10-K 1 d10k.htm FORM 10-K Form 10-K
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

(Mark One)

x

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2005

OR

 

¨

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                      to                     

 

Commission file number 001-16751

 

WELLPOINT, INC.

(Exact name of registrant as specified in its charter)

 

Indiana   35-2145715
(State or other jurisdiction of   (I.R.S. Employer Identification No.)
incorporation or organization)    
120 Monument Circle    
Indianapolis, Indiana   46204
(Address of principal executive offices)   (Zip Code)

 

Registrant’s telephone number, including area code: (317) 488-6000

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class


 

Name of each exchange on which registered


Common Stock, Par Value $0.01

  New York Stock Exchange

 

Securities registered pursuant to Section 12(g) of the Act: NONE

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  x  No  ¨

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes  ¨  No  x

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x  No  ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  x

  Accelerated filer  ¨  

Non-acceleratedfiler  ¨

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  ¨  No  x

 

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant (assuming solely for the purposes of this calculation that all Directors and executive officers of the Registrant are “affiliates”) as of June 30, 2005 was approximately $42,376,993,166.

 

As of February 15, 2006, 657,005,900 shares of the Registrant’s Common Stock were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Part III of this Annual Report on Form 10-K incorporates by reference information from the Registrant’s Definitive Proxy Statement for the Annual Meeting of Shareholders to be held May 16, 2006.


Table of Contents

WELLPOINT, INC.

Indianapolis, Indiana

 

Annual Report to Securities and Exchange Commission

December 31, 2005

 

TABLE OF CONTENTS

 

         Page

PART I

        

ITEM 1.

  BUSINESS    3

ITEM 1A.

  RISK FACTORS    19

ITEM 1B.

  UNRESOLVED SEC STAFF COMMENTS    29

ITEM 2.

  PROPERTIES    30

ITEM 3.

  LEGAL PROCEEDINGS    30

ITEM 4.

  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS    33

PART II

        

ITEM 5.

  MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES    33

ITEM 6.

  SELECTED FINANCIAL DATA    34

ITEM 7.

  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS    35

ITEM 7A.

  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK    71

ITEM 8.

  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA    74

ITEM 9.

  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE    125

ITEM 9A.

  CONTROLS AND PROCEDURES    125

ITEM 9B.

  OTHER INFORMATION    128

PART III

        

ITEM 10.

  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT    128

ITEM 11.

  EXECUTIVE COMPENSATION    128

ITEM 12.

  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS    128

ITEM 13.

  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS    128

ITEM 14.

  PRINCIPAL ACCOUNTANT FEES AND SERVICES    128

PART IV

        

ITEM 15.

  EXHIBITS AND FINANCIAL STATEMENT SCHEDULES    129
SIGNATURES        137
INDEX TO EXHIBITS    139

 

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This Annual Report on Form 10-K, including the Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that reflect our views about future events and financial performance. When used in this report, the words “may,” “will,” “should,” “anticipate,” “estimate,” “expect,” “plan,” “believe,” “predict,” “potential,” “intend” and similar expressions are intended to identify forward-looking statements. Forward-looking statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those projected. You are cautioned not to place undue reliance on these forward-looking statements that speak only as of the date hereof. You are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including “Risk Factors” set forth in Part I Item 1A hereof and our reports filed with the Securities and Exchange Commission from time to time.

 

References in this Annual Report on Form 10-K to the term “WellPoint” or the “Company” refer to WellPoint, Inc. and its direct and indirect subsidiaries, as the context requires, after the merger of Anthem, Inc. and WellPoint Health Networks Inc. on November 30, 2004. References to the term “WHN” refers to WellPoint Health Networks Inc. prior to the merger. References to the terms “we,” “our,” or “us,” refer to WellPoint.

 

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PART I

 

ITEM 1. BUSINESS.

 

General

 

We are the largest commercial health benefits company in terms of membership in the United States, serving approximately 34 million medical members as of December 31, 2005. We are an independent licensee of the Blue Cross Blue Shield Association, or BCBSA, an association of independent health benefit plans. We serve our members as the Blue Cross licensee for California and as the Blue Cross and Blue Shield, or BCBS, licensee for Colorado, Connecticut, Georgia, Indiana, Kentucky, Maine, Missouri (excluding 30 counties in the Kansas City area), Nevada, New Hampshire, New York (as BCBS in 10 New York city metropolitan counties, and as Blue Cross or BCBS in selected upstate counties only), Ohio, Virginia (excluding the Northern Virginia suburbs of Washington, D.C.), and Wisconsin. We also serve our members throughout various parts of the United States as UniCare. We are licensed to conduct insurance operations in all 50 states through our subsidiaries and Puerto Rico through an affiliate.

 

We offer a broad spectrum of network-based managed care plans to the large and small employer, individual, Medicaid and senior markets. Our managed care plans include preferred provider organizations, or PPOs, health maintenance organizations, or HMOs, point-of-service plans, or POS plans, traditional indemnity plans and other hybrid plans, including consumer-driven health plans, or CDHPs, hospital only and limited benefit products. In addition, we provide a broad array of managed care services to self-funded customers, including claims processing, underwriting, stop loss insurance, actuarial services, provider network access, medical cost management and other administrative services. We also provide an array of specialty and other products and services including pharmacy benefit management, group life and disability insurance, dental, vision, behavioral health benefits, workers compensation and long-term care insurance. For our insured products, we charge a premium and assume all or a portion of the health care risk. Under self-funded and partially insured products, we charge a fee for services, and the employer or plan sponsor reimburses us for all or most of the health care costs. Approximately 93% of our 2005 operating revenue was derived from premium income, while approximately 7% was derived from administrative services and other revenues.

 

Our customer base primarily includes large groups with 51 to 4,999 eligible employees (48% of our medical members at December 31, 2005), and individuals under age 65 and small groups of one to 50 eligible employees, also known as ISG (17% of our medical members as of December 31, 2005). Other major customer types include National Accounts (multi-state employer groups with 5,000 or more employees), BlueCard Host (enrollees of non-owned BCBS plans who receive benefits in our BCBS markets), Senior (over age 65 individuals enrolled in Medicare Supplement or Medicare Advantage policies) and State Sponsored Programs (primarily Medicaid and State Children’s Health Insurance Plans). We market our products through an extensive network of independent agents and brokers (primarily for Individual, Small Group and Senior customers) and through our in-house sales force that are compensated on a commission basis for new sales and retention of existing business (primarily for Large Group customers).

 

The aging of the population and other demographic characteristics and advances in medical technology continue to contribute to rising health care costs. Our managed care plans and products are designed to encourage providers and members to participate in quality, cost-effective health benefit plans by using the full range of our innovative medical management services, quality initiatives and financial incentives. Our leading market share enables us to realize the long-term benefits of investing in preventive and early detection programs. Our ability to provide cost-effective health benefits products and services is enhanced through a disciplined approach to internal cost containment, prudent management of our risk exposure and successful integration of acquired businesses.

 

Our results of operations depend in large part on accurately predicting health care costs and on our ability to manage future health care costs through underwriting criteria, medical management, product design and negotiation of favorable provider contracts.

 

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We believe health care is local, and feel that we have the strong local presence required to understand and meet local customer needs. Our local presence and national expertise have created opportunities for collaborative programs that reward physicians and hospitals for clinical quality and excellence. We feel that our commitment to health improvement and care management provides added value to customers and health care professionals.

 

Our vision is to transform health care and become the most valued company in our industry. Our mission is to improve the lives of people we serve and the health of our communities. One of the strategies to achieve our vision and fulfill our mission is automation of interactions with customers, brokers, agents, employees and other stakeholders through web-enabling technology and enhancing internal operations. We continue to develop our e-business strategy with the goal of becoming widely regarded as an e-business leader in the health benefits industry. The strategy includes not only sales and distribution of health benefits products on the Internet, but also implementation of advanced self-service capabilities benefiting customers, agents, brokers, partners and our associates.

 

WellPoint is a large accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934, as amended) and is required, pursuant to Item 101 of Regulation S-K, to provide certain information regarding its website and the availability of certain documents filed with or furnished to the Securities and Exchange Commission, or SEC. Our website is www.wellpoint.com. We make available free of charge on or through our Internet website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with or furnish it to the SEC. We also include on our Internet website our Corporate Governance Guidelines, our Standards of Ethical Business Conduct and the charter of each standing committee of our Board of Directors. In addition, we intend to disclose on our Internet website any amendments to, or waivers from, our Standards of Ethical Business Conduct that are required to be publicly disclosed pursuant to rules of the SEC and the New York Stock Exchange, or NYSE. WellPoint is an Indiana corporation incorporated on July 17, 2001.

