WELLCARE HEALTH PLANS, INC. – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations.

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Forward-Looking Statements

  Statements contained in this Form 10-Q for the quarterly period ended September 30, 2012 ("2012 Form 10-Q") that are not historical fact may be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and Section 21E of the Securities Exchange Act of 1934, as amended, and we intend such statements to be covered by the safe harbor provisions for forward-looking statements contained therein. Such statements, which may address, among other things, market acceptance of our products and services, product development, our ability to finance growth opportunities, our ability to respond to changes in laws and government regulations, implementation of our sales and marketing strategies, projected capital expenditures, liquidity and the availability of additional funding sources may be found in the section of this 2012 Form 10-Q entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" and generally elsewhere in this report. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "targets," "predicts," "potential," "continues" or the negative of such terms or other comparable terminology. You are cautioned that forward-looking statements involve risks and uncertainties, including economic, regulatory, competitive and other factors that may affect our business. Please refer to Risk Factors in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2011 ("2011 Form 10-K") and in Part II, Item 1A of this 2012 Form 10-Q, for a discussion of certain risk factors which could materially affect our business, financial condition, cash flows, and results of operations. These forward-looking statements are inherently susceptible to uncertainty and changes in circumstances, as they are based on management's current expectations and beliefs about future events and circumstances. We undertake no obligation beyond that required by law to update publicly any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.  

Overview

  We are a leading provider of managed care services to government-sponsored health care programs, serving approximately 2.6 million members nationwide as of September 30, 2012. We operate exclusively within the Medicare and Medicaid programs, serving the full spectrum of eligibility groups, with a focus on lower-income beneficiaries. Our primary mission is to help our government customers deliver cost-effective health care solutions, while improving health care quality and access to these programs. We are committed to operating our business in a manner that serves our key constituents - members, providers, government clients, and associates - while delivering competitive returns for our investors.  

Our strategic priorities for 2012 include improving health care quality and access for our members, achieving a competitive cost position, and delivering prudent, profitable growth.

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Key Developments and Accomplishments

Presented below are key developments and accomplishments relating to progress on our strategic business priorities that occurred or impacted our financial condition and results of operations during 2012.

• In October 2012, we entered into an agreement to acquire

UnitedHealthcare's Medicaid business in South Carolina, which, as of

October 2012, served approximately 65,000 members in South Carolina's

Healthy Connections Choices program across 39 of the state's 46 counties.

• In August 2012, we entered into an agreement to acquire all outstanding

interests in America's 1st Choice California Holdings, LLC, which is the

majority shareholder of Easy Choice Health Plan, Inc. of California ("Easy

Choice"). As of October 2012, Easy Choice served approximately 36,000

Medicare Advantage ("MA") plan members in Los Angeles, Orange, Riverside,

and San Bernardino Counties in southern California. This includes

approximately 12,000 MA dual special needs plan ("D-SNP") members, making

<p> Easy Choice one of the largest D-SNPs in Los Angeles County. Easy Choice

will increase its 2013 service area to 11 California counties, including

the San Diego area and five counties in northern California. More than 60%

of California's 5 million Medicare eligibles reside in these counties. In

addition, in 2013, Easy Choice anticipates offering MA chronic condition

       special needs plans in five of the 11 counties in its service area. The        Easy Choice acquisition will provide us with a presence in a new and        attractive market, and will give us a platform for meaningful growth in        the western United States across our complementary range of lines of        business. Additionally, Easy Choice's position with D-SNPs dovetails with        our strategy to focus on this population.   

• We were recently awarded a contract by the Commonwealth of Kentucky to

coordinate physical, behavioral and dental care for a total of

approximately 170,000 Medicaid eligible beneficiaries in Medicaid Managed

Care Region 3, which consists of 16 counties. We expect to begin serving

Medicaid beneficiaries in Region 3 effective January 1, 2013.    •      In July 2012, the New York State Department of Health approved our

participation in the expansion of its Managed Long-Term Care ("MLTC")

program by five additional counties, which began in August 2012. With this

expansion, we now serve four of the five New York City boroughs as well as

five upstate counties. The MLTC program is designed to help people with

chronic illnesses or who have disabilities and need health and long-term

       care services, such as home care or adult day care, stay in their homes        and communities as long as possible.   

• In July 2012, the Florida Healthy Kids Corporation ("FHKC") informed us

that our Florida Children's Health Insurance Program plans were chosen as

       part of a re-procurement effort to continue providing comprehensive        managed care coverage to children enrolled in the Florida Healthy Kids        Program. The new contract began on October 1, 2012, and we added        approximately 20,000 new members as a result of our expansion from

servicing 18 counties to 65 of Florida's 67 counties. We now offer Florida

Healthy Kids services in more counties than any other participating plan.

The new contract term expires on September 30, 2014, but may be extended

for up to two additional one-year terms at FHKC's option. It may also be

terminated earlier by FHKC at any time with cause or for convenience.

• In October 2012, we expanded our service area in the Florida Medicaid

       program to include Hardee, St. Johns, Columbia and Flagler counties. With        this expansion, we now serve 42 of the 67 counties across Florida.   

• In July 2012, we were approved by the Florida Department of Elder Affairs

to participate in the state's Long-Term Care Community Diversion Pilot

Project (the "Diversion Program"). Our services under this new program

began on July 1, 2012 and initially focused on program enrollees in

Escambia and Santa Rosa Counties. In September 2012, we were approved to

expand our services under this program to an additional 17 counties, and

we could potentially expand our services under this program to additional

counties in the future. The Florida Diversion Program has been designed to

provide frail elders, age 65 and older, with alternatives to nursing home

care. Enrollees in the program are dually eligible Medicare and Medicaid

recipients who qualify for Medicaid nursing home placement and include as

many as 20,000 beneficiaries across the state. We coordinate care that is

integrated with community-based services, which helps ensure these members

       have access to what they need to remain safely in their homes and        communities as an alternative to institutionalized care.   

• In July 2012, we entered into a definitive agreement with Humana, Inc. to

       acquire certain assets of Arcadian Health Plan, Inc.'sDesert Canyon        Community Care ("Desert Canyon") MA plans. Under the agreement,        approximately 5,000 Desert Canyon plan members in Mohave and Yavapai        Counties will become members of our Arizona MA health plan. The        transaction is expected to close on December 31, 2012, subject to

customary regulatory approvals and closing conditions. The membership

       transfer is expected to occur on January 1, 2013.                                            30

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• We continue to expand the geographic footprint of our MA plans and offer

D-SNPs for those who are dually-eligible for Medicare and Medicaid in all

of the MA markets we serve. This expansion is consistent with our focus on

the lower-income demographic of the market and our ability over time to

serve both the Medicaid- and Medicare-related coverage of these members.

MA membership as of September 30, 2012 was approximately 167,000, an

increase from 158,000 as of June 30, 2012. We project that MA segment

       membership will continue to grow during the remaining months of 2012.    •      In April 2012, our Hawaii health plan received accreditation from the        National Committee for Quality Assurance ("NCQA"). Previously, our        Missouri and Georgia health plans received NCQA accreditation. The NCQA        measures health plans'' commitment to high-quality care, effective        management, and accountability. We remain dedicated to our long-term        target of accreditation for all of our health plans.    •      We have continued to enhance our care management capabilities. For        example, we recently strengthened our resources that are focused        exclusively on outreach to our Medicaid members to both educate them on        care gaps and facilitate the closure of such care gaps. Intervention and        support activities include arranging transportation assistance and        three-way calls with a member and his or her primary care physician to

schedule appointments, as well as language translation for non-English

speaking members. Also, we have made enhancements to our case management

       model to more effectively serve our most medically complex members. The        model leverages both field-based and telephonic resources using        state-specific, multi-disciplinary care teams.  Additionally, we are        upgrading our systems related to Healthcare Effectiveness Data and        Information Set reporting, replacing our care and medical management        technology platform and launching a web-based care gap eligibility check        tool.   

• In October 2012, our MA plans in Florida, Hawaii, Illinois, Connecticut

and Ohio each achieved a three Star summary rating while our MA plans in

Georgia, Louisiana, Missouri, New York, Texas and New Jersey each received

a 2.5 Star summary rating. We are focused on improving quality across all

of our lines of business. For example, as a result of our quality

improvement measures, we anticipate that we will meet the performance

requirements of our contracts under the New York Medicaid and FHP

programs, which were subject to termination if our quality scores did not

       improve, and will continue to provide services to members of our New York        health plans.   

• On April 3, 2012, we were notified that the Deferred Prosecution Agreement

(the "DPA") entered into on May 5, 2009 among the United States Attorney's

Office for the Middle District of Florida (the "USAO"), the Florida

Attorney General's Office and us was terminated effective immediately. The

criminal charges against us were dismissed on April 4, 2012. These actions

       acknowledge that we have fulfilled all of our obligations under the DPA.   

Business and Financial Outlook

Market Developments

  A number of states are evaluating new strategies for their Medicaid programs. Given ongoing fiscal challenges, economic conditions, and the success of Medicaid managed care programs over the long run, states continue to recognize the value of collaborating with managed care plans to deliver quality, cost-effective health care solutions.  

Medicaid

  In August 2012, AHCA renewed our Florida Medicaid contracts for an interim period beginning September 1, 2012. The contracts expire on August 31, 2015, but the term of the contracts may be superseded by the implementation of a reform of the statewide Medicaid Managed Care program (the "Medicaid Reform Program"). We expect the state to publish a request for proposals in the first quarter of 2013 for participation in the Medicaid Reform Program for a five year contract term; however, the implementation date of the Medicaid Reform Program is uncertain. We are anticipating a highly competitive process, with as many as 20 companies, including us, expected to participate.  Earlier this year, the Florida Agency for Health Care Administration ("AHCA") released an invitation to negotiate for the Florida Statewide Medicaid Managed Care Long Term Care program. The total number of eligible participants in this program is estimated at 85,000 and includes seniors and adults with disabilities across 11 regions in the state. Services for the first region are expected to begin on August 1, 2013. We are interested in the opportunity to expand our presence in Florida. We have submitted a bid to participate and are anticipating a highly competitive process.  Earlier this year, the Georgia Department of Community Health (the "Georgia DCH") announced further refinements to its Medicaid redesign initiatives. At this time, the Georgia DCH will not conduct a re-procurement of the Georgia Families program, which currently serves Temporary Assistance for Needy Families ("TANF") and Children's Health Insurance Program ("CHIP")                                         31 --------------------------------------------------------------------------------   members, and will not begin to include aged, blind and disabled ("ABD") beneficiaries as previously planned, given what the Georgia DCH describes as increasing uncertainty at the federal level. Our current Georgia Medicaid contract provides for two one-year renewal options exercisable by the Georgia DCH. The Georgia DCH exercised its option to extend the term of our GeorgiaMedicaid contract until June 30, 2013 and the remaining renewal option potentially extends the contract through June 30, 2014. The Georgia DCH has also indicated its intent to amend our Georgia Medicaid contract to include two additional one-year renewal options, exercisable by the Georgia DCH, that could potentially extend the contract term to June 30, 2016.  The Georgia DCH also plans to move forward with several changes to modernize the Georgia Families program. These may include the promotion of a Primary Care Medical Home initiative, a move to value-based purchasing, and the adoption of a common preferred drug list. Additionally, the state is looking to simplify the administrative process for providers by moving all three care management organizations operating in the state to a common platform for functions such as credentialing, and prior authorization management. We look forward to working with the Georgia DCH to accomplish these initiatives.  With respect to Medicaid rates, we continue to expect the environment to be challenging, given state and federal fiscal conditions. In particular, we continue to experience pressure on rates in Florida and Georgia, two states from which we derive a substantial portion of our revenue. The ultimate premium rate is based on program type, demographic mix and geographic location.  

