to six years, depending on the level of

         payment reduction in a county. In addition, beginning in 2011, the gap in          coverage for Medicare Part D prescription drug coverage began to          incrementally close.    

• Beginning in 2014, the Health Insurance Reform Legislation requires: all

individual and group health plans to guarantee issuance and renew coverage

without pre-existing condition exclusions or health-status rating

adjustments; the elimination of annual limits on coverage on certain

plans; the establishment of state-based exchanges for individuals and

small employers (with up to 100 employees) coupled with programs designed

to spread risk among insurers; the introduction of standardized plan

designs based on set actuarial values; the establishment of a minimum

benefit ratio of 85% for Medicare plans; and insurance industry

assessments, including an annual premium-based assessment and a three-year

commercial reinsurance fee. The annual premium-based assessment levied on

         the insurance industry is $8 billion in 2014 with increasing annual          amounts thereafter and is not deductible for income tax purposes, which          will significantly increase our effective income tax rate in 2014. In

December 2011, the National Association of Insurance Commissioners, or

NAIC, issued proposed guidance indicating the insurance industry

premium-based assessment may require accrual and associated subsidiary

funding consideration in 2013 instead of 2014. This proposed NAIC guidance

is contradictory to final GAAP guidance issued by the Financial Accounting

Standards Board, or FASB, in July 2011, which indicates the insurance

industry premium-based assessment should be accrued beginning in 2014, the

year in which it is payable. Refer to Recently Issued Accounting

Pronouncements in Note 2 to the consolidated financial statements included

in Item 8. - Financial Statements and Supplementary Data.

   The Health Insurance Reform Legislation also specifies required benefit designs, limits rating and pricing practices, encourages additional competition (including potential incentives for new market entrants) and expands eligibility for Medicaid programs. In addition, the law will significantly increase federal oversight of health plan premium rates and could adversely affect our ability to appropriately adjust health plan premiums on a timely basis. Financing for these reforms will come, in part, from material additional fees and taxes on us and other health insurers, health plans and individuals beginning in 2014, as well as reductions in certain levels of payments to us and other health plans under Medicare as described herein.  In addition, certain provisions in the Health Insurance Reform Legislation tie Medicare Advantage premiums to the achievement of certain quality performance measures (Star Ratings). Beginning in 2012, Medicare Advantage plans with an overall Star Rating of three or more stars (out of five) will be eligible for a quality bonus in their basic premium rates. Initially quality bonuses were limited to the few plans that achieved four or more stars as an overall rating, but CMS has expanded the quality bonus to three Star plans for a three year period through 2014. Recent Star Ratings issued by CMS indicated that 98% of our Medicare Advantage members are now in plans that will qualify for quality bonus payments in 2013. Notwithstanding successful efforts to improve our Star Ratings and other quality measures for 2012 and 2013 and the continuation of such efforts, there can be no assurances that we will be successful in maintaining or improving our Star Ratings in                                           45 

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  future years. Accordingly, our plans may not be eligible for full level quality bonuses, which could adversely affect the benefits such plans can offer, reduce membership, and/or reduce profit margins.  As discussed above, implementing regulations and related interpretive guidance continue to be issued on several significant provisions of the Health Insurance Reform Legislation. The implementation of the individual mandate as well as Medicaid expansion in the Health Insurance Reform Legislation are also being considered by the U.S. Supreme Court, seeking to have all or portions of the Health Insurance Reform Legislation declared unconstitutional. We cannot predict the results of these proceedings. Congress may also withhold the funding necessary to implement the Health Insurance Reform Legislation, or may attempt to replace the legislation with amended provisions or repeal it altogether. Given the breadth of possible changes and the uncertainties of interpretation, implementation, and timing of these changes, which we expect to occur over the next several years, the Health Insurance Reform Legislation could change the way we do business, potentially impacting our pricing, benefit design, product mix, geographic mix, and distribution channels. In particular, implementing regulations and related guidance are forthcoming on various aspects of the minimum benefit ratio requirement's applicability to Medicare, including aggregation, credibility thresholds, and its possible application to prescription drug plans. The response of other companies to the Health Insurance Reform Legislation and adjustments to their offerings, if any, could cause meaningful disruption in the local health care markets. Further, various health insurance reform proposals are also emerging at the state level. It is reasonably possible that the Health Insurance Reform Legislation and related regulations, as well as future legislative changes, in the aggregate may have a material adverse effect on our results of operations, including restricting revenue, enrollment and premium growth in certain products and market segments, restricting our ability to expand into new markets, increasing our medical and operating costs, lowering our Medicare payment rates and increasing our expenses associated with the non-deductible federal premium tax and other assessments; our financial position, including our ability to maintain the value of our goodwill; and our cash flows. If the new non-deductible federal premium tax and other assessments, including a three-year commercial reinsurance fee, were imposed as enacted, and if we are unable to adjust our business model to address these new taxes and assessments, such as through the reduction of our operating costs, there can be no assurance that the non-deductible federal premium tax and other assessments would not have a material adverse effect on our results of operations, financial position, and cash flows.  We intend for the discussion of our financial condition and results of operations that follows to assist in the understanding of our financial statements and related changes in certain key items in those financial statements from year to year, including the primary factors that accounted for those changes. Transactions between reportable segments consist of sales of services rendered by our Health and Well-Being Services segment, primarily pharmacy and behavioral health services, to our Retail and Employer Group customers and are described in Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data.                                           46

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Comparison of Results of Operations for 2011 and 2010

Certain financial data on a consolidated basis and for our segments was as follows for the years ended December 31, 2011 and 2010:

  Consolidated                                                                                              Change                                               2011               2010          Dollars          Percentage                                                  (dollars in millions, except per                                                       common share results) Revenues: Premiums: Retail                                     $    21,402         $ 19,052        $  2,350                12.3 % Employer Group                                   8,877            9,080            (203 )              (2.2 )% Other Businesses                                 4,827            4,580             247                 5.4 %  Total premiums                                  35,106           32,712           2,394                 7.3 %  Services: Retail                                              16               11               5                45.5 % Employer Group                                     356              395             (39 )              (9.9 )% Health and Well-Being Services                     903               34             869                  nm Other Businesses                                    85              115             (30 )             (26.1 )%  Total services                                   1,360              555             805               145.0 %  Investment income                                  366              329              37                11.2 %  Total revenues                                  36,832           33,596           3,236                 9.6 %  Operating expenses: Benefits                                        28,823           27,117           1,706                 6.3 % Operating costs                                  5,395            4,380           1,015                23.2 % Depreciation and amortization                      270              245              25                10.2 %  Total operating expenses                        34,488           31,742           2,746                 8.7 %  Income from operations                           2,344            1,854             490                26.4 % Interest expense                                   109              105               4                 3.8 %  Income before income taxes                       2,235            1,749             486                27.8 % Provision for income taxes                         816              650             166                25.5 %  Net income                                 $     1,419         $  1,099        $    320                29.1 % 

Diluted earnings per common share $ 8.46 $ 6.47

   $   1.99                30.8 % Benefit ratio (a)                                 82.1 %           82.9 %                              (0.8 )% Operating cost ratio (b)                          14.8 %           13.2 %                               1.6 % Effective tax rate                                36.5 %           37.2 %                              (0.7 )%    

(a) Represents total benefit expenses as a percentage of premiums revenue.

(b) Represents total operating costs as a percentage of total revenues less

    investment income.   nm - not meaningful  Summary  Net income was $1.4 billion, or $8.46 per diluted common share, in 2011 compared to $1.1 billion, or $6.47 per diluted common share, in 2010 primarily due to improved operating performance in the Retail and Health and Well-Being Services segments and the negative impact of certain charges described below on 2010 results that did not recur in 2011. Share repurchase activity also contributed to the year-over-year increase in diluted  

earnings per common share. Our diluted earnings per common share include the beneficial impact of favorable

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  prior-period medical claims reserve development of approximately $0.77 per diluted common share for 2011 compared to $0.86 per diluted common share for 2010. Net income for the 2010 period also included the negative impact of a $147 million ($0.55 per diluted common share) write-down of deferred acquisition costs associated with our individual commercial medical policies in our Retail Segment, and a net charge of $139 million ($0.52 per diluted common share) for reserve strengthening associated with our closed block of long-term care policies in our Other Businesses as discussed in Note 17 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data.  

Premiums Revenue

  Consolidated premiums increased $2.4 billion, or 7.3%, from 2010 to $35.1 billion for 2011, primarily due to an increase in Retail segment premiums, partially offset by a decline in Employer Group segment premiums. The increase in Retail segment premiums primarily resulted from higher average individual Medicare Advantage membership. The decrease in Employer Group segment premiums primarily resulted from lower average fully-insured commercial group medical membership. Average membership is calculated by summing the ending membership for each month in a period and dividing the result by the number of months in a period. Premiums revenue reflects changes in membership and increases in average per member premiums. Items impacting average per member premiums include changes in premium rates as well as changes in the geographic mix of membership, the mix of product offerings, and the mix of benefit plans selected by our membership.  

Services Revenue

  Consolidated services revenue increased $805 million, or 145.0%, from 2010 to $1.4 billion for 2011, primarily due to an increase in primary care services revenue in our Health and Well-Being Services segment, primarily as a result of the acquisition of Concentra on December 21, 2010.  

Investment Income

Investment income totaled $366 million for 2011, an increase of $37 million from 2010, primarily reflecting higher interest rates as well as higher average invested balances as a result of the reinvestment of operating cash flows.

Benefit Expenses

  Consolidated benefit expenses were $28.8 billion for 2011, an increase of $1.7 billion, or 6.3%, from 2010. The increases were primarily due to a $1.8 billion, or 11.3%, year-over-year increase in Retail segment benefit expenses in 2011, primarily driven by an increase in the average number of Medicare members, partially offset by a decline in Employer Group segment benefit expenses.  

The consolidated benefit ratio for 2011 was 82.1%, declining 80 basis points from the 2010 benefit ratio of 82.9%, primarily driven by a decline in the Retail segment benefit ratio and a net charge for reserve strengthening associated with our closed block of long-term care policies in our Other Businesses in 2010 that did not recur in 2011.

Operating Costs

  Our segments incur both direct and shared indirect operating costs. We allocate the indirect costs shared by the segments primarily as a function of revenues. As a result, the profitability of each segment is interdependent.  Consolidated operating costs increased $1.0 billion, or 23.2%, during 2011 compared to 2010, primarily due an increase in operating costs in our Health and Well-Being Segment as a result of the acquisition of Concentra on December 21, 2010, as well as an increase in operating costs in our Retail segment as a result of increased expenses associated with servicing higher average Medicare Advantage membership. Operating costs for 2010 include $147 million for the write-down of deferred acquisition costs associated with our individual commercial medical policies in our Retail Segment.                                           48

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  The consolidated operating cost ratio for 2011 was 14.8%, increasing 160 basis points from the 2010 operating cost ratio of 13.2%. The $147 million write-down of deferred acquisition costs in 2010 increased the operating cost ratio 50 basis points for 2010. Excluding the impact of the write-down of deferred acquisition costs in 2010, the increase primarily reflects the greater percentage of our revenues derived from Concentra, acquired December 21, 2010, in our Health and Well-Being Services segment, which carries a higher operating cost ratio on external revenues than our other segments, as well as an increase in the Retail and Employer Group segment operating cost ratios.  

Depreciation and Amortization

  Depreciation and amortization for 2011 totaled $270 million, an increase of $25 million, or 10.2%, from 2010, primarily reflecting depreciation and amortization expense associated with our Concentra operations, acquired on December 21, 2010.  

Interest Expense

Interest expense was $109 million for 2011, compared to $105 million for 2010, an increase of $4 million, or 3.8%.