 

As required by NYSE Rule 303A.12, in 2005 we filed with the NYSE the annual chief executive officer certificate with no qualifications, indicating that the chief executive officer is unaware of any violations of the NYSE corporate governance standards. In addition, we are filing certifications required by Section 302 of the Sarbanes-Oxley Act of 2002 as exhibits to this Annual Report on Form 10-K.

 

Recent Transactions

 

We intend to continue our expansion through organic growth and strategic acquisitions. Listed below are the more significant transactions that were completed by WellPoint during the last two years.

 

    On December 28, 2005 (December 31, 2005 for accounting purposes) we completed our previously announced acquisition of WellChoice, Inc., or WellChoice. Under the terms of the merger agreement, the stockholders of WellChoice received consideration of $38.25 in cash and 0.5191 of a share of WellPoint common stock for each share of WellChoice common stock outstanding. In addition, WellChoice stock options and other awards were converted to WellPoint awards in accordance with the merger agreement. The purchase price including cash, fair value of stock and stock awards and estimated transaction costs was approximately $6.5 billion. WellChoice merged with and into WellPoint Holding Corp., a direct and wholly-owned subsidiary of WellPoint, with WellPoint Holding Corp. as the surviving entity in the merger.

 

    On June 9, 2005, we completed our acquisition of Lumenos, Inc., or Lumenos, for approximately $185.0 million in cash paid to the stockholders of Lumenos. Lumenos is recognized as a pioneer and market leader in consumer-driven health programs.

 

   

On April 25, 2005, WellPoint’s Board of Directors approved a two-for-one split of shares of common stock, which was effected in the form of a 100 percent common stock dividend. All shareholders of record on May 13, 2005 received one additional share of WellPoint common stock for each share of

 

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common stock held on that date. The additional shares of common stock were distributed to shareholders of record in the form of a stock dividend on May 31, 2005. All applicable historical weighted average share and per share amounts and all references to stock compensation data and market prices of our common stock for all periods presented in this Annual Report on Form 10-K have been adjusted to reflect this two-for-one stock split.

 

    On November 30, 2004, Anthem, Inc., or Anthem, and WellPoint Health Networks Inc., or WHN, completed their merger. WHN merged with and into Anthem Holding Corp., a direct and wholly-owned subsidiary of Anthem, with Anthem Holding Corp. as the surviving entity in the merger. In connection with the merger, Anthem amended its articles of incorporation to change its name to WellPoint, Inc., or WellPoint. As a result of the merger, each WHN stockholder received consideration of $23.80 in cash and one share of WellPoint common stock for each share of WHN common stock held. In addition, WHN stock options and other awards were converted to WellPoint awards in accordance with the merger agreement. The purchase price including cash, fair value of stock and stock awards and estimated transaction costs was approximately $15.8 billion.

 

Industry Overview

 

The health benefits industry has experienced significant change in the last decade. The increasing focus on health care costs by employers, the government and consumers has led to the growth of alternatives to traditional indemnity health insurance. HMO, PPO, CDHPs and hybrid plans, such as POS plans, are among the various forms of managed care products that have developed over the past decade. Through these types of products, we attempt to contain the cost of health care by negotiating contracts with hospitals, physicians and other providers to deliver health care to our members at favorable rates. These products usually feature medical management and other quality and cost optimization measures such as pre-admission review and approval for certain non-emergency services, pre-authorization of outpatient surgical procedures, network credentialing to determine that network doctors and hospitals have the required certifications and expertise, and various levels of care management programs to help members better understand and navigate the medical system. In addition, providers may have incentives to achieve certain quality measures, may share medical cost risk or have other incentives to deliver quality medical services in a cost-effective manner. Members are charged periodic, pre-paid premiums and pay co-payments, coinsurance and deductibles when they receive services. While the distinctions between the various types of plans have lessened over recent years, PPO and POS products generally provide reduced benefits for out-of-network services, while traditional HMO products generally provide little to no reimbursement for non-emergency out-of-network utilization. An HMO plan may also require members to select one of the network primary care physicians to coordinate their care and approve any specialist or other services.

 

Recently, economic factors and greater consumer awareness have resulted in the increasing popularity of products that offer larger, more extensive networks, more member choice related to coverage, physicians and hospitals, and a desire for greater flexibility for customers to assume larger deductibles and co-payments in return for lower premiums. CDHPs, which are relatively high deductible PPO products and which are often paired with some type of member health care expenditure account that can be used at the member’s discretion to help fund member out-of-pocket costs, help to meet this demand. CDHPs also usually incorporate member education, wellness, and care management programs, to help customers make better informed health care decisions. We believe we are well-positioned in each of our regions to respond to these market preferences.

 

Each of the BCBS companies, of which there where 38 independent primary licensees as of December 31, 2005, works cooperatively in a number of ways that create significant market advantages, especially when competing for very large multi-state employer groups. As a result of this cooperation, each BCBS company is able to take advantage of other BCBS licensees’ substantial provider networks and discounts when any member from one state works or travels outside of the state in which the policy is written. This program is referred to as BlueCard®, and is a source of revenue for providing member services in our states for individuals who are customers of BCBS plans not affiliated with us.

 

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Competition

 

The managed care industry is highly competitive, both nationally and in our regional markets. Competition continues to be intense due to aggressive marketing, business consolidations, a proliferation of new products and increased quality awareness and price sensitivity among customers.

 

Health benefits industry participants compete for customers mainly on the following factors:

 

    price;

 

    quality of service;

 

    access to provider networks;

 

    flexibility of benefit designs;

 

    reputation (including National Committee on Quality Assurance, or NCQA, accreditation status);

 

    brand recognition; and

 

    financial stability.

 

Over the last few years, a health plan’s ability to interact with employers, members and other third parties (including health care professionals) via the Internet has become a more important competitive factor. During the last several years, we have made significant investments in technology to enhance our electronic interaction with employers, members and third parties.

 

We believe our exclusive right to market products under the BCBS brand in many of our markets provides us with an advantage over our competition. In addition, our provider networks in our regions enable us to achieve cost-efficiencies and service levels enabling us to offer a broad range of health benefits to our customers on a more cost-effective basis than many of our competitors. We strive to distinguish our products through provider access, service, product value and brand recognition.

 

To build our provider networks, we compete with other health benefits plans for contracts with hospitals, physicians and other providers. We believe that physicians and other providers primarily consider member volume, reimbursement rates, timeliness of reimbursement and administrative service capabilities along with the reduction of non-value added administrative tasks when deciding whether to contract with a health benefits plan.

 

At the sales and distribution level, we compete for qualified agents and brokers to distribute our products. Strong competition exists among insurance companies and health benefits plans for agents and brokers with demonstrated ability to secure new business and maintain existing accounts. We believe that commission structure, support services, reputation, prior relationships, quality and price of the products are the factors agents and brokers consider in choosing whether to market our products. We believe that we have good relationships with our agents and brokers, and that our products, support services and commission structure compare favorably to our competitors in all of our regions.

 

Reportable Segments

 

We manage our operations through three reportable segments: Health Care, Specialty and Other.

 

Health Care

 

Our Health Care segment is an aggregation of various operating segments, principally differentiated by geographic areas within which we offer similar health benefit products and services, including commercial accounts, senior, Medicaid and other state sponsored businesses. These geographic areas include California, Colorado, Connecticut, Georgia, Indiana, Kentucky, Maine, Missouri, Nevada, New Hampshire, New York, Ohio, Virginia, and Wisconsin. In addition, UniCare provides services in various other areas of the United States.

 

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Specialty

 

Our Specialty segment is comprised of businesses providing pharmacy benefit management, specialty pharmacy distribution, group life and disability insurance benefits, dental, workers’ compensation and long-term care insurance. We also provide benefits for vision and behavioral health services.

 

Other

 

Our Other segment is comprised of our Medicare processing business, including AdminaStar Federal and United Government Services; Arcus Enterprises, which works to develop innovative means to promote quality care, well being and education; intersegment revenue and expense eliminations; and corporate expenses not allocated to our Health Care or Specialty segments. Effective December 31, 2005, Empire Medical Services, the Medicare processing company of the former WellChoice, was also included in our Other segment.