Medicare

  As we look toward the 2013 annual election period, we are expanding our MA service area by 53 counties, to a total of 191 counties. In addition to growing our presence in our existing states of Florida, Georgia, Illinois, New York, and Texas, we will for the first time offer MA plans in Kentucky. This will enable us to offer our MA plans to some of the dually eligible members we currently serve through the Kentucky Medicaid program. Upon the completion of the acquisitions of Easy Choice and Desert Canyon, we will further expand our MA services to California and Arizona.  Based on the outcome of our 2013 stand-alone prescription drug plan ("PDP") bids, our plans will be below the benchmarks in 14 of the 34 Centers for Medicare & Medicaid Services ("CMS") regions and within the de minimis range of the benchmark in five other CMS regions. Comparatively, in 2012, our plans are below the benchmark in five regions and within the de minimis range in 17 other regions. In 2013, we will be auto-assigned newly-eligible members into our plans for the 14 regions that are below the benchmark. We will retain our auto-assigned members in the 5 regions in which we bid within the de minimis range, however, we will not be auto-assigned new members in those regions during 2013. Members previously auto-assigned to our PDP plans in regions for which our 2013 bids were not within the de minimus range will be reassigned to other plans in 2013. We anticipate a net reduction of 200,000 to 210,000 PDP members due to the reassignment to other plans of members who were auto-assigned to us in 2012 and prior years, primarily in California, offset in part by additional auto-assignments to us in other regions. A decrease in premium rates will further affect our PDP segment's results of operations in 2013.  Twenty-five states have submitted applications to participate in the CMS "Duals Alignment Demonstration Program," covering approximately 2 million individuals fully eligible for both Medicare and Medicaid, or dual eligible beneficiaries. This program is intended to provide integrated care on a capitated or fee for service basis. Of the 25 states, 20 are proposing capitated programs and five are proposing managed fee for service programs. Thirteen of the 25 states are proposing to begin implementation in 2013. The remaining implementations are scheduled to begin in 2014. CMS has issued guidance that no programs will begin before April 1, 2013 and the target enrollment will be limited to 1 to 2 million beneficiaries. Exact implementation times vary by state. CMS has issued guidance indicating that dual eligible beneficiaries participating in the states' duals alignment demonstration programs cannot be forced to remain in a duals alignment plan and will be allowed to switch between plans on a monthly basis. However, enrollment in a Medicare Advantage plan is limited to the federally designated annual enrollment period or in the event of a special election period unless the individual seeks to enroll in a plan that has obtained a score of 5 on Medicare's quality performance system ("Star Ratings"). None of our health plans have yet achieved 5 stars. For this reason, dual eligible beneficiaries subject to a dual alignment demonstration programs will only be able to elect to remain in or join a WellCare plan during the annual enrollment period or special election periods.  To date, rates have not been released for any state's duals alignment program. The guidance promulgated by CMS requires a cost savings to both Medicare and Medicaid. To the extent that the assumed savings are deemed unrealistic, these programs could limit the number of states in which we choose to provide services. If the rates are deemed sufficient to support the provision of high quality care, we may choose to bid for participation in these programs. In addition, certain state's programs have not permitted us to participate in their project, due to our plan's program design. For those states that have a dual eligible demonstration program in which we do not participate, the membership in our MA and PDP plans in those states would be reduced.                                         32 --------------------------------------------------------------------------------

General Economic and Political Environment

  The political environment is uncertain. The November 2012 election campaigns have focused substantially on the role of the government in health care as well as the nation's fiscal challenges. The Republican Party has generally expressed its intent to repeal or significantly limit provisions of the Patient Protection and Affordable Care Act and The Health Care and Education Reconciliation Act of 2010 (collectively, the "2010 Acts") and to implement significant reforms related to Medicare and Medicaid. The Democratic Party has generally expressed an opinion in favor of continuing to implement the 2010 Acts and to preserve the Medicare and Medicaid programs for current beneficiaries. The results of the November election could have a significant impact on the implementation of the Acts, and the funding and future design of Medicare and Medicaid and other programs created by the Acts.  The U.S. House of Representatives continues to attempt to repeal, amend or restrict funding for various aspects of the 2010 Acts. Several states filed suits challenging the constitutionality of certain aspects of the 2010 Acts. Those cases ultimately reached the U.S. Supreme Court, which, on June 28, 2012, upheld the constitutionality of the provisions of the 2010 Acts requiring all Americans meeting certain income qualifications to purchase health insurance meeting certain standards or to pay a financial penalty. The Supreme Court also modified the Acts' requirement that all states expand their Medicaid programs to individuals up to 133% of the federal poverty line, making that expansion optional for states; however, the effect of the modification to the Medicaid expansion requirements remains to be seen. We expect some, but not all, of the states we operate in will participate in the Medicaid expansion. We also anticipate further guidance will be released regarding, among other things, the delivery of care to individuals under 65 with incomes up to 133 percent of poverty, who reside in those states that elect not to participate in the Medicaid expansion. As of September 23, 2012, only 15 states and the District of Columbia have formally committed to running their own health insurance exchanges for plans eligible for federal subsidies. Three states are planning on a federal-state partnership for the exchanges.The governors in seven states have said they will not create a state-run exchange and the remaining states are exploring their options. November 16, 2012 is the deadline for states to commit to running an exchange or leave it to the federal government to run it for them.  The economic environment remains challenging, with continued high unemployment throughout 2012 and sluggish job growth. As a result, budgetary challenges at the federal and state level may continue. We expect that the state and the federal governments will continue to look for budgetary cost control savings through reductions in health care costs. We may also experience delays in premium payments from our state customers. The "maintenance of effort" requirements under the 2010 Acts generally prohibit states from restricting Medicaid eligibility or tightening enrollment procedures. These provisions are due to phase out for adults in Medicaid in 2014 and for children in 2019. However, the Supreme Court decision has created some uncertainty regarding whether the maintenance of effort provisions can be enforced. In the event that they cannot, states could seek to restrict eligibility or tighten enrollment procedures.  Although the President signed into law the Budget Control Act of 2011 on August 2, 2011, the Congressional Super Committee has since failed to reach an agreement on a budget. As a result, in the absence of Congressional intervention, approximately $1.2 trillion in domestic and defense spending reductions would begin on January 1, 2013. The Budget Control Act of 2011 stipulates that payments to Medicare providers may be reduced by no more than 2% and exempts Medicaid from the automatic spending cuts. At this time, we cannot predict the impact that of this pending action.  Because the rate of growth of the expenses for Medicare is outpacing the growth rate of the economy, and the trust funds are not adequately funded, Congress has proposed several plans to restructure Medicare that would change Medicare from a defined benefit to a defined contribution program and to move the selection of Medicare benefits into an exchange-like facilitated selection venue. Medicaid is similarly situated, consuming ever greater portions of the federal budget. As a result, several programs have been offered to modify the Medicaid program including moving from a match program to a block grant, moving to a per-capita system, and limited the use of provider taxes to fund the state's portion of the Medicaid program. We do not know whether these proposals will pass, or the effect their ultimate form will have on our business.  In addition, Congress has annually appropriated funds to avoid the imposition of the Sustainable Growth Rate formula, enacted by the Balanced Budget Act of 1997, on physician payments under Medicare. The cut to physician payments that would result from the imposition of the Sustainable Growth Rate formula would be more than 30% at the start of 2013. The cuts could have a significant impact on health care provider willingness to participate in Medicare programs. Congress has not yet appropriated funds for these payments for 2013 and may fail to do so, or may delay doing so which could cause delays in receipt of payments from CMS for our MA plans.                                          33

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  Basis of Presentation  Segments  Reportable operating segments are defined as components of an enterprise for which discrete financial information is available and evaluated on a regular basis by the enterprise's decision-makers to determine how resources should be allocated to an individual segment and to assess performance of those segments. Accordingly, we have three reportable segments: Medicaid, MA and PDP.  

Medicaid

Medicaid was established to provide medical assistance to low-income and disabled persons. It is operated and implemented by state agencies, although it is funded and regulated by both the state and federal governments. Our Medicaid segment includes TANF, Supplemental Security Income ("SSI"), ABD, and other state-based programs that are not part of the Medicaid program, such as CHIP, Family Health Plus ("FHP") and MLTC. TANF generally provides assistance to low-income families with children. ABD and SSI generally provide assistance to low-income aged, blind or disabled individuals. CHIP and FHP programs provide assistance to qualifying families who are not eligible for Medicaid because their income exceeds the applicable income thresholds. The MLTC program is designed to help people with chronic illnesses or who have disabilities and need health and long-term care services, such as home care or adult day care, stay in their homes and communities as long as possible.  The Medicaid programs and services we offer to our members vary by state and county and are designed to effectively serve our various constituencies in the communities we serve. Although our Medicaid contracts determine to a large extent the type and scope of health care services that we arrange for our members, in certain markets we customize our benefits in ways that we believe make our products more attractive. Our Medicaid plans provide our members with access to a broad spectrum of medical benefits from many facets of primary care and preventive programs to full hospitalization and tertiary care.  In general, members are required to use our network, except in cases of emergencies, transition of care or when network providers are unavailable to meet their medical needs, and generally must receive a referral from their primary care provider ("PCP") in order to receive medical services from specialists, such as surgeons or neurologists. Members do not pay any premiums, deductibles or co-payments for most of our Medicaid plans.  

MA

Medicare is a federal program that provides eligible persons age 65 and over, and some disabled persons with a variety of hospital, medical and prescription drug benefits. Our MA segment consists of MA plans, comprised of coordinated care plans ("CCPs"). MA is Medicare's managed care alternative to original Medicare fee-for-service ("Original Medicare"), which provides individuals standard Medicare benefits directly through CMS. Our CCPs are administered through our health maintenance organizations ("HMOs") and insurance subsidiaries, and generally require members to seek health care services and select a PCP from a network of health care providers. In addition, we offer Medicare Part D coverage, which provides prescription drug benefits, as a component of most of our MA plans.  We cover a wide spectrum of medical services through our MA plans, including, in some cases, additional benefits not covered by Original Medicare, such as vision, dental and hearing services. Through these enhanced benefits, the out-of-pocket expenses incurred by our members are reduced, which allows our members to better manage their health care costs.  Most of our MA plans require members to pay a co-payment, which varies depending on the services and level of benefits provided. Typically, members of our MA CCPs are required to use our network of providers except in cases such as emergencies, transition of care or when specialty providers are unavailable to meet a member's medical needs. MA CCP members may see out-of-network specialists if they receive referrals from their PCPs and may pay incremental cost-sharing. In all of our MA markets, we also offer special needs plans to individuals who are dually eligible for Medicare and Medicaid. These plans, commonly called D-SNPs, are designed to provide specialized care and support for beneficiaries who are eligible for both Medicare and Medicaid. We believe that our D-SNPs are attractive to these beneficiaries due to the enhanced benefit offerings and clinical support programs.                                          34 --------------------------------------------------------------------------------

PDP

  We offer stand-alone Medicare Part D coverage to Medicare-eligible beneficiaries through our PDP segment. The Medicare Part D prescription drug benefit is supported by risk sharing with the federal government through risk corridors designed to limit the losses and gains of the drug plans and by reinsurance for catastrophic drug costs. The government subsidy is based on the national weighted average monthly bid for this coverage, adjusted for risk factor payments. Additional subsidies are provided for dually-eligible beneficiaries and specified low-income beneficiaries. The Medicare Part D program offers national in-network prescription drug coverage that is subject to limitations in certain circumstances.  Depending on medical coverage type, a beneficiary has various options for accessing drug coverage. Beneficiaries enrolled in Original Medicare can either join a stand-alone PDP or forgo Medicare Part D drug coverage. Beneficiaries enrolled in MA CCPs can join a plan with Medicare Part D coverage, select a separate Medicare Part D plan, or forgo Medicare Part D coverage.  