Income Taxes Our effective tax rate during 2011 was 36.5% compared to the effective tax rate of 37.2% in 2010. The higher tax rate for 2010 primarily was due to the cumulative adjustment associated with estimating the retrospective aspect of new limitations on the deductibility of annual compensation in excess of $500,000 per employee as mandated by the Health Insurance Reform Legislation. See Note 10 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for a complete reconciliation of the federal statutory rate to the effective tax rate. Retail Segment Change 2011 2010 Members Percentage Membership: Medical membership: Individual Medicare Advantage 1,640,300 1,460,700 179,600 12.3 %

Individual Medicare stand-alone PDP 2,540,400 1,670,300

    870,100             52.1  %  Total individual Medicare                   4,180,700        3,131,000        1,049,700             33.5  % Individual commercial                         493,200          411,200           82,000             19.9  %  Total individual medical members            4,673,900        3,542,200        1,131,700             31.9  %  Individual specialty membership (a)           782,500          510,000          272,500             53.4  %     

(a) Specialty products include dental, vision, and other supplemental health and

financial protection products. Members included in these products may not be

unique to each product since members have the ability to enroll in multiple

    products.                                            49 

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  Table of Contents                                                                               Change                                         2011          2010        Dollars       Percentage                                                  (in millions) Premiums and Services Revenue: Premiums: Individual Medicare Advantage         $ 18,100      $ 16,265      $  1,835            11.3  % Individual Medicare stand-alone PDP      2,317         1,959           358            18.3  %  Total individual Medicare               20,417        18,224         2,193            12.0  % Individual commercial                      861           746           115            15.4  % Individual specialty                       124            82            42            51.2  %  Total premiums                          21,402        19,052         2,350            12.3  %  Services                                    16            11             5            45.5  % 

Total premiums and services revenue $ 21,418$ 19,063$ 2,355

          12.4  %  Income before income taxes            $  1,587      $  1,289      $    298            23.1  % Benefit ratio                             81.2 %        82.0 %                        (0.8  )% Operating cost ratio                      11.2 %        11.1 %                         0.1  %   Pretax Results   

• Retail segment pretax income was $1.6 billion in 2011, an increase of $298

million, or 23.1%, from $1.3 billion in 2010, primarily driven by higher

average individual Medicare membership and a lower benefit ratio,

partially offset by a higher operating cost ratio, discussed below. Pretax

income for 2010 included the negative impact of a $147 million write-down

of deferred acquisition costs associated with our individual commercial

medical policies. In addition, the Retail segment's pretax income for 2011

included the beneficial effect of an estimated $147 million in favorable

prior-period medical claims reserve development versus $198 million in

          2010.   Enrollment   

• Individual Medicare Advantage membership increased 179,600 members, or

12.3%, from December 31, 2010 to December 31, 2011 due to a successful

enrollment season associated with the 2011 plan year as well as age-in

enrollment throughout the year. Individual Medicare Advantage membership

at December 31, 2011 included approximately 12,100 members acquired with

          our acquisition of MD Care as of December 30, 2011.          •   Individual Medicare stand-alone PDP membership increased 870,100 members,

or 52.1%, from December 31, 2010 to December 31, 2011 primarily from

higher gross sales year-over-year, particularly due to our low-price-point

Humana Walmart-Preferred Rx Plan that we began offering for the 2011 plan

year, supplemented by dual eligible and age-in enrollments throughout the

          year.          •   Individual specialty membership increased 272,500, or 53.4%, from

December 31, 2010 to December 31, 2011 primarily driven by increased sales

in dental offerings.

  Premiums revenue   

• Retail segment premiums increased $2.4 billion, or 12.3%, from 2010 to

2011 primarily due to a 10.3% increase in average individual Medicare

Advantage membership. Individual Medicare stand-alone PDP premiums revenue

increased $358 million, or 18.3%, in 2011 compared to 2010 primarily due

to a 41.9% increase in average individual PDP membership, partially offset

by a decrease in individual Medicare stand-alone PDP per member premiums.

         This was primarily a result of sales of our low-price-point Humana          Walmart-Preferred Rx Plan that we began offering for the 2011 plan year.                                            50 

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  Table of Contents  Benefit expenses   

• The Retail segment benefit ratio decreased 80 basis points from 82.0% in

2010 to 81.2% in 2011. The decline primarily reflects a lower Medicare

Advantage benefit ratio due to lower cost trends arising out of our

cost-reduction and outcome-enhancing strategies, including care

coordination and disease management, as well as a significant increase in

our individual Medicare stand-alone PDP membership in 2011 that carries a

lower benefit ratio, partially offset by lower favorable prior-period

medical claims reserve development in 2011 than in 2010. Favorable reserve

development decreased the Retail segment benefit ratio by approximately 70

basis points in 2011 versus approximately 100 basis points in 2010.

   Operating costs    

• The Retail segment operating cost ratio of 11.2% for 2011 increased 10

basis points from 11.1% for 2010. The $147 million write-down of deferred

acquisition costs in 2010 increased the operating cost ratio 80 basis

points in 2010. Excluding the impact of the write-down of deferred

acquisition costs, the increase in the operating cost ratio year-over-year

         primarily reflects increased expenses associated with the Medicare sales          season for 2012 offerings which began a month earlier than in the prior

year and staffing necessary to service anticipated Medicare membership

additions. Further, a higher percentage of membership in individual

Medicare stand-alone PDP products contributed to the higher operating cost

ratio, in light of the Humana Walmart-Preferred Rx Plan, first offered in

          2011, which carries a higher operating cost ratio than other Medicare          products.   Employer Group Segment                                                                                        Change                                           2011             2010           Members          Percentage Membership: Medical membership: Fully-insured commercial group           1,180,200        1,252,200         (72,000 )             (5.7 )% ASO                                      1,292,300        1,453,600        (161,300 )            (11.1 )% Group Medicare Advantage                   290,600          273,100          17,500                6.4 % Medicare Advantage ASO                      27,600           28,200            (600 )             (2.1 )%  Total group Medicare Advantage             318,200          301,300          16,900                5.6 %  Group Medicare stand-alone PDP               4,200            2,400           1,800               75.0 %  Total group Medicare                       322,400          303,700          18,700                6.2 %  Total group medical members              2,794,900        3,009,500        (214,600 )             (7.1 )%  Group specialty membership (a)           6,532,600        6,517,500          15,100                0.2 %     

(a) Specialty products include dental, vision, and other supplemental health and

financial protection products. Members included in these products may not be

unique to each product since members have the ability to enroll in multiple

    products.                                            51 

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  Table of Contents                                                                              Change                                        2011         2010         Dollars        Percentage                                                  (in millions) Premiums and Services Revenue: Premiums: Fully-insured commercial group        $ 4,782      $ 5,169      $    (387 )            (7.5 )% Group Medicare Advantage                3,152        3,021            131               4.3 % Group Medicare stand-alone PDP              8            5              3              60.0 %  Total group Medicare                    3,160        3,026            134               4.4 % Group specialty                           935          885             50               5.6 %  Total premiums                          8,877        9,080           (203 )            (2.2 )%  Services                                  356          395            (39 )            (9.9 )% 

Total premiums and services revenue $ 9,233$ 9,475 $ (242 )

           (2.6 )%  Income before income taxes            $   242      $   288      $     (46 )           (16.0 )% Benefit ratio                            82.4 %       82.4 %                            0.0 % Operating cost ratio                     17.8 %       17.5 %                            0.3 %   Pretax Results   

• Employer Group segment pretax income decreased $46 million, or 16%, to

$242 million in 2011 primarily due to the impact of minimum benefit ratios

required under the Health Insurance Reform Legislation which became

effective in 2011. The Employer Group segment's pretax income for 2011

included the beneficial effect of an estimated $52 million in favorable

         prior-period medical claims reserve development versus $33 million in          2010.   Enrollment    

• Fully-insured commercial group medical membership decreased 72,000

members, or 5.7%, from December 31, 2010 to December 31, 2011 primarily

due to continued pricing discipline in a highly competitive environment

         for large group business partially offset by small group business          membership gains.    

• Group ASO commercial medical membership decreased 161,300 members, or

         11.1%, from December 31, 2010 to December 31, 2011 primarily due to          continued pricing discipline in a highly competitive environment for          self-funded accounts.   Premiums revenue    

• Employer Group segment premiums decreased by $203 million, or 2.2%, from

2010 to $8.9 billion for 2011 primarily due to lower average commercial

         group medical membership year-over-year and rebates associated with          minimum benefit ratios required under the Health Insurance Reform          Legislation which became effective in 2011, partially offset by an          increase in group Medicare Advantage membership. Rebates result in the          recognition of lower premiums revenue, as amounts are set aside for          payments to commercial customers during the following year.   Benefit expenses    

• The Employer Group segment benefit ratio of 82.4% for 2011 was unchanged

from 2010 due to offsetting factors. Factors increasing the 2011 ratio

compared to the 2010 ratio include growth in our group Medicare Advantage

         products which generally carry a higher benefit ratio than our          fully-insured commercial group products and the effect of rebates accrued          in 2011 associated with the minimum benefit ratios required under the          Health Insurance Reform Legislation. Factors decreasing the 2011                                            52 

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ratio compared to the 2010 ratio include the beneficial effect of higher

favorable prior-period medical claims reserve development in 2011 versus

2010 and lower utilization of benefits in our commercial group products in

2011. Fully-insured group Medicare Advantage members represented 10.4% of

       total Employer Group segment medical membership at December 31, 2011        compared to 9.1% at December 31, 2010. Favorable reserve development        decreased the Employer Group segment benefit ratio by approximately 60        basis points in 2011 versus 40 basis points in 2010.   Operating costs    

• The Employer Group segment operating cost ratio of 17.8% for 2011

increased 30 basis points from 17.5% for 2010 primarily reflecting the

impact of lower premiums revenue due to the minimum benefit ratio

regulatory requirements which became effective in 2011.

Health and Well-Being Services Segment

                                                                                          Change                                                2011           2010          Dollars          Percentage                                                           (in millions) Revenues: Services: Primary care services                        $    880        $    21        $    859                  nm Integrated wellness services                       12             13              (1 )              (7.7 )% Pharmacy solutions                                 11              0              11                100  %  Total services revenues                           903             34             869                  nm  Intersegment revenues: Pharmacy solutions                              9,886          8,410           1,476                17.6 % Primary care services                             185            170              15                 8.8 % Integrated wellness services                      175            167               8                 4.8 % Home care services                                 84             39              45               115.4 %  Total intersegment revenues                    10,330          8,786           1,544                17.6 %  

Total services and intersegment revenues $ 11,233$ 8,820$ 2,413

                27.4 %  Income before income taxes                   $    353        $   219        $    134                61.2 % Operating cost ratio                             96.1 %         97.2 %                              (1.1 )%   nm - not meaningful  Pretax results   

• Health and Well-Being Services segment pretax income increased $134

million, or 61.2%, from 2010 to $353 million in 2011 primarily due to

growth in our pharmacy solutions business together with the addition of

the Concentra business, acquired on December 21, 2010.

  Services revenue   

• Primary care services revenue increased $859 million from 2010 to $880

million in 2011 primarily due to the acquisition of Concentra on

December 21, 2010.   Intersegment revenues   

• Intersegment revenues increased $1.5 billion, or 17.6%, from 2010 to $10.3

billion for 2011 primarily due to growth in our pharmacy solutions

          business as it serves our growing membership, particularly Medicare          stand-alone PDP.                                            53 

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  Table of Contents  Operating costs   

• The Health and Well-Being Services segment operating cost ratio decreased

110 basis points from 2010 to 96.1% for 2011 reflecting scale efficiencies

         associated with growth in our pharmacy solutions business together with          the addition of our acquired Concentra operations which carry a lower          operating cost ratio than other lines of business in this segment.  

Other Businesses

  Pretax income for our Other Businesses of $84 million for 2011 compared to pretax losses of $2 million for 2010. Pretax losses for 2010 include the impact of a net charge of $139 million associated with reserve strengthening for our closed block of long-term care policies. Excluding this charge, the year-over-year decline primarily reflects a decrease in pretax income associated with our contract with CMS to administer the LI-NET program.  

Comparison of Results of Operations for 2010 and 2009

Certain financial data on a consolidated basis and for our segments was as follows for the years ended December 31, 2010 and 2009:

  Consolidated                                                                                                    Change                                     2010                     2009                    Dollars              Percentage                                     (dollars in millions, except per common share results) Revenues: Premiums: Retail                         $        19,052          $        18,349          $           703                  3.8 % Employer Group                           9,080                    7,466                    1,614                 21.6 % Other Businesses                         4,580                    4,112                      468                 11.4 %  Total premiums                          32,712                   29,927                    2,785                  9.3 %  Services: Retail                                      11                       10                        1                 10.0 % Employer Group                             395                      370                       25                  6.8 % Health and Well-Being Services                                    34                       17                       17                100.0 % Other Businesses                           115                      123                       (8 )               (6.5 )%  Total services                             555                      520                       35                  6.7 %  Investment income                          329                      296                       33                 11.1 %  Total revenues                          33,596                   30,743                    2,853                  9.3 %  Operating expenses: Benefits                                27,117                   24,784                    2,333                  9.4 % Operating costs                          4,380                    4,014                      366                  9.1 % Depreciation and amortization                               245                      237                        8                  3.4 %  Total operating expenses                31,742                   29,035                    2,707                  9.3 %  Income from operations                   1,854                    1,708                      146                  8.5 % Interest expense                           105                      106                       (1 )               (0.9 )%  Income before income taxes               1,749                    1,602                      147                  9.2 % Provision for income taxes                 650                      562                       88                 15.7 %  Net income                     $         1,099          $         1,040          $            59                  5.7 %  Diluted earnings per common share                   $          6.47          $          6.15          $          0.32                  5.2 % Benefit ratio (a)                         82.9 %                   82.8 %                                         0.1 % Operating cost ratio (b)                  13.2 %                   13.2 %                                         0.0 % Effective tax rate                        37.2 %                   35.1 %                                         2.1 %    

(a) Represents total benefit expenses as a percentage of premiums revenue.

