Humana Inc: Form 10-Q for the period ended Sep 30, 2014

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The condensed consolidated financial statements of Humana Inc. in this document present the Company’s financial position, results of operations and cash flows, and should be read in conjunction with the following discussion and analysis. References to “we,” “us,” “our,” “Company,” and “Humana” mean Humana Inc. and its subsidiaries. This discussion includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. When used in filings with the SEC, in our press releases, investor presentations, and in oral statements made by or with the approval of one of our executive officers, the words or phrases like “believes,” “expects,” “anticipates,” “intends,” “likely will result,” “estimates,” “projects” or variations of such words and similar expressions are intended to identify such forward–looking statements. These forward–looking statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions, including, among other things, information set forth in Item 1A. – Risk Factors in our 2013 Form 10-K, as modified by any changes to those risk factors included in this document and in other reports we filed subsequent to February 19, 2014, in each case incorporated by reference herein. In making these statements, we are not undertaking to address or update such forward-looking statements in future filings or communications regarding our business or results. In light of these risks, uncertainties and assumptions, the forward–looking events discussed in this document might not occur. There may also be other risks that we are unable to predict at this time. Any of these risks and uncertainties may cause actual results to differ materially from the results discussed in the forward–looking statements.

Executive Overview

General

Humana Inc., headquartered in Louisville, Ky., is a leading health and well-being company focused on making it easy for people to achieve their best health with clinical excellence through coordinated care. The company’s strategy integrates care delivery, the member experience, and clinical and consumer insights to encourage engagement, behavior change, proactive clinical outreach and wellness for the millions of people we serve across the country.

Our industry relies on two key statistics to measure performance. The benefit ratio, which is computed by taking total benefits expense as a percentage of premiums revenue, represents a statistic used to measure underwriting profitability. The operating cost ratio, which is computed by taking total operating costs as a percentage of total revenue less investment income, represents a statistic used to measure administrative spending efficiency.

Business Segments

On January 1, 2014, we reclassified certain of our businesses from our Healthcare Services segment to our Employer Group segment to correspond with internal management reporting changes. Our reportable segments remain the same and prior period segment financial information has been recast to conform to the 2014 presentation.

We manage our business with three reportable segments: Retail, Employer Group, and Healthcare Services. In addition, the Other Businesses category includes businesses that are not individually reportable because they do not meet the quantitative thresholds required by generally accepted accounting principles. These segments are based on a combination of the type of health plan customer and adjacent businesses centered on well-being solutions for our health plans and other customers, as described below. These segment groupings are consistent with information used by our Chief Executive Officer to assess performance and allocate resources.

The Retail segment consists of Medicare and commercial fully-insured medical and specialty health insurance benefits, including dental, vision, and other supplemental health and financial protection products, marketed directly to individuals, and includes our contract with CMS to administer the Limited Income Newly Eligible Transition, or LI-NET, prescription drug plan program and contracts with various states to provide Medicaid, dual eligible, and Long-Term Support Services benefits, collectively our state-based contracts. The Employer Group segment consists of Medicare and commercial fully-insured medical and specialty health insurance benefits, including dental, vision, and voluntary benefit products, as well as administrative services only, or ASO, products and our health and wellness products primarily marketed to employer groups. The Healthcare Services segment includes services offered to our health plan members as well as to third parties including pharmacy, provider services, home based services, integrated behavioral health services and predictive modeling and informatics services. The Other Businesses category consists of our military services, primarily our TRICARE South Region contract, closed-block of long-term care insurance policies, and our Puerto Rico Medicaid contracts under which coverage was terminated effective September 30, 2013.

The results of each segment are measured by income before income taxes. Transactions between reportable segments primarily consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, and behavioral health services, to our Retail and Employer Group customers. Intersegment sales and expenses are recorded at fair value and eliminated in consolidation. Members served by our segments often use the same provider networks, enabling us in some instances to obtain more favorable contract terms with providers. Our segments also share indirect costs and assets. As a result, the profitability of each segment is interdependent. We allocate most operating expenses to our segments. Assets and certain corporate income and expenses are not allocated to the segments, including the portion of investment income not supporting segment operations, interest expense on corporate debt, and certain other corporate expenses. These items are managed at a corporate level. These corporate amounts are reported separately from our reportable segments and are included with intersegment eliminations.

Seasonality

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

Our Employer Group segment also experiences seasonality in the benefit ratio pattern. However, the effect is opposite of Medicare stand-alone PDP in the Retail segment, with the Employer Group’s benefit ratio increasing as fully-insured members progress through their annual deductible and maximum out-of-pocket expenses. Similarly, certain of our fully-insured individual commercial medical products in our Retail segment experience seasonality in the benefit ratio akin to the Employer Group segment; however, we expect our new plans compliant with the Health Care Reform Law to experience less seasonality than our historical individual commercial medical products.

In addition, the Retail segment also experiences seasonality in the operating cost ratio as a result of costs incurred in the second half of the year associated with the Medicare and individual health care exchange marketing seasons.

2014 Highlights

Consolidated

• Our 2014 results reflect the continued implementation of our strategy to offer our members affordable health care combined with a positive consumer experience in growing markets. At the core of this strategy is our integrated care delivery model, which unites quality care, high member engagement, and sophisticated data analytics. Our approach to primary, physician-directed care for our members aims to provide quality care that is consistent, integrated, cost-effective, and member-focused, provided by both employed physicians and physicians with network contract arrangements. The model is designed to improve health outcomes and affordability for individuals and for the health system as a whole, while offering our members a simple, seamless healthcare experience. We believe this strategy is positioning us for long-term growth in both membership and earnings. At September 30, 2014, approximately 689,900 members, or 28.5%, of our individual Medicare Advantage membership were in risk arrangements under our integrated care delivery model, as compared to 561,500 members, or 27.1%, at December 31, 2013 and 550,600 members, or 26.9%, at September 30, 2013.
• Our results for the three and nine months ended September 30, 2014 as compared to the three and nine months ended September 30, 2013, were impacted by investments in health care exchanges and state-based contracts

as well as higher specialty prescription drug costs associated with a new treatment for Hepatitis C, partially offset by membership growth in our Medicare Advantage, Medicare stand-alone PDP, and individual commercial medical offerings as well as improved utilization from increased membership in our clinical programs.