Segment Financial Performance Measures

  We use three measures to assess the performance of our reportable operating segments: premium revenue, medical benefits ratio ("MBR") and gross margin. MBR measures the ratio of medical benefits expense to premium revenue excluding Medicaid premium taxes. Gross margin is defined as premium revenue less medical benefits expense.  Our profitability depends in large part on our ability to, among other things, effectively price our health and prescription drug plans; predict and effectively manage medical benefits expense relative to the primarily fixed premiums we receive, including reserve estimates and pharmacy costs; contract with health care providers; and attract and retain members. In addition, factors such as regulation, competition and general economic conditions affect our operations and profitability. The effect of escalating health care costs, as well as any changes in our ability to negotiate competitive rates with our providers may impose further risks to our profitability and may have a material impact on our business, financial condition and results of operations.  

Premium Revenue

  We receive premiums from CMS and state government agencies for the members that are assigned to, or have selected, us to provide health care services under our Medicare and Medicaid contracts. The primarily fixed premiums we receive for each member varies according to the specific government program. The premiums we receive under each of our government benefit plans are generally determined at the beginning of the contract period. These premiums are subject to adjustment throughout the term of the contract, although such adjustments are typically made at the commencement of each new contract period. For further information regarding premium revenues, please refer below to "Premium Revenue Recognition and Premiums Receivable" under "Critical Accounting Estimates."  

Medical Benefits Expense and Medical Benefits Payable

  Our largest expense is the cost of medical benefits that we provide, which is based primarily on our arrangements with health care providers and utilization of health care services by our members. Our arrangements with providers primarily fall into two broad categories: capitation arrangements, pursuant to which we pay the capitated providers a fixed per member per month ("PMPM") fee or a fixed fee-for-service, and risk-sharing arrangements, pursuant to which the provider assumes a portion of the risk of the cost of the health care provided. Other components of medical benefits expense are variable and require estimation and ongoing cost management.  We use a variety of techniques to manage our medical benefits expense, including payment methods to providers, referral requirements, quality and disease management programs, reinsurance and member co-payments and premiums for some of our Medicare plans. National health care costs have been increasing at a higher rate than the general inflation rate and relatively small changes in our medical benefits expense relative to premiums that we receive can create significant changes in our financial results. Changes in health care laws, regulations and practices, levels of use of health care services, competitive pressures, hospital costs, major epidemics, terrorism or bio-terrorism, new medical technologies and other external factors could reduce our ability to manage our medical benefits expense effectively.  Estimation of medical benefits payable and medical benefits expense is our most significant critical accounting estimate. For further information regarding medical benefits expense, please refer below to "Medical Benefits Expense and Medical Benefits Payable" under "Critical Accounting Estimates."                                          35 --------------------------------------------------------------------------------

Gross Margin and MBR

  Our primary tools for measuring profitability are gross margin and MBR. Changes in gross margin and MBR from period to period result from, among other things, changes in Medicaid and Medicare funding, changes in the mix of Medicaid and Medicare membership, our ability to manage medical costs and changes in accounting estimates related to incurred but not reported ("IBNR") claims. We use gross margin and MBRs both to monitor our management of medical benefits and medical benefits expense and to make various business decisions, including which health care plans to offer, which geographic areas to enter or exit and which health care providers to select. Although gross margin and MBRs play an important role in our business strategy, we may be willing to enter new geographical markets and/or enter into provider arrangements that might produce a less favorable gross margin and MBR if those arrangements, such as capitation or risk sharing, would likely lower our exposure to variability in medical costs or for other reasons.  Results of Operations 

Summary of Consolidated Financial Results

  The following table sets forth consolidated statements of operations data, as well as other key data used in our results of operations discussion for the three months and nine months ended September 30, 2012 compared to the three and nine months ended September 30, 2011. These historical results are not necessarily indicative of results to be expected for any future period.                                              For the Three Months Ended                                                    September 30,                        Change                                               2012                2011          Dollars       Percentage Revenues:                                                 (In millions) Premium                                 $    1,816.4         $    1,541.9     $    274.5          17.8  % Investment and other income                      2.0                  2.4           (0.4 )       (16.7 )% Total revenues                               1,818.4              1,544.3          274.1          17.7  %  Expenses: Medical benefits (1)                         1,549.4              1,214.8          334.6          27.5  % Selling, general and administrative (1)        176.8                160.6           16.2          10.1  % Medicaid premium taxes                          20.6                 18.9            1.7           9.0  % Depreciation and amortization                    8.2                  6.5            1.7          26.2  % Interest                                         1.0                  3.6           (2.6 )       (71.3 )% Total expenses                               1,756.0              1,404.4          351.6          25.0  % Income before income taxes                      62.4                139.9          (77.5 )       (55.4 )% Income tax expense                              24.1                 51.7          (27.6 )       (53.4 )% Net income                              $       38.3         $       88.2     $    (49.9 )       (56.6 )% Consolidated MBR (1)                            86.3 %               79.8 %                        6.5  % Effective tax rate                              38.6 %               37.0 %                        1.6  %                                            36

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                                             For the Nine Months Ended                                                  September 30,                       Change                                               2012              2011         Dollars       Percentage Revenues:                                                (In millions) Premium                                 $     5,414.1       $  4,499.7     $    914.4          20.3  % Investment and other income                       6.8              7.0           (0.2 )        (2.9 )% Total revenues                                5,420.9          4,506.7          914.2          20.3  % Expenses: Medical benefits (1)                          4,617.4          3,680.2          937.2          25.5  % Selling, general and administrative (1)         497.5            458.6           38.9           8.5  % Medicaid premium taxes                           61.0             55.8            5.2           9.3  % Depreciation and amortization                    22.7             19.8            2.9          14.6  % Interest                                          3.2              3.8           (0.6 )       (15.8 )% Total expenses                                5,201.8          4,218.2          983.6          23.3  % Income before income taxes                      219.1            288.5          (69.4 )       (24.1 )% Income tax expense                               83.1            109.3          (26.2 )       (24.0 )% Net income                              $       136.0       $    179.2     $    (43.2 )       (24.1 )% Consolidated MBR (1)                             86.3 %           82.8 %                        3.5  % Effective tax rate                               37.9 %           37.9 %                          -  %      (1)  Medical benefits expense, MBR, and selling, general and administrative      expense for the three months and nine months ended September 30, 2011      reflect the reclassification of certain quality improvement costs from 

selling, general and administrative expense to medical benefits expense as

discussed within "Medical Benefits Expense" below.

    Membership                       At September 30, 2012                  At December 31, 2011                  At September 30, 2011                                     Percentage of                         Percentage of                          Percentage of Segment           Membership            Total           Membership            Total            Membership            Total Medicaid         1,515,000                59.2 %        1,451,000               56.6 %        1,313,000                54.5 % MA                 167,000                 6.5 %          135,000                5.3 %          130,000                 5.4 % PDP                879,000                34.3 %          976,000               38.1 %          967,000                40.1 % Total            2,561,000               100.0 %        2,562,000              100.0 %        2,410,000               100.0 %    As of September 30, 2012, we served approximately 2,561,000 members, consistent with membership at December 31, 2011 and an increase of approximately 151,000 members at September 30, 2011. We experienced membership growth in both our Medicaid and MA segments when compared to December 31, 2011, which was offset by a decline in PDP membership. Medicaid segment membership increased by 64,000 compared to December 31, 2011, mainly from membership growth in Florida, membership growth in our Kentucky Medicaid program following its launch in the fourth quarter of 2011, and membership growth in our Hawaii Medicaid program due to participation in Hawaii's QUEST program beginning in July 2012. Our KentuckyMedicaid membership increased from 129,000 at December 31, 2011 to 159,000 at September 30, 2012. Members participating in the Kentucky Medicaid program were able to switch plans until January 31, 2012. Additionally, membership has increased due to retroactive member re-assignments. MA segment membership increased by 32,000 compared to December 31, 2011 based on results of the annual election period, which resulted in an increase of approximately 10,000 members effective January 1, 2012, as well as our continued focus on dually-eligible beneficiaries and expansion into 19 new counties. In our PDP segment, membership decreased by 97,000 compared to December 31, 2011 as a result of our 2012 PDP bids, which resulted in the reassignment to other plans, effective January 1, 2012, of members who were auto-assigned to us in 2011 or prior years.                                          37 --------------------------------------------------------------------------------   The Kentucky Medicaid program recently completed an open enrollment period. As a result of this activity, we expect our membership to increase to over 195,000 members on the service effective date of November 1, 2012. Effective October 1, 2012, we added approximately 20,000 members as a result of our Florida Healthy Kids program expansion to 65 out of Florida's 67 counties, up from 18 counties. We project MA segment membership will continue to grow during the remaining months of 2012 due to our ability to market to and enroll dually-eligible beneficiaries, and overall Medicare population growth. We anticipate PDP segment membership will decrease slightly during the remainder of 2012 due to normal attrition being offset by fewer new members as we will be auto-assigned newly eligible members in fewer regions.  

Net Income

  For the three and nine months ended September 30, 2012, our net income was $38.3 million and $136.0 million, respectively, compared to net income of $88.2 million and $179.2 million for the same three and nine month periods in 2011. Excluding investigation-related litigation and other resolution costs of $7.9 million and $4.9 million, net of tax, for the three months ended September 30, 2012 and 2011, respectively, net income decreased by $47.0 million in 2012 compared to the same three month period in 2011. Excluding investigation-related litigation and other resolution costs of $22.0 million and $18.8 million, net of tax, for the nine months ended September 30, 2012 and 2011, respectively, net income decreased by $40.0 million in 2012 compared to the same nine month period in 2011. The decrease for the three months ended September 30, 2012 compared to the same period in 2011 resulted mainly from a decrease in our Medicaid and MA segment results, higher selling, general and administrative expense ("SG&A") expense and a higher effective income tax rate, partially offset by improved results in PDP segment. The decrease for the nine months ended September 30, 2012 resulted from a decrease in our Medicaid segment results and increased SG&A expense, partially offset by improved results in our MA and PDP segments. The decreases in our Medicaid segment results were due to the impact of higher net favorable development of prior period medical benefits payable experienced in 2011, the relatively higher MBR in the Kentucky Medicaid program, and a $17.7 million reduction to premium revenue recorded during the three months ended September 30, 2012 related to a reconciliation of duplicate member records in Georgia dating back to the beginning of the program in 2006. These decreases were partially offset by the impact of higher membership and related premium revenues and the impact of rate increases in certain markets. The improved results in our MA segment for the nine month period in 2012 were due to increased membership and related premium revenues, while the improvement in the PDP segment resulted mainly from favorable claims experience. The increase in SG&A was driven primarily by higher membership, but the rate of increase was lower than the overall rate of increase in premium revenues.  

Premium Revenue

  Premium revenue for the three months ended September 30, 2012 increased by approximately $274.5 million, or 17.8%, compared to the same period in the prior year. Premium revenue for the nine months ended September 30, 2012 increased by approximately $914.4 million, or 20.3%, compared to the same period in the prior year. The increases are primarily attributable to membership growth in our Medicaid and MA segments and rate increases in certain of our Medicaid markets, offset by the $17.7 million reduction to premium revenue related to the GeorgiaMedicaid program as previously discussed. Premium revenue includes $20.6 million and $61.0 million of Medicaid premium taxes for the three and nine months ended September 30, 2012, respectively, and $18.9 million and $55.8 million million for the same three and nine months in 2011, respectively.  