(b) Represents total operating costs as a percentage of total revenues less

    investment income.                                            54 

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Summary

  Net income was $1.1 billion, or $6.47 per diluted common share, in 2010 compared to $1.0 billion, or $6.15 per diluted common share, in 2009 primarily as a result of an increase in average Medicare Advantage membership and favorable prior-period medical claims reserve development in 2010 in both our Retail and Employer Group segments. Our diluted earnings per common share for 2010 include the beneficial impact of favorable prior-period medical claims reserve development of approximately $0.86 per diluted common share. These increases were partially offset by a $147 million ($0.55 per diluted common share) write-down of deferred acquisition costs associated with our individual commercial medical policies in our Retail segment and a net charge of $139 million ($0.52 per diluted common share) for reserve strengthening associated with our closed block of long-term care policies in our Other Businesses in 2010 as discussed in Note 17 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Net income for 2009 also included the favorable impact of the reduction of the liability for unrecognized tax benefits ($0.10 per diluted common share) as a result of Internal Revenue Service audit settlements.  Premiums revenue  Consolidated premiums increased $2.8 billion, or 9.3%, from 2009 to $32.7 billion for 2010. The increase primarily was due to higher premiums revenue in the Employer Group and Retail segments primarily as a result of higher average Medicare Advantage membership and an increase in per member premiums, as well as increased premiums for Other Businesses as a result of our new contract with CMS to administer the LI-NET program in 2010.  

Services Revenue

  Consolidated services revenue increased $35 million, or 6.7%, from 2009 to $555 million for 2010, primarily due to an increase in services revenue in our Employer Group segment primarily as a result of a new group Medicare ASO account in 2010 partially offset by a decline in commercial ASO membership, as well as an increase in primary care services revenue in our Health and Well-Being Services segment primarily as a result of the acquisition of Concentra on December 21, 2010.  

Investment Income

  Investment income totaled $329 million for 2010, an increase of $33 million from $296 million for 2009, primarily reflecting higher average invested balances as a result of the reinvestment of operating cash flows, partially offset by lower interest rates.  Benefit Expenses  Consolidated benefit expenses were $27.1 billion for 2010, an increase of $2.3 billion, or 9.4%, from $24.8 billion for 2009. The increase primarily was driven by an increase in the average number of Medicare Advantage members.  

The consolidated benefit ratio for 2010 was 82.9%, essentially unchanged, increasing only 10 basis points from the 2009 benefit ratio of 82.8%.

Operating Costs

  Our segments incur both direct and shared indirect operating costs. We allocate the indirect costs shared by the segments primarily as a function of revenues. As a result, the profitability of each segment is interdependent.  

Consolidated operating costs increased $366 million, or 9.1%, during 2010 compared to 2009, primarily due to the $147 million write-down of deferred acquisition costs associated with our individual commercial medical

                                       55

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  policies in 2010, increased Medicare investment spending for our 2011 offerings, and operating costs associated with servicing higher average Medicare Advantage membership, partially offset by a decrease in the number of our employees as a result of our administrative cost reduction strategies, including planned workforce reductions in 2010. Excluding employees added with the acquisition of Concentra on December 21, 2010, the number of employees decreased by 800 to 27,300 at December 31, 2010 from 28,100 at December 31, 2009, or 2.8%, as we aligned the size of our workforce with our membership.  The consolidated operating cost ratio for 2010 of 13.2% remained unchanged from the 2009 ratio as an increase in the Retail segment operating cost ratio was offset by declines in the Employer Group and Health and Well-Being Services segment operating cost ratios.  

Depreciation and Amortization

Depreciation and amortization for 2010 totaled $245 million compared to $237 million for 2009, an increase of $8 million, or 3.4%, primarily reflecting depreciation expense associated with capital expenditures.

Interest Expense

Interest expense was $105 million for 2010, compared to $106 million for 2009, a decrease of $1 million, or 0.9%.

Income Taxes

  Our effective tax rate during 2010 was 37.2% compared to the effective tax rate of 35.1% in 2009. The increase from 2009 to 2010 primarily was due to the reduction of the $17 million liability for unrecognized tax benefits as a result of audit settlements which reduced the effective income tax rate by 1.0% during 2009. In addition, the tax rate for 2010 reflects the estimated impact of new limitations on the deductibility of annual compensation in excess of $500,000 per employee as mandated by recent health insurance reforms. See Note 10 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for a complete reconciliation of the federal statutory rate to the effective tax rate.  Retail Segment                                                                                           Change                                            2010              2009            Members          Percentage Membership: Medical membership: Individual Medicare Advantage             1,460,700         1,406,600           54,100                3.8 % 

Individual Medicare stand-alone PDP 1,670,300 1,925,400

   (255,100 )            (13.2 )%  Total individual Medicare                 3,131,000         3,332,000         (201,000 )             (6.0 )% Individual commercial                       411,200           397,400           13,800                3.5 %  

Total individual medical members 3,542,200 3,729,400

   (187,200 )             (5.0 )%  Individual specialty membership (a)         510,000           297,300          212,700               71.5 %     

(a) Specialty products include dental, vision, and other supplemental health and

financial protection products. Members included in these products may not be

unique to each product since members have the ability to enroll in multiple

    products.                                            56 

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  Table of Contents                                                                                           Change                                            2010             2009            Dollars           Percentage                                                     (dollars in millions) Premiums and Services Revenue: Premiums: Individual Medicare Advantage            $ 16,265         $ 15,333         $     932                  6.1 % Individual Medicare stand-alone PDP         1,959            2,323              (364 )              (15.7 )%  Total individual Medicare                  18,224           17,656               568                  3.2 % Individual commercial                         746              638               108                 16.9 % Individual specialty                           82               55                27                 49.1 %  Total premiums                             19,052           18,349               703                  3.8 %  Services                                       11               10                 1                 10.0 % 

Total premiums and services revenue $ 19,063$ 18,359$ 704

                  3.8 %  Income before income taxes               $  1,289         $  1,359         $     (70 )               (5.2 )% Benefit ratio                                82.0 %           81.7 %                                  0.3 % Operating cost ratio                         11.1 %           10.8 %                                  0.3 %   Pretax Results   

• Retail segment pretax income was $1.3 billion in 2010, a decrease of $70

million, or 5.2%, from 2009 primarily due to the negative impact of a $147

million write-down of deferred acquisition costs associated with our

individual commercial medical policies in 2010 and a decline in average

individual Medicare stand-alone PDP membership from 2009 to 2010,

partially offset by the beneficial impact of an estimated $198 million in

favorable prior-period medical claims reserve development in 2010.

  Enrollment   

• Individual Medicare Advantage membership increased 54,100 members, or

3.8%, from December 31, 2009 to December 31, 2010, with sales of our PPO

          products driving the majority of the increase.          •   Individual Medicare stand-alone PDP membership decreased 255,100 members,

or 13.2%, from December 31, 2009 to December 31, 2010 primarily from our

competitive positioning as we realigned stand-alone PDP premium and

benefit designs to correspond with our historical prescription drug claims

          experience.          •   Individual specialty membership increased 212,700, or 71.5%, from

December 31, 2009 to December 31, 2010, primarily driven by increased

sales in dental and vision offerings.

  Premiums revenue   

• Retail segment premiums increased $703 million, or 3.8%, from 2009 to 2010

primarily due to higher average individual Medicare Advantage membership

and an increase in per member premiums, partially offset by a decline in

average individual stand-alone PDP membership. Individual Medicare

Advantage premiums revenue increased $932 million, or 6.1%, from 2009 to

2010. Average individual Medicare Advantage membership increased 4.4% in

2010 compared to 2009. Individual Medicare Advantage per member premiums

increased approximately 1.6% during 2010 compared to 2009. Individual

Medicare stand-alone PDP premiums revenue decreased $364 million, or

15.7%, from 2009 to 2010 primarily due to a 14.8% decrease in average

individual PDP membership.

  Benefit expenses   

• The Retail segment benefit ratio increased 30 basis points from 81.7% in

2009 to 82.0% in 2010 primarily driven by a 40 basis point increase in the

Medicare benefit ratio primarily as a result of                                            57 

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higher average membership in products that generally carry higher benefit

ratios, partially offset by favorable prior-period medical claims reserve

development. This favorable development decreased the Retail segment

benefit ratio by approximately 100 basis points in 2010.

  Operating costs   

• The Retail segment operating cost ratio of 11.1% for 2010 increased 30

basis points from 10.8% for 2009. The $147 million write-down of deferred

acquisition costs in 2010 increased the operating cost ratio 80 basis

points. Excluding the impact of the write-down of deferred acquisition

costs, the decrease in the operating cost ratio year-over-year primarily

reflects efficiency gains associated with servicing higher average

individual Medicare Advantage membership as well as our continued focus on

administrative cost reductions, partially offset by increased Medicare

investment spending for our 2011 offerings.

   Employer Group Segment                                                                                        Change                                         2010              2009            Members          Percentage Membership: Medical membership: Fully-insured commercial group         1,252,200         1,442,100         (189,900 )            (13.2 )% ASO                                    1,453,600         1,571,300         (117,700 )             (7.5 )% Group Medicare Advantage                 273,100           101,900          171,200              168.0 % Medicare Advantage ASO                    28,200                 0           28,200              100.0 %  Total group Medicare Advantage           301,300           101,900          199,400              195.7 %  Group Medicare stand-alone PDP             2,400             2,500             (100 )             (4.0 )%  Total group Medicare                     303,700           104,400          199,300              190.9 %  Total group medical members            3,009,500         3,117,800         (108,300 )             (3.5 )%  

Group specialty membership (a) 6,517,500 6,761,900 (244,400 )

             (3.6 )%      

(a) Specialty products include dental, vision, and other supplemental health and

financial protection products. Members included in these products may not be

     unique to each product since members have the ability to enroll in multiple     products.                                                                                Change                                         2010         2009        Dollars        Percentage                                                  (in millions)

Premiums and Services Revenue:

Premiums:

Fully-insured commercial group $ 5,169$ 5,547 $ (378 )

            (6.8 )%  Group Medicare Advantage                3,021        1,080         1,941   

179.7 %

  Group Medicare stand-alone PDP              5            5             0               0.0 %   Total group Medicare                    3,026        1,085         1,941             178.9 %  Group specialty                           885          834            51               6.1 %   Total premiums                          9,080        7,466         1,614              21.6 %   Services                                  395          370            25               6.8 % 

Total premiums and services revenue $ 9,475$ 7,836$ 1,639

            20.9 %  

Income (loss) before income taxes $ 288 $ (13 ) $ 301

             nm  Benefit ratio                            82.4 %       84.2 %                          (1.8 )%  Operating cost ratio                     17.5 %       19.5 %                          (2.0 )%   nm - not meaningful                                           58 

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  Table of Contents  Pretax Results   

• Employer Group segment pretax income of $288 million in 2010 increased

$301 million from 2009 primarily due to an increase in group Medicare

Advantage membership, decreased utilization and our continued focus on

pricing discipline primarily associated with our fully-insured commercial

group products, as well as administrative cost reductions and the

previously mentioned favorable prior-period medical claims reserve

development. The Employer Group segment's pretax income for 2010 included

the beneficial effect of an estimated $33 million in favorable

prior-period medical claims reserve development.

  Enrollment   

• Fully-insured group Medicare Advantage membership increased 171,200

members from December 31, 2009 to December 31, 2010. Approximately 109,600

of the members were associated with a new contract added during the first

         quarter of 2010.    

• During 2010, we added 28,200 group Medicare Advantage ASO members due to a

          new account in 2010.          •   Fully-insured commercial group medical membership decreased 189,900

members, or 13.2%, from December 31, 2009 to December 31, 2010 primarily

         due to continued pricing discipline.    

• Group ASO commercial medical membership decreased 117,700 members, or

7.5%, from December 31, 2009 to December 31, 2010 primarily reflecting the

loss of a large group account on July 1, 2010.