 

For additional information regarding the operating results of our segments, see the Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 19 to our audited consolidated financial statements for the year ended December 31, 2005 included in this Form 10-K.

 

Products and Services

 

Health Care

 

A general description of our health benefit products and services is provided below:

 

Preferred Provider Organization.    PPO products offer the member an option to select any health care provider, with benefits reimbursed by us at a higher level when care is received from a participating network provider. Coverage is subject to co-payments or deductibles and coinsurance, with member cost sharing usually limited by out-of-pocket maximums.

 

Traditional Indemnity.    Indemnity products offer the member an option to select any health care provider for covered services. Coverage is subject to deductibles and coinsurance, with member cost sharing usually limited by out-of-pocket maximums.

 

Health Maintenance Organization.    HMO products include comprehensive managed care benefits, generally through a participating network of physicians, hospitals and other providers. A member in one of our HMOs must typically select a primary care physician, or PCP, from our network. PCPs generally are family practitioners, internists or pediatricians who provide necessary preventive and primary medical care, and are generally responsible for coordinating other necessary health care services. Preventive care services are emphasized in these plans. We offer HMO plans with varying levels of co-payments, which result in different levels of premium rates.

 

Point-of-Service.    POS products blend the characteristics of HMO and indemnity plans. Members can have comprehensive HMO-style benefits through participating network providers with minimum out-of-pocket expense (co-payments) and also can go directly, without a referral, to any provider they choose, subject to, among other things, certain deductibles and coinsurance. Member cost sharing is limited by out-of-pocket maximums.

 

Consumer-Driven Health Plans.    CDHPs provide consumers with increased financial responsibility, choice and control regarding how their health care dollars are spent. Generally, CDHPs combine a high-deductible PPO plan with an employer-funded and/or employee-funded personal care account. Some or all of the dollars remaining in the personal care account at year-end can be rolled over to the next year for future health care needs.

 

Management Services.    In addition to fully insured products, we provide administrative services to large group employers that maintain self-funded health plans. These administrative services include underwriting,

 

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actuarial services, medical management, claims processing and administrative services for self-funded employers. Self-funded health plans are also able to use our provider networks and to realize savings through our negotiated provider arrangements, while allowing employers the ability to design certain health benefit plans in accordance with their own requirements and objectives. We also underwrite stop loss insurance for self-funded plans.

 

Senior Plans.    We offer numerous Medicare supplemental plans, which typically pay the difference between health care costs incurred by a beneficiary and amounts paid by Medicare. We also offer a managed care alternative to the Medicare program in certain geographic areas. Additionally, we offer Medicare Advantage plans, HMO fee-for-service and Medicare approved drug discount cards in certain geographic regions. Currently, our Medicare Advantage plans provide Medicare beneficiaries with a managed care alternative to traditional Medicare. Our Medicare-approved drug discount cards afford Medicare beneficiaries, without prescription drug coverage, access to our drug discounts. Effective January 1, 2006, we began marketing Medicare Part D Prescription Drug Plans, or Part D, to eligible Medicare beneficiaries in all 50 states.

 

BlueCard.    BlueCard host members are generally members who reside in or travel to a state in which a WellPoint subsidiary is the Blue Cross and/or Blue Shield licensee and who are covered under an employer sponsored health plan serviced by a non-WellPoint controlled BCBS licensee, who is the “home” plan. We perform certain administrative functions for BlueCard host members, for which we receive administrative fees from the BlueCard members’ home plans. Other administrative functions, including maintenance of enrollment information and customer service, are performed by the home plan.

 

Medicaid Plans and Other State-Sponsored Programs.    In California, a subsidiary holds contracts with the state to provide managed care programs to MediCal, California’s Medicaid program, in a large part of the state. We have also obtained Medicaid contracts to serve members in several other states including, but not limited to Virginia, West Virginia and Connecticut (and the Commonwealth of Puerto Rico) in which we conduct business.

 

Specialty

 

Pharmacy Products.    We offer pharmacy services and pharmacy benefit management services to our members. Our pharmacy services incorporate features such as drug formularies (where we develop lists of preferred, cost effective drugs), a pharmacy network and maintenance of a prescription drug database and mail order capabilities. Pharmacy benefit management services provided by us include management of drug utilization through outpatient prescription drug formularies, retrospective review and drug education for physicians, pharmacists and members. Two of our subsidiaries are also licensed pharmacies and make prescription dispensing services available through mail order for pharmacy benefit management clients. In July 2005, we launched Precision Rx Specialty Solutions, a full service specialty pharmacy designed to help improve quality and cost of care by coordinating a relatively new class of prescription medications commonly referred to as biopharmaceuticals, also known as specialty medications.

 

In September 2005, we were awarded contracts to offer Medicare Part D Prescription Drug Plans, or Part D, to eligible Medicare beneficiaries in all 50 states. We began offering these plans to customers through our health benefit subsidiaries throughout the country and providing administrative services for Part D offerings through our pharmacy benefits management companies, on January 1, 2006.

 

Life Insurance.    We offer an array of competitive group life insurance benefit products to both large and small group customers in conjunction with our health plans. The life products include term life, accidental death and dismemberment.

 

Disability.    We offer short-term and long-term disability programs, usually in conjunction with our health plans.

 

Behavioral Health.    We offer specialized behavioral health plans and benefit management. These plans cover mental health and substance abuse treatment services on both an inpatient and an outpatient basis. We have implemented employee assistance and behavioral managed care programs for a wide variety of businesses

 

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throughout the United States. These programs are offered through our subsidiaries and through third party behavioral health networks.

 

Dental.    Our dental plans include networks in certain states in which we operate. Many of the dental benefits are provided to customers enrolled in our health plans and are offered on both an insured and self-funded basis.

 

Vision Services.    Our vision plans include networks within the states we operate. Many of the vision benefits are provided to customers enrolled in our health plans and are offered on both an insured and self-funded basis.

 

Long-Term Care Insurance.    We offer long-term care insurance products to our California members through a subsidiary. The long-term care products include tax-qualified and non-tax qualified versions of a skilled nursing home care plan and comprehensive policies covering skilled, intermediate and custodial long-term care and home health services.

 

Workers Compensation Plan.    We offer workers compensation products to employees principally in the states of Wisconsin, Illinois and Iowa. We ceased underwriting workers compensation business effective December 28, 2005; however, we continue to provide network rental and medical management services to workers compensation carriers.

 

Other

 

Medicare Fiscal Intermediary Operations.    Through our AdminaStar Federal and United Government Services subsidiaries, we serve as fiscal intermediaries for the Medicare program, which generally provides coverage for persons who are 65 or older and for persons who are disabled or with end-stage renal disease. Part A of the Medicare program provides coverage for services provided by hospitals, skilled nursing facilities and other health care facilities. Part B of the Medicare program provides coverage for services provided by physicians, physical and occupational therapists and other professional providers. As a fiscal intermediary, we receive reimbursement for certain costs and expenditures. Effective December 31, 2005, Empire Medical Services, the Medicare processing company of the former WellChoice, was also included in our Other segment.

 

Customer Types

 

Our products are generally developed and marketed with an emphasis on the differing needs of various customer groups. In particular, our product development and marketing efforts take into account the differing characteristics between the various customer groups served by us, including individuals and small employers, large employers, seniors and Medicaid recipients, as well as the unique needs of educational and public entities, federal employee health and benefit programs, national employers and state-run programs servicing low-income, high-risk and under-served markets. Each business unit is responsible for product design, pricing, enrolling, underwriting and servicing customers in specific customer groups. We believe that one of the keys to our success has been the focus on distinct customer groups defined generally by employer size and geographic region, which better enables us to develop benefit plans and services that meet the unique needs of the distinct markets.

 

In each geographic region, we balance the need to customize products with the efficiencies of product standardization. Overall, we seek to establish pricing and product designs to achieve an appropriate level of profitability for each of our customer categories. As of December 31, 2005, our customer types include the following categories:

 

   

Large groups include employers with 51 to 4,999 employees eligible to participate as a member in one of our health plans as well as public entities that serve educational and public sector clients. In addition, Large group includes customers with 5,000 or more eligible employees with less than 5% of eligible employees located outside of the headquarter’s state. These groups are generally sold through brokers or consultants working with industry specialists from our in-house sales force. Large group cases may be experience rated or sold on a self-insured basis. The customer’s buying decision is typically based upon the size and breadth of our networks, customer service, the quality of our medical management services,

 

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the administrative cost included in our quoted price, our financial stability, and our ability to effectively service large complex accounts. Large group also includes members in the Federal Employee Program. As a BCBSA licensee, we participate in a nationwide contract with the Federal government whereby we cover Federal employees and their dependents in our multi-state service area. Service area is defined as the geographic area in which we are licensed to sell BCBS products. We participate in the overall financial risk for medical claims on a pooled basis with the other participating BCBS companies, and are reimbursed for our costs plus a fee. Large groups accounted for 48% of our members at December 31, 2005.