• Year-over-year comparisons of the operating cost ratio are impacted by fees mandated by the Health Care Reform Law beginning in 2014, including the non-deductible health insurance industry fee. Likewise, year-over-year comparisons of the benefit ratio reflect the inclusion of these mandated fees in the pricing of our products for 2014.
• Year-over-year comparisons of diluted earnings per common share are favorably impacted by a lower number of shares used to compute diluted earnings per common share reflecting the impact of share repurchases.
• Our operating cash flow was $1.4 billion for the nine months ended September 30, 2014 compared to operating cash flow of $1.7 billion for the nine months ended September 30, 2013. Our operating cash flows for the nine months ended September 30, 2014 reflect the payment of the non-deductible health insurance industry fee, lower net income, enrollment activity, and the timing of working capital items including the timing of receipts and payments under certain provisions of the Health Care Reform Law that became effective in 2014. For 2014, the effect of the commercial risk adjustment, risk corridor, and reinsurance provisions of the Health Care Reform Law are impacting the timing of our operating cash flows, as we build a receivable in 2014 that will be collected in 2015. For the full year 2014, we expect our operating cash flows to decline from 2013.
• Our 2014 financing cash flows have been negatively impacted by the timing of payments to and receipts from CMS associated with Medicare Part D reinsurance subsidies for which we do not assume risk. Claims payments were higher than receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk by $761 million during the 2014 period and $191 million during the 2013 period. We are experiencing higher specialty prescription drug costs associated with a new treatment for Hepatitis C than were contemplated in our bids which is resulting in higher reinsurance subsidy receivable balances in 2014 that will be settled in 2015 under the terms of our contracts with CMS.
• In September 2014, we paid the federal government $562 million for the annual health insurance industry fee. This fee is not deductible for tax purposes, which has significantly increased our effective income tax rate in 2014. The health insurance industry fee is further described below under the section titled “Health Care Reform.”
• In September 2014, we issued $400 million of 2.625% senior notes due October 1, 2019, $600 million of 3.85% senior notes due October 1, 2024 and $750 million of 4.95% senior notes due October 1, 2044. Our net proceeds, reduced for the underwriters' discount and commission and offering expenses, were $1.73 billion. We used a portion of the net proceeds to redeem the 6.45% senior unsecured notes as discussed below, and intend to use some or all of the remaining net proceeds to repurchase shares of our common stock and for general corporate purposes.
• In October 2014, we redeemed the $500 million 6.45% senior unsecured notes due June 1, 2016, at 100% of the principal amount plus applicable premium for early redemption and accrued and unpaid interest to the redemption date, for cash totaling approximately $560 million. We recognized a loss on extinguishment of debt of approximately $37 million, or $0.15 per diluted common share, in October 2014 for the redemption of these notes.
• During the nine months ended September 30, 2014, we repurchased 1.87 million shares in open market transactions for $230 million and paid dividends to stockholders of $129 million.
• In September 2014, the Board of Directors replaced a previous share repurchase authorization of up to $1 billion (of which $816 million remained unused) with a new authorization for repurchases of up to $2 billion of our common shares exclusive of shares repurchased in connection with employee stock plans, expiring on December 31, 2016. We intend to repurchase $1 billion of shares (of the $2 billion authorized in September

2014) no later than June 30, 2015. During the period commencing on October 1, 2014 and ending on November 6, 2014, we repurchased 0.77 million shares in open market transactions for $100 million at an average price of $130.50 under the current authorization. As of November 7, 2014, the remaining authorized amount under the new authorization totaled $1.87 billion.

• On November 7, 2014, we announced that we intend to enter into an agreement with a third party financial institution to effect a $500 million accelerated stock repurchase program. We will repurchase shares through the program as part of the $2 billion authorized in September 2014. The actual number of shares repurchased under the agreement will be determined based on a volume-weighted average price of our common stock during the purchase period.

Retail

• On April 7, 2014, CMS announced final 2015 Medicare benchmark payment rates and related technical factors impacting the bid benchmark premiums, which we refer to as the Final Rate Notice. We believe the Final Rate Notice together with the impact of payment cuts associated with the Health Care Reform Law, quality bonuses, sunset of the Star quality CMS demonstration in 2015, risk coding modifications, the impact of the health insurance industry fee, and other funding formula changes, indicate 2015 Medicare Advantage funding cuts of approximately 2%. While we believe our senior members’ benefits may be adversely impacted, we believe we can effectively design Medicare Advantage products based upon these levels of rate reduction while continuing to remain competitive compared to both the combination of original Medicare with a supplement policy as well as Medicare Advantage products offered by our competitors. Failure to execute these strategies may result in a material adverse effect on our results of operations, financial position, and cash flows.
• Automatic across-the-board budget cuts under the Budget Control Act of 2011 and the American Taxpayer Relief Act of 2012, known as “sequestration,” commenced in March 2013, including a 2% reduction in Medicare Advantage and Medicare Part D payments beginning April 1, 2013. While we believe we can reduce Medicare Advantage payments to providers under our network provider contracts in connection with sequestration, a number of hospitals and other providers have asserted that we are not entitled to do so, which have led, and may lead, to arbitration demands or other litigation regarding these matters.
• For the nine months ended September 30, 2014, our Retail segment pretax income declined by $193 million, or 17.5%, primarily driven by the same factors impacting our consolidated results as described above.
• Individual Medicare Advantage membership of 2,417,900 at September 30, 2014 increased 349,200, or 16.9%, from 2,068,700 at December 31, 2013 and increased 373,500 members, or 18.3%, from 2,044,400 at September 30, 2013 reflecting net membership additions, particularly for our Health Maintenance Organization, or HMO, offerings for the 2014 plan year as well as dual eligible members from state-based contracts in Virginia and Illinois.
• Medicare stand-alone PDP membership of 3,936,400 at September 30, 2014 increased 664,700 members, or 20.3%, from 3,271,700 at December 31, 2013 and increased 681,300 members, or 20.9%, from 3,255,100 at September 30, 2013 reflecting net membership additions, primarily for our Humana-Walmart plan offering for the 2014 plan year.
• Our state-based Medicaid membership as of September 30, 2014 increased 201,200 members compared to September 30, 2013, primarily due to the addition of members under our Florida Medicaid and Florida Long-Term Support Services contracts.
• Individual commercial medical membership of 1,215,000 at September 30, 2014 increased 614,900 members, or 102.5%, from 600,100 at December 31, 2013 and increased 629,700 members, or 107.6%, from 585,300 at September 30, 2013 primarily reflecting new sales, both on-exchange and off-exchange, of plans compliant with the Health Care Reform Law. At September 30, 2014, individual commercial medical membership in plans compliant with the Health Care Reform Law, both on-exchange and off-exchange, was 727,800 members. In addition, federal and state regulatory changes in December 2013 allowed certain individuals to remain in

their existing underwritten health plans that are not compliant with the Health Care Reform Law, which has led to much higher than previously expected retention of our existing underwritten health plans. We believe that this is occurring at other health insurance issuers as well and will result in an overall deterioration of the risk pool in plans compliant with the Health Care Reform Law, as more previously underwritten members remain with their current health plans rather than enter the exchanges. However, we expect that the commercial risk adjustment, risk corridor, and reinsurance provisions of the Health Care Reform Law will mitigate this deterioration to some extent.

Employer Group Segment

• For the nine months ended September 30, 2014, our Employer Group segment pretax income decreased $94 million, or 22.3%, primarily due to a higher benefit ratio year-over-year as a result of higher utilization, mainly due to higher specialty prescription drug costs associated with a new treatment for Hepatitis C, as well as the continuing impact of transitional policy changes. The Employer Group segment benefit ratio increased 220 basis points to 86.5% for the three months ended September 30, 2014 and increased 80 basis points to 82.9% for the nine months ended September 30, 2014.
• Fully-insured group Medicare Advantage membership of 484,900 at September 30, 2014 increased 55,800 members, or 13.0%, from 429,100 at December 31, 2013 and increased 59,500 members, or 14.0%, from 425,400 at September 30, 2013 primarily due to the January 2014 addition of a new large group account.
• Membership in HumanaVitality®, our wellness and loyalty rewards program, rose 35.6% to 3,838,800 at September 30, 2014 from 2,831,000 at December 31, 2013 and rose 39.4% from 2,753,900 at September 30, 2013 primarily due to the addition of group Medicare members as well as individual Medicare Advantage and fully-insured individual commercial medical membership growth.