  Premiums revenue   

• Employer Group segment premiums increased $1.6 billion, or 21.6%, from

2009 to 2010 primarily due to increased fully-insured group Medicare

Advantage membership and an increase in fully-insured commercial group per

member premiums, partially offset by a decline in fully-insured commercial

         group medical membership year-over-year. Per member premiums for          commercial fully-insured group accounts increased 7.6% during 2010          compared to 2009.   Benefit expenses    

• The Employer Group segment benefit ratio of 82.4% for 2010 decreased 180

basis points from 84.2% for 2009 primarily due to medical trend that was

         lower than trend assumed in pricing as well as continued pricing          discipline, in each case particularly for our commercial business, and          favorable prior-period medical claims reserve development in 2010. These

decreases were partially offset by growth in our group Medicare Advantage

business which generally carries a higher benefit ratio than our

fully-insured commercial group business. Medical trend was favorable,

         primarily affected by lower utilization of services as well as the use of          services at lower levels of intensity than in the prior year. The          favorable development decreased the Employer Group segment benefit ratio

by approximately 40 basis points in 2010. Fully-insured group Medicare

Advantage members represented 9.1% of total Employer Group segment medical

membership at December 31, 2010 compared to 3.3% at December 31, 2009.

   Operating costs    

• The Employer Group segment operating cost ratio of 17.5% for 2010

decreased 200 basis points from 19.5% for 2009 primarily reflecting

administrative scale efficiencies associated with an increase in average

fully-insured group Medicare Advantage membership and our continued focus

         on administrative cost reductions.                                            59 

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Health and Well-Being Services Segment

                                                                                         Change                                               2010           2009           Dollars          Percentage                                                           (in millions) Revenues: Services: Primary care services                        $    21        $     3        $      18               600.0 % Integrated wellness services                      13             14               (1 )              (7.1 )%  Total services revenues                           34             17               17               100.0 %  Intersegment revenues: Pharmacy solutions                             8,410          8,630             (220 )              (2.5 )% Primary care services                            170            149               21                14.1 % Integrated wellness services                     167            150               17                11.3 % Home care services                                39             23               16                69.6 %  Total intersegment revenues                    8,786          8,952             (166 )              (1.9 )%  

Total services and intersegment revenues $ 8,820$ 8,969 $ (149 )

              (1.7 )%  Income before income taxes                   $   219        $   183        $      36                19.7 % Operating cost ratio                            97.2 %         97.8 %                               (0.6 )%   Pretax results         •   Health and Well-Being Services segment pretax income increased $36          million, or 19.7%, from 2009 to $219 million in 2010 primarily due to

growth in both our mail order pharmacy business and our CAC medical

centers. The opening of our new facility for processing specialty

prescription drugs in late 2009 and continued growth from our processing

         facility opened in 2008 contributed to the growth in our mail order          business in 2010.   Services revenue         •   Services revenue increased $17 million, or 100.0%, from 2009 to $34

million in 2010 primarily due to an increase in primary care services

revenue primarily as a result of the acquisition of Concentra on

December 21, 2010.   Intersegment revenues   

• Intersegment revenues decreased $166 million, or 1.9%, from 2009 to $8.8

billion for 2010 primarily due to a decline in our pharmacy solutions

business primarily as a result of a decrease in average Medicare

stand-alone PDP membership from our competitive positioning as we

realigned stand-alone PDP premium and benefit designs to correspond with

our historical prescription drug claims experience.

  Operating costs   

• The Health and Well-Being Services segment operating cost ratio decreased

60 basis points from 2009 to 97.2% for 2010 reflecting growth in our CAC

medical centers as well as LifeSynch, our integrated behavioral health and

         wellness business, which carry lower operating cost ratios than other          lines of business in this segment.  

Other Businesses

  Pretax losses for our Other Businesses of $2 million for 2010 compared to pretax income of $97 million for 2009. The decline in operating performance from 2009 to 2010 primarily resulted from a net charge of $139 million                                           60

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  associated with reserve strengthening for our closed block of long-term care policies in 2010, partially offset by pretax income in 2010 associated with our new contract with CMS to administer the LI-NET program, under which we began providing services in the first quarter of 2010.  

Liquidity

  Our primary sources of cash include receipts of premiums, services revenues, and investment and other income, as well as proceeds from the sale or maturity of our investment securities and borrowings. Our primary uses of cash include disbursements for claims payments, operating costs, interest on borrowings, taxes, purchases of investment securities, acquisitions, capital expenditures, repayments on borrowings, dividends, and share repurchases. Because premiums generally are collected in advance of claim payments by a period of up to several months, our business normally should produce positive cash flows during periods of increasing premiums and enrollment. Conversely, cash flows would be negatively impacted during periods of decreasing premiums and enrollment. From period to period, our cash flows may also be affected by the timing of working capital items. The use of operating cash flows may be limited by regulatory requirements which require, among other items, that our regulated subsidiaries maintain minimum levels of capital and seek approval before paying dividends from the subsidiaries to the parent.  Cash and cash equivalents decreased to $1.4 billion at December 31, 2011 from $1.7 billion at December 31, 2010. The change in cash and cash equivalents for the years ended December 31, 2011, 2010 and 2009 is summarized as follows:                                                               2011            2010            2009                                                                       (in millions) Net cash provided by operating activities                $  2,079        $  2,242        $  1,422 Net cash used in investing activities                      (1,358 )        (1,811 )        (1,859 ) Net cash (used in) provided by financing activities        (1,017 )          (371 )            80  

(Decrease) increase in cash and cash equivalents $ (296 ) $

60 $ (357 )

Cash Flow from Operating Activities

  The change in operating cash flows over the three year period primarily results from the corresponding change in earnings, enrollment activity, and changes in working capital items as discussed below. Cash flows were positively impacted by Medicare enrollment gains in 2011 and 2010 because premiums generally are collected in advance of claim payments by a period of up to several months. Conversely, during 2009, cash flows were negatively impacted by the payment of run-off claims associated with enrollment losses in our stand-alone PDP business.  Comparisons of our operating cash flows also are impacted by other changes in our working capital. The most significant drivers of changes in our working capital are typically the timing of payments of benefit expenses and receipts for premiums. We illustrate these changes with the following summaries of benefits payable and receivables.  The detail of benefits payable was as follows at December 31, 2011, 2010 and 2009:                                                                                       Change                                            2011        2010        2009       2011        2010                                                               (in millions)  IBNR (1)                                 $ 2,056     $ 2,051     $ 1,903     $   5      $  148

Military services benefits payable (2) 339 255 279

84 (24 )

  Reported claims in process (3)               376         137         358       239        (221 )  Other benefits payable (4)                   983       1,026         682       (43 )       344   Total benefits payable                   $ 3,754     $ 3,469     $ 3,222       285         247   Payables from acquisition                                                      (29 )         0   Total benefits payable                                                       $ 256      $  247                                             61 

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(1) IBNR represents an estimate of benefits payable for claims incurred but not

reported (IBNR) at the balance sheet date. The level of IBNR is primarily

impacted by membership levels, medical claim trends and the receipt cycle

time, which represents the length of time between when a claim is initially

incurred and when the claim form is received (i.e. a shorter time span

results in a lower IBNR).

(2) Military services benefits payable primarily results from the timing of the

cost of providing health care services to beneficiaries and the payment to

the provider. A corresponding receivable for reimbursement by the federal

government is included in the base receivable in the receivables table that

follows.

(3) Reported claims in process represents the estimated valuation of processed

    claims that are in the post claim adjudication process, which consists of     administrative functions such as audit and check batching and handling, as

well as amounts owed to our pharmacy benefit administrator which fluctuate

due to bi-weekly payments and the month-end cutoff.

(4) Other benefits payable include amounts owed to providers under capitated and

risk sharing arrangements.

   The increase in benefits payable in 2011 primarily was due to an increase in the amount of processed but unpaid claims, including amounts due to our pharmacy benefit administrator, which fluctuate due to month-end cutoff, and an increase in Military services benefits payable. The increase in benefits payable in 2010 and 2009 primarily was due to an increase in amounts owed to providers under capitated and risk sharing arrangements as well as an increase in IBNR, both primarily as a result of Medicare Advantage membership growth, partially offset by a decrease in the amount of processed but unpaid claims, including pharmacy claims, which fluctuate due to the month-end cutoff.  The detail of total net receivables was as follows at December 31, 2011, 2010 and 2009:                                                                                            Change                                              2011         2010        2009        2011          2010                                                                   (in millions) Military services: Base receivable                             $   467       $ 425       $ 451       $  42        $  (26 ) Change orders                                     1           2           2          (1 )           0  Military services subtotal                      468         427         453          41           (26 ) Medicare                                        336         216         238         120           (22 ) Commercial and other                            315         368         183         (53 )         185 Allowance for doubtful accounts                 (85 )       (52 )       (51 )       (33 )          (1 )  Total net receivables                       $ 1,034       $ 959       $ 823          75           136  Reconciliation to cash flow statement: Provision for doubtful accounts                                                      31            19 Receivables from acquisition                                                

0 (109 )

  Change in receivables per cash flow statement resulting in cash from operations                                                                        $ 106        $   46    Military services base receivables consist of estimated claims owed from the federal government for health care services provided to beneficiaries and underwriting fees. The claim reimbursement component of military services base receivables is generally collected over a three to four month period. The timing of claim reimbursements resulted in the $42 million increase in base receivables for 2011 as compared to 2010, the $26 million decrease in base receivables for 2010 as compared to 2009, and the $15 million increase in base receivables for 2009 as compared to 2008.  

Medicare receivables are impacted by the timing of accruals and related collections associated with the CMS risk-adjustment model.

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  Commercial and other receivables for 2011 and 2010 include $144 million and $109 million, respectively, of patient services receivables acquired with the acquisition of Concentra in December 2010. In addition, the allowance for doubtful accounts increased $33 million from 2010 to 2011 primarily due to the Concentra acquisition. The increase in Concentra receivables and the related allowance in 2011 result from the requirement to record acquired balances at fair value at the acquisition date. Excluding the receivables acquired with Concentra, the timing of reimbursements from the Puerto Rico Health Insurance Administration for our Medicaid business primarily resulted in the increase in commercial and other receivables for 2010 as compared to 2009 followed by a decrease from 2010 to 2011.  In addition to the timing of receipts for premiums and services fees and payments of benefit expenses, other working capital items impacting operating cash flows over the past three years primarily resulted from the timing of payments for the Medicare Part D risk corridor provisions of our contracts with CMS as well as changes in the timing of collections of pharmacy rebates.  

Cash Flow from Investing Activities

  We reinvested a portion of our operating cash flows in investment securities, primarily investment-grade fixed income securities, totaling $850 million in 2011, $827 million in 2010, and $2.0 billion in 2009. Our ongoing capital expenditures primarily relate to our information technology initiatives, support of services in our Concentra and other medical facilities and administrative facilities necessary for activities such as claims processing, billing and collections, wellness solutions, care coordination, regulatory compliance and customer service. Total capital expenditures, excluding acquisitions, were $346 million in 2011, $222 million in 2010, and $185 million in 2009, with 2011 reflecting increased spending associated with growth in our primary care services and pharmacy businesses in our Health and Well-Being Services segment. Excluding acquisitions, we expect total capital expenditures in 2012 of approximately $350 million. Cash consideration paid for acquisitions, net of cash acquired, of $226 million in 2011, $833 million in 2010, and $12 million in 2009 primarily related to the Anvita and MD Care acquisitions in 2011 and the Concentra acquisition in 2010.  

Cash Flow from Financing Activities

  Receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk were $378 million less than claims payments during 2011, $237 million less than claim payments during 2010, and $493 million higher than claims payments during 2009. See Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for further description.  During 2011, we repurchased 6.7 million shares for $492 million under the stock repurchase plans authorized by the Board of Directors in December 2009 and April 2011. During 2010, we repurchased 1.99 million shares for $100 million under the stock repurchase plan authorized by the Board of Directors in December 2009. We also acquired common shares in connection with employee stock plans for an aggregate cost of $49 million in 2011, $8 million in 2010, and $23 million in 2009.  

During 2011, we paid dividends to stockholders of $82 million as discussed further below. No dividends were paid during 2010 or 2009.

In 2009, net borrowings under our then existing credit agreement decreased $250 million primarily from the repayment of amounts borrowed to fund a 2008 acquisition.

  The remainder of the cash used in or provided by financing activities in 2011, 2010, and 2009 primarily resulted from proceeds from stock option exercises, the change in the book overdraft, and the change in the securities lending payable. The decrease in securities lending since 2009 resulted from lower margins earned under the program which terminated in the fourth quarter of 2011.                                           63

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Future Sources and Uses of Liquidity

Dividends

  In April 2011, our Board of Directors approved the initiation of a quarterly cash dividend policy. Declaration and payment of future quarterly dividends is at the discretion of the Board and may be adjusted as business needs or market conditions change.  