 

    Individual (under 65) and small groups are defined as members who purchase health insurance services as individuals or through employers with one to 50 eligible employees. While individual policies are generally sold through independent agents and brokers or our in-house sales force, small groups are sold almost exclusively through independent agents and brokers. Small group cases are sold on a fully-insured basis. Underwriting and pricing is typically done on a community rated basis. Conversely, individual business is also sold on a fully-insured basis and is usually medically underwritten at the point of initial issuance. Individual and small group customers are generally more sensitive to product pricing and, to a lesser extent, the configuration of the network, and the efficiency of administration. Account turnover is generally higher with individual and small groups as compared to large groups. Individuals and small groups accounted for 17% of our members at December 31, 2005.

 

    National Accounts are defined as multi-state employer groups headquartered in a WellPoint service area with 5,000 or more eligible employees, including 5% or more located in a service area outside of the headquarter’s state. National Accounts are generally sold through independent brokers or consultants retained by the customer working with our in-house sales force. We have a significant advantage when competing for very large National Accounts due to our ability to access the national provider networks of BCBS companies and take advantage of their provider discounts in their local markets. National Accounts represented 14% of our members at December 31, 2005.

 

    BlueCard host customers are defined as enrollees of other BCBS plans, or the “home” plans, who receive health care services in our BCBS licensed markets. BlueCard host membership accounted for 11% of our members at December 31, 2005.

 

    Senior customers are defined as members age 65 and over with Medicare Supplement or Medicare Advantage policies. Medicare Supplement policies are sold to Medicare recipients as supplements to the benefits they receive from the Medicare program. Rates are filed with and in some cases approved by state insurance departments. The Medicare Advantage program is the managed care alternative to the federally funded Medicare program. Most of the premium is paid directly by the Federal government on behalf of the participant who may also be charged a small premium. Medicare Supplement and Medicare Advantage products are marketed in the same manner. Senior business accounted for 4% of our members at December 31, 2005.

 

    State sponsored program membership is defined as eligible members with state sponsored managed care alternatives for the Medicaid and State Children’s Health Insurance programs that we manage. In 2000, WHN entered into a joint venture with Medical Card Systems, Inc., a Puerto Rico-based group health and life insurer, to pursue contracts under the Health Reform Program in Puerto Rico. As of December 31, 2005, the Company’s 50% share of this joint venture served approximately 254,000 members. Total state sponsored program business accounted for 6% of our members at December 31, 2005.

 

In addition to reporting our medical membership by customer type, we report by funding arrangement according to the level of risk that we assume in the product contract. Our two principal funding arrangement categories are fully-insured and self-funded. Fully-insured products are products in which we indemnify our policyholders against costs for health benefits. Self-funded products are offered to customers, generally larger employers, who elect to retain most or all of the financial risk associated with their employees’ health care costs. Some employers choose to purchase stop-loss coverage to limit their retained risk. These employers are reported with our self-funded business.

 

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The following tables set forth our medical membership by customer type and funding arrangement:

 

     December 31

     20051

   2004

     (In thousands)

Customer Type

         

Large Group

   16,362    13,073

Individual and Small Group (ISG)

   5,645    5,199

National Accounts

   4,776    3,212

BlueCard

   3,915    3,463
    
  

Total National

   8,691    6,675

Senior

   1,224    1,059

State Sponsored

   1,934    1,722
    
  

Total medical membership by customer type

   33,856    27,728
    
  

Funding Arrangement

         

Self-Funded

   16,234    13,039

Fully-Insured

   17,622    14,689
    
  

Total medical membership by funding arrangement

   33,856    27,728
    
  
 
  1 Includes 1,798 self-funded and 2,989 fully-insured members from the WellChoice acquisition that closed on December 28, 2005.

 

For additional information regarding the change in medical membership between years, see the Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this Form 10-K.

 

Networks and Provider Relations

 

Our relationships with physicians, hospitals and professionals that provide health care services to our members are guided by regional and national standards for network development, reimbursement and contract methodologies.

 

It is generally our philosophy not to delegate full financial responsibility to our physician providers in the form of capitation-based reimbursement. However, in certain markets we believe capitation can be a useful method to lower costs and reduce underwriting risk, and we therefore have some capitation contracts.

 

We attempt to provide market-based hospital reimbursement along industry standards. We also seek to ensure physicians in our network are paid in a timely manner at appropriate rates. We use multi-year contracting strategies, including case or fixed rates, to limit our exposure to medical cost inflation and increase cost predictability. In all regions, we seek to maintain broad provider networks to ensure member choice while implementing programs designed to improve the quality of care received by our members.

 

Depending on the consolidation and integration of physician groups and hospitals, reimbursement strategies vary across markets. Fee-for-service is our predominant reimbursement methodology for physicians. We generally use a resource-based relative value system, or RBRVS, fee schedule to determine fee for service reimbursement. However, we also use proprietary fee schedules in certain markets. The RBRVS structure was developed and is maintained by the Centers for Medicare & Medicaid Services, or CMS, and is used by the Medicare program and other major payers. The RBRVS and proprietary systems are independent of submitted fees and therefore are not as vulnerable to inflation. In addition, we have implemented and continue to expand physician incentive contracting which recognizes clinical quality and performance as a basis for reimbursement.

 

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Like our physician contracts, our hospital contracts provide for a variety of reimbursement arrangements depending on the network. Our hospital contracts recognize unique hospital attributes, such as academic medical centers or community hospitals, and the volume of care performed for our members. Many hospitals are reimbursed on a fixed amount per day for covered services (per diem) or a case rate basis similar to Medicare (Diagnosis Related Groups). Other hospitals are reimbursed on a discount from approved charge basis for covered services. Hospital outpatient services are reimbursed based on fixed case rates, fee schedules or percent of charges. To improve predictability of expected cost, we frequently use a multi-year contracting approach and have been transitioning to case rate payment methodologies. Many of our hospital contracts have reimbursement linked to improved clinical performance, patient safety and medical error reduction.

 

Medical Management Programs

 

Our medical management programs include a broad array of activities that facilitate improvements in the quality of care provided to our members and promote cost effective medical care. These medical management activities and programs are administered and directed by physicians and trained nurses employed by us. One of the goals of our medical management strategies is to assure that the care delivered to our members is supported by appropriate medical and scientific evidence.

 

Precertification.    A traditional medical management program involves assessment of the appropriateness of certain hospitalizations and other medical services prior to the service being rendered. For example, precertification is used to determine whether a set of hospital and medical services is being appropriately applied to the member’s clinical condition, in accordance with criteria for medical necessity as that term is defined in the member’s benefits contract. Many of our health plans have implemented precertification programs for certain high cost radiology studies, addressing an area of historically significant cost trends.

 

Concurrent review.    Another traditional medical management strategy we use is concurrent review, which is based on nationally recognized criteria developed by third-party medical specialists. With concurrent review, the requirements and intensity of services during a patient’s hospital stay are reviewed, often by an onsite skilled nurse professional in collaboration with the hospital’s medical and nursing staff, in order to coordinate care and determine the most effective transition of care from the hospital setting.

 

Disease management.    We use sophisticated care models built around disease management and advanced care management. These programs focus on those members who have chronic and/or complex illness and require the greatest amount of medical services and allow us to provide important information to our physician providers and members to help them optimally manage the care of their specific conditions. For example, certain therapies and interventions for patients with diabetes help prevent some of the serious, long-term medical consequences of diabetes and reduce the risks of kidney, eye and heart disease. Our information systems can provide feedback to our physicians to enable them to improve the quality of care. For other prevalent medical conditions such as heart disease and asthma, our ability to correlate pharmacy data and medical management data allows us to provide important information to our members, physicians and other providers, which enable them to more effectively manage these conditions.

 

Advanced care management.    A significant amount of health care expenditures are for services consumed by a small percent of our members who suffer from complex or chronic illnesses. We have developed a series of programs aimed at helping our network physicians better manage and improve the health of these members. Often, these programs provide benefits for home care services and other support to reduce the need for repeated, expensive hospitalizations.