Healthcare Services Segment

• As discussed in the detailed Healthcare Services segment results of operations discussion that follows, our Healthcare Services segment pretax income increased $53 million, or 35.6%, and $202 million, or 51.7%, for the three and nine months ended September 30, 2014, respectively, as compared to the three and nine months ended September 30, 2013. These increases primarily were due to an operating cost ratio that remained unchanged year-over-year for the three months ended September 30, 2014 and declined for the nine months ended September 30, 2014 on a revenue base that reflects growth from our pharmacy solutions and home based services businesses as they serve our growing Medicare membership.
• Programs to enhance the quality of care for members are key elements of our integrated care delivery model. We have accelerated our process for identifying and reaching out to members in need of clinical intervention. At September 30, 2014, we had approximately 379,900 members with complex chronic conditions in the Humana Chronic Care Program, a 35.6% increase compared with approximately 280,200 members at December 31, 2013, and an increase of 53.2% compared with approximately 248,000 members at September 30, 2013. These increases reflect enhanced predictive modeling capabilities and focus on proactive clinical outreach and member engagement, particularly for our Medicare Advantage membership. We believe these initiatives lead to better health outcomes for our members and lower health care costs.

Other Businesses

• Year-over-year comparisons within Other Businesses are impacted by the loss of our Medicaid contracts in Puerto Rico effective September 30, 2013 and a reduction in benefits expense for the nine months ended September 30, 2013 related to a favorable settlement of contract claims with the United States Department of Defense, or DoD, associated with previously disclosed litigation.

Health Care Reform

The Health Care Reform Law enacted significant reforms to various aspects of the U.S. health insurance industry. While regulations and interpretive guidance on many provisions of the Health Care Reform Law have been issued to date by the Department of Health and Human Services, or HHS, the Department of Labor, the Treasury Department, and the National Association of Insurance Commissioners, or NAIC, there are certain provisions of the law that will require additional guidance and clarification in the form of regulations and interpretations in order to fully understand the impact of the law on our overall business.

Implementation dates of the Health Care Reform Law began in September 2010 and will continue through 2018, and many aspects of the Health Care Reform Law are already effective and have been implemented by us. Certain significant provisions of the Health Care Reform Law include, among others, mandated coverage requirements, mandated benefits and guarantee issuance associated with commercial medical insurance, rebates to policyholders based on minimum benefit ratios, adjustments to Medicare Advantage premiums, the establishment of federally-facilitated or state-based exchanges coupled with programs designed to spread risk among insurers, an annual insurance industry premium-based assessment, and a three-year commercial reinsurance fee. The following outlines certain provisions of the Health Care Reform Law:

• Currently Effective with Phased-In Implementation: In 2012, additional cuts to Medicare Advantage plan payment benchmarks began to take effect (with plan payment benchmarks ultimately ranging from 95% in high-cost areas to 115% in low-cost areas of Medicare fee-for-service rates), with changes being phased-in over two to six years, depending on the level of payment reduction in a county. In addition, since 2011 the gap in coverage for Medicare Part D prescription drug coverage has been incrementally closing.

Certain provisions in the Health Care Reform Law tie Medicare Advantage premiums to the achievement of certain quality performance measures (Star Ratings). Beginning in 2012, Medicare Advantage plans with an overall Star Rating of three or more stars (out of five) were eligible for a quality bonus in their basic premium rates. By law, quality bonuses were limited to the few plans that achieved four or more stars as an overall rating, but CMS, through its demonstration authority, expanded the quality bonus to three Star plans for a three-year period through 2014. Beginning in 2015, quality bonus amounts will be determined by the provisions in the Health Care Reform Law. In part, this means that plans must have a Star Rating of four or higher to qualify for bonus money. Star Ratings issued by CMS in October 2014 indicated that plans covering 92% of our Medicare Advantage membership for the 2015 plan year achieved a Star Rating of 4.0 or higher. Beginning in 2015, plans must have a Star Rating of four or higher to qualify for quality bonuses in the basic premium rates. We have 23 Medicare Advantage plans that achieved a rating of four or more stars, an increase from 18 the previous year. We are offering one Medicare Advantage plan that achieved a 5.0 Star Rating, our CarePlus Health Plans, Inc. HMO plan in Florida, as well as five Medicare Advantage plans that achieved a 4.5 Star Rating. Plans that earn an overall Star Rating of five become eligible to enroll members year round. Notwithstanding successful historical efforts to improve our Star Ratings and other quality measures, there can be no assurances that we will be successful in maintaining or improving our Star Ratings in future years. Additionally, as a result of the expiration of a CMS quality bonus demonstration, for plans that maintain a four Star or higher rating in 2015, other provisions of the Health Care Reform Law may, in certain areas of the country, reduce the amount of the quality bonus that is added to the basic premium rate. Accordingly, our plans may not be eligible for full level quality bonuses, which, in isolation, could adversely affect the benefits such plans can offer, reduce membership, and/or reduce profit margins.

In addition, on March 31, 2014, with certain exceptions, we completed the initial open enrollment period for plans offered through federally-facilitated, federal-state partnerships or state-based exchanges for individuals in certain metropolitan areas in the 14 states where we have public exchange offerings.

• Newly Effective in 2014: Beginning in 2014, the Health Care Reform Law requires: all individual and group health plans to guarantee issuance and renew coverage without pre-existing condition exclusions or health-status rating adjustments; the elimination of annual limits on coverage on certain benefits; the establishment of federally-facilitated, federal-state partnerships or state-based exchanges for individuals and small employers (with up to 100 employees) coupled with programs designed to spread risk among insurers; the introduction

of plan designs based on set actuarial values; the establishment of a minimum benefit ratio of 85% for Medicare Advantage plans; and insurance industry assessments, including an annual health insurance industry fee and a three-year $25 billion industry wide commercial reinsurance fee. The annual health insurance industry fee levied on the insurance industry is $8 billion in 2014 with increasing annual amounts thereafter, growing to $14 billion by 2017, and is not deductible for income tax purposes, which will significantly increase our effective income tax rate in 2014 to approximately 46% to 47%. In addition, statutory accounting for the health insurance industry fee requires us to restrict surplus in the year preceding payment of the health insurance industry fee beginning in 2014. Accordingly, in addition to recording the full-year 2014 assessment in the first quarter of 2014, we are required to restrict surplus for the 2015 assessment ratably in 2014. In 2014, we paid the federal government $562 million for the annual health insurance industry fee. In 2015, the health insurance industry fee increases by 41% for the industry taken as a whole. Accordingly, absent changes in market share, we would expect a 41% increase in our fee in 2015.

The Health Care Reform Law also specifies benefit design guidelines, limits rating and pricing practices, encourages additional competition from the establishment of two multi-state plans (one not-for-profit; one for-profit) administered through the Office of Personnel Management, and expands eligibility for Medicaid programs. In addition, the Health Care Reform Law has increased and will continue to increase federal oversight of health plan premium rates and could adversely affect our ability to appropriately adjust health plan premiums on a timely basis. Financing for these reforms comes, in part, from material additional fees and taxes on us (as discussed above) and other health plans and individuals beginning in 2014, as well as reductions in certain levels of payments to us and other health plans under Medicare as described in this report.