The following table provides details of dividends declared in 2011:

                      Record      Payment      Amount         Total                     Date         Date      per Share      Amount                                                        (in millions)                  6/30/2011    7/28/2011      $0.25          $41                  9/30/2011    10/28/2011     $0.25          $41                  12/30/2011   1/31/2012      $0.25          $41  

Stock Repurchase Authorization

  In April 2011, the Board of Directors replaced its previously approved share repurchase authorization of up to $250 million with a new authorization for repurchases of up to $1 billion of our common shares exclusive of shares repurchased in connection with employee stock plans. The new authorization will expire June 30, 2013. Under the new share repurchase authorization, shares could be purchased from time to time at prevailing prices in the open market, by block purchases, or in privately-negotiated transactions, subject to certain regulatory restrictions on volume, pricing, and timing. As of February 6, 2012, the remaining authorized amount under the new authorization totaled $561 million.  

Senior Notes

  We previously issued $500 million of 6.45% senior notes due June 1, 2016, $500 million of 7.20% senior notes due June 15, 2018, $300 million of 6.30% senior notes due August 1, 2018, and $250 million of 8.15% senior notes due June 15, 2038. The 7.20% and 8.15% senior notes are subject to an interest rate adjustment if the debt ratings assigned to the notes are downgraded (or subsequently upgraded) and contain a change of control provision that may require us to purchase the notes under certain circumstances. All four series of our senior notes, which are unsecured, may be redeemed at our option at any time at 100% of the principal amount plus accrued interest and a specified make-whole amount. Our senior notes are more fully discussed in Note 11 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data.  

Credit Agreement

  In November 2011, we amended and restated our 3-year $1.0 billion unsecured revolving credit agreement which was set to expire in December 2013 and replaced it with a 5-year $1.0 billion unsecured revolving agreement expiring November 2016. Under the new credit agreement, at our option, we can borrow on either a competitive advance basis or a revolving credit basis. The revolving credit portion bears interest at either LIBOR plus a spread or the base rate plus a spread. The LIBOR spread, currently 120 basis points, varies depending on our credit ratings ranging from 87.5 to 147.5 basis points. We also pay an annual facility fee regardless of utilization. This facility fee, currently 17.5 basis points, may fluctuate between 12.5 and 27.5 basis points, depending upon our credit ratings. The competitive advance portion of any borrowings will bear interest at market rates prevailing at the time of borrowing on either a fixed rate or a floating rate based on LIBOR, at our option.  The terms of the new credit agreement include standard provisions related to conditions of borrowing, including a customary material adverse effect clause which could limit our ability to borrow additional funds. In addition, the new credit agreement contains customary restrictive and financial covenants as well as customary                                           64 

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  events of default, including financial covenants regarding the maintenance of a minimum level of net worth of $6.0 billion at December 31, 2011 and a maximum leverage ratio of 3.0:1. We are in compliance with the financial covenants, with actual net worth of $8.1 billion and actual leverage ratio of 0.6:1, as measured in accordance with the new credit agreement as of December 31, 2011. In addition, the new credit agreement includes an uncommitted $250 million incremental loan facility.  At December 31, 2011, we had no borrowings outstanding under the new credit agreement. We have outstanding letters of credit of $14 million secured under the new credit agreement. No amounts have been drawn on these letters of credit. Accordingly, as of December 31, 2011, we had $986 million of remaining borrowing capacity under the new credit agreement, none of which would be restricted by our financial covenant compliance requirement. We have other customary, arms-length relationships, including financial advisory and banking, with some parties to the credit agreement.  

Other Long-Term Borrowings

  Other long-term borrowings of $36 million at December 31, 2011 represent junior subordinated debt. The junior subordinated debt, which is due in 2037, may be called by us without penalty in 2012 and bears a fixed annual interest rate of 8.02% payable quarterly until 2012, and then payable at a floating rate based on LIBOR plus 310 basis points.  

Liquidity Requirements

  We believe our cash balances, investment securities, operating cash flows, and funds available under our credit agreement or from other public or private financing sources, taken together, provide adequate resources to fund ongoing operating and regulatory requirements, future expansion opportunities, and capital expenditures for at least the next twelve months, as well as to refinance or repay debt and repurchase shares.  Adverse changes in our credit rating may increase the rate of interest we pay and may impact the amount of credit available to us in the future. Our investment-grade credit rating at December 31, 2011 was BBB according to Standard & Poor's Rating Services, or S&P, and Baa3 according to Moody's Investors Services, Inc., or Moody's. A downgrade by S&P to BB+ or by Moody's to Ba1 triggers an interest rate increase of 25 basis points with respect to $750 million of our senior notes. Successive one notch downgrades increase the interest rate an additional 25 basis points, or annual interest expense by $2 million, up to a maximum 100 basis points, or annual interest expense by $8 million.  In addition, we operate as a holding company in a highly regulated industry. The parent company is dependent upon dividends and administrative expense reimbursements from our subsidiaries, most of which are subject to regulatory restrictions. We continue to maintain significant levels of aggregate excess statutory capital and surplus in our state-regulated operating subsidiaries. Cash, cash equivalents, and short-term investments at the parent company were $494 million at December 31, 2011 and $553 million at December 31, 2010. During 2011, our subsidiaries paid dividends of $1.1 billion to the parent compared to $747 million in 2010 and $774 million in 2009. Refer to our parent company financial statements and accompanying notes in Schedule I - Parent Company Financial Information. As described in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations under the section titled "Health Insurance Reform," in December 2011, the NAIC issued proposed guidance indicating the insurance industry premium-based assessment may require accrual and associated subsidiary funding consideration in 2013 instead of 2014. This proposed NAIC guidance is contradictory to final GAAP guidance issued by the FASB in July 2011, which indicates the insurance industry premium-based assessment should be accrued beginning in 2014, the year in which it is payable.  

Regulatory Requirements

Certain of our subsidiaries operate in states that regulate the payment of dividends, loans, or other cash transfers to Humana Inc., our parent company, and require minimum levels of equity as well as limit investments

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  to approved securities. The amount of dividends that may be paid to Humana Inc. by these subsidiaries, without prior approval by state regulatory authorities, is limited based on the entity's level of statutory income and statutory capital and surplus. In most states, prior notification is provided before paying a dividend even if approval is not required.  Although 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. Our state regulated subsidiaries had aggregate statutory capital and surplus of approximately $4.7 billion and $4.3 billion as of December 31, 2011 and 2010, respectively, which exceeded aggregate minimum regulatory requirements. The amount of dividends that may be paid to our parent company in 2012 without prior approval by state regulatory authorities is approximately $970 million in the aggregate. This compares to dividends that were able to be paid in 2011 without prior regulatory approval of approximately $740 million.  Contractual Obligations 

We are contractually obligated to make payments for years subsequent to December 31, 2011 as follows:

                                                                  Payments Due by Period                                                  Less than                                               More than                                    Total          1 Year           1-3 Years         3-5 Years            5 Years                                                                     (in millions) Debt                              $ 1,585       $         0       $         0       $       500         $     1,085 Interest (1)                        1,094               111               221               205                 557 Operating leases (2)                  850               207               332               188                 123 Purchase obligations (3)              245               117                95                18                  15 Future policy benefits payable and other long-term liabilities (4)                     1,987                68               237               162               1,520  Total (5)                         $ 5,761       $       503       $       885       $     1,073         $     3,300     

(1) Interest includes the estimated contractual interest payments under our debt

agreements.

(2) We lease facilities, computer hardware, and other furniture and equipment

under long-term operating leases that are noncancelable and expire on various

dates through 2025. We sublease facilities or partial facilities to third

party tenants for space not used in our operations which partially mitigates

our operating lease commitments. An operating lease is a type of off-balance

sheet arrangement. Assuming we acquired the asset, rather than leased such

asset, we would have recognized a liability for the financing of these

assets. See also Note 15 to the consolidated financial statements included in

Item 8. - Financial Statements and Supplementary Data.

(3) Purchase obligations include agreements to purchase services, primarily

information technology related services, or to make improvements to real

estate, in each case that are enforceable and legally binding on us and that

specify all significant terms, including: fixed or minimum levels of service

    to be purchased; fixed, minimum or variable price provisions; and the     appropriate timing of the transaction. Purchase obligations exclude     agreements that are cancelable without penalty.  

(4) Includes future policy benefits payable ceded to third parties through 100%

coinsurance agreements as more fully described in Note 18 to the consolidated

financial statements included in Item 8. - Financial Statements and

Supplementary Data. We expect the assuming reinsurance carriers to fund these

obligations and reflected these amounts as reinsurance recoverables included

in other long-term assets on our consolidated balance sheet. Amounts payable

in less than one year are included in trade accounts payable and accrued

expenses in the consolidated balance sheet.

(5) Excludes the pending acquisitions of Arcadian Management Services, Inc. and

SeniorBridge, both announced in the second half of 2011 and subject to

regulatory approval. Refer to Note 3 to the consolidated financial statements

    included in Item 8. - Financial Statements and Supplementary Data.                                            66 

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Off-Balance Sheet Arrangements

  As part of our ongoing business, we do not participate or knowingly seek to participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities (SPEs), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2011, we were not involved in any SPE transactions.  

Guarantees and Indemnifications

  Through indemnity agreements approved by the state regulatory authorities, certain of our regulated subsidiaries generally are guaranteed by Humana Inc., our parent company, in the event of insolvency for (1) member coverage for which premium payment has been made prior to insolvency; (2) benefits for members then hospitalized until discharged; and (3) payment to providers for services rendered prior to insolvency. Our parent also has guaranteed the obligations of our military services subsidiaries.  In the ordinary course of business, we enter into contractual arrangements under which we may agree to indemnify a third party to such arrangement from any losses incurred relating to the services they perform on behalf of us, or for losses arising from certain events as defined within the particular contract, which may include, for example, litigation or claims relating to past performance. Such indemnification obligations may not be subject to maximum loss clauses. Historically, payments made related to these indemnifications have been immaterial.  Government Contracts  Our Medicare products, which accounted for approximately 65% of our total premiums and services revenue for the year ended December 31, 2011, primarily consisted of products covered under the Medicare Advantage and Medicare Part D Prescription Drug Plan contracts with the federal government. These contracts are renewed generally for a calendar year term unless CMS notifies us of its decision not to renew by August 1 of the calendar year in which the contract would end, or we notify CMS of our decision not to renew by the first Monday in June of the calendar year in which the contract would end. All material contracts between Humana and CMS relating to our Medicare products have been renewed for 2012, and all of our product offerings filed with CMS for 2012 have been approved.  CMS uses a risk-adjustment model which apportions premiums paid to Medicare Advantage plans according to health severity. The risk-adjustment model pays more for enrollees with predictably higher costs. Under this model, rates paid to Medicare Advantage plans are based on actuarially determined bids, which include a process that bases our prospective payments on a comparison of our beneficiaries' risk scores, derived from medical diagnoses, to those enrolled in the government's original Medicare program. Under the risk-adjustment methodology, all Medicare Advantage plans must collect and submit the necessary diagnosis code information from hospital inpatient, hospital outpatient, and physician providers to CMS within prescribed deadlines. The CMS risk-adjustment model uses this diagnosis data to calculate the risk-adjusted premium payment to Medicare Advantage plans. We generally rely on providers to code their claim submissions with appropriate diagnoses, which we send to CMS as the basis for our payment received from CMS under the actuarial risk-adjustment model. We also rely on providers to appropriately document all medical data, including the diagnosis data submitted with claims.  

CMS is continuing to perform audits of various companies' selected Medicare Advantage contracts related to this risk adjustment diagnosis data. These audits are referred to herein as Risk-Adjustment Data Validation Audits, or RADV audits. RADV audits review medical record documentation in an attempt to validate provider coding practices and the presence of risk adjustment conditions which influence the calculation of premium payments to Medicare Advantage plans.