 

Formulary management.    We have developed formularies, which are selections of drugs based on clinical quality and effectiveness. A pharmacy and therapeutics committee of physicians uses scientific and clinical evidence to ensure that our members have access to the appropriate drug therapies.

 

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Medical policy.    A medical policy group comprised of physician leaders from all of our geographic regions, working in cooperation with academic medical centers, practicing community physicians and medical specialty organizations such as the American College of Radiology and national organizations such as the Centers for Disease Control and the American Cancer Society, determines our national policy for the application of new technologies.

 

Quality programs.    We are actively engaged with our hospital networks to enable them to improve medical and surgical care and achieve better outcomes for our members. We endorse, encourage and incent hospitals to support national initiatives to improve clinical care, patient outcomes and reduce medication errors and hospital infections. We have been recognized as a national leader in developing hospital quality programs.

 

External review procedures.    In light of public concerns about health plans denying coverage of medical services, we work with outside experts through a process of external review to provide our members scientifically and clinically, evidenced-based medical care. When we receive member concerns, we have formal appeals procedures that ultimately allow coverage disputes related to medical necessity decisions under the benefits contract to be settled by independent expert physicians.

 

Service management.    In HMO and POS networks, primary care physicians serve as the overall coordinators of members’ health care needs by providing an array of preventive health services and overseeing referrals to specialists for appropriate medical care. In PPO networks, patients have access to network physicians without a primary care physician serving as the coordinator of care.

 

Health Care Quality Initiatives

 

Increasingly, the health care industry is able to define quality health care based on preventive health measurements, outcomes of care and optimal care management for chronic disease. A key to our success has been our ability to work with our network physicians and hospitals to improve the quality and outcomes of the health care services provided to our members. Our ability to promote quality medical care has been recognized by the NCQA, the largest and most respected national accreditation program for managed care health plans.

 

A range of quality health care measures, including the Health Plan Employer Data and Information Set, or HEDIS, has been incorporated into the oversight certification by NCQA. HEDIS measures range from preventive services, such as screening mammography and pediatric immunization, to elements of care, including decreasing the complications of diabetes and improving treatment for patients with heart disease. For the HMO and POS plans, NCQA’s highest accreditation is granted only to those plans that demonstrate levels of service and clinical quality that meet or exceed NCQA’s rigorous requirements for consumer protection and quality improvement. Plans earning this accreditation level must also achieve HEDIS results that are in the highest range of national or regional performance. For the PPO plans, NCQA’s highest accreditation is granted to those plans that have excellent programs for quality improvement and consumer protection and that meet or exceed NCQA’s standards. Overall, our managed care plans have been rated “Excellent” by the NCQA, with certain plans scheduled to receive accreditation in the near future.

 

In addition, we have initiated a broad array of quality programs, including those built around smoking cessation and transplant management, and increasingly effective hospital and physician quality initiatives centered on women’s health care, diabetes and patient safety. During 2005, we created a strategic partnership with WebMD Health, which provides members access to online health information products and provides members the ability to search for medically sound information and innovative ways to proactively manage their health. Our online tool set offered through WebMD encourages members to adopt healthy behaviors and lifestyles that lead to better health outcomes and lower care costs associated with manageable and preventable chronic illnesses.

 

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Pricing and Underwriting of Our Products

 

We price our products based on our assessment of current health care claim costs and emerging health care cost trends, combined with charges for administrative expenses, risk and profit. We continually review our product designs and pricing guidelines on a national and regional basis so that our products remain competitive and consistent with our profitability goals and strategies.

 

In applying our pricing to each employer group and customer, we maintain consistent, competitive, strict underwriting standards. We employ our proprietary accumulated actuarial data in determining underwriting and pricing parameters. Where allowed by law and regulation, we underwrite individual policies based upon the medical history of the individual applying for coverage, small groups based upon case specific underwriting procedures and large groups based on each group’s aggregate claim experience. Also, we employ credit underwriting procedures with respect to our self-funded products.

 

In most circumstances, our pricing and underwriting decisions follow a prospective rating process in which a fixed premium is determined at the beginning of the contract period. Any deviation, favorable or unfavorable, from the medical costs assumed in determining the premium is our responsibility. Some of our larger groups employ retrospective rating reviews, where positive experience is partially refunded to the group, and negative experience is charged against a rate stabilization fund established from the group’s favorable experience, or charged against future favorable experience.

 

BCBSA License

 

We have filed for registration of and maintain several service marks, trademarks and trade names at the federal level and in various states in which we operate. We have the exclusive right to use the BCBS names and marks for our health benefits products in California (Blue Cross only), Colorado, Connecticut, Georgia, Indiana, Kentucky, Maine, Missouri (excluding 30 counties in the Kansas City area), Nevada, New Hampshire, Ohio, Virginia (excluding the Northern Virginia suburbs of Washington, D.C.), and Wisconsin. In addition, following our December 28, 2005 acquisition of WellChoice, we have the exclusive right to use the Blue Cross and Blue Shield names and marks in ten counties in the New York City metropolitan area and in six counties in upstate New York, and the non-exclusive right to use these names and marks in one upstate New York county. Further, we have an exclusive right to use only the Blue Cross names and marks in seven counties in our upstate New York service area and a nonexclusive right to use only Blue Cross names and marks in an additional four upstate New York counties.

 

Each license requires an annual fee to be paid to the BCBSA. The fee is based upon enrollment and premium. BCBSA is a national trade association of Blue Cross and Blue Shield licensees, the primary function of which is to promote and preserve the integrity of the BCBS names and marks, as well as provide certain coordination among the member companies. Each BCBSA licensee is an independent legal organization and is not responsible for obligations of other BCBSA member organizations. We have no right to market products and services using the BCBS names and marks outside of the states in which we are licensed to sell BCBS products.

 

We believe that the BCBS names and marks are valuable identifiers of our products and services in the marketplace. The license agreements, which have a perpetual term, contain certain requirements and restrictions regarding our operations and our use of the BCBS names and marks. Upon termination of the license agreements, we would cease to have the right to use the BCBS names and marks in one or more of the states that we are authorized to use the marks and the BCBSA could thereafter issue a license to use the BCBS names and marks in these states to another entity. Events that could cause the termination of a license agreement with the BCBSA include failure to comply with minimum capital requirements, a change of control or violation of the BCBSA ownership limits on our capital stock, impending financial insolvency, the appointment of a trustee or receiver or the commencement of any action against a licensee seeking its dissolution.

 

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The license agreements with the BCBSA contain certain requirements and restrictions regarding our operations and our use of the BCBS names and marks, including:

 

    minimum capital and liquidity requirements;

 

    enrollment and customer service performance requirements;

 

    participation in programs that provide portability of membership between plans;

 

    disclosure to the BCBSA relating to enrollment and financial conditions;

 

    disclosures as to the structure of the BCBS system in contracts with third parties and in public statements;

 

    plan governance requirements;

 

    a requirement that at least 80% (or, in the case of Blue Cross of California, substantially all) of a licensee’s annual combined net revenue attributable to health benefit plans within its service area must be sold, marketed, administered or underwritten under the BCBS names and marks;

 

    a requirement that at least 66 2/3% of a licensee’s annual combined national revenue attributable to health benefits plans must be sold, marketed, administered or underwritten under the BCBS names and marks;

 

    a requirement that neither a plan nor any of its licensed affiliates may permit an entity other than a plan or a licensed affiliate to obtain control of the plan or the licensed affiliate or to acquire a substantial portion of its assets related to licensable services;

 

    a requirement that limits beneficial ownership of our capital stock to less than 10% for institutional investors and less than 5% for non-institutional investors;

 

    a requirement that we guarantee certain contractual and financial obligations of our licensed affiliates; and

 

    a requirement that we indemnify the BCBSA against any claims asserted against us resulting from the contractual and financial obligations of any subsidiary that serves as a fiscal intermediary providing administrative services for Medicare Parts A and B.

 

We believe that we and our licensed affiliates are currently in compliance with these standards. The standards under the license agreements may be modified in certain instances by the BCBSA.

 

Regulation

 

General

 

Our operations are subject to comprehensive and detailed state and federal regulation throughout the United States in the jurisdictions in which we do business. Supervisory agencies, including state health, insurance and corporation departments, have broad authority to:

 

    grant, suspend and revoke licenses to transact business;

 

    regulate many aspects of our products and services;

 

    monitor our solvency and reserve adequacy; and

 

    scrutinize our investment activities on the basis of quality, diversification and other quantitative criteria.