Medical Benefits Expense

  Total medical benefits expense for the three months ended September 30, 2012 increased $334.6 million, or 27.5%, compared to the same period in 2011. Total medical benefits expense for the nine months ended September 30, 2012 increased $937.2 million, or 25.5%, compared to the same period in 2011. The increases are due mainly to increased membership in the Medicaid and MA segments and the impact of higher net favorable development of prior period medical benefits payable experienced in 2011 and the relatively higher MBR in the KentuckyMedicaid program, partially offset by a decrease in the PDP segment. For the three months ended September 30, 2012, medical benefits expense was impacted by approximately $15.4 million of net unfavorable development related to prior periods, which includes approximately $23.3 million of unfavorable development related to the first and second quarters of 2012 that was partially offset by $7.9 million of favorable development related to prior fiscal years. For the nine months ended September 30, 2012, medical benefits expense was impacted by approximately $79.7 million of net favorable development related to prior years. Net favorable development of prior period medical benefits payable amounted to $36.7 million and $154.8 million for the three and nine months ended September 30, 2011, respectively. Our consolidated MBR was 86.3% for the three and nine months ended September 30, 2012, compared to 79.8% and 82.8% for the same periods in 2011, respectively. The increase in MBR was primarily due to the impact of higher net favorable prior period developments of medical benefits payable in 2011 and the relatively high MBR in the KentuckyMedicaid program, partially offset by rate increases in certain of our Medicaid markets and the impact of our medical cost initiatives.                                          38 --------------------------------------------------------------------------------   Effective January 1, 2012, we reclassified to medical benefits expense certain costs related to quality improvement activities that were formerly reported in SG&A expense. The quality improvement costs that we reclassified are consistent with the criteria specified and defined in guidance issued by the Department of Health and Human Services ("HHS") for costs that qualify to be reported as medical benefits under the minimum medical loss ratio provision of the 2010 Acts and include:  

• Preventive health and wellness and care management;

• Case and disease management;

• Health plan accreditation costs;

• Provider education and incentives for closing care gaps;

• Health risk assessments and member outreach; and

• Information technology costs related to the above activities.

    The reclassification of these quality improvement costs impacted our medical benefits expense and MBR by reportable segment for the three and nine months ended September 30, 2011 as follows.                                                   For the Three Months                                                Ended September 30, 2011                                        Previously       Amounts           As                                         Reported      Reclassified     Adjusted                                                  (Dollars in millions)

Medicaid medical benefits expense $ 696.0 $ 12.3 $ 708.3 Medicaid MBR %

                              79.0 %           1.4 %         80.4 % MA medical benefits expense                304.7             4.1          

308.8

 MA MBR %                                    80.9 %           1.1 %         82.0 % PDP medical benefits expense               196.3             1.4          

197.7

 PDP MBR%                                    73.9 %           0.5 %         74.4 % Consolidated medical benefits expense $  1,197.0     $      17.8      $ 1,214.8 Consolidated MBR %                          78.6 %           1.2 %         79.8 %                                                      For the Nine Months                                                Ended September 30, 2011                                        Previously       Amounts           As                                         Reported      Reclassified     Adjusted                                                  (Dollars in millions)

Medicaid medical benefits expense $ 2,047.4 $ 36.6 $ 2,084.1 Medicaid MBR %

                              80.5 %           1.5 %         82.0 % MA medical benefits expense                879.7            13.6          

893.4

 MA MBR %                                    80.2 %           1.2 %         81.4 % PDP medical benefits expense               699.2             3.6          

702.7

 PDP MBR%                                    87.0 %           0.4 %         87.4 % Consolidated medical benefits expense $  3,626.3     $      53.8      $ 3,680.2 Consolidated MBR %                          81.6 %           1.2 %         82.8 %    The reclassification of quality improvement costs impacted our consolidated MBR by approximately 1.3%, 1.1% and 0.8% for the fiscal years ended December 31, 2011, 2010 and 2009, respectively, and impacted our SG&A ratio by approximately 1.3%, 1.0% and 0.8% for the same periods, respectively.                                          39 --------------------------------------------------------------------------------

Selling, General and Administrative Expense

  SG&A expense includes aggregate costs related to the resolution of the previously disclosed governmental and Company investigations and related litigation, such as settlement accruals and related fair value accretion, legal fees and other similar costs. Refer to Part I - Item 1 - Note 10 - "Commitments and Contingencies" for additional discussion of investigation-related litigation and other resolution costs. We believe it is appropriate to evaluate SG&A expense exclusive of these investigation-related litigation and other resolution costs because we do not consider them to be indicative of long-term business operations. Additionally, as discussed above, we reclassified costs related to quality improvement activities that were formerly reported in SG&A expenses to medical benefits expense effective January 1, 2012. Prior year amounts have been reclassified to conform to the current year presentation.  

The reconciliation of SG&A expense, including and excluding such costs, as well as the reclassification of quality improvement costs, is as follows:

                                                       For the Three Months Ended September 30,                                           2012                                   2011                                                          Previously                                     As                                                           Reported        Amounts Reclassified       Adjusted                                                                     (In millions) SG&A expense                         $     176.8       $       178.4     $           (17.8 )       $     160.6 Adjustments: Investigation-related litigation and other resolution costs                      (0.8 )              (0.5 )                   -                (0.5 ) Investigation-related administrative costs                                      (11.4 )              (7.3 )                   -                (7.3 ) Total investigation-related litigation and other resolution costs                                      (12.2 )              (7.8 )                   -                (7.8 ) SG&A expense, excluding investigation-related litigation and other resolution costs               $     164.6       $       170.6     $           (17.8 )       $     152.8 SG&A ratio                                   9.8 %              11.7 %                (1.2 )%             10.5 % SG&A ratio, excluding investigation-related litigation and other resolution costs                       9.2 %              11.2 %                (1.2 )%             10.0 %                                                           For the Nine Months Ended September 30,                                           2012                                   2011                                                          Previously                                     As                                                           Reported        Amounts Reclassified       Adjusted                                                                     (In millions) SG&A expense                         $     497.5       $       512.4     $           (53.8 )       $     458.6 Adjustments: Investigation-related litigation and other resolution costs                      (3.0 )              (6.8 )                   -                (6.8 ) Investigation-related administrative costs                                      (34.5 )             (23.9 )                   -               (23.9 ) Total investigation-related litigation and other resolution costs                                      (37.5 )             (30.7 )                   -               (30.7 ) SG&A expense, excluding investigation-related litigation and other resolution costs               $     460.0       $       481.7     $           (53.8 )       $     427.9 SG&A ratio                                   9.3 %              11.5 %                (1.2 )%             10.3 % SG&A ratio, excluding investigation-related litigation and other resolution costs                       8.6 %              10.8 %                (1.2 )%              9.6 %                                            40

--------------------------------------------------------------------------------   Excluding total investigation-related litigation and other resolution costs, our SG&A expense for the three months ended September 30, 2012, increased approximately $11.8 million, or 7.7%, to $164.6 million from $152.8 million for the same period in 2011. Similarly, our SG&A expense for the nine months ended September 30, 2012, increased approximately $32.1 million, or 7.5% to $460.0 million from $427.9 million for the same period in 2011. The increase in both periods was due to technology investments, including those required by regulatory changes, as well as medical cost initiatives, increased spending related to the launch of our Kentucky Medicaid program and other growth initiatives. These increases were partially offset by improvements in operating efficiency. Our SG&A expense as a percentage of total revenue, excluding premium taxes ("SG&A ratio"), was 9.8% for the three months ended September 30, 2012 compared to 10.5% for the same period in 2011. After excluding the investigation-related litigation and other resolution costs, our SG&A ratio for the three months ended September 30, 2012 was 9.2% compared to 10.0% for the same period in 2011. Our SG&A ratio was 9.3% for the nine months ended September 30, 2012 compared to 10.3% for the same period in 2011. After excluding the investigation-related litigation and other resolution costs, our SG&A ratio for the nine months ended September 30, 2012 was 8.6% compared to 9.6% for the same period in 2011. The improvement in our SG&A ratio, excluding investigation-related litigation and other resolution costs, is related to the growth in premium revenue and improvement in our administrative cost structure driven by business simplification projects, process management in our shared services functions, and continued evaluation of our organizational design. The improvement was partially offset by costs incurred from debt incurred in 2011 to settle investigation-related litigation that was later redeemed in the fourth quarter of 2011, and quality, regulatory and growth initiatives.  

Medicaid Premium Taxes

Medicaid premium taxes incurred for the three and nine months ended September 30, 2012 were $20.6 million and $61.0 million, respectively, compared to $18.9 million and $55.8 million, respectively, for the same three and nine month periods in 2011. The increase corresponds to the increase in Medicaid premium revenues.  

Interest Expense

  Interest expense for the three and nine months ended September 30, 2012 was $1.0 million and $3.2 million, respectively, compared to $3.6 million and $3.8 million, respectively, for the same periods in 2011. The decrease in interest expense is mainly from debt incurred in 2011 to settle investigation-related litigation that was later redeemed in the fourth quarter of 2011, partially offset by interest on the $150.0 million borrowed under a term loan on August 1, 2011.                                          41

--------------------------------------------------------------------------------

Income Tax Expense

  Income tax expense for the three and nine months ended September 30, 2012 was $24.1 million and $83.1 million , respectively, compared to $51.7 million and $109.3 million, respectively, for the same three and nine month periods in the prior year. Our effective income tax rate on pre-tax income was 38.6% and 37.9% for the three and nine months ended September 30, 2012, respectively, compared to 37.0% and 37.9% for the same three and nine month periods in 2011. The effective tax rate for the three months ended September 30, 2011 was lower than the rate for the three months ended September 30, 2012 as the 2011 rate was reduced by changes in estimated non-deductible amounts associated with investigation-related litigation. The effective tax rate for the nine months ended September 30, 2012 was comparable to the same period in 2011. In 2012, a decrease in the prevailing state income tax rate lowered the effective rate, but was offset by the settlement of a state tax matter which increased the effective rate. The impact from changes in estimated non-deductible amounts associated with investigation-related litigation lowered the effective rate for 2012 and thus was comparable to the same period in 2011.   

Reconciling Segment Results

  The following table reconciles our reportable segment results to income before income taxes, as reported in conformity with accounting principles generally accepted in the United States ("GAAP").                                 For the Three Months Ended                                       September 30,                     Change                                  2012               2011         Dollar     Percentage                                             (In millions) Gross Margin (1): Medicaid                    $      116.9       $      191.4     $ (74.5 )      (38.9 )% MA                                  62.1               67.8        (5.7 )       (8.4 )% PDP                                 87.9               67.9        20.0         29.5  % Total gross margin                 266.9              327.1       (60.2 )      (18.4 )% Investment and other income          2.0                2.4        (0.4 )      (16.7 )% Other expenses (1)                (206.5 )           (189.6 )     (16.9 )        8.9  % Income before income taxes  $       62.4       $      139.9     $ (77.5 )      (55.4 )%                                    For the Nine Months Ended                                       September 30,                     Change                                  2012               2011         Dollar     Percentage                                             (In millions) Gross Margin (1): Medicaid                    $      424.5       $      514.8     $ (90.3 )      (17.5 )% MA                                 231.1              203.7        27.4         13.5  % PDP                                141.1              101.0        40.1         39.7  % Total gross margin                 796.7              819.5       (22.8 )       (2.8 )% Investment and other income          6.8                7.0        (0.2 )       (2.9 )% Other expenses (1)                (584.4 )           (538.0 )     (46.4 )        8.6  % Income before income taxes  $      219.1       $      288.5     $ (69.4 )      (24.1 )%     

(1) Gross margin by reportable segment and other expenses shown above reflects

the reclassification of quality improvement costs from selling, general and

administrative expense to medical benefits expense as discussed in "Medical

Benefits Expense" under "Summary of Consolidated Results." Refer to Part I -

Item 1 - Note 2 - "Segment Reporting" for reclassification by reportable

     segment through the gross margin level.                                            42

--------------------------------------------------------------------------------

  Medicaid Segment Results                                           For the Three Months Ended                                                September 30,                        Change                                            2012               2011           Dollar       Percentage                                                    (Dollars in millions) Premium revenue                      $      1,076.3       $     880.8     $    195.5          22.2  % Medicaid premium taxes                         20.6              18.9            1.7           9.0  % Total premiums                              1,096.9             899.7          197.2          21.9  % Medical benefits expense (2)                  980.0             708.3          271.7          38.4  % Gross margin (2)                     $        116.9       $     191.4     $    (74.5 )       (38.9 )% Medicaid MBR (excluding premium taxes) (1) (2)                                 91.1 %            80.4 %                       10.7  %                                             For the Nine Months Ended                                                September 30,                       Change                                            2012              2011           Dollar       Percentage                                                   (Dollars in millions) Premium revenue                      $     3,208.0       $   2,543.1     $    664.9          26.1  % Medicaid premium taxes                        61.0              55.8            5.2           9.3  % Total premiums                             3,269.0           2,598.9          670.1          25.8  % Medical benefits expense (2)               2,844.5           2,084.1          760.4          36.5  % Gross margin (2)                     $       424.5       $     514.8     $    (90.3 )       (17.5 )% Medicaid membership: Georgia                                    566,000           561,000                          0.9  % Florida                                    434,000           395,000                          9.9  % Other states                               515,000           357,000                         44.3  %                                          1,515,000         1,313,000                         15.4  % Medicaid MBR (excluding premium taxes) (1) (2)                                88.7 %            82.0 %                        6.7  %     

(1) MBR measures the ratio of our medical benefits expense to premium revenue

excluding Medicaid premium taxes. Because Medicaid premium taxes are

included in the premium rates established in certain of our Medicaid

contracts and also recognized separately as a component of expense, we

exclude these taxes from premium revenue when calculating key ratios as we

believe that their impact is not indicative of operating performance. For

GAAP reporting purposes, Medicaid premium taxes are included in premium

     revenue.   