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  On December 21, 2010, CMS posted a description of the agency's proposed RADV sampling and payment adjustment calculation methodology to its website, and invited public comment, noting that CMS may revise its sampling and payment error calculation methodology based upon the comments received. We believe the audit and payment adjustment methodology proposed by CMS is fundamentally flawed and actuarially unsound. In essence, in making the comparison referred to above, CMS relies on two interdependent sets of data to set payment rates for Medicare Advantage (MA) plans: (1) fee for service (FFS) data from the government's original Medicare program; and (2) MA data. The proposed methodology would review medical records for only one set of data (MA data), while not performing the same exercise on the other set (FFS data). However, because these two sets of data are inextricably linked, we believe CMS must audit and validate both of them before determining the financial implications of any potential RADV audit results, in order to ensure that any resulting payment adjustment is accurate. We believe that the Social Security Act, under which the payment model was established, requires the consistent use of these data sets in determining risk-adjusted payments to MA plans. Furthermore, our payment received from CMS, as well as benefits offered and premiums charged to members, is based on bids that did not, by CMS design, include any assumption of retroactive audit payment adjustments. We believe that applying a retroactive audit adjustment after CMS acceptance of bids would improperly alter this process of establishing member benefits and premiums.  CMS has received public comments, including our comments and comments from other industry participants and the American Academy of Actuaries, which expressed concerns about the failure to appropriately compare the two sets of data. On February 3, 2011, CMS issued a statement that it was closely evaluating the comments it has received on this matter and anticipates making changes to the proposed methodology based on input it has received, although we are unable to predict the extent of changes that they may make.  To date, six Humana contracts have been selected by CMS for RADV audits for the 2007 contract year, consisting of one "pilot" audit and five "targeted" audits for Humana plans. We believe that the proposed methodology for these audits is actuarially unsound and in violation of the Social Security Act. We intend to defend that position vigorously. However, if CMS moves forward with implementation of the proposed methodology without changes to adequately address the data inconsistency issues described above, it would have a material adverse effect on our revenues derived from the Medicare Advantage program and, therefore, our results of operations, financial position, and cash flows.  At December 31, 2011, our military services business, which accounted for approximately 10% of our total premiums and services revenue for the year ended December 31, 2011, primarily consisted of the TRICARE South Region contract. The original 5-year South Region contract expired on March 31, 2009 and was extended through March 31, 2012. On February 25, 2011, the Department of Defense TRICARE Management Activity, or TMA, awarded the new TRICARE South Region contract to us, which we expect to take effect on April 1, 2012. The new 5-year South Region contract, which expires March 31, 2017, is subject to annual renewals on April 1 of each year during its term at the government's option.  Under the current TRICARE South Region contract, any variance from the negotiated target health care cost is shared with the federal government. Accordingly, events and circumstances not contemplated in the negotiated target health care cost amount may have a material adverse effect on us. These changes may include an increase or reduction in the number of persons enrolled or eligible to enroll due to the federal government's decision to increase or decrease U.S. military deployments. In the event government reimbursements were to decline from projected amounts, our failure to reduce the health care costs associated with these programs may have a material adverse effect on our results of operations, financial position, and cash flows.  Our Medicaid business, which accounted for approximately 3% of our total premiums and services revenue for the year ended December 31, 2011, consists of contracts in Puerto Rico and Florida, with the vast majority in Puerto Rico. Effective October 1, 2010, as amended in May 2011, the Puerto Rico Health Insurance Administration, or PRHIA, awarded us three contracts for the East, Southeast, and Southwest regions for a three year term through June 30, 2013.                                           68 

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  The loss of any of the contracts above or significant changes in these programs as a result of legislative action, including reductions in premium payments to us, or increases in member benefits without corresponding increases in premium payments to us, may have a material adverse effect on our results of operations, financial position, and cash flows.  

Critical Accounting Policies and Estimates

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

Benefit Expense Recognition

  Benefit expenses are recognized in the period in which services are provided and include an estimate of the cost of services which have been incurred but not yet reported, or IBNR. IBNR represents a substantial portion of our benefits payable as follows:                                       December 31,         Percentage         December 31,         Percentage                                        2011              of Total              2010              of Total                                                             (dollars in millions) IBNR                               $       2,056               54.8 %      $       2,051               59.1 % Reported claims in process                   376               10.0 %                137                3.9 % Other benefits payable                       983               26.2 %              1,026               29.6 %  Benefits payable, excluding military services                          3,415               91.0 %              3,214               92.6 % Military services benefits payable                                      339                9.0 %                255                7.4 %  Total benefits payable             $       3,754              100.0 %      $       3,469              100.0 %    Military services benefits payable primarily consists of our estimate of incurred healthcare services provided to beneficiaries which are in turn reimbursed by the federal government as more fully described in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. This amount is generally offset by a corresponding receivable due from the federal government, as more fully-described in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations under the section titled "Cash Flow from Operating Activities."  Estimating IBNR is complex and involves a significant amount of judgment. Changes in this estimate can materially affect, either favorably or unfavorably, our results of operations and overall financial position. Accordingly, it represents a critical accounting estimate. Most benefit claims are paid within a few months of the member receiving service from a physician or other health care provider. As a result, these liabilities generally are described as having a "short-tail". As such, we expect that substantially all of the December 31, 2011 estimate of benefits payable will be known and paid during 2012.  Our reserving practice is to consistently recognize the actuarial best point estimate within a level of confidence required by actuarial standards. Actuarial standards of practice generally require a level of confidence such that the liabilities established for IBNR have a greater probability of being adequate versus being insufficient, or such that the liabilities established for IBNR are sufficient to cover obligations under an                                           69

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  assumption of moderately adverse conditions. Adverse conditions are situations in which the actual claims are expected to be higher than the otherwise estimated value of such claims at the time of the estimate. Therefore, in many situations, the claim amounts ultimately settled will be less than the estimate that satisfies the actuarial standards of practice.  We develop our estimate for IBNR using actuarial methodologies and assumptions, primarily based upon historical claim experience. Depending on the period for which incurred claims are estimated, we apply a different method in determining our estimate. For periods prior to the most recent three months, the key assumption used in estimating our IBNR is that the completion factor pattern remains consistent over a rolling 12-month period after adjusting for known changes in claim inventory levels and known changes in claim payment processes. Completion factors result from the calculation of the percentage of claims incurred during a given period that have historically been adjudicated as of the reporting period. For the most recent three months, the incurred claims are estimated primarily from a trend analysis based upon per member per month claims trends developed from our historical experience in the preceding months, adjusted for known changes in estimates of recent hospital and drug utilization data, provider contracting changes, changes in benefit levels, changes in member cost sharing, changes in medical management processes, product mix, and weekday seasonality.  The completion factor method is used for the months of incurred claims prior to the most recent three months because the historical percentage of claims processed for those months is at a level sufficient to produce a consistently reliable result. Conversely, for the most recent three months of incurred claims, the volume of claims processed historically is not at a level sufficient to produce a reliable result, which therefore requires us to examine historical trend patterns as the primary method of evaluation. Changes in claim processes, including recoveries of overpayments, receipt cycle times, claim inventory levels, outsourcing, system conversions, and processing disruptions due to weather or other events affect views regarding the reasonable choice of completion factors. Claim payments to providers for services rendered are often net of overpayment recoveries for claims paid previously, as contractually allowed. Claim overpayment recoveries can result from many different factors, including retroactive enrollment activity, audits of provider billings and/or payment errors. Changes in patterns of claim overpayment recoveries can be unpredictable and result in completion factor volatility, as they often impact older dates of service. The receipt cycle time measures the average length of time between when a medical claim was initially incurred and when the claim form was received. Increased electronic claim submissions from providers have decreased the receipt cycle time over the last several years. If claims are submitted or processed on a faster (slower) pace than prior periods, the actual claim may be more (less) complete than originally estimated using our completion factors, which may result in reserves that are higher (lower) than required.  Medical cost trends potentially are more volatile than other segments of the economy. The drivers of medical cost trends include increases in the utilization of hospital facilities, physician services, new higher priced technologies and medical procedures, and new prescription drugs and therapies, as well as the inflationary effect on the cost per unit of each of these expense components. Other external factors such as government-mandated benefits or other regulatory changes, the tort liability system, increases in medical services capacity, direct to consumer advertising for prescription drugs and medical services, an aging population, lifestyle changes including diet and smoking, catastrophes, and epidemics also may impact medical cost trends. Internal factors such as system conversions, claims processing cycle times, changes in medical management practices and changes in provider contracts also may impact our ability to accurately predict estimates of historical completion factors or medical cost trends. All of these factors are considered in estimating IBNR and in estimating the per member per month claims trend for purposes of determining the reserve for the most recent three months. Additionally, we continually prepare and review follow-up studies to assess the reasonableness of the estimates generated by our process and methods over time. The results of these studies are also considered in determining the reserve for the most recent three months. Each of these factors requires significant judgment by management.  

The completion and claims per member per month trend factors are the most significant factors impacting the IBNR estimate. The portion of IBNR estimated using completion factors for claims incurred prior to the most

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  recent three months is generally less variable than the portion of IBNR estimated using trend factors. The following table illustrates the sensitivity of these factors assuming moderate adverse experience and the estimated potential impact on our operating results caused by reasonably likely changes in these factors based on December 31, 2011 data:                   Completion Factor (a):         Claims Trend Factor (b):               Factor       Decrease in        Factor       Decrease in             Change (c)   Benefits Payable   Change (c)   Benefits Payable                                 (dollars in millions)               1.60%           $(263)         (4.75)%          $(269)               1.20%           $(198)         (4.25)%          $(241)               0.80%           $(132)         (3.50)%          $(198)               0.40%           $ (66)         (3.00)%          $(170)               0.30%           $ (49)         (2.50)%          $(142)               0.20%           $ (33)         (2.00)%          $(113)               0.10%           $ (16)         (1.50)%          $ (85)    

(a) Reflects estimated potential changes in benefits payable at December 31, 2011

caused by changes in completion factors for incurred months prior to the most

recent three months.

(b) Reflects estimated potential changes in benefits payable at December 31, 2011

caused by changes in annualized claims trend used for the estimation of per

member per month incurred claims for the most recent three months.

(c) The factor change indicated represents the percentage point change.

   The following table provides a historical perspective regarding the accrual and payment of our benefits payable, excluding military services. Components of the total incurred claims for each year include amounts accrued for current year estimated benefit expenses as well as adjustments to prior year estimated accruals.                                            2011           2010           2009                                                    (in millions)             Balances at January 1     $   3,214      $   2,943      $   2,898             Acquisitions                     29              0              0             Incurred related to:             Current year                 25,821         24,186         21,944             Prior years                    (372 )         (434 )         (253 )              Total incurred               25,449         23,752         21,691              Paid related to:             Current year                (22,729 )      (21,269 )      (19,211 )             Prior years                  (2,548 )       (2,212 )       (2,435 )              Total paid                  (25,277 )      (23,481 )      (21,646 )              Balances at December 31   $   3,415      $   3,214      $   2,943    The following table summarizes the changes in estimate for incurred claims related to prior years attributable to our key assumptions. As previously described, our key assumptions consist of trend and completion factors estimated using an assumption of moderately adverse conditions. The amounts below represent the difference between our original estimates and the actual benefit expenses ultimately incurred as determined from subsequent claim payments.                                           71

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   Table of Contents                                                   Favorable Development by Changes in Key Assumptions                                      2011                              2010                              2009                                             Factor                           Factor                            Factor                            Amount         Change (a)         Amount        Change (a)         Amount         Change (a)                                                               (dollars in millions) Trend factors             $   (189 )             (3.8 )%     $  (213 )            (4.7 )%     $  (151 )             (3.5 )% Completion factors            (183 )              1.2 %         (221 )             1.6 %         (102 )              0.8 %  Total                     $   (372 )                         $  (434 )                        $  (253 )     

(a) The factor change indicated represents the percentage point change.