 

To carry out these tasks, these regulators periodically examine our operations and accounts.

 

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Regulation of Insurance Company and HMO Business Activity

 

The federal government, as well as the governments of the states in which we conduct our operations, have adopted laws and regulations that govern our business activities in various ways. These laws and regulations, which vary significantly by state, may restrict how we conduct our businesses and may result in additional burdens and costs to us. Areas of governmental regulation include but are not limited to:

 

    licensure;

 

    premium rates;

 

    benefits;

 

    service areas;

 

    market conduct;

 

    utilization review activities;

 

    prompt payment of claims;

 

    universal health care regulation based on the availability to individuals and small groups of a government sponsored health plan administered by a private contractor and funded by increased premium taxes;

 

    assessments for state run immunization programs;

 

    requirements that pharmacy benefit managers pass manufacturers’ rebates to customers;

 

    member rights and responsibilities;

 

    sales and marketing activities;

 

    quality assurance procedures;

 

    plan design and disclosures, including mandated benefits;

 

    collection, access or use of protected health information;

 

    eligibility requirements;

 

    provider rates of payment;

 

    surcharges on provider payments;

 

    provider contract forms;

 

    provider access standards;

 

    premium taxes and assessments for the uninsured and or underinsured;

 

    underwriting, marketing and rating restrictions for small group products;

 

    member and provider complaints and appeals;

 

    underwriting and pricing;

 

    financial arrangements;

 

    financial condition (including reserves and minimum capital or risk based capital requirements);

 

    reimbursement or payment levels for government funded business; and

 

    corporate governance.

 

These laws and regulations are subject to amendments and changing interpretations in each jurisdiction.

 

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States generally require health insurers and HMOs to obtain a certificate of authority prior to commencing operations. If we were to establish a health insurance company or an HMO in any state where we do not presently operate, we generally would have to obtain such a certificate. The time necessary to obtain such a certificate varies from state to state. Each health insurer and HMO must file periodic financial and operating reports with the states in which it does business. In addition, health insurers and HMOs are subject to state examination and periodic license renewal. The health benefits business also may be adversely impacted by court and regulatory decisions that expand the interpretations of existing statutes and regulations. It is uncertain whether we can recoup, through higher premiums or other measures, the increased costs of mandated benefits or other increased costs caused by potential legislation, regulation or court rulings.

 

Medicare Changes

 

The Medicare Prescription Drug, Improvement and Modernization Act of 2003, or MMA, became law in December 2003. The MMA significantly changed and expanded Medicare. In a pertinent part, the MMA added prescription drug benefits to Medicare for all Medicare eligible individuals starting January 1, 2006. Effective January 1, 2006, we began offering Medicare approved prescription drug plans to Medicare eligible individuals in all regions of the country. In addition, we are also providing various administrative services for other entities offering prescription drug plans to their employees and retirees through our pharmacy benefit management companies and other affiliated companies.

 

HIPAA and Gramm-Leach-Bliley Act

 

The federal Health Insurance Portability and Accountability Act of 1996, or HIPAA imposes obligations for issuers of health insurance coverage and health benefit plan sponsors. This law requires guaranteed health care coverage for small employers having 2 to 50 employees and for individuals who meet certain eligibility requirements. It also requires guaranteed renewability of health care coverage for most employers and individuals. The law limits exclusions based on preexisting conditions for individuals covered under group policies to the extent the individuals had prior creditable coverage.

 

The Administrative Simplification provisions of HIPAA imposed a number of requirements on covered entities (including insurers, HMOs, group health plans, providers and clearinghouses). These requirements include uniform standards of common electronic health care transactions; privacy and security regulations; and unique identifier rules for employers, health plans and providers. We complied timely with requirements that have gone into effect, and intend to comply with future requirements on or before the compliance dates.

 

Other federal legislation includes the Gramm-Leach-Bliley Act, which generally placed restrictions on the disclosure of non-public information to non-affiliated third parties, and required financial institutions including insurers, to provide customers with notice regarding how their non-public personal information is used, including an opportunity to “opt out” of certain disclosures. The federal law required state departments of insurance, and certain federal agencies, to adopt implementing regulations, and as such, there has been a great deal of activity at the state and federal level. The Gramm-Leach-Bliley Act also gives banks and other financial institutions the ability to affiliate with insurance companies, which may lead to new competitors in the insurance and health benefits fields.

 

Employee Retirement Income Security Act of 1974

 

The provision of services to certain employee welfare benefit plans is subject to the Employee Retirement Income Security Act of 1974, as amended, or ERISA, a complex set of laws and regulations subject to interpretation and enforcement by the Internal Revenue Service and the Department of Labor, or DOL. ERISA regulates certain aspects of the relationships between us, the employers who maintain employee welfare benefit plans subject to ERISA and participants in such plans. Some of our administrative services and other activities may also be subject to regulation under ERISA. In addition, certain states require licensure or registration of companies providing third party claims administration services for benefit plans. We provide a variety of products and services to employee welfare benefit plans that are covered by ERISA. Plans subject to ERISA can

 

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also be subject to state laws and the question of whether ERISA preempts a state law has been, and will continue to be, interpreted by many courts.

 

HMO and Insurance Holding Company Laws

 

We are regulated as an insurance holding company and are subject to the insurance holding company acts of the states in which our subsidiaries are domiciled. These acts contain certain reporting requirements as well as restrictions on transactions between an insurer or HMO and its affiliates. These holding company laws and regulations generally require insurance companies and HMOs within an insurance holding company system to register with the insurance department of each state where they are domiciled and to file with those states’ insurance departments certain reports describing capital structure, ownership, financial condition, certain intercompany transactions and general business operations. In addition, various notice and reporting requirements generally apply to transactions between insurance companies and HMOs and their affiliates within an insurance holding company system, depending on the size and nature of the transactions. Some insurance holding company laws and regulations require prior regulatory approval or, in certain circumstances, prior notice of certain material intercompany transfers of assets as well as certain transactions between insurance companies, HMOs, their parent holding companies and affiliates. Among other restrictions, state insurance and HMO laws may restrict the ability of our regulated subsidiaries to pay dividends.

 

Additionally, the holding company acts of the states in which our subsidiaries are domiciled restrict the ability of any person to obtain control of an insurance company or HMO without prior regulatory approval. Under those statutes, without such approval (or an exemption), no person may acquire any voting security of an insurance holding company, which controls an insurance company or HMO, or merge with such a holding company, if as a result of such transaction such person would “control” the insurance holding company. “Control” is generally defined as the direct or indirect power to direct or cause the direction of the management and policies of a person and is presumed to exist if a person directly or indirectly owns or controls 10% or more of the voting securities of another person.

 

Guaranty Fund Assessments

 

Under insolvency or guaranty association laws in most states, insurance companies can be assessed for amounts paid by guaranty funds for policyholder losses incurred when an insurance company becomes insolvent. Most state insolvency or guaranty association laws currently provide for assessments based upon the amount of premiums received on insurance underwritten within such state (with a minimum amount payable even if no premium is received). Under many of these guaranty association laws, assessments against insurance companies that issue policies of accident or sickness insurance are made retrospectively. The amount and timing of any future assessments, however, cannot be reasonably estimated and are beyond our control.

 

While the amount of any assessments applicable to life and health guaranty funds cannot be predicted with certainty, we believe that future guaranty association assessments for insurer insolvencies will not have a material adverse effect on our liquidity and capital resources.

 

Risk-Based Capital Requirements

 

The states of domicile of our regulated subsidiaries have statutory risk-based capital, or RBC, requirements for health and other insurance companies based on the RBC Model Act. These RBC requirements are intended to assess the capital adequacy of life and health insurers, taking into account the risk characteristics of an insurer’s investments and products. The RBC Model Act sets forth the formula for calculating the RBC requirements, which are designed to take into account asset risks, insurance risks, interest rate risks and other relevant risks with respect to an individual insurance company’s business. In general, under these laws, an insurance company must submit a report of its RBC level to the insurance department or insurance commissioner of its state of domicile for each calendar year.