As discussed above, implementing regulations and related interpretive guidance continue to be issued on certain provisions of the Health Care Reform Law. Given the breadth of possible changes and the uncertainties of interpretation, implementation, and timing of these changes, the Health Care Reform Law has and will change the way we do business, impacting our pricing, benefit design, product mix, geographic mix, and distribution channels. The response of other companies to the Health Care Reform Law and adjustments to their and our offerings could cause meaningful disruption in local health care markets. It is reasonably possible that the Health Care Reform Law and related regulations, as well as future legislative changes, including legislative restrictions on our ability to manage our provider network or otherwise operate our business, or regulatory restrictions on profitability, including by comparison of our Medicare Advantage profitability to our non-Medicare Advantage business profitability and a requirement that they remain within certain ranges of each other, in the aggregate may have a material adverse effect on our results of operations (including restricting revenue, enrollment and premium growth in certain products and market segments, restricting our ability to expand into new markets, increasing our medical and operating costs, further lowering our Medicare payment rates and increasing our expenses associated with the non-deductible health insurance industry fee and other assessments); our financial position (including our ability to maintain the value of our goodwill); and our cash flows (including the receipt of amounts due under the commercial risk adjustment, risk corridor, and reinsurance provisions of the Health Care Reform Law in 2015 related to claims paid in 2014, which payments may be subject to the requisite appropriation of funds by Congress). If we are unable to adjust our business model to address the non-deductible health insurance industry fee and other assessments, including the three-year commercial reinsurance fee, such as through the reduction of our operating costs or adjustments to premium pricing or benefit design, there can be no assurance that the non-deductible health insurance industry fee and other assessments would not have a material adverse effect on our results of operations, financial position, and cash flows.

We intend for the discussion of our financial condition and results of operations that follows to assist in the understanding of our financial statements and related changes in certain key items in those financial statements from year to year, including the primary factors that accounted for those changes. Transactions between reportable segments primarily consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, and behavioral health services, to our Retail and Employer Group customers and are described in Note 13 to the condensed consolidated financial statements.

Comparison of Results of Operations for 2014 and 2013

The following discussion primarily deals with our results of operations for the three months ended September 30, 2014, or the 2014 quarter, the three months ended September 30, 2013, or the 2013 quarter, the nine months ended September 30, 2014, or the 2014 period, and the nine months ended September 30, 2013, or the 2013 period.

Consolidated

(dollars in millions, except per common share results)

(a) Represents total benefits expense as a percentage of premiums revenue.

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

(dollars in millions, except per common share results)

(a) Represents total benefits expense as a percentage of premiums revenue.

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

Summary

Net income was $290 million, or $1.85 per diluted common share, in the 2014 quarter compared to $368 million, or $2.31 per diluted common share, in the 2013 quarter. Net income was $1.0 billion, or $6.39 per diluted common share, in the 2014 period compared to $1.3 billion, or $7.90 per diluted common share, in the 2013 period. These decreases were primarily due to investments in health care exchanges and state-based contracts as well as higher specialty prescription drug costs associated with a new treatment for Hepatitis C. These items were partially offset by membership growth in our Medicare Advantage, Medicare stand-alone PDP, and individual commercial medical offerings as well as improved utilization from increased membership in our clinical programs. Year-over-year comparisons were also negatively impacted by sequestration which became effective April 1, 2013. In addition, our diluted earnings per common share for the 2013 period included the benefit of a reduction in benefits expense related to a favorable settlement of contract claims with the DoD. Year-over-year comparisons of diluted earnings per common share are also favorably impacted by a lower number of shares used to compute diluted earnings per common share in the 2014 quarter and period reflecting the impact of share repurchases.

Premiums

Consolidated premiums increased $1.9 billion, or 19.7%, from the 2013 quarter to $11.6 billion for the 2014 quarter and increased $5.0 billion, or 17.1%, from the 2013 period to $34.3 billion for the 2014 period. These increases are primarily due to increases in both Retail and Employer Group segment premiums mainly driven by higher average individual and group Medicare Advantage membership as well as higher individual commercial medical membership. In addition, year-over-year comparisons to the 2013 period were negatively impacted by sequestration which became effective April 1, 2013. Premiums revenue for our Other Businesses declined primarily due to the loss of our Puerto Rico Medicaid contracts effective September 30, 2013. Average membership is calculated by summing the ending membership for each month in a period and dividing the result by the number of months in a period. Premiums revenue reflects changes in membership and average per member premiums. Items impacting average per member premiums include changes in premium rates as well as changes in the geographic mix of membership, the mix of product offerings, and the mix of benefit plans selected by our membership.

Services revenue

Consolidated services revenue increased $8 million, or 1.5%, from the 2013 quarter to $536 million for the 2014 quarter and increased $39 million, or 2.5%, from the 2013 period to $1.6 billion for the 2014 period. These increases are primarily due to an increase in services revenue in our Retail segment due to the acquisition of American Eldercare in September 2013.

Investment income

Investment income totaled $95 million for the 2014 quarter compared to $93 million for the 2013 quarter as higher average invested balances were partially offset by lower interest rates. Investment income was $278 million for both the 2014 period and the 2013 period.

Benefits expense

Consolidated benefits expense was $9.7 billion for the 2014 quarter, an increase of $1.6 billion, or 19.7%, from the 2013 quarter. For the 2014 period, benefits expense was $28.4 billion, an increase of $4.1 billion, or 16.6%, from the 2013 period. These increases are primarily due to increases in both Retail and Employer Group segments mainly driven by higher average individual and group Medicare Advantage membership as well as higher individual commercial medical membership. We experienced favorable medical claims reserve development related to prior fiscal years of $94 million in the 2014 quarter as compared to $66 million in the 2013 quarter, and $440 million in the 2014 period as compared to $432 million in the 2013 period.

The consolidated benefit ratio remained flat at 83.3% for both the 2014 and 2013 quarters. The consolidated benefit ratio for the 2014 period was 82.9%, a 30 basis point decrease from the 2013 period. The decrease in the 2014 period is primarily due to a decline in the Retail segment ratio as well as the loss of our Medicaid contracts in Puerto Rico effective September 30, 2013 which more than offset a higher ratio year-over-year in the Employer Group segment.

Operating costs

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

Consolidated operating costs increased $358 million, or 23.2%, during the 2014 quarter compared to the 2013 quarter and increased $1.1 billion, or 24.1%, during the 2014 period compared to the 2013 period. These increases are primarily due to costs mandated by the Health Care Reform Law, including the non-deductible health insurance industry fee, and investments in health care exchanges and state-based contracts, partially offset by operating cost efficiencies.

The consolidated operating cost ratio for the 2014 quarter was 15.6%, increasing 50 basis points from the 2013 quarter. The consolidated operating cost ratio for the 2014 period was 15.4%, increasing 100 basis points from the 2014 period. These increases are primarily due to increases in the operating cost ratios in our Retail and Employer Group segments due to the same factors impacting consolidated operating costs as described above.

Depreciation and amortization

Depreciation and amortization for the 2014 quarter totaled $85 million, comparable to $83 million for the 2013 quarter. For the 2014 period, depreciation and amortization of $246 million compared to $243 million for the 2013 period.

Interest expense

Interest expense for the 2014 quarter totaled $38 million, compared to $35 million for the 2013 quarter. For the 2014 period, interest expense totaled $108 million compared to $105 million for the 2013 period.

Income Taxes

Our effective tax rate during the 2014 quarter was 47.5% compared to the effective tax rate of 37.2% in the 2013 quarter. For the 2014 period our effective tax rate was 46.8% compared to the effective tax rate of 36.0% for the 2013 period. The non-deductible nature of the health insurance industry fee levied on the insurance industry beginning in 2014 as mandated by the Health Care Reform Law increased our effective tax rate by approximately 10 percentage points for the 2014 period. In addition, the effective tax for the 2013 quarter and 2013 period includes the beneficial effect of a change in our estimated tax liability associated with limitations on the deductibility of annual compensation in excess of $500,000 per employee as mandated by the Health Care Reform Law.