(2) Medicaid medical benefits expense, MBR and gross margin shown above reflect

the reclassification of quality improvement costs from selling, general and

administrative expenses to medical benefits expense as discussed in Medical

     Benefits Expense under Summary of Consolidated Results. Refer to Part I -      Item 1 - Note 2 - "Segment Reporting" for reclassification of Medicaid      segment results through the gross margin level.    Excluding Medicaid premium taxes, Medicaid premium revenue for the three and nine months ended September 30, 2012 increased 22.2% and 26.1%, respectively, when compared to the same periods in 2011. The increase was mainly due to premiums associated with our Kentucky Medicaid program, which was launched on November 1, 2011, premiums associated with the July 1, 2012 launch of the new Hawaii QUEST program for TANF and CHIP members, the carve-in of the pharmacy benefit in our New York and Ohio Medicaid programs which were effective in October 2011, membership growth in Florida, and rate increases implemented in most markets in late 2011. Partially offsetting these increases was a $17.7 million reduction of premium revenue recorded during the three months ended September 30, 2012 related to a reconciliation of duplicate member records in Georgia dating back to the beginning of the program in 2006.                                          43 --------------------------------------------------------------------------------   Medicaid medical benefits expense for the three and nine months ended September 30, 2012 increased 38.4% and 36.5%, respectively, when compared to the same periods in 2011. The increase in both the three and nine month periods was due mainly to the increase in membership and the relatively higher MBR in the Kentucky Medicaid program, partially offset by the impact of medical cost initiatives that we have implemented. The increase for the three months ended September 30, 2012 reflects the recognition of net unfavorable development of prior period medical benefits payable compared to net favorable development recognized in 2011 and the increase for the nine months ended September 30, 2012 reflects the impact of higher net favorable development of prior period medical benefits payable experienced in 2011 compared to 2012. Our Medicaid MBR for the three and nine months ended September 30, 2012 increased by 1,070 and 670 basis points, respectively, when compared to the same three and nine month periods in 2011. The increase was driven by the relatively higher MBR in the KentuckyMedicaid program, the $17.7 million reduction of premium revenue for duplicate member record reconciliation adjustments, and the impact of the higher net favorable development experienced in 2011 compared to 2012. The KentuckyMedicaid program MBR for the nine month period ending September 30, 2012 was approximately 106% due to the relatively high transitional medical benefit expenses for the program. As a result of processes that we have begun to improve care coordination and manage costs, and revenue enhancements that are expected in the fourth quarter of 2012, we currently expect the Kentucky Medicaid program to operate with an MBR of approximately 91% to 92% during the fourth quarter of 2012.  Outlook  The Kentucky Medicaid program recently completed an open enrollment period. As a result, we expect our membership to increase by approximately 30,000 members, effective November 1, 2012. We estimate that our premium revenue for the Kentucky Medicaid program for the year 2012 will reach approximately $675 million to $700 million. Effective October 1, 2012, we added approximately 20,000 Medicaid members as a result of the expansion of our Florida Healthy Kids program from 18 counties to 65 counties, out of Florida's 67 counties. We expect the full year MBR for our Medicaid segment to be higher in 2012 when compared to 2011, due to the high amount of favorable development of medical benefits payable that we recognized in 2011.  MA Segment Results                                  For the Three Months Ended                                        September 30,                     Change                                   2012               2011         Dollar     Percentage                                         (Dollars in millions) Premium revenue              $      470.8       $      376.6     $ 94.2        25.0  % Medical benefits expense (1)        408.7              308.8       99.9        32.4  % Gross margin (1)             $       62.1       $       67.8     $ (5.7 )      (8.4 )% MA MBR (1)                           86.8 %             82.0 %                  4.8  %                                    For the Nine Months Ended                                       September 30,                    Change                                    2012             2011        Dollar    Percentage                                        (Dollars in millions) Premium revenue              $     1,364.5       $ 1,097.0     $ 267.5        24.4 % Medical benefits expense (1)       1,133.4           893.3       240.1        26.9 % Gross margin (1)             $       231.1       $   203.7     $  27.4        13.5 % MA Membership                      167,000         130,000                    28.5 % MA MBR (1)                            83.1 %          81.4 %                   1.7 %    

(1) Medicare medical benefits expense, MBR and gross margin shown above reflect

the reclassification of quality improvement costs from selling, general and

administrative expense to medical benefits expense as discussed in "Medical

Benefits Expense" under "Summary of Consolidated Results." Refer to Part I -

     Item 1 - Note 2 - "Segment Reporting" for reclassification of Medicare      segment results through the gross margin level.                                            44

--------------------------------------------------------------------------------   MA premium revenue for the three and nine months ended September 30, 2012 increased 25.0% and 24.4%, respectively, when compared to the same three and nine month periods in 2011 and was mainly attributable to an increase in membership, which increased by approximately 37,000 members between September 30, 2011 and September 30, 2012 due to our product design, strengthening of our sales processes and heightened focus on membership growth activities during the annual election period in 2011. MA segment MBR increased by 480 basis points for the three months ended September 30, 2012, but increased only 170 basis points for the nine months ended September 30, 2012, compared to the same periods in 2011. The changes in the MBR were primarily due to increased quality improvement costs and less net favorable development of prior year's medical benefits payable in 2012 than we recognized in 2011.  

Outlook

  We expect ultimate 2012 MBR for the MA segment to be higher than that in the prior year due to the recognition of significant prior period development that favorably impacted the 2011 MBR.  PDP Segment Results                                  For the Three Months Ended                                        September 30,                     Change                                   2012               2011         Dollar     Percentage                                          (Dollars in millions) Premium revenue              $      248.7       $      265.6     $ (16.9 )       (6.4 )% Medical benefits expense (1)        160.8              197.7       (36.9 )      (18.7 )% Gross margin (1)             $       87.9       $       67.9     $  20.0         29.5  % PDP MBR (1)                          64.7 %             74.4 %                   (9.7 )%                                     For the Nine Months Ended                                        September 30,                      Change                                   2012               2011         Dollar      Percentage                                          (Dollars in millions) Premium revenue              $      780.6       $      803.7     $ (23.1 )      (2.9 )% Medical benefits expense (1)        639.5              702.7       (63.2 )      (9.0 )% Gross margin (1)             $      141.1       $      101.0     $  40.1        39.7  % PDP Membership                    879,000            967,000                    (9.1 )% PDP MBR (1)                          81.9 %             87.4 %                  (5.5 )%     

(1) PDP medical benefits expense, MBR and gross margin shown above reflect the

reclassification of quality improvement costs from selling, general and

administrative expense to medical benefits expense as discussed in "Medical

Benefits Expense" under "Summary of Consolidated Results." Refer to Part I

- Item 1 - Note 2 - "Segment Reporting" for reclassification of PDP segment

results through the gross margin level.

    PDP premium revenue for the three and nine months ended September 30, 2012 decreased by 6.4% and 2.9%, respectively, when compared to the same periods in 2011 primarily due to the decline in membership. Membership decreased by approximately 88,000 members from September 30, 2011 to September 30, 2012 due to the reassignment to other plans, effective January 1, 2012, of members who were auto-assigned to us in 2011 or prior years. PDP MBR for the three and nine months ended September 30, 2012 decreased 970 and 550 basis points, respectively, over the same periods in 2011 due to the outcome of our 2012 bids and improvements in our pharmacy claims experience, resulting from our focus on member utilization, cost sharing patterns and generic medication utilization.                                          45 --------------------------------------------------------------------------------

Outlook

  We expect PDP membership and premium revenues to decrease slightly during the remainder of 2012 due to normal attrition being offset by fewer new members as we will be auto-assigned newly eligible members in only the five regions where we are below the benchmark.  Additionally, we now expect that our PDP segment MBR will decrease in 2012 compared to 2011 based on the segment operating results for the nine months period ended September 30, 2012, which were better than anticipated.  

Liquidity and Capital Resources

Overview

  Each of our existing and anticipated sources of cash is impacted by operational and financial risks that influence the overall amount of cash generated and the capital available to us. For a further discussion of risks that can affect our liquidity, see Part I - Item 1A - "Risk Factors" included in our 2011 Form 10-K and Part II - Item 1A - Risk Factors in this 2012 Form 10-Q.  

Cash and Investment Positions

  Our business consists of operations conducted by our regulated subsidiaries, including HMOs and insurance subsidiaries, and our non-regulated subsidiaries. The primary sources of cash for our regulated subsidiaries include premium revenue, investment income and capital contributions made by us to our regulated subsidiaries. Our regulated subsidiaries are each subject to applicable state regulations that, among other things, require the maintenance of minimum levels of capital and surplus. Our regulated subsidiaries' primary uses of cash include payment of medical expenses, management fees to our non-regulated third-party administrator subsidiary (the "TPA") and direct administrative costs, which are not covered by the agreement with the TPA, such as selling expenses and legal costs. We refer collectively to the cash and investment balances maintained by our regulated subsidiaries as "regulated cash" and "regulated investments," respectively.  The primary sources of cash for our non-regulated subsidiaries are management fees and dividends received from our regulated subsidiaries and investment income. Our non-regulated subsidiaries' primary uses of cash include payment of administrative costs not charged to our regulated subsidiaries for corporate functions, including, but not limited to, business development, branding, certain information technology services and debt service. Other primary uses include capital contributions made by our non-regulated subsidiaries to our regulated subsidiaries. We refer collectively to the cash and investment balances available in our non-regulated subsidiaries as "unregulated cash" and "unregulated investments," respectively.  Regulated cash and cash equivalents can fluctuate significantly in a particular period depending on the timing of receipts for premiums from our government partners. Our unregulated cash, cash equivalents and investments was $349.7 million as of September 30, 2012, an increase of $41.2 million from a balance of $308.5 million as of December 31, 2011. During the nine months ended September 30, 2012, certain of our regulated subsidiaries paid $157.0 million in dividends to our non-regulated subsidiaries. These increases in unregulated cash were partially offset by capital contributions made by our non-regulated subsidiaries to certain other regulated subsidiaries and payment of certain investigation-related litigation and other resolution costs in connection with our settlement of the Civil Division of the U.S. Department of Justice (the "Civil Division").  