   As previously discussed, our reserving practice is to consistently recognize the actuarial best estimate of our ultimate liability for claims. Actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. The amount of redundancy over the last three years primarily has been impacted by the growth in our Medicare products, coupled with the application of consistent reserving practices. When we recognize a release of the redundancy, we disclose the amount that is not in the ordinary course of business, if material.  During 2011 and 2010, we experienced prior year favorable reserve releases not in the ordinary course of business of approximately $205 million and $231 million, respectively. This favorable reserve development primarily resulted from improvements in the claims processing environment and, to a lesser extent, better than originally estimated utilization. In addition, in 2010, a shortening of the cycle time associated with provider claim submissions was a contributing factor. The improvements in the claims processing environment benefited all lines of business during 2011, but were most prominent in our Medicare PFFS line of business in 2010. As a result of these improvements, we experienced a significant increase in claim overpayment recoveries during 2011 for claims with 2010 and 2009 dates of service and during 2010 for claims with 2009 and 2008 dates of service, primarily as a result of increased audits of provider billings, as well as system enhancements that improved the claim recovery functionality. This increase resulted in our historical completion factors being understated for those periods since they had been developed using our previous historical experience. The remaining reserve redundancy primarily resulted from our consistent application of trend and completion factors estimated using an assumption of moderately adverse conditions as described above. We believe we have consistently applied our methodology in determining our best estimate for benefits payable.  We continually adjust our historical trend and completion factor experience with our knowledge of recent events that may impact current trends and completion factors when establishing our reserves. Because our reserving practice is to consistently recognize the actuarial best point estimate using an assumption of moderately adverse conditions as required by actuarial standards, there is a reasonable possibility that variances between actual trend and completion factors and those assumed in our December 31, 2011 estimates would fall towards the middle of the ranges previously presented in our sensitivity table.  Benefit expenses associated with military services and provisions associated with future policy benefits excluded from the previous table were as follows for the years ended December 31, 2011, 2010 and 2009:                                               2011        2010        2009                                                    (in millions)                  Military services        $ 3,247     $ 3,059     $ 3,020                  Future policy benefits       127         306          73                   Total                    $ 3,374     $ 3,365     $ 3,093    Our current TRICARE contract contains provisions whereby the federal government bears a substantial portion of the risk of financing health benefits. The federal government both reimburses us for our cost of providing health benefits and bears responsibility for 80% of any variance from the annual targeted health care cost and actual health care cost as more fully described in Item 7. Management's Discussion and Analysis of                                           72

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  Financial Condition and Results of Operations under the section titled "Military Services." Therefore, the impact on our income from operations from changes in estimate for TRICARE benefits payable is reduced substantially by corresponding adjustments to revenues. The net change in income from operations as determined retrospectively, after giving consideration to claim development occurring in the current period, was a decrease of approximately $14 million for 2010 and an increase of approximately $9 million for 2009. The impact from changes in estimates for 2011 is not yet determinable as the amount of prior period development recorded in 2012 will change as our December 31, 2011 benefits payable estimate develops throughout 2012.  Future policy benefits payable of $1.7 billion and $1.5 billion at December 31, 2011 and 2010, respectively, represent liabilities for long-duration insurance policies including long-term care, life insurance, annuities, and certain health and other supplemental policies sold to individuals for which some of the premium received in the earlier years is intended to pay anticipated benefits to be incurred in future years. These reserves are recognized on a net level premium method based on interest rates, mortality, morbidity, withdrawal and maintenance expense assumptions from published actuarial tables, modified based upon actual experience. The assumptions used to determine the liability for future policy benefits are established and locked in at the time each contract is acquired and would only change if our expected future experience deteriorated to the point that the level of the liability, together with the present value of future gross premiums, are not adequate to provide for future expected policy benefits.  Future policy benefits payable include $938 million at December 31, 2011 and $825 million at December 31, 2010 associated with a closed block of long-term care policies acquired in connection with the November 30, 2007 KMG acquisition. Long-term care policies provide for long-duration coverage and, therefore, our actual claims experience will emerge many years after assumptions have been established. The risk of a deviation of the actual morbidity and mortality rates from those assumed in our reserves are particularly significant to our closed block of long-term care policies. We monitor the loss experience of these long-term care policies and, when necessary, apply for premium rate increases through a regulatory filing and approval process in the jurisdictions in which such products were sold. To the extent premium rate increases and/or loss experience vary from our acquisition date assumptions, future adjustments to reserves could be required. During the fourth quarter of 2010, certain states approved premium rate increases for a large portion of our long-term care block that were significantly below our acquisition date assumptions. Based on these actions by the states, combined with lower interest rates and higher actual expenses as compared to acquisition date assumptions, we determined that our existing future policy benefits payable, together with the present value of future gross premiums, associated with our long-term care policies were not adequate to provide for future policy benefits under these policies; therefore we unlocked and modified our assumptions based on current expectations. Accordingly, during the fourth quarter of 2010 we recorded $139 million of additional benefit expense, with a corresponding increase in future policy benefits payable of $170 million partially offset by a related reinsurance recoverable of $31 million included in other long-term assets. In addition, future policy benefits payable include amounts of $224 million at December 31, 2011 and $229 million at December 31, 2010 which are subject to 100% coinsurance agreements as more fully described in Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data, and as such are offset by a related reinsurance recoverable included in other long-term assets.  Revenue Recognition  We generally establish one-year commercial membership contracts with employer groups, subject to cancellation by the employer group on 30-day written notice. Our Medicare contracts with CMS renew annually. Our military services contracts with the federal government and our contracts with various state Medicaid programs generally are multi-year contracts subject to annual renewal provisions.  Our commercial contracts establish rates on a per member basis for each month of coverage. Our Medicare and Medicaid contracts also establish monthly rates per member. However, our Medicare contracts also have additional provisions as outlined in the following separate section.                                           73

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  Premiums revenue and administrative services only, or ASO, fees are estimated by multiplying the membership covered under the various contracts by the contractual rates. In addition, we adjust revenues for estimated changes in an employer's enrollment and individuals that ultimately may fail to pay, and beginning January 1, 2011, for estimated rebates to policyholders under the minimum benefit ratios required under the Health Insurance Reform Legislation. Enrollment changes not yet processed or not yet reported by an employer group or the government, also known as retroactive membership adjustments, are estimated based on available data and historical trends. We routinely monitor the collectibility of specific accounts, the aging of receivables, historical retroactivity trends, estimated rebates, as well as prevailing and anticipated economic conditions, and reflect any required adjustments in the current period's revenue.  We bill and collect premium remittances from employer groups and members in our Medicare and other individual products monthly. We receive monthly premiums from the federal government and various states according to government specified payment rates and various contractual terms. Changes in revenues from CMS for our Medicare products resulting from the periodic changes in risk-adjustment scores for our membership are recognized when the amounts become determinable, based on the submission of diagnosis data to CMS, and the collectibility is reasonably assured.  

Medicare Part D Provisions

  We cover prescription drug benefits in accordance with Medicare Part D under multiple contracts with CMS. The payments we receive monthly from CMS and members, which are determined from our annual bid, represent amounts for providing prescription drug insurance coverage. We recognize premiums revenue for providing this insurance coverage ratably over the term of our annual contract. Our CMS payment is subject to risk sharing through the Medicare Part D risk corridor provisions. In addition, receipts for reinsurance and low-income cost subsidies as well as receipts for certain discounts on brand name prescription drugs in the coverage gap represent payments for prescription drug costs for which we are not at risk.  The risk corridor provisions compare costs targeted in our bids to actual prescription drug costs, limited to actual costs that would have been incurred under the standard coverage as defined by CMS. Variances exceeding certain thresholds may result in CMS making additional payments to us or require us to refund to CMS a portion of the premiums we received. We estimate and recognize an adjustment to premiums revenue related to these risk corridor provisions based upon pharmacy claims experience to date as if the annual contract were to terminate at the end of the reporting period. Accordingly, this estimate provides no consideration to future pharmacy claims experience. We record a receivable or payable at the contract level and classify the amount as current or long-term in the consolidated balance sheets based on the timing of expected settlement.  The estimate of the settlement associated with risk corridor provisions requires us to consider factors that may not be certain at period end, including member eligibility and risk adjustment score differences with CMS as well as pharmacy rebates from manufacturers. These factors have an offsetting effect on changes in the risk corridor estimate. In 2011, we paid $380 million related to our reconciliation with CMS regarding the 2010 Medicare Part D risk corridor provisions compared to our estimate of $388 million at December 31, 2010. In 2010, we paid $180 million related to our reconciliation with CMS regarding the 2009 Medicare Part D risk corridor provisions compared to our estimate of $145 million at December 31, 2009. The net liability associated with the 2011 risk corridor estimate, which will be settled in 2012, was $329 million at December 31, 2011.  Reinsurance and low-income cost subsidies represent funding from CMS in connection with the Medicare Part D program for which we assume no risk. Reinsurance subsidies represent funding from CMS for its portion of prescription drug costs which exceed the member's out-of-pocket threshold, or the catastrophic coverage level. Low-income cost subsidies represent funding from CMS for all or a portion of the deductible, the coinsurance and co-payment amounts above the out-of-pocket threshold for low-income beneficiaries. Monthly prospective payments from CMS for reinsurance and low-income cost subsidies are based on assumptions submitted with our annual bid. A reconciliation and related settlement of CMS's prospective subsidies against actual prescription drug costs we paid is made after the end of the year. Beginning in 2011, the Health Reform Legislation mandates                                           74 

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  consumer discounts of 50% on brand name prescription drugs for Part D plan participants in the coverage gap. These discounts are funded by CMS and pharmaceutical manufacturers while we administer the application of these funds. We account for these subsidies and discounts as a deposit in our consolidated balance sheets and as a financing activity in our consolidated statements of cash flows. We do not recognize premiums revenue or benefit expenses for these subsidies or discounts. Receipt and payment activity is accumulated at the contract level and recorded in our consolidated balance sheets in other current assets or trade accounts payable and accrued expenses depending on the contract balance at the end of the reporting period. Gross financing receipts were $2.5 billion and gross financing withdrawals were $2.9 billion during 2011. CMS subsidy and brand name prescription drug discount activity recorded to the consolidated balance sheets at December 31, 2011 was $363 million to other current assets and $139 million to trade accounts payable and accrued expenses.  In order to allow plans offering enhanced benefits the maximum flexibility in designing alternative prescription drug coverage, CMS provided a demonstration payment option in lieu of the reinsurance subsidy for plans offering enhanced coverage, or coverage beyond CMS's defined standard benefits. The demonstration payment option, available to plans through 2010, was an arrangement in which CMS agreed to pay a capitation amount to a plan for assuming the government's portion of prescription drug costs in the catastrophic layer of coverage. The capitation amount represented a fixed monthly amount per member to provide prescription drug coverage in the catastrophic layer. We chose the demonstration payment option for some of our plans that offered enhanced coverage for plan years through 2010. This capitation amount, derived from our annual bid submissions, was recorded as premiums revenue. The variance between the capitation amount and actual drug costs in the catastrophic layer was subject to risk sharing as part of the risk corridor settlement.  

Settlement of the reinsurance and low-income cost subsidies as well as the brand name prescription drug discounts and risk corridor payment is based on a reconciliation made approximately 9 months after the close of each calendar year. We continue to revise our estimates with respect to the risk corridor provisions based on subsequent period pharmacy claims data.

Medicare Risk-Adjustment Provisions

  CMS utilizes a risk-adjustment model which apportions premiums paid to Medicare Advantage plans according to health severity. The risk-adjustment model pays more for enrollees with predictably higher costs. Under the risk-adjustment methodology, all Medicare Advantage plans must collect and submit the necessary diagnosis code information from hospital inpatient, hospital outpatient, and physician providers to CMS within prescribed deadlines. The CMS risk-adjustment model uses this diagnosis data to calculate the risk-adjusted premium payment to Medicare Advantage plans. Rates paid to Medicare Advantage plans are established under an actuarial bid model, including a process that bases our payments on a comparison of our beneficiaries' risk scores, derived from medical diagnoses, to those enrolled in the government's original Medicare program. We generally rely on providers to code their claim submissions with appropriate diagnoses, which we send to CMS as the basis for our payment received from CMS under the actuarial risk-adjustment model. We also rely on providers to appropriately document all medical data, including the diagnosis data submitted with claims. We estimate risk-adjustment revenues based on the submission of diagnosis data to CMS. The risk-adjustment model is more fully described in Item 1. - Business under the section titled "Individual Medicare."  

Military services

  In 2011, revenues derived from our military services business represented approximately 10% of consolidated premiums and services revenue. Military services premiums and services revenue primarily is derived from our TRICARE South Region contract with the Department of Defense. The current TRICARE contract for the South Region includes multiple revenue generating activities. We allocate the consideration to the various components of the contract based on the relative fair value of the components. TRICARE revenues consist generally of (1) an insurance premium for assuming underwriting risk for the cost of civilian health care services delivered to eligible beneficiaries; (2) health care services provided to beneficiaries which are in turn                                           75

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  reimbursed by the federal government; and (3) administrative services fees related to claim processing, customer service, enrollment, and other services. We recognize the insurance premium as revenue ratably over the period coverage is provided. Health care services reimbursements are recognized as revenue in the period health services are provided. Administrative services fees are recognized as revenue in the period services are performed.  The current TRICARE South Region contract contains provisions whereby the federal government bears a substantial portion of the risk associated with financing the cost of health benefits. Annually, we negotiate a target health care cost amount, or target cost, with the federal government and determine an underwriting fee. Any variance from the target cost is shared. We earn more revenue or incur additional costs based on the variance of actual health care costs versus the negotiated target cost. We receive 20% for any cost underrun, subject to a ceiling that limits the underwriting profit to 10% of the target cost. We pay 20% for any cost overrun, subject to a floor that limits the underwriting loss to negative 4% of the target cost. A final settlement occurs 12 to 18 months after the end of each contract year to which it applies. We defer the recognition of any revenues for favorable contingent underwriting fee adjustments related to cost underruns until the amount is determinable and the collectibility is reasonably assured. We estimate and recognize unfavorable contingent underwriting fee adjustments related to cost overruns currently in operations as an increase in benefit expenses. We continually review these benefit expense estimates of future payments to the government for cost overruns and make necessary adjustments to our reserves.  The military services contracts contain provisions to negotiate change orders. Change orders occur when we perform services or incur costs under the directive of the federal government that were not originally specified in our contract. Under federal regulations we may be entitled to an equitable adjustment to the contract price in these situations. Change orders may be negotiated and settled at any time throughout the year. We record revenue applicable to change orders when services are performed and these amounts are determinable and the collectibility is reasonably assured.  