Retail Segment

(a) Individual commercial medical membership includes Medicare Supplement members.

(b) Specialty products include dental, vision, and other supplemental health and financial protection products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products.

(in millions)

42

(in millions)

Pretax Results

• Retail segment pretax income was $322 million in the 2014 quarter, a decrease of $16 million, or 4.7%, compared to $338 million in the 2013 quarter. Retail segment pretax income was $913 million in the 2014 period, a decrease of $193 million, or 17.5%, compared to $1.1 billion in the 2013 period. These decreases are primarily driven by investment spending for health care exchanges and state-based contracts and higher specialty prescription drug costs associated with a new treatment for Hepatitis C, partially offset by Medicare Advantage and individual commercial medical membership growth as well as improved utilization from increased membership in our clinical programs.

Enrollment

• Individual Medicare Advantage membership increased 373,500 members, or 18.3%, from September 30, 2013 to September 30, 2014 reflecting net membership additions, particularly for our HMO offerings, for the 2014 plan year as well as dual eligible members from state-based contracts in Virginia and Illinois. Individual Medicare Advantage membership at September 30, 2014 includes 15,100 dual eligible members from state-based contracts.
• Medicare stand-alone PDP membership increased 681,300 members, or 20.9%, from September 30, 2013 to September 30, 2014 reflecting net membership additions, primarily for our Humana-Walmart plan offering, for the 2014 plan year.
• Individual commercial medical membership increased 629,700 members, or 107.6%, from September 30, 2013 to September 30, 2014 primarily reflecting new sales, both on-exchange and off-exchange, of plans compliant with the Health Care Reform Law.
• State-based Medicaid membership increased 201,200 members, or 251.5%, from September 30, 2013 to September 30, 2014, primarily driven by the addition of members under our Florida Medicaid and Florida Long-Term Support Services contracts.
• Individual specialty membership increased 179,600 members, or 17.3%, from September 30, 2013 to September 30, 2014 primarily driven by increased membership in dental and vision offerings.

Premiums

• Retail segment premiums increased $1.9 billion, or 28.0%, from the 2013 quarter to the 2014 quarter and increased $4.9 billion, or 24.0% from the 2013 period to the 2014 period. These increases primarily were due to an 18.0% and 16.6% increase for the quarter and period, respectively, in average individual Medicare Advantage membership as well as individual commercial medical membership growth, primarily on the health care exchanges. Individual Medicare Advantage per member premiums decreased approximately 0.7% in the 2014 quarter as compared to the 2013 quarter and decreased approximately 1.1% in the 2014 period compared to the 2013 period primarily due to Medicare rate reductions. In addition, the decrease in the 2014 period reflects the impact of sequestration which became effective April 1, 2013.

Benefits expense

• The Retail segment benefit ratio decreased 30 basis points from 84.1% in the 2013 quarter to 83.8% in the 2014 quarter and decreased 10 basis points from the 2013 period to 84.6% in the 2014 period. The decreases primarily were due to improved utilization from increased membership in our clinical programs and the inclusion of the health insurance industry fee in the pricing of our products, partially offset by higher specialty prescription drug costs associated with a new treatment for Hepatitis C, higher planned clinical investment spending, and higher benefit ratios associated with members from state-based contracts.
• The Retail segment’s pretax income for the 2014 quarter included the beneficial effect of $66 million in favorable prior-period medical claims reserve development versus $54 million in the 2013 quarter. For the 2014 period, the Retail segment's benefit expense included the beneficial effect of $330 million in favorable prior-period medical claims reserve development versus $304 million in the 2013 period. This favorable prior-period medical claims reserve development decreased the Retail segment benefit ratio by approximately 80 basis points in both the 2014 and 2013 quarters, and by approximately 130 basis points in the 2014 period versus approximately 150 basis points in the 2013 period.

Operating costs

• The Retail segment operating cost ratio of 12.4% for the 2014 quarter increased 170 basis points from 10.7% for the 2013 quarter. The Retail segment operating cost ratio of 11.7% for the 2014 period increased 200 basis points from 9.7% for the 2013 period. These increases are primarily due to the non-deductible health insurance industry fee mandated by the Health Care Reform Law and investment spending for health care exchanges and state-based contracts, partially offset by scale efficiencies from Medicare and individual commercial medical membership growth.

Employer Group Segment

(a) Specialty products include dental, vision, and voluntary benefit products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products.

(in millions)

45

(in millions)

Pretax Results

• Employer Group segment pretax income decreased $63 million, or 82.9%, to $13 million in the 2014 quarter, and decreased $94 million, or 22.3%, to $328 million for the 2014 period primarily reflecting higher utilization, mainly due to higher specialty prescription drug costs associated with a new treatment for Hepatitis C, as well as the continuing impact of transitional policy changes.

Enrollment

• Fully-insured group Medicare Advantage membership increased 59,500 members, or 14.0%, from September 30, 2013 to September 30, 2014 primarily due to the addition of a new large group account.
• Fully-insured commercial group medical membership remained relatively unchanged, increasing 13,700 members, or 1.1%, from September 30, 2013 to September 30, 2014 as an increase in small group business membership was generally offset by lower membership in large group accounts.
• Group ASO commercial medical membership decreased 49,100 members, or 4.2%, from September 30, 2013 to September 30, 2014 primarily due to continued pricing discipline in a highly competitive environment for self-funded accounts. We expect our group ASO commercial medical membership to decline approximately 400,000 to 425,000 members January 1, 2015 primarily due to the loss of a few large group accounts.
• Group specialty membership decreased 682,000 members, or 9.5%, from September 30, 2013 to September 30, 2014 primarily due to declines in dental and vision membership related to our planned discontinuance of certain unprofitable product distribution partnerships.

Premiums

• Employer Group segment premiums increased $246 million, or 9.0%, to $3.0 billion for the 2014 quarter, and increased $755 million, or 9.2%, to $8.9 billion for the 2014 period primarily due to higher average group Medicare Advantage membership.

Benefits expense

• The Employer Group segment benefit ratio increased 220 basis points from 84.3% in the 2013 quarter to 86.5% in the 2014 quarter, and increased 80 basis points from 82.1% in the 2013 period to 82.9% in the 2014 period. The increases primarily reflect higher utilization, mainly due to higher specialty prescription drug costs associated with a new treatment for Hepatitis C, as well as the continuing impact of transitional policy changes, partially offset by the inclusion of the health insurance industry fee and other fees mandated by the Health Care Reform Law in our pricing.

The Employer Group segment’s pretax income for the 2014 quarter included the beneficial effect of $27 million in favorable prior-period medical claims reserve development versus $11 million in the 2013 quarter. For the 2014 period, the Employer Group segment's pretax income included the beneficial effect of $110 million in favorable prior-period medical claims reserve development versus $124 million in the 2013 period. This favorable prior-period medical claims reserve development decreased the Employer Group segment benefit ratio by approximately 90 basis points in the 2014 quarter versus approximately 40 basis points in the 2013 quarter, and by approximately 120 basis points in the 2014 period versus 150 basis points in the 2013 period.