Regulatory Capital and Dividend Restrictions

  Our operations are conducted primarily through HMO and insurance subsidiaries. Each of these subsidiaries is licensed by the insurance department in the state in which it operates, except our New York HMO subsidiary, which is licensed by the New York State Department of Health, and is subject to the rules, regulation and oversight of the applicable state agency in the areas of licensing and solvency. State insurance laws and regulations prescribe accounting practices for determining statutory net income and capital and surplus. Each of our regulated subsidiaries is required to report regularly on its operational and financial performance to the appropriate regulatory agency in the state in which it is licensed. These reports describe each of our regulated subsidiaries' capital structure, ownership, financial condition, certain intercompany transactions and business operations. From time to time, any of our regulated subsidiaries may be selected to undergo periodic audits, examinations or reviews of our operational and financial assertions by the applicable state agency.  Each of our regulated subsidiaries generally must obtain approval from, or provide notice to, the state in which it is domiciled before entering into certain transactions such as declaring dividends in excess of certain thresholds, entering into other arrangements with related parties, and acquisitions or similar transactions involving an HMO or insurance company, or any change in control. For purposes of these laws, in general, control commonly is presumed to exist when a person, group of persons or entity, directly or indirectly, owns, controls or holds the power to vote 10% or more of the voting securities of another entity.                                          46 --------------------------------------------------------------------------------   Each of our HMO and insurance subsidiaries must maintain a minimum amount of statutory capital determined by statute or regulation. The minimum statutory capital requirements differ by state and are generally based on a percentage of annualized premium revenue, a percentage of annualized health care costs, a percentage of certain liabilities, a statutory minimum risk-based capital ("RBC") requirement or other financial ratios. However, one or more of our regulators could require one or more of our subsidiaries to maintain minimum levels of statutory net worth in excess of the amount required under the current applicable state laws if the regulators were to determine that such a requirement were in the interest of our members. The RBC requirements are based on guidelines established by the National Association of Insurance Commissioners ("NAIC"), and have been adopted by most states. As of September 30, 2012, our HMO operations in Connecticut, Georgia, Illinois, Indiana, Louisiana, Missouri, New Jersey, Ohio and Texas as well as three of our insurance company subsidiaries were subject to RBC requirements. The RBC requirements may be modified as each state legislature deems appropriate for that state. The RBC formula, based on asset risk, underwriting risk, credit risk, business risk and other factors, generates the authorized control level ("ACL"), which represents the amount of capital required to support the regulated entity's business. For states in which the RBC requirements have been adopted, the regulated entity typically must maintain minimum capital equal to the greater of 200% of the ACL and the minimum statutory net worth requirement calculated pursuant to pre-RBC guidelines. Our subsidiaries operating in Texas, Georgia and Ohio are required to maintain statutory capital at RBC levels equal to 225%, 250% and 300%, respectively, of the applicable ACL. Failure to maintain these requirements would trigger regulatory action by the state. At September 30, 2012, our HMO and insurance subsidiaries were in compliance with these minimum capital requirements.  

Credit Agreement

  In August 2011, we entered into a $300.0 million senior secured credit agreement, amended on July 20, 2012 (the "Amended Credit Agreement") that can be used for general corporate purposes. The Amended Credit Agreement provides for a $150.0 million term loan facility as well as a $150.0 million revolving credit facility. Upon closing, we borrowed $150.0 million pursuant to the term loan facility.  Both the term loan and revolving credit facility are set to expire in August 2016. Payments of principal on the term loan are due on a quarterly basis through July 31, 2016. As of September 30, 2012, our remaining term loan balance was $138.8 million, which is included in the current portion of long-term debt and long-term debt line items in our consolidated balance sheet.  Our term loan bears interest at 1.94% as of September 30, 2012. Under the Amended Credit Agreement, outstanding loans designated by us at the time of borrowing as Alternate Base Rate ("ABR") Loans bear interest at a rate per annum equal to (i) the greatest of (a) the prime rate in effect on such day; (b) the federal funds effective rate in effect on such day plus 0.50%; and (c) the adjusted London Inter-Bank Offered Rate ("Adjusted LIBOR") for a one-month interest period on such day plus 1% plus (ii) the applicable margin. Outstanding loans designated by us at the time of borrowing as "Eurodollar Loans" bear interest at a rate per annum equal to the Adjusted LIBOR for the interest period in effect for such borrowing plus the applicable margin. The "applicable margin" means a percentage ranging from 0.50% to 2.25% per annum for ABR Loans and a percentage ranging from 1.50% to 3.25% per annum for Eurodollar Loans, depending upon our ratio of total consolidated debt to consolidated earnings before interest, taxes, depreciation and amortization, as defined in the Amended Credit Agreement (our "Cash Flow Leverage Ratio"). Unutilized commitments under the Amended Credit Agreement are subject to a fee of 0.25% to 0.50% depending upon our Cash Flow Leverage Ratio. Interest on the term loan is payable based on the LIBOR election period, which ranges from one to six months based upon our election, with interest on the unutilized commitment payable quarterly. Commitment fees on the unutilized revolving credit facility and interest on borrowings under the term loan were $0.3 million and $2.3 million, respectively, for a total interest expense amount of $2.6 million for the nine month period ended September 30, 2012. As of September 30, 2012 interest payable for the term loan was $0.3 million.  The Amended Credit Agreement is subject to customary covenants and restrictions which, among other things, limit our ability to incur additional indebtedness. However, we are permitted to incur additional senior and subordinated unsecured indebtedness provided that our Cash Flow Leverage Ratio, calculated to include any such debt incurred, is at least 0.25 times less than the maximum Cash Flow Leverage Ratio. In addition, the Amended Credit Agreement also includes certain financial covenants that require (a) a Cash Flow Leverage Ratio of not more than 2.75 times; (b) a minimum fixed charge coverage ratio (as defined in the Amended Credit Agreement) of 3.00 times; (c) capital expenditures of not more than 1.75% of total consolidated revenue; (d) a minimum level of statutory net worth for our HMO and insurance subsidiaries; and (e) a requirement to maintain cash in an amount equal to one year of payment obligations due and payable to the Civil Division during the next twelve consecutive months, so long as such obligations remain outstanding. For more information regarding our obligations to the Department of Justice see Item 1 - Financial Statements - Note 10, Commitments and Contingencies - Government Investigations.                                          47 --------------------------------------------------------------------------------   The Amended Credit Agreement also contains customary representations and warranties and events of default. The payment of outstanding principal under the Amended Credit Agreement and accrued interest thereon may be accelerated and become immediately due and payable upon our default of payment or other performance obligations or our failure to comply with financial or other covenants in the Amended Credit Agreement, subject to applicable notice requirements and cure periods as provided in the Amended Credit Agreement.  

As of the date of this filing, the revolving credit facility has not been drawn upon and we remain in compliance with all covenants.

Auction Rate Securities

  As of September 30, 2012, $32.1 million of our long-term investments were comprised of municipal note securities with an auction reset feature ("auction rate securities"), which are issued by various state and local municipal entities for the purpose of financing student loans, public projects and other activities and carry investment grade credit ratings. Liquidity for these auction rate securities is typically provided by an auction process which allows holders to sell their notes and resets the applicable interest rate at pre-determined intervals, usually every seven or 35 days. As of the date of this 2012 Form 10-Q, auctions have failed for our auction rate securities and there is no assurance that auctions will succeed in the future. An auction failure means that the parties wishing to sell their securities could not be matched with an adequate volume of buyers. In the event that there is a failed auction the indenture governing the security requires the issuer to pay interest at a contractually defined rate that is generally above market rates for other types of similar instruments. The securities for which auctions have failed will continue to accrue interest at the contractual rate and be auctioned every seven or 35 days until the auction succeeds, the issuer calls the securities, or they mature. As a result, our ability to liquidate and fully recover the carrying value of our remaining auction rate securities in the near term may be limited or non-existent. In addition, while all of our auction rate securities currently carry investment grade ratings, if the issuers are unable to successfully close future auctions and their credit ratings deteriorate, we may in the future be required to record an impairment charge on these investments.  Although auctions continue to fail, we believe we will be able to liquidate these securities without significant loss. There are government guarantees or municipal bond insurance in place and we have the ability and the present intent to hold these securities until maturity or market stability is restored. Accordingly, we do not believe our auction rate securities are impaired and as a result, we have not recorded any impairment losses for our auction rate securities. However, it could take until the final maturity of the underlying securities to realize our investments' recorded value. The final maturity of the underlying securities could be as long as 25 years. The weighted-average life of the underlying securities for our auction rate securities portfolio is 21 years.  

Financial Impact of Government Investigation and Litigation

  Under the terms of settlement agreements entered into on April 26, 2011, and finalized on March 23, 2012, to resolve matters under investigation by the Civil Division of the U.S. Department of Justice ("Civil Division") and certain other federal and state enforcement agencies (the "Settlement"), WellCare agreed to pay the Civil Division a total of $137.5 million over 36 months plus interest accrued at 3.125%. On March 30, 2012, we made a payment of $39.8 million to the Civil Division, consisting of a $34.4 million principal payment and $5.5 million of accrued interest. The estimated fair value of the discounted remaining liability, to be paid in three annual installments of $34.4 million, and related interest, was $104.7 million at September 30, 2012.  The Settlement also provides for a contingent payment of an additional $35.0 million in the event that we are acquired or otherwise experience a change in control within three years of the effective date of the Settlement, provided that the change in control transaction exceeds certain minimum transaction value thresholds as specified in the Settlement.  

Shelf Registration Statement

  In August 2012, we filed a shelf registration statement on Form S-3 with the SEC that became automatically effective covering the registration, issuance and sale of an indeterminate amount of our securities, including common stock, preferred stock, senior or subordinated debt securities, depository shares, securities purchase contracts, units or warrants. We may publicly offer securities in the future at prices and terms to be determined at the time of the offering.                                          48 --------------------------------------------------------------------------------

Cash Flow Activities

Our cash flows are summarized as follows:

                                                                For the Nine Months Ended                                                                      September 30,                                                                  2012              2011                                                                      (In millions)

Net cash (used in) provided by operating activities $ (134.4 )

    $     319.0 Net cash used in investing activities                              (68.1 )          (112.4 ) Net cash (used in) provided by financing activities                (60.3 )  

221.5

Total net (decrease) increase in cash and cash equivalents $ (262.8 )

$ 428.1

Net Cash (Used In) Provided by Operating Activities

  We generally receive premiums in advance of payments of claims for health care services; however, cash flows related to our operations can fluctuate significantly in a particular period depending on the timing of premiums receipts from our government partners or payments related to the resolution of government investigations and related litigation. For the nine months ended September 30, 2012, cash from operating activities was negatively impacted by certain delayed Medicaid premiums, primarily associated with our GeorgiaMedicaid supplemental payments for obstetric deliveries and newborns, and the $39.8 million payment made to the Civil Division on March 30, 2012.  Net cash provided by operating activities for the nine months ended September 30, 2011 included $275.8 million in premium prepayments received from CMS and the Florida Agency for Health Care Administration for October premiums, a timing benefit to our cash flows related to $72.7 million of premiums estimated to be returned under the risk corridor provisions for our Part D products, partially offset by investigation-related litigation and other resolution payments of $87.5 million.  

Net Cash Used In Investing Activities

  During the nine months ended September 30, 2012, cash used in investing activities primarily reflects our investment in marketable securities and restricted investments of approximately $357.2 million and purchases of property and equipment of $47.7 million, partially offset by $343.0 million of proceeds from maturities of marketable securities and restricted investments.  During the nine months ended September 30, 2011, cash used in investing activities primarily reflects our investment of proceeds provided by our term loan into higher yielding investment alternatives, which had a net impact totaling approximately $124.1 million, and purchases of software and equipment totaling approximately $30.8 million, partially offset by $42.6 million of proceeds from the maturities of restricted investments, net of purchases.  

Net Cash (Used In) Provided By Financing Activities

  Included in financing activities are funds receivable for the benefit of members, which decreased approximately $57.2 million and increased by approximately $74.1 million during the nine months ended September 30, 2012 and 2011, respectively. These funds represent reinsurance, low-income cost sharing, and coverage gap discount subsidies funded by CMS in connection with the Medicare Part D program, for which we assume no risk. Net cash provided by financing activities during the nine months ended September 30, 2011 also increased by $147.7 million due to proceeds from the issuance of the term loan, net of issuance costs.                                          49

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Contractual Obligations

  In our 2011 Form 10-K, we reported our contractual obligations as of December 31, 2011. Since then, the Company entered into new operating lease agreements for additional office space in Tampa, Florida. Expected future cash payments under these leases as of September 30, 2012 are set forth below.    Payments due within:  (In millions)   Less than 1 year     $           1.2   1 - 3 years                      5.8   3 - 5 years                      6.6   More than 5 years                5.0                        $          18.6    Critical Accounting Estimates  In the ordinary course of business, we make a number of estimates and assumptions relating to the reporting of our results of operations and financial condition in conformity with GAAP. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ significantly from those estimates under different assumptions and conditions. We believe that our accounting estimates relating to premium revenue recognition, medical benefits expense and medical benefits payable, and goodwill and intangible assets, are those that are most important to the portrayal of our financial condition and results and require management's most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. We have not changed our methodology in deriving these critical accounting estimates from those previously disclosed in our 2011 Form 10-K.  