Patient Services

  Patient services revenue associated with the December 21, 2010 acquisition of Concentra includes (1) workers' compensation injury care and related services and (2) other healthcare services related to employer needs or statutory requirements. Patient services revenues are recognized in the period services are provided to the customer when the sales price is fixed or determinable, and are net of contractual allowances.  The provider reimbursement methods for workers' compensation injury care and related services vary on a state-by-state basis. Most states have fee schedules pursuant to which all healthcare providers are uniformly reimbursed. The fee schedules are determined by each state and generally prescribe the maximum amounts that may be reimbursed for a designated procedure. In the states without fee schedules, healthcare providers are reimbursed based on usual, customary, and reasonable fees charged in the particular state in which the services are provided. We include billings for services in revenue net of allowance for estimated differences between list prices and allowable fee schedule rates or amounts allowed as usual, customary and reasonable, as applicable.  Revenue for other healthcare services is recognized on a fee-for-service basis at estimated collectible amounts at the time services are rendered. Our fees are determined in advance for each type of service performed.                                           76

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Investment Securities

Investment securities totaled $9.5 billion, or 53% of total assets at December 31, 2011, and $8.4 billion, or 52% of total assets at December 31, 2010. Debt securities, detailed below, comprised this entire investment portfolio at December 31, 2011 and at December 31, 2010. The fair value of debt securities were as follows at December 31, 2011 and 2010:

                                       December 31,         Percentage         December 31,         Percentage                                        2011              of Total              2010              of Total                                                             (dollars in millions) U.S. Treasury and other U.S. government corporations and agencies: U.S. Treasury and agency obligations                        $         725                7.7 %      $         712                8.5 % Mortgage-backed securities                 1,784               18.9 %              1,664               19.9 % Tax-exempt municipal securities                                 2,856               30.2 %              2,433               29.1 % Mortgage-backed securities: Residential                                   44                0.4 %                 56                0.6 % Commercial                                   381                4.0 %                321                3.8 % Asset-backed securities                       83                0.9 %                150                1.8 % Corporate debt securities                  3,580               37.9 %              3,032               36.2 % Redeemable preferred stock                     0                0.0 %                  5                0.1 %  Total debt securities              $       9,453              100.0 %      $       8,373              100.0 %    Approximately 95% of our debt securities were investment-grade quality, with a weighted average credit rating of AA- by S&P at December 31, 2011. Most of the debt securities that were below investment-grade were rated BB, the higher end of the below investment-grade rating scale. Our investment policy limits investments in a single issuer and requires diversification among various asset types.  Tax-exempt municipal securities included pre-refunded bonds of $332 million at December 31, 2011 and $344 million at December 31, 2010. These pre-refunded bonds were secured by an escrow fund consisting of U.S. government obligations sufficient to pay off all amounts outstanding at maturity. The ratings of these pre-refunded bonds generally assume the rating of the government obligations at the time the fund is established. Tax-exempt municipal securities that were not pre-refunded were diversified among general obligation bonds of U.S. states and local municipalities and special revenue bonds. General obligation bonds, which are backed by the taxing power and full faith of the issuer, accounted for $1.1 billion of these municipals in the portfolio. Special revenue bonds, issued by a municipality to finance a specific public works project such as utilities, water and sewer, transportation, and education, and supported by the revenues of that project, accounted for $1.4 billion of these municipals. Our general obligation bonds are diversified across the U.S. with no individual state exceeding 11%. In addition, certain monoline insurers guarantee the timely repayment of bond principal and interest when a bond issuer defaults and generally provide credit enhancement for bond issues related to our tax-exempt municipal securities. We have no direct exposure to these monoline insurers. We owned $634 million and $597 million at December 31, 2011 and 2010, respectively, of tax-exempt securities guaranteed by monoline insurers. The equivalent weighted average S&P credit rating of these tax-exempt securities without the guarantee from the monoline insurer was AA.  Our direct exposure to subprime mortgage lending is limited to investment in residential mortgage-backed securities and asset-backed securities backed by home equity loans. The fair value of securities backed by Alt-A and subprime loans was $3 million at December 31, 2011 and December 31, 2010. There are no collateralized debt obligations or structured investment vehicles in our investment portfolio.  

The percentage of corporate securities associated with the financial services industry was 19.3% at December 31, 2011 and 29.4% at December 31, 2010.

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  Gross unrealized losses and fair values aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position were as follows at December 31, 2011:                                       Less than 12 months                 12 months or more                         Total                                                   Gross                              Gross                              Gross                                  Fair           Unrealized          Fair           Unrealized          Fair           Unrealized                                  Value            Losses            Value            Losses           Value             Losses                                                                          (in millions) December 31, 2011 U.S. Treasury and other U.S. government corporations and agencies: U.S. Treasury and agency obligations                    $     117       $          0       $       0       $          0        $  117         $          0 Mortgage-backed securities            67                 (1 )            18                 (1 )          85                   (2 ) Tax-exempt municipal securities                            53                  0              48                 (2 )         101                   (2 ) Mortgage-backed securities: Residential                            3                  0              24                 (2 )          27                   (2 ) Commercial                            14                  0               0                  0            14                    0 Asset-backed securities               16                  0               4                  0            20                    0 Corporate debt securities            355                (10 )            41                 (1 )         396                  (11 )  Total debt securities          $     625       $        (11 )     $     135       $         (6 )      $  760         $        (17 )    Under the other-than-temporary impairment model for debt securities held, we recognize an impairment loss in income in an amount equal to the full difference between the amortized cost basis and the fair value when we have the intent to sell the debt security or it is more likely than not we will be required to sell the debt security before recovery of our amortized cost basis. However, if we do not intend to sell the debt security, we evaluate the expected cash flows to be received as compared to amortized cost and determine if a credit loss has occurred. In the event of a credit loss, only the amount of the impairment associated with the credit loss is recognized currently in income with the remainder of the loss recognized in other comprehensive income.  When we do not intend to sell a security in an unrealized loss position, potential other-than-temporary impairment is considered using a variety of factors, including the length of time and extent to which the fair value has been less than cost; adverse conditions specifically related to the industry, geographic area or financial condition of the issuer or underlying collateral of a security; payment structure of the security; changes in credit rating of the security by the rating agencies; the volatility of the fair value changes; and changes in fair value of the security after the balance sheet date. For debt securities, we take into account expectations of relevant market and economic data. For example, with respect to mortgage and asset-backed securities, such data includes underlying loan level data and structural features such as seniority and other forms of credit enhancements. A decline in fair value is considered other-than-temporary when we do not expect to recover the entire amortized cost basis of the security. We estimate the amount of the credit loss component of a debt security as the difference between the amortized cost and the present value of the expected cash flows of the security. The present value is determined using the best estimate of future cash flows discounted at the implicit interest rate at the date of purchase. The risks inherent in assessing the impairment of an investment include the risk that market factors may differ from our expectations, facts and circumstances factored into our assessment may change with the passage of time, or we may decide to subsequently sell the investment. The determination of whether a decline in the value of an investment is other than temporary requires us to exercise significant diligence and judgment. The discovery of new information and the passage of time can significantly change these judgments. The status of the general economic environment and significant changes in the national securities markets influence the determination of fair value and the assessment of investment impairment. There is a continuing risk that declines in fair value may occur and additional material realized losses from sales or other-than-temporary impairments may be recorded in future periods.  The recoverability of our residential and commercial mortgage-backed securities is supported by factors such as seniority, underlying collateral characteristics and credit enhancements. Our residential and commercial                                           78

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mortgage-backed securities at December 31, 2011 primarily were composed of senior tranches having high credit support, with 99% of the collateral consisting of prime loans. The weighted average credit rating of all commercial mortgage-backed securities was AA at December 31, 2011.

Several European countries, including Spain, Italy, Ireland, Portugal, and Greece, have been subject to credit deterioration due to weakness in their economic and fiscal situations. We have no direct exposure to sovereign issuances of these five countries.

  All issuers of securities we own that were trading at an unrealized loss at December 31, 2011 remain current on all contractual payments. After taking into account these and other factors previously described, we believe these unrealized losses primarily were caused by an increase in market interest rates and tighter liquidity conditions in the current markets than when the securities were purchased. At December 31, 2011, we did not intend to sell the securities with an unrealized loss position in accumulated other comprehensive income, and it is not likely that we will be required to sell these securities before recovery of their amortized cost basis. As a result, we believe that the securities with an unrealized loss were not other-than-temporarily impaired at December 31, 2011.  

There were no material other-than-temporary impairments in 2011, 2010, or 2009.

Goodwill and Long-lived Assets

  At December 31, 2011, goodwill and other long-lived assets represented 23% of total assets and 51% of total stockholders' equity, compared to 23% and 55%, respectively, at December 31, 2010.  We are required to test at least annually for impairment at a level of reporting referred to as the reporting unit, and more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. A reporting unit either is our operating segments or one level below the operating segments, referred to as a component, which comprise our reportable segments. A component is considered a reporting unit if the component constitutes a business for which discrete financial information is available that is regularly reviewed by management. We are required to aggregate the components of an operating segment into one reporting unit if they have similar economic characteristics. Goodwill is assigned to the reporting unit that is expected to benefit from a specific acquisition. The realignment of our business segments and corresponding change in our reportable segments, more fully described in Note 16 to the consolidated financial statements included in Item 8.-Financial Statements and Supplementary Data, resulted in a change in the composition of our reporting units. Accordingly, we reassigned goodwill to our reporting units as of January 1, 2011 using the relative fair value approach based on an evaluation of future discounted cash flows as discussed in Note 8 to the consolidated financial statements included in Item 8.-Financial Statements and Supplementary Data. A significant portion of our historical goodwill was supported by future cash flows associated with our mail-order pharmacy and behavioral health businesses now grouped with our Health & Well-Being Services businesses. This, in addition with the Concentra acquisition on December 21, 2010, resulted in the allocation of a substantial portion of our goodwill to the Health & Well-Being Services segment. We completed an interim impairment test as of January 1, 2011 based on the new reporting units which did not result in an impairment loss.  We use a two-step process to review goodwill for impairment. The first step is a screen for potential impairment, and the second step measures the amount of impairment, if any. Our strategy, long-range business plan, and annual planning process support our goodwill impairment tests. These tests are performed, at a minimum, annually in the fourth quarter, and are based on an evaluation of future discounted cash flows. We rely on this discounted cash flow analysis to determine fair value. However outcomes from the discounted cash flow analysis are compared to other market approach valuation methodologies for reasonableness. We use discount rates that correspond to a market-based weighted-average cost of capital and terminal growth rates that correspond to long-term growth prospects, consistent with the long-term inflation rate. Key assumptions in our cash flow projections, including changes in membership, premium yields, medical and operating cost trends, and certain government contract extensions, are consistent with those utilized in our long-range business plan and                                           79 

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  annual planning process. If these assumptions differ from actual, including the impact of the ultimate outcome of the Health Insurance Reform Legislation the estimates underlying our goodwill impairment tests could be adversely affected. Goodwill impairment tests completed in each of the last three years did not result in an impairment loss. The fair value of our reporting units with significant goodwill exceeded carrying amounts by a substantial margin. A 100 basis point increase in the discount rate would not have a significant impact on the amount of margin for any of our reporting units with significant goodwill.  Beginning in 2012, we are allowed to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Refer to Recently Issued Accounting Pronouncements in Note 2 to the consolidated financial statements included in Item 8.-Financial Statements and Supplementary Data.  Long-lived assets consist of property and equipment and other finite-lived intangible assets. These assets are depreciated or amortized over their estimated useful life, and are subject to impairment reviews. We periodically review long-lived assets whenever adverse events or changes in circumstances indicate the carrying value of the asset may not be recoverable. In assessing recoverability, we must make assumptions regarding estimated future cash flows and other factors to determine if an impairment loss may exist, and, if so, estimate fair value. We also must estimate and make assumptions regarding the useful life we assign to our long-lived assets. If these estimates or their related assumptions change in the future, we may be required to record impairment losses or change the useful life, including accelerating depreciation or amortization for these assets. There were no material impairment losses in the last three years. 

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