 

The law requires increasing degrees of regulatory oversight and intervention as an insurance company’s RBC declines. The RBC Model Act provides for four different levels of regulatory attention depending on the

 

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ratio of a company’s total adjusted capital (defined as the total of its statutory capital, surplus and asset valuation reserve) to its risk-based capital. The level of regulatory oversight ranges from requiring the insurance company to inform and obtain approval from the domiciling insurance commissioner of a comprehensive financial plan for increasing its RBC, to mandatory regulatory intervention requiring an insurance company to be placed under regulatory control in a rehabilitation or liquidation proceeding. As of December 31, 2005, the RBC levels of our insurance subsidiaries exceeded all RBC thresholds.

 

Employees

 

At December 31, 2005, we had approximately 42,000 persons employed on a full-time basis. As of December 31, 2005, a small portion of employees were covered by collective bargaining agreements: 156 employees in the Sacramento, California area with the Office and Professional Employees International Union, Local 29; 141 employees in the greater Detroit, Michigan area with the International Brotherhood of Teamsters, Chauffeurs, Warehousemen and Helpers of America, Local No. 614; 20 employees in New York city metropolitan area with the Office and Professional Employees International Union, Local 153; and 183 employees in Milwaukee, Wisconsin with the Office and Professional Employees International Union, Local 9. Our employees are an important asset, and we seek to develop them to their full potential. We believe that our relationship with our employees is good.

 

ITEM 1A. RISK FACTORS.

 

The following factors, among others, could cause actual results to differ materially from those contained in forward-looking statements made in this Annual Report on Form 10-K and presented elsewhere by management from time to time. Such factors, among others, may have a material adverse effect on our business, financial condition, and results of operations and you should carefully consider them. It is not possible to predict or identify all such factors. Consequently, you should not consider any such list to be a complete statement of all our potential risks or uncertainties. Because of these and other factors, past performance should not be considered an indication of future performance.

 

Changes in state and federal regulations, or the application thereof, may adversely affect our business, financial condition and results of operations.

 

Our insurance, managed health care and health maintenance organization, or HMO, subsidiaries are subject to extensive regulation and supervision by the insurance, managed health care or HMO regulatory authorities of each state in which they are licensed or authorized to do business, as well as to regulation by federal and local agencies. We cannot assure you that future regulatory action by state insurance or HMO authorities will not have a material adverse effect on the profitability or marketability of our health benefits or managed care products or on our business, financial condition and results of operations. In addition, because of our participation in government-sponsored programs such as Medicare and Medicaid, changes in government regulations or policy with respect to, among other things, reimbursement levels, could also adversely affect our business, financial condition and results of operations. In addition, we cannot assure you that application of the federal and/or state tax regulatory regime that currently applies to us will not, or future tax regulation by either federal and/or state governmental authorities concerning us could not, have a material adverse effect on our business, operations or financial condition.

 

State legislatures and Congress continue to focus on health care issues. From time to time, Congress has considered various forms of managed care reform legislation which, if adopted, could fundamentally alter the treatment of coverage decisions under ERISA. Additionally, there have been legislative attempts to limit ERISA’s preemptive effect on state laws. If adopted, such limitations could increase our liability exposure and could permit greater state regulation of our operations. Other proposed bills and regulations, including those related to consumer-driven health plans and health savings accounts and insurance market reforms, at state and federal levels may impact certain aspects of our business, including premium receipts, provider contracting, claims payments and processing and confidentiality of health information. While we cannot predict if any of

 

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these initiatives will ultimately become effective or, if enacted, what their terms will be, their enactment could increase our costs, expose us to expanded liability or require us to revise the ways in which we conduct business. Further, as we continue to implement our e-business initiatives, uncertainty surrounding the regulatory authority and requirements in this area may make it difficult to ensure compliance.

 

As a holding company, we are dependent on dividends from our subsidiaries. Our regulated subsidiaries are subject to state regulations, including restrictions on the payment of dividends and maintenance of minimum levels of capital.

 

We are a holding company whose assets include all of the outstanding shares of common stock of our subsidiaries including our intermediate holding companies and regulated insurance and HMO subsidiaries. As a holding company, we depend on dividends from our subsidiaries. Among other restrictions, state insurance and HMO laws may restrict the ability of our regulated subsidiaries to pay dividends. Our ability to pay dividends in the future to our shareholders and meet our obligations, including paying operating expenses and debt service on our outstanding and future indebtedness, will depend upon the receipt of dividends from our subsidiaries. An inability of our subsidiaries to pay dividends in the future in an amount sufficient for us to meet our financial obligations may materially adversely affect our business, financial condition and results of operations.

 

Most of our regulated subsidiaries are subject to risk-based capital, known as RBC, standards, imposed by their states of domicile. These laws are based on the RBC Model Act adopted by the National Association of Insurance Commissioners, or NAIC, and require our regulated subsidiaries to report their results of risk-based capital calculations to the departments of insurance and the NAIC. Failure to maintain the minimum RBC standards could subject our regulated subsidiaries to corrective action, including state supervision or liquidation. Our regulated subsidiaries are currently in compliance with the risk-based capital or other similar requirements imposed by their respective states of domicile. As discussed in more detail below, we are a party to license agreements with the Blue Cross Blue Shield Association, which contain certain requirements and restrictions regarding our operations, including minimum capital and liquidity requirements, which could restrict the ability of our regulated subsidiaries to pay dividends.

 

We face risks related to litigation.

 

We are, or may be in the future, a party to a variety of legal actions that affect any business, such as employment and employment discrimination-related suits, employee benefit claims, breach of contract actions, tort claims and intellectual property-related litigation. In addition, because of the nature of our business, we are subject to a variety of legal actions relating to our business operations, including the design, management and offering of our products and services. These could include: claims relating to the denial of health care benefits; medical malpractice actions; allegations of anti-competitive and unfair business activities; provider disputes over compensation and termination of provider contracts; disputes related to self-funded business; disputes over co-payment calculations; claims related to the failure to disclose certain business practices; and claims relating to customer audits and contract performance.

 

A number of class action lawsuits have been filed against us and certain of our competitors in the managed care business. The suits are purported class actions on behalf of certain of our managed care members and network providers for alleged breaches of various state and federal laws. While we intend to defend these suits vigorously, we will incur expenses in the defense of these suits and cannot predict their outcome.

 

Recent court decisions and legislative activity may increase our exposure for any of these types of claims. In some cases, substantial non-economic, treble or punitive damages may be sought. We currently have insurance coverage for some of these potential liabilities. Other potential liabilities may not be covered by insurance, insurers may dispute coverage or the amount of insurance may not be enough to cover the damages awarded. In addition, certain types of damages, such as punitive damages, may not be covered by insurance, and insurance coverage for all or certain forms of liability may become unavailable or prohibitively expensive in the future. Any adverse judgment against us resulting in such damage awards could have an adverse effect on our cash flows, results of operations and financial condition.

 

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In addition, we are also involved in pending and threatened litigation of the character incidental to the business transacted, arising out of our operations, and are from time to time involved as a party in various governmental investigations, audits, reviews and administrative proceedings. These investigations, audits and reviews include routine and special investigations by various state insurance departments, state attorneys general and the U.S. Attorney General. Such investigations could result in the imposition of civil or criminal fines, penalties and other sanctions. We believe that any liability that may result from any one of these actions, or in the aggregate, is unlikely to have a material adverse effect on our consolidated results of operations or financial position.

 

Our inability to contain health care costs, implement increases in premium rates on a timely basis, maintain adequate reserves for policy benefits, maintain our current provider agreements or avoid a downgrade in our ratings may adversely affect our business and profitability.

 

Our profitability depends in large part on accurately predicting health care costs and on our ability to manage future health care costs through underwriting criteria, medical management, product design and negotiation of favorable provider contracts. The aging of the population and other demographic characteristics and advances in medical technology continue to contribute to rising health care costs. Government-imposed limitations on Medicare and Medicaid reimbursement have also caused the private sector to bear a greater share of increasing health care costs. Changes in health care practices, inflation, new technologies, the cost of prescription drugs, clusters of high cost cases, changes in the regulatory environment and numerous other factors affecting the cost of health care may adversely affect our ability to predict and manage health care costs, as well as our business, financial condition and results of operations.

 

In addition to the challenge of managing health care costs, we face pressure to contain premium rates. Our customer contracts may be subject to renegotiation as customers seek to contain their costs. Alternatively, our customers may move to a competitor to obtain more favorable premiums. Fiscal concerns regarding the continued viability of programs such as Medicare and Medicaid may cause decreasing reimbursement rates for government-sponsored programs in which we participate. A limitation on our ability to increase or maintain our premium levels could adversely affect our business, financial condition and results of operations.