Premium Revenue Recognition and Premiums Receivable

  We receive premiums from CMS and state agencies for the members that are assigned to, or have selected, us to provide health care services under our Medicare and Medicaid contracts. The premiums we receive for each member vary according to the specific government program and are generally determined at the beginning of the respective contract period. These premiums are subject to adjustment by CMS and state agencies throughout the terms of the contracts, although such adjustments are typically made at the commencement of each new contract renewal period or each state's fiscal year.  We recognize premium revenue in the period in which we are obligated to provide services to our members. We are generally paid by CMS and state agencies in the month in which we provide services. Any amounts that have been earned and have not been received are recorded in our consolidated balance sheets as premiums receivable. Any amounts received by us in advance of the period of service are recorded as unearned premiums in the consolidated balance sheets and are not recognized as revenue until the respective services have been provided. On a monthly basis, we bill members for any premiums for which they are responsible according to their respective plan. We estimate, on an ongoing basis, the amount of member billings that may not be fully collectible based on historical trends. An allowance is established for the estimated amount that may not be collectible. Historically, the allowance for member premiums receivable has not been significant relative to premium revenue. In addition, we routinely monitor the collectability of specific premiums receivable, including Medicaid receivables for obstetric deliveries and newborns (see "Medicaid" below) and net receivables for member retroactivity as described below, and reflect any required adjustments in current operations.                                          50 --------------------------------------------------------------------------------   We record adjustments to premium revenue based on member retroactivity. These adjustments reflect changes in the number and eligibility status of enrollees subsequent to when revenue was billed. Premium payments are based upon eligibility lists produced by CMS and state agencies. We verify these lists to determine whether we have been paid for the correct premium category and program. From time to time, CMS and state agencies require us to reimburse them for premiums that we received for individuals who were subsequently determined by us, or by CMS or state agencies, to be ineligible for any government-sponsored program or to belong to a plan other than ours. Additionally, the verification of membership may result in additional premiums due to us from CMS and state agencies for individuals who were subsequently determined to belong to our plan for periods in which we received no premium for those members. We estimate the amount of outstanding retroactivity adjustments each period and adjust premium revenue accordingly. As applicable, the estimates of retroactivity adjustments are based on historical trends, premiums billed, the volume of member and contract renewal activity and other information. We continue to work with the Georgia Department of Community Health (the "Georgia DCH") on retroactive premium adjustments related to a reconciliation of duplicate member records dating back to the beginning of the program in 2006. As a result of this activity, we revised our previous estimate for additional premium revenue receivable related to a previous settlement negotiated with the Georgia DCH in 2011. Recently, the settlement was partially disallowed by CMS and we recorded a related reduction of premium revenue of approximately $17.7 million during the three months ended September 30, 2012. The settlement resolved issues with certain premium payments that covered the period from the inception of the program through the settlement, and resulted from a comprehensive review and negotiation involving the three health plans that operate in the program. The amounts receivable or payable identified by us through reconciliation and verification of membership eligibility lists, which relate to current and prior periods, are included in premiums receivable, net and other accrued expenses and liabilities in the accompanying consolidated balance sheets.  

Medicaid

Medicaid was established to provide medical assistance to low-income and disabled persons. It is state operated and implemented, although it is funded and regulated by both state and federal governments. Our Medicaid segment generates revenue primarily from PMPM premiums earned pursuant to our contracts with government agencies in the states in which we operate health plans. Our Medicaid contracts with state agencies are generally multi-year contracts subject to annual renewal provisions. Annual rate changes are recorded when they become effective. In some instances, our fixed base PMPM premiums are subject to risk score adjustments based on the acuity of our membership. Generally, the risk score is determined by the state agency's analysis of encounter submissions of processed claims data to determine the acuity of our membership relative to the entire state's Medicaid membership. In Georgia, Illinois, Kentucky, New York and Ohio, we are eligible to receive supplemental payments for obstetric deliveries and newborns. In Missouri, we earned supplemental payments for obstetric deliveries and newborns through the expiration of our contract on June 30, 2012. Each contract is specific as to how and when these supplemental payments are earned and paid. Upon delivery of a newborn, the state agency is notified according to the contract terms. Revenue is recognized in the period that the delivery occurs and the related services are provided to our member. Additionally, in some states, supplemental payments are received for certain services such as high cost drugs and early childhood prevention screenings.  

Minimum Medical Expense Provisions

  Our Florida Medicaid and Healthy Kids contracts and Illinois Medicaid contract require us to expend a minimum percentage of premiums on eligible medical benefits expense. To the extent that we expend less than the minimum percentage of the premiums on eligible medical benefits expense, we are required to refund all or some portion of the difference between the minimum and our actual allowable medical benefits expense. We estimate the amounts due to the state agencies as a return of premium based on the terms of our contracts with the applicable state agency. Such amounts are included in operations as reductions of premium.  MA  The amount of premiums we receive for each MA member is established by contract, although the rates vary according to a combination of factors, including upper payment limits established by CMS, a member's geographic location, age, gender, medical history or condition, or the services rendered to the member. Changes to monthly premiums are also based upon a member's health status as described under "Risk-Adjusted Premiums" below. MA premiums are due monthly and are recognized as revenue during the period in which we are obligated to provide services to members. Our MA contracts with CMS generally have terms of one year and expire at the end of each calendar year. We also offer coverage of prescription drug benefits under the Medicare Part D program as a component of most of our MA plans. See further discussion of revenue recognition policies specific to Medicare Part D in "PDP" below.                                          51 --------------------------------------------------------------------------------

Risk-Adjusted Premiums

  CMS employs a risk-adjustment model to determine the premium amount it pays for each MA member. This model apportions premiums paid to all plans according to the health status of each beneficiary enrolled. As a result, our CMS PMPM premiums may change materially, either favorably or unfavorably. The CMS risk-adjustment model pays more for MA members with predictably higher costs. Diagnosis data from inpatient and ambulatory treatment settings are used to calculate the risk-adjusted premiums we receive. We collect claims and encounter data for our MA members and submit the necessary diagnosis data to CMS within prescribed deadlines. After reviewing the respective submissions, CMS establishes the premium payments to MA plans generally at the beginning of the plan year, and then adjusts premium levels on two separate occasions on a retroactive basis. The first retroactive adjustment for a given plan year generally occurs during the third quarter of that year. This initial settlement represents the update of risk scores for the current plan year based on the severity of claims incurred in the prior plan year. CMS then issues a final retroactive risk-adjusted premium settlement for that plan year in the following year.  We develop our estimates for MA risk-adjusted premiums utilizing historical experience and predictive models as sufficient member risk score data becomes available over the course of each CMS plan year. Our models are populated with available risk score data on our members. Risk premium adjustments are based on member risk score data from the previous year. Because we are not privy to risk score data for members new to our plans in the current plan year, our models include assumptions regarding these members' risk scores. Estimates of risk-adjusted premiums are periodically updated as additional diagnosis code information is reported to CMS and are adjusted to actual amounts when the ultimate adjustment settlements are either received from CMS or we receive notification from CMS of such settlement amounts. As a result of the variability of factors that determine our estimates for MA risk-adjusted premiums, the actual amount of the CMS retroactive payment could be materially more or less than our estimates. Resulting changes in estimates are reflected in current operations as adjustments to premium revenue and could have a material adverse effect on our results of operations, financial position and cash flows. Historically, we have not experienced significant differences between the amounts that we have recorded and ultimately received.  Additionally, the data provided to CMS to determine members' risk scores is subject to audit by CMS even after the annual settlements occur. An audit may result in the refund of premiums to CMS. While our experience to date has not resulted in a material refund, future refunds could materially reduce premium revenue in the year in which CMS determines a refund is required.  

PDP

  We offer Medicare Part D coverage on a stand-alone basis through our PDPs. PDP premiums received from CMS are also based upon a contract with CMS that has a term of one year and expires at the end of each calendar year. Annually, we provide written bids to CMS for our PDPs, which reflect the estimated costs of providing prescription drug benefits over the plan year. Substantially all of the premium for Medicare Part D coverage is paid by CMS, and the balance is due from enrolled members. Payments received under the Medicare Part D program are described below.  Member Premium-We bill members for monthly premiums for which they are responsible based on the plan year bid submitted to CMS. The member premium, which is fixed for the entire plan year, is recognized over the contract period and reported as premium revenue. We establish an allowance for uncollectible member premiums.  CMS Direct Premium Subsidy-We receive a PMPM premium from CMS based on the plan year bid submitted to CMS. The monthly payment is a risk-adjusted amount per member and is based upon the member's health status as determined by CMS, as more fully described above under "MA - Risk Adjusted Premiums". As we do not have access to diagnosis data with respect to our stand-alone PDP members, we cannot anticipate changes in our members' risk scores. Changes in CMS premiums related to risk-score adjustments for our stand-alone PDP membership are recognized when the amounts become determinable and collectability is reasonably assured, which occurs when we are notified by CMS of such adjustments. Although we have not historically experienced material adjustments, future adjustments could be material to our results of operations, financial position and cash flows.  Low-Income Premium Subsidy-For qualifying low-income subsidy ("LIS") members, CMS pays for some or all of the LIS members' monthly premium. The CMS payment is dependent upon the member's income level as determined by the Social Security Administration.  Low-Income Cost Sharing Subsidy-For qualifying LIS members, CMS reimburses us for all or a portion of deductible, coinsurance and co-payment amounts above the out-of-pocket threshold. Low-income cost sharing subsidies are paid by CMS prospectively as a fixed PMPM amount and are determined based upon the plan year bid submitted to CMS.                                          52

--------------------------------------------------------------------------------   Catastrophic Reinsurance Subsidy-CMS reimburses us for 80% of the drug costs after a member reaches his or her out-of-pocket catastrophic threshold through a catastrophic reinsurance subsidy. Catastrophic reinsurance subsidies are paid by CMS prospectively as a fixed PMPM amount and are determined based upon the plan year bid submitted to CMS.  Coverage Gap Discount Subsidy-We receive monthly prospective payments from CMS for advancing gap coverage discounts at the point of sale. The prospective discount payments are determined based upon the plan year bid submitted by plan sponsors to CMS and current plan enrollment. On a quarterly basis, CMS bills pharmaceutical manufacturers for discounts provided by us and pharmaceutical manufacturers remit payments for invoiced amounts directly to us. Subsequent prospective payments made to us by CMS are then reduced by these discount amounts billed to manufacturers.  After the close of the annual plan year, CMS reconciles our actual experience to prospective payments we received for low income cost sharing, catastrophic reinsurance, and coverage gap discount subsidies and any differences are settled between CMS and our plans. As such, these subsidies represent funding from CMS for which we assume no risk. The receipt of these subsidies and the payments of the actual prescription drug costs related to the low-income cost sharing, catastrophic reinsurance and coverage gap discounts are not recognized as premium revenue or medical benefits expense, but are reported on a net basis as funds receivable/funds held for the benefit of members in the consolidated balance sheets. These receipts and payments are reported as financing activities in our consolidated statements of cash flows. Historically, we have not experienced material adjustments related to the CMS annual reconciliation of prior plan year low-income cost sharing and catastrophic reinsurance subsidies. We do not have a history of adjustments for the coverage gap discount subsidy as the 2011 plan year, which was the year CMS implemented the coverage gap discount subsidy, has not yet been settled by CMS.  CMS Risk Corridor- Premiums received from CMS are subject to risk sharing through the Medicare Part D risk corridor provisions. The CMS risk corridor calculation compares our actual experience to the target amount of prescription drug costs, limited to costs under the standard coverage as defined by CMS, less rebates included in our submitted plan year bid. Variances of more than 5% above the target amount result in additional payments by CMS to us. Variances of more than 5% below the target amount require us to refund amounts to CMS. We estimate the risk corridor receivable or payable throughout the year as if the annual contract were to terminate at the end of the reporting period and reflect any adjustments to premium in current operations. This estimate provides no consideration of future pharmacy claims experience, but does require us to consider factors that may not be certain, including membership, risk scores, prescription drug events, and rebates. Approximately nine months after the close of the annual plan year, CMS reconciles actual experience to the target amount and any differences are settled between CMS and our plans. Historically, we have not experienced material adjustments related to the CMS settlement of prior years' risk corridor estimates.  