Operating costs

• The Employer Group segment operating cost ratio of 15.7% for the 2014 quarter increased 20 basis points from 15.5% for the 2013 quarter. For the 2014 period, the Employer Group segment operating cost ratio of 16.0% increased 70 basis points from 15.3% for the 2013 period. The increases primarily reflect the impact of the non-deductible health insurance industry fee and other fees mandated by the Health Care Reform Law as well as a higher percentage of small group commercial business which carries a higher operating cost ratio than large group business. These increases were partially offset by an increase in group Medicare Advantage membership which generally carries a lower operating cost ratio than our commercial group medical membership as well as operating cost efficiencies.

Healthcare Services Segment

(in millions)

(in millions)

48

Pretax results

• Healthcare Services segment pretax income of $202 million for the 2014 quarter increased $53 million, or 35.6%, from $149 million for the 2013 quarter. For the 2014 period, the Healthcare Services segment pretax income of $593 million increased $202 million, or 51.7%, from $391 million for the 2013 period. These increases are primarily due to an operating cost ratio that remained unchanged year-over-year in the 2014 quarter and declined in the 2014 period on a revenue base that reflects growth from our pharmacy solutions and home based services businesses as they serve our growing Medicare membership.

Script Volume

• Humana Pharmacy Solutions® script volumes for Retail and Employer Group segment membership increased to approximately 84 million in the 2014 quarter, up 20% versus scripts of approximately 70 million in the 2013 quarter. For the 2014 period, script volumes for Retail and Employer Group segment membership increased to approximately 244 million, up 20% versus scripts of approximately 204 million in the 2013 period. These increases primarily reflect growth associated with higher average medical membership for the 2014 quarter and period than in the 2013 quarter and period.

Services revenue

• Services revenue for the 2014 quarter and period were relatively unchanged from the 2013 quarter and period, increasing $1 million, or 0.3%, and $4 million, or 0.4%, respectively.

Intersegment revenues

• Intersegment revenues increased $1.1 billion, or 29.7%, from the 2013 quarter to $4.8 billion for the 2014 quarter and increased $3.0 billion, or 27.9%, from the 2013 period to $13.8 billion for the 2014 period primarily due to growth in our Medicare membership which resulted in higher utilization of our pharmacy solutions and home based services businesses.

Operating costs

• The Healthcare Services segment operating cost ratio of 95.4% for the 2014 quarter was unchanged from the 2013 quarter and decreased 50 basis points to 95.2% for the 2014 period from 95.7% for the 2013 period. The decrease primarily reflects an improvement in the ratio for our pharmacy solutions business partially offset by the build out of home based services and other businesses across the segment.

Other Businesses

Pretax income for our Other Businesses of $14 million for the 2014 quarter decreased $9 million compared to pretax income of $23 million for the 2013 quarter. For the 2014 period, pretax income of $56 million increased $5 million compared to pretax income of $51 million in the 2013 period. These year-over-year comparisons primarily reflect the loss of our Medicaid contracts in Puerto Rico and associated costs in 2013, as discussed previously. In addition, the 2013 period included a reduction in benefits expense related to a favorable settlement of contract claims with the DoD associated with previously disclosed litigation.

Liquidity

Our primary sources of cash include receipts of premiums, services revenue, and investment and other income, as well as proceeds from the sale or maturity of our investment securities and borrowings. Our primary uses of cash include disbursements for claims payments, operating costs, interest on borrowings, taxes, purchases of investment securities, acquisitions, capital expenditures, repayments on borrowings, dividends, and share repurchases. Because premiums generally are collected in advance of claim payments by a period of up to several months, our business normally should produce positive cash flows during periods of increasing premiums and enrollment. Conversely, cash flows would be negatively impacted during periods of decreasing premiums and enrollment. From period to period, our cash flows may also be affected by the timing of working capital items including taxes and assessments. The use of operating cash flows may be limited by regulatory requirements which require, among other items, that our regulated subsidiaries maintain minimum levels of capital and seek approval before paying dividends from the subsidiaries to the parent. Our use of operating cash flows derived from our non-insurance subsidiaries, such as in our Healthcare Services segment, is generally not restricted by Departments of Insurance.

For 2014, the effect of the commercial risk adjustment, risk corridor, and reinsurance provisions of the Health Care Reform Law are impacting the timing of our operating cash flows, as we build a receivable in 2014 that will be collected in 2015. For the full year 2014, we expect our operating cash flows to decline from 2013. The net receivable balance associated with the 3Rs was approximately $456 million at September 30, 2014. In addition, our 2014 financing cash flows have been negatively impacted by the timing of payments to and receipts from CMS associated with Medicare Part D reinsurance subsidies for which we do not assume risk. We are experiencing higher specialty prescription drug costs associated with a new treatment for Hepatitis C than were contemplated in our bids which is resulting in higher reinsurance subsidy receivable balances in 2014 that will be settled in 2015 under the terms of our contracts with CMS. Any amounts receivable or payable associated with these risk limiting programs and CMS subsidies may have an impact on subsidiary liquidity, with any temporary shortfalls funded by the parent company.

For additional information on our liquidity risk, please refer to the section entitled “Risk Factors” in this report and in our 2013 Form 10-K.

Cash and cash equivalents increased to $2.7 billion at September 30, 2014 from $1.1 billion at December 31, 2013. The change in cash and cash equivalents for the nine months ended September 30, 2014 and 2013 is summarized as follows:

(in millions)

Cash Flow from Operating Activities

The decrease in operating cash flows from the 2013 period to the 2014 period primarily results from lower earnings and the timing of working capital items. The most significant drivers of changes in our working capital are typically the timing of payments of benefits expense and receipts for premiums. We illustrate these changes with the following summaries of benefits payable and receivables.

The detail of benefits payable was as follows at September 30, 2014 and December 31, 2013:

(in millions)

(1) IBNR represents an estimate of benefits payable for claims incurred but not reported (IBNR) at the balance sheet date. The level of IBNR is primarily impacted by membership levels, medical claim trends and the receipt cycle time, which represents the length of time between when a claim is initially incurred and when the claim form is received (i.e. a shorter time span results in a lower IBNR).

(2) Reported claims in process represents the estimated valuation of processed claims that are in the post claim adjudication process, which consists of administrative functions such as audit and check batching and handling, as well as amounts owed to our pharmacy benefit administrator which fluctuate due to bi-weekly payments and the month-end cutoff.

(3) Other benefits payable primarily include amounts owed to providers under capitated and risk sharing arrangements.

The increase in benefits payable from December 31, 2013 to September 30, 2014 largely was due to an increase in IBNR, primarily as a result of Medicare Advantage and individual commercial medical membership growth, and an increase in the amount of processed but unpaid claims, including amounts due to our pharmacy benefit administrator, which fluctuate due to month-end cutoff. These items were partially offset by a decrease in amounts owed to providers under capitated and risk sharing arrangements primarily related to the disbursement of a portion of our Medicare risk adjustment collections under our contractual obligations associated with our risk sharing arrangements. The increase in benefits payable from December 31, 2012 to September 30, 2013 primarily was due to an increase in IBNR, primarily as a result of Medicare Advantage membership growth, and an increase in the amount of processed but unpaid claims, including amounts due to our pharmacy benefit administrator, which fluctuate due to month-end cutoff.

The detail of total net receivables was as follows at September 30, 2014 and December 31, 2013:

(in millions)

The small changes in Medicare receivables reflect the typical pattern caused by the timing of accruals and related collections associated with the CMS risk-adjustment model. Significant collections occur with the final and mid-year settlements with CMS in July and August, respectively.

The increase in commercial and other receivables primarily relates to the commercial risk adjustment provisions of the Health Care Reform Law.

Military services receivables at September 30, 2014 and December 31, 2013 primarily consist of administrative services only fees owed from the federal government for administrative services provided under our TRICARE South Region contract and final settlement balances due under our previous TRICARE South Region contract. The decline in military services receivables in the 2014 period primarily relates to the settlement of certain balances due under our previous TRICARE South Region contract. Payments of the federal government’s claims and related reimbursements under our current TRICARE South Region contract are classified with receipts (withdrawals) from contract deposits as a financing item in our consolidated statements of cash flows.

Many provisions of the Health Care Reform Law became effective in 2014, including the commercial risk adjustment, risk corridor, and reinsurance provisions as well as the non-deductible health insurance industry fee. As discussed previously, the timing of payments and receipts associated with these provisions are impacting our operating cash flows as we build a receivable in 2014 that will be collected in 2015. The net receivable balance associated with the 3Rs was approximately $456 million at September 30, 2014, including certain amounts recorded in receivables as noted above. In September 2014, we paid the federal government $562 million for the annual health insurance industry fee.

In addition to the timing of receipts for premiums and services revenues, payments of benefits expense, and amounts due under the risk limiting and health insurance industry fee provisions of the Health Care Reform Law, other working capital items impacting operating cash flows primarily resulted from the timing of the collection of pharmacy rebates and the timing of payments for the Medicare Part D risk corridor provisions of our contracts with CMS.

Cash Flow from Investing Activities

We reinvested a portion of our operating cash flows in investment securities, primarily investment-grade fixed income securities, totaling $76 million in the 2014 period and $705 million in the 2013 period.

Our ongoing capital expenditures primarily relate to our information technology initiatives, support of services in our provider services operations including medical and administrative facility improvements necessary for activities such as the provision of care to members, claims processing, billing and collections, wellness solutions, care coordination, regulatory compliance and customer service. Total capital expenditures, excluding acquisitions, were $361 million in the 2014 period and $310 million in the 2013 period reflecting increased spending associated with growth in our provider services and pharmacy businesses in our Healthcare Services segment. Excluding acquisitions, we expect total capital expenditures in 2014 in a range of approximately $500 million to $525 million.

Cash Flow from Financing Activities

Claims payments were higher than receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk by $761 million during the 2014 period and $191 million during the 2013 period. As discussed previously, our 2014 financing cash flows have been negatively impacted by the timing of payments to and receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk. We are experiencing higher specialty prescription drug costs associated with a new treatment for Hepatitis C than were contemplated in our bids which is resulting in higher subsidy receivable balances in 2014 that will be settled in 2015 under the terms of our contracts with CMS. Our net receivable for CMS subsidies and brand name prescription drug discounts was $1.5 billion at September 30, 2014 compared to $749 million at September 30, 2013 and $713 million at December 31, 2013. Refer to Note 6 to the condensed consolidated financial statements.

Under our administrative services only TRICARE South Region contract, health care cost payments for which we do not assume risk exceeded reimbursements from the federal government by $11 million during the 2014 period compared to $10 million during the 2013 period.

Receipts from HHS associated with cost sharing provisions of the Health Care Reform Law for which we do not assume risk were $29 million higher than claims payments during the 2014 period.

We repurchased 1.87 million shares for $230 million in the 2014 period and 3.78 million shares for $301 million in the 2013 period under share repurchase plans authorized by the Board of Directors. We also acquired common shares in connection with employee stock plans for an aggregate cost of $40 million in the 2014 period and $24 million in the 2013 period.

During the 2014 period we paid dividends to stockholders of $129 million as compared to $125 million in the 2013 period, as discussed further below.

Future Sources and Uses of Liquidity

Dividends

The following table provides details of dividend payments in 2013 and 2014 under our Board approved quarterly cash dividend policy:

(in millions)

53

In October 2014, the Board declared a cash dividend of $0.28 per share payable on January 30, 2015 to stockholders of record on December 31, 2014. Declaration and payment of future quarterly dividends is at the discretion of the Board and may be adjusted as business needs or market conditions change.

Stock Repurchases

In September 2014, the Board of Directors replaced a previous share repurchase authorization of up to $1 billion (of which $816 million remained unused) with a new authorization for repurchases of up to $2 billion of our common shares exclusive of shares repurchased in connection with employee stock plans, expiring on December 31, 2016. Under the new share repurchase authorization, shares may be purchased from time to time at prevailing prices in the open market, by block purchases, or in privately-negotiated transactions, subject to certain regulatory restrictions on volume, pricing, and timing. During the nine months ended September 30, 2014, we repurchased 1.60 million shares in open market transactions for $195 million at an average price of $121.68 under a previous share repurchase authorization and we repurchased 0.27 million shares in open market transactions for $35 million at an average price of $128.34 under the current authorization. During the nine months ended September 30, 2013, we repurchased 3.78 million shares in open market transactions for $301 million at an average price of $79.79 under previous share repurchase authorizations. We intend to repurchase $1 billion of shares (of the $2 billion authorized in September 2014) no later than June 30, 2015. During the period commencing on October 1, 2014 and ending on November 6, 2014, we repurchased 0.77 million shares in open market transactions for $100 million at an average price of $130.50 under the current authorization. As of November 7, 2014, the remaining authorized amount under the new authorization totaled $1.87 billion.

In connection with employee stock plans, we acquired 0.4 million common shares for $40 million and 0.3 million common shares for $24 million during the nine months ended September 30, 2014 and 2013, respectively.

On November 7, 2014, we announced that we intend to enter into an agreement with a third party financial institution to effect a $500 million accelerated stock repurchase program. We will repurchase shares through the program as part of the $2 billion authorized in September 2014. The actual number of shares repurchased under the agreement will be determined based on a volume-weighted average price of our common stock during the purchase period.

Senior Notes

In September 2014, we issued $400 million of 2.625% senior notes due October 1, 2019, $600 million of 3.85% senior notes due October 1, 2024 and $750 million of 4.95% senior notes due October 1, 2044. Our net proceeds, reduced for the underwriters' discount and commission and offering expenses, were $1.73 billion. We used a portion of the net proceeds to redeem the 6.45% senior unsecured notes as discussed below, and intend to use some or all of the remaining net proceeds to repurchase shares of our common stock and for general corporate purposes. We previously issued $500 million of 6.45% senior notes due June 1, 2016, $500 million of 7.20% senior notes due June 15, 2018, $300 million of 6.30% senior notes due August 1, 2018, $600 million of 3.15% senior notes due December 1, 2022, $250 million of 8.15% senior notes due June 15, 2038, and $400 million of 4.625% senior notes due December 1, 2042.

Our senior notes, which are unsecured, may be redeemed at our option at any time at 100% of the principal amount plus accrued interest and a specified make-whole amount. The 7.20% and 8.15% senior notes are subject to an interest rate adjustment if the debt ratings assigned to the notes are downgraded (or subsequently upgraded). In addition, our senior notes (other than the 6.30% senior notes) contain a change of control provision that may require us to purchase the notes under certain circumstances.

In October 2014, we redeemed the $500 million 6.45% senior unsecured notes due June 1, 2016, at 100% of the principal amount plus applicable premium for early redemption and accrued and unpaid interest to the redemption date, for cash totaling approximately $560 million. We recognized a loss on extinguishment of debt of approximately $37 million in October 2014 for the redemption of these notes.