Medical Benefits Expense and Medical Benefits Payable

  The cost of medical benefits is recognized in the period in which services are provided and includes an estimate of the cost of incurred but not reported ("IBNR") medical benefits. Medical benefits payable represents amounts for claims fully adjudicated but not yet paid and estimates for IBNR, and includes direct medical expenses and medically-related administrative costs. Direct medical expenses include amounts paid or payable to hospitals, physicians and providers of ancillary services, such as laboratories and pharmacies. Recorded direct medical expenses are reduced by the amount of pharmacy rebates earned, which are estimated based on historical utilization of specific pharmaceuticals, current utilization and contract terms. Pharmacy rebates earned but not yet received from pharmaceutical manufacturers are included in pharmacy rebates receivable in the accompanying consolidated balance sheets. Direct medical expenses may also include reserves for estimated referral claims related to health care providers under contract with us who are financially troubled or insolvent and who may not be able to honor their obligations for the costs of medical services provided by other providers. In these instances, we may be required to honor these obligations for legal or business reasons. Based on our current assessment of providers under contract with us, such losses have not been and are not expected to be significant. Also, included in direct medical expense are estimates for provider settlements due to clarification of contract terms, out-of-network reimbursement, claims payment differences and amounts due to contracted providers under risk-sharing arrangements. Medically-related administrative costs such as preventive health and wellness, care management, case and disease management, and other quality improvement costs are included in medical benefits expense. Other medically-related administrative costs such as utilization review services, network and provider credentialing and claims handling costs,are recorded in selling, general, and administrative expenses.                                          53 --------------------------------------------------------------------------------   Medical benefits payable is the most significant estimate included in the consolidated financial statements. We use a consistent methodology to record management's best estimate of medical benefits payable based on the experience and information available to us at the time. This estimate is determined utilizing standard actuarial methodologies based upon historical experience and key assumptions consisting of trend factors and completion factors using an assumption of moderately adverse conditions, which vary by business segment. These standard actuarial methodologies include using, among other factors, contractual requirements, historic utilization trends, the interval between the date services are rendered and the date claims are paid, denied claims activity, disputed claims activity, benefits changes, expected health care cost inflation, seasonality patterns, maturity of lines of business and changes in membership.  The factors and assumptions described above that are used to develop our estimate of medical benefits expense and medical benefits payable inherently are subject to greater variability when there is more limited experience or information available to us. The ultimate claims payment amounts, patterns and trends for new products and geographic areas cannot be precisely predicted at their onset, since we, the providers and the members do not have experience in these products or geographic areas. Standard accepted actuarial methodologies, discussed above, would allow for this inherent variability. This can result in larger differences between the originally estimated medical benefits payable and the actual claims amounts paid. Conversely, during periods where our products and geographies are more stable and mature, we have more reliable claims payment patterns and trend experience. With more reliable data, we should be able to more closely estimate the ultimate claims payment amounts; therefore, we may experience smaller differences between our original estimate of medical benefits payable and the actual claim amounts paid.  In developing our estimates, we apply different estimation methods depending on the month for which incurred claims are being estimated. For the more recent months, which constitute the majority of the amount of the medical benefits payable, we estimate claims incurred by applying observed trend factors to the fixed fee PMPM costs for prior months, which costs have been estimated using completion factors, in order to estimate the PMPM costs for the most recent months. We validate our estimates of the most recent PMPM costs by comparing the most recent months' utilization levels to the utilization levels in prior months and actuarial techniques that incorporate a historical analysis of claim payments, including trends in cost of care provided and timeliness of submission and processing of claims.  Many aspects of the managed care business are not predictable. These aspects include the incidences of illness or disease (such as congestive heart failure cases, cases of upper respiratory illness, the length and severity of the flu season, diabetes cases, the number of full-term versus premature births and the number of neonatal intensive care babies). Therefore, we must continually monitor our historical experience in determining our trend assumptions to reflect the ever-changing mix, needs and size of our membership. Among the factors considered by management are changes in the level of benefits provided to members, seasonal variations in utilization, identified industry trends and changes in provider reimbursement arrangements, including changes in the percentage of reimbursements made on a capitation as opposed to a fee-for-service basis. These considerations are reflected in the trends in our medical benefits expense. Other external factors such as government-mandated benefits or other regulatory changes, catastrophes and epidemics may impact medical cost trends. Other internal factors such as system conversions and claims processing interruptions may impact our ability to accurately predict estimates of historical completion factors or medical cost trends. Medical cost trends potentially are more volatile than other segments of the economy. Management uses considerable judgment in determining medical benefits expense trends and other actuarial model inputs. We believe that the amount of medical benefits payable as of September 30, 2012 is adequate to cover our ultimate liability for unpaid claims as of that date; however, actual payments may differ from established estimates. If the completion factors we used in estimating our IBNR for the nine months ended September 30, 2012 were decreased by 1%, our net income would decrease by approximately $52.7 million. If the completion factors were increased by 1%, our net income would increase by approximately $56.6 million.  Changes in medical benefits payable estimates are primarily the result of obtaining more complete claims information and medical expense trend data over time. Volatility in members' needs for medical services, provider claims submissions and our payment processes result in identifiable patterns emerging several months after the causes of deviations from assumed trends occur. Since our estimates are based upon PMPM claims experience, changes cannot typically be explained by any single factor, but are the result of a number of interrelated variables, all of which influence the resulting medical cost trend. Differences between actual experience and estimates used to establish the liability, which we refer to as prior period developments, are recorded in the period when such differences become known and have the effect of increasing or decreasing the reported medical benefits expense in such periods.                                          54 --------------------------------------------------------------------------------   After determining an estimate of the base reserve, actuarial standards of practice require that a margin for uncertainty be considered in determining the estimate for unpaid claim liabilities. If such a margin is included, the claim liabilities should be adequate under moderately adverse conditions. Therefore, we make an additional estimate in the process of establishing the IBNR, which also uses standard actuarial techniques, to account for moderately adverse conditions that may cause actual claims to be higher than estimated compared to the base reserve. We refer to this additional liability as the provision for moderately adverse conditions. The provision for moderately adverse conditions is a component of our overall determination of the adequacy of our IBNR reserve and is intended to capture the potential adverse development from factors such as our entry into new geographical markets, our provision of services to new populations such as the aged, blind and disabled, the variations in utilization of benefits and increasing medical cost, changes in provider reimbursement arrangements, variations in claims processing speed and patterns, claims payment, the severity of claims, and outbreaks of disease such as the flu. Because of the complexity of our business, the number of states in which we operate, and the need to account for different health care benefit packages among those states, we make an overall assessment of IBNR after considering the base actuarial model reserves and the provision for moderately adverse conditions. We consistently apply our IBNR estimation methodology from period to period. We review our overall estimates of IBNR on a monthly basis. As additional information becomes known to us, we adjust our assumptions accordingly to change our estimate of IBNR. Therefore, if moderately adverse conditions do not occur, evidenced by more complete claims information in the following period, then our prior period estimates will be revised downward, resulting in favorable development. However, when a portion of the development related to the prior year incurred claims is offset by an increase determined to address moderately adverse conditions for the current year incurred claims, we do not consider that development amount as having any impact on net income during the period. If moderately adverse conditions occur and are more than we estimated, then our prior period estimates will be revised upward, resulting in unfavorable development, which would decrease current period net income.  For the three months ended September 30, 2012, medical benefits expense was impacted by approximately $15.4 million of net unfavorable development related to prior periods, which includes $23.3 million of unfavorable development related to the first half of 2012, that was partially offset by approximately $7.9 million of favorable development related to prior fiscal years. For the nine months ended September 30, 2012, medical benefits expense was impacted by approximately $79.7 million of net favorable development related to prior years. For the three and nine months ended September 30, 2011, medical benefits expense was impacted by approximately $36.7 million and $154.8 million, respectively, of net favorable development related to prior periods. The unfavorable development recognized in the three months ended September 30, 2012 relating to earlier periods in 2012 was primarily due to higher than expected medical services in our Medicaid segment, particularly in Kentucky, that were not discernible until the impact became clearer over time as claim payments were processed. The net favorable prior year development recognized in 2012 was due mainly to lower than projected utilization in all of our segments. The net favorable prior year and prior period development in 2011 was attributable to the medical cost trend emerging favorably, mostly in our Medicaid segment and to a lesser extent in our MA segment, primarily due to lower than projected utilization.   

Goodwill and Intangible Assets

  We review goodwill and intangible assets for impairment at least annually, or more frequently if events or changes in our business climate occur that may potentially affect the estimated useful life or the recoverability of the remaining balance of goodwill or intangible assets. Events or changes in circumstances would include significant changes in membership, state funding, federal and state government contracts and provider networks. Goodwill is evaluated for impairment by first performing a qualitative assessment to determine whether a quantitative assessment is necessary. If, based on the qualitative assessment, we determine the fair value of the reporting unit is more likely than not less than the carrying value, we perform a two-step quantitative goodwill impairment test. The first step is to determine the fair value of the reporting unit using both the income and market approach. In doing so, we must make assumptions and estimates, such as projected revenues and the discount factor, in estimating fair values. While we believe these assumptions and estimates are appropriate, other assumptions and estimates could be applied and may produce significantly different results. If the fair value of the reporting unit is less than its carrying value, we measure and record the amount of the goodwill impairment, if any, by comparing the implied fair value of the reporting unit's goodwill with the carrying value. We select the second quarter of each year for our annual goodwill impairment test, which generally coincides with the finalization of federal and state contract negotiations and our initial budgeting process, with the test completed during the third quarter of that year. Based on the results of the qualitative assessments performed as of our most recent testing date in 2012, and our review at September 30, 2012, we determined that the fair value of our Medicaid reporting unit is more likely than not greater than the carrying value as of September 30, 2012. Our review included consideration of the termination of our Missouri and Ohio Medicaid contracts as discussed in Part I - Item 1 - Note 1 - "Organization, Basis of Presentation and Significant Accounting Policies."                                          55 --------------------------------------------------------------------------------

Commitments and Contingencies

  Based on the nature of our business, we are subject to regulatory reviews or other investigations by various state insurance and health care regulatory authorities and other state and federal regulatory authorities. These authorities regularly scrutinize the business practices of health insurance and benefits companies and their reviews focus on numerous facets of our business, including claims payment practices, provider contracting, competitive practices, commission payments, privacy issues and utilization management practices, among others. Some of these reviews have historically resulted in fines imposed on us and some have required changes to our business practices. We continue to be subject to such reviews, which may result in additional fines and/or sanctions being imposed or additional changes in our business practices.  We are also involved in other legal actions in the normal course of our business, including without limitation, wage and hour disputes, tax disputes, vendor disputes and provider disputes regarding payment of claims. Some of these actions seek monetary damages, including claims for liquidated or punitive damages, which are not covered by insurance. We accrue losses for such contingencies to the extent that we believe it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. It is possible the actual outcomes of legal actions may differ materially from our current estimates and may materially impact our results of operations, financial condition and cash flows. 

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