Credit Agreement

Our 5-year $1.0 billion unsecured revolving credit agreement expires July 2018. Under the credit agreement, at our option, we can borrow on either a competitive advance basis or a revolving credit basis. The revolving credit portion bears interest at either LIBOR plus a spread or the base rate plus a spread. The LIBOR spread, currently 110 basis points, varies depending on our credit ratings ranging from 90.0 to 150.0 basis points. We also pay an annual facility fee regardless of utilization. This facility fee, currently 15 basis points, may fluctuate between 10.0 and 25.0 basis points, depending upon our credit ratings. The competitive advance portion of any borrowings will bear interest at market rates prevailing at the time of borrowing on either a fixed rate or a floating rate based on LIBOR, at our option.

The terms of the credit agreement include standard provisions related to conditions of borrowing, including a customary material adverse effect clause which could limit our ability to borrow additional funds. In addition, the credit agreement contains customary restrictive and financial covenants as well as customary events of default, including financial covenants regarding the maintenance of a minimum level of net worth of $7.6 billion at September 30, 2014 and a maximum leverage ratio of 3.0:1. We are in compliance with the financial covenants, with actual net worth of $10.1 billion and an actual leverage ratio of 1.8:1, as measured in accordance with the credit agreement as of September 30, 2014. In addition, the credit agreement includes an uncommitted $250 million incremental loan facility.

At September 30, 2014, we had no borrowings outstanding under the credit agreement and we had outstanding letters of credit of $5 million secured under that credit agreement. No amounts have been drawn on these letters of credit. Accordingly, as of September 30, 2014, we had $995 million of remaining borrowing capacity under the credit agreement, none of which would be restricted by our financial covenant compliance requirement. We have other customary, arms-length relationships, including financial advisory and banking, with some parties to the credit agreement.

Commercial Paper

In October 2014, we entered into a commercial paper program pursuant to which we may issue short-term, unsecured commercial paper notes privately placed on a discount basis through certain broker dealers. Amounts available under the program may be borrowed, repaid and re-borrowed from time to time, with the aggregate face or principal amounts outstanding under the program at any time not to exceed $1.0 billion. The net proceeds of issuances are expected to be used for general corporate purposes, including to repurchase shares of our common stock. As of November 6, 2014, we had $150 million outstanding in our commercial paper program.

Liquidity Requirements

We believe our cash balances, investment securities, operating cash flows, and funds available under our credit agreement and our commercial paper program or from other public or private financing sources, taken together, provide adequate resources to fund ongoing operating and regulatory requirements, acquisitions, future expansion opportunities, and capital expenditures for at least the next twelve months, as well as to refinance or repay debt, and repurchase shares.

Adverse changes in our credit rating may increase the rate of interest we pay and may impact the amount of credit available to us in the future. Our investment-grade credit rating at September 30, 2014 was BBB+ according to Standard & Poor’s Rating Services, or S&P, and Baa3 according to Moody’s Investors Services, Inc., or Moody’s. A downgrade by S&P to BB+ or by Moody’s to Ba1 triggers an interest rate increase of 25 basis points with respect to $750 million of our senior notes. Successive one notch downgrades increase the interest rate an additional 25 basis points, or annual interest expense by $2 million, up to a maximum 100 basis points, or annual interest expense by $8 million.

In addition, we operate as a holding company in a highly regulated industry. Humana Inc., our parent company, is dependent upon dividends and administrative expense reimbursements from our subsidiaries, most of which are subject to regulatory restrictions. We continue to maintain significant levels of aggregate excess statutory capital and surplus in our state-regulated operating subsidiaries. Cash, cash equivalents, and short-term investments at the parent company were $2.5 billion at September 30, 2014 compared to $508 million at December 31, 2013, primarily due to net proceeds of $1.73 billion from the September 2014 issuance of senior notes, reduced for the underwriters' discount and commissions and offering expenses. As described in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations under the section titled “Health Care Reform,” statutory accounting for the health insurance industry fee requires us to restrict surplus in the year preceding payment beginning in 2014. Therefore, in addition to recording the full-year 2014 assessment in the first quarter of 2014, we are required to restrict surplus for the 2015 assessment ratably in 2014. In September 2014, we paid the federal government $562 million for the annual health insurance industry fee. In 2015, the health insurance industry fee increases by 41% for the industry taken as a whole. Accordingly, absent changes in market share, we would expect a 41% increase in our fee in 2015.

Regulatory Requirements

Certain of our subsidiaries operate in states that regulate the payment of dividends, loans, or other cash transfers to Humana Inc., our parent company, and require minimum levels of equity as well as limit investments to approved securities. The amount of dividends that may be paid to Humana Inc. by these subsidiaries, without prior approval by state regulatory authorities, or ordinary dividends, is limited based on the entity’s level of statutory income and statutory capital and surplus. In most states, prior notification is provided before paying a dividend even if approval is not required. Actual dividends paid may vary due to consideration of excess statutory capital and surplus and expected future surplus requirements related to, for example, premium volume and product mix.

Although minimum required levels of equity are largely based on premium volume, product mix, and the quality of assets held, minimum requirements vary significantly at the state level. Based on the most recently filed statutory financial statements as of June 30, 2014, our state regulated subsidiaries had aggregate statutory capital and surplus of approximately $5.3 billion, which exceeded aggregate minimum regulatory requirements of $3.7 billion. The amount of dividends that were paid to our parent company in the 2014 period was approximately $927 million in the aggregate compared to dividends that were paid for the full year 2013 of approximately $967 million. The year-over-year decline is a result of higher surplus requirements associated with premium growth due to increases in membership.

Our earnings and financial position are exposed to financial market risk, including those resulting from changes in interest rates.

Interest rate risk also represents a market risk factor affecting our consolidated financial position due to our significant investment portfolio, consisting primarily of fixed maturity securities of investment-grade quality with a weighted average S&P credit rating of AA- at September 30, 2014. Our net unrealized position increased $202 million from a net unrealized gain position of $250 million at December 31, 2013 to a net unrealized gain position of $452 million at September 30, 2014. At September 30, 2014, we had gross unrealized losses of $51 million on our investment portfolio primarily due to an increase in market interest rates since the time the securities were purchased. There were no material other-than-temporary impairments during the three months ended September 30, 2014. While we believe that these impairments are temporary and we currently do not have the intent to sell such securities, given the current market conditions and the significant judgments involved, there is a continuing risk that future declines in fair value may occur and material realized losses from sales or other-than-temporary impairments may be recorded in future periods.

Duration is the time-weighted average of the present value of the bond portfolio’s cash flow. Duration is indicative of the relationship between changes in fair value and changes in interest rates, providing a general indication of the sensitivity of the fair values of our fixed maturity securities to changes in interest rates. However, actual fair values may differ significantly from estimates based on duration. The average duration of our investment portfolio, including cash and cash equivalents, was approximately 3.7 years as of September 30, 2014 and 4.3 years as of December 31, 2013. Based on the duration, including cash equivalents, a 1% increase in interest rates would generally decrease the fair value of our securities by approximately $470 million.

Under the supervision and with the participation of our Chief Executive Officer, or CEO, our Chief Financial Officer, or CFO, and our Principal Accounting Officer, we carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures for the quarter ended September 30, 2014.

Based on our evaluation, our CEO, CFO, and our Principal Accounting Officer concluded that our disclosure controls and procedures are effective to provide reasonable assurance that information the Company is required to disclose in its reports under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, including, without limitation, ensuring that such information is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.

There have been no changes in the Company’s internal control over financial reporting during the quarter ended September 30, 2014 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.