 

The reserves that we establish for health insurance policy benefits and other contractual rights and benefits are based upon assumptions concerning a number of factors, including trends in health care costs, expenses, general economic conditions and other factors. Actual experience will likely differ from assumed experience, and to the extent the actual claims experience is less favorable than estimated based on our underlying assumptions, our incurred losses would increase and future earnings could be adversely affected.

 

In addition, our profitability is dependent upon our ability to contract on favorable terms with hospitals, physicians and other health care providers. The failure to maintain or to secure new cost-effective health care provider contracts may result in a loss in membership or higher medical costs. In addition, our inability to contract with providers, or the inability of providers to provide adequate care, could adversely affect our business.

 

Claims-paying ability and financial strength ratings by recognized rating organizations have become an increasingly important factor in establishing the competitive position of insurance companies and health benefits companies. Rating organizations continue to review the financial performance and condition of insurers. Each of the rating agencies reviews its ratings periodically and there can be no assurance that our current ratings will be maintained in the future. We believe our strong ratings are an important factor in marketing our products to customers, since ratings information is broadly disseminated and generally used throughout the industry. If our ratings are downgraded or placed under surveillance or review, with possible negative implications, the downgrade, surveillance or review could adversely affect our business, financial condition and results of operations. These ratings reflect each rating agency’s opinion of our financial strength, operating performance and ability to meet our obligations to policyholders and creditors, and are not evaluations directed toward the protection of investors in our common stock.

 

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A reduction in the enrollment in our health benefits programs could have an adverse effect on our business and profitability.

 

A reduction in the number of enrollees in our health benefits programs could adversely affect our business, financial condition and results of operations. Factors that could contribute to a reduction in enrollment include: failure to obtain new customers or retain existing customers; premium increases and benefit changes; our exit from a specific market; reductions in workforce by existing customers; negative publicity and news coverage; failure to attain or maintain nationally recognized accreditations; and general economic downturn that results in business failures.

 

The health benefits industry is subject to negative publicity, which can adversely affect our business and profitability.

 

The health benefits industry is subject to negative publicity. Negative publicity may result in increased regulation and legislative review of industry practices, which may further increase our costs of doing business and adversely affect profitability by: adversely affecting our ability to market our products and services; requiring us to change our products and services; or increasing the regulatory burdens under which we operate.

 

In addition, as long as we use the Blue Cross and Blue Shield names and marks in marketing our health benefits products and services, any negative publicity concerning the Blue Cross Blue Shield Association or other Blue Cross Blue Shield Association licensees may adversely affect us and the sale of our health benefits products and services. Any such negative publicity could adversely affect our business, financial condition and results of operations.

 

We face competition in many of our markets and customers and brokers have flexibility in moving between competitors.

 

As a health benefits company, we operate in a highly competitive environment and in an industry that is currently subject to significant changes from business consolidations, new strategic alliances, legislative reform, aggressive marketing practices by other health benefits organizations and market pressures brought about by an informed and organized customer base, particularly among large employers. This environment has produced and will likely continue to produce significant pressures on the profitability of health benefits companies.

 

We are dependent on the services of independent agents and brokers in the marketing of our health care products, particularly with respect to individuals, seniors and small employer group members. Such independent agents and brokers are typically not exclusively dedicated to us and may frequently also market health care products of our competitors. We face intense competition for the services and allegiance of independent agents and brokers. We cannot assure you that we will be able to compete successfully against current and future competitors or that competitive pressures faced by us will not materially and adversely affect our business, financial condition and results of operations.

 

A change in our health care product mix may impact our profitability.

 

Our health care products that involve greater potential risk generally tend to be more profitable than administrative services products and those health care products where we are able to shift risk to employer groups. Individuals and small employer groups are more likely to purchase our higher-risk health care products because such purchasers are generally unable or unwilling to bear greater liability for health care expenditures. Typically, government-sponsored programs also involve our higher-risk health care products. From time to time, we have implemented price increases in certain of our health care businesses. While these price increases may improve profitability, there can be no assurance that this will occur. Subsequent unfavorable changes in the relative profitability between our various products could have a material adverse effect on our business, financial condition, and results of operations.

 

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Our pharmacy benefit management companies operate in an industry faced with a number of risks and uncertainties in addition to those we face with our core health care business.

 

The following are some of the pharmacy benefit industry-related risks that could have a material adverse effect on our business, financial condition and results of operations:

 

    the application of federal and state anti-remuneration laws;

 

    compliance requirements for pharmacy benefit manager fiduciaries under ERISA, including compliance with fiduciary obligations under ERISA in connection with the development and implementation of items such as formularies, preferred drug listings and therapeutic intervention programs; and potential liability regarding the use of patient-identifiable medical information;

 

    a number of federal and state legislative proposals are being considered that could adversely affect a variety of pharmacy benefit industry practices, such as the receipt of rebates from pharmaceutical manufacturers;

 

    the application of state laws related to the operation of Internet and mail-service pharmacies.

 

We believe that our pharmacy benefit management business is currently being conducted in compliance in all material respects with applicable legal requirements. However, there can be no assurance that our business will not be subject to challenge under various laws and regulations, or that any such challenge will not have a material adverse effect on our business, financial condition and results of operations.

 

We are a party to license agreements with the Blue Cross Blue Shield Association that entitle us to the exclusive and in certain areas non-exclusive use of the Blue Cross and Blue Shield names and marks in our geographic territories. The termination of these license agreements or changes in the terms and conditions of these license agreements could adversely affect our business, financial condition and results of operations.

 

We use the Blue Cross and Blue Shield names and marks as identifiers for our products and services under licenses from the Blue Cross Blue Shield Association. Our license agreements with the Blue Cross Blue Shield Association contain certain requirements and restrictions regarding our operations and our use of the Blue Cross and Blue Shield names and marks, including: minimum capital and liquidity requirements; enrollment and customer service performance requirements; participation in programs that provide portability of membership between plans; disclosures to the Blue Cross Blue Shield Association relating to enrollment and financial conditions; disclosures as to the structure of the Blue Cross Blue Shield system in contracts with third parties and in public statements; plan governance requirements; a requirement that at least 80% (or, in the case of Blue Cross of California, substantially all) of a licensee’s annual combined local net revenue attributable to health benefits plans within its service areas must be sold, marketed, administered or underwritten under the Blue Cross and Blue Shield names and marks; a requirement that at least 66 2/3% of a licensee’s annual combined national net revenue attributable to health benefits plans must be sold, marketed, administered or underwritten under the Blue Cross and Blue Shield names and marks; a requirement that neither a plan nor any of its licensed affiliates may permit an entity other than a plan or a licensed affiliate to obtain control of the plan or the licensed affiliate or to acquire a substantial portion of its assets related to licensable services; a requirement that we guarantee certain contractual and financial obligations of our licensed affiliates; and a requirement that we indemnify the Blue Cross Blue Shield Association against any claims asserted against us resulting from the contractual and financial obligations of any subsidiary that serves as a fiscal intermediary providing administrative services for Medicare Parts A and B. Failure to comply with the foregoing requirements could result in a termination of the license agreements.

 

The standards under the license agreements may be modified in certain instances by the Blue Cross Blue Shield Association. For example, from time to time there have been proposals considered by the Blue Cross Blue Shield Association to modify the terms of the license agreements to restrict various potential business activities of licensees. These proposals have included, among other things, a limitation on the ability of a licensee to make

 

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its provider networks available to insurance carriers or other entities not holding a Blue Cross or Blue Shield license. To the extent that such amendments to the license agreements are adopted in the future, they could have a material adverse effect on our future expansion plans or results of operations.

 

Upon the occurrence of an event causing termination of the license agreements, we would no longer have the right to use the Blue Cross and Blue Shield names and marks in one or more of our geographic territories. Furthermore, the Blue Cross Blue Shield Association would be free to issue a license to use the Blue Cross and Blue Shield names and marks in these states to another entity. Events that could cause the termination of a license agreement with the Blue Cross Blue Shield Association include failure to comply with minimum capital requirements imposed by the Blue Cross Blue Shield Association, a change of control or violation of the Blue Cross Blue Shield Association ownership limitations on our capital stock, impending financial insolvency and the appointment of a trustee or receiver or the commencement of any action against a licensee seeking its dissolution. We believe that the Blue Cross and Blue Shield names and marks are valuable identifiers of our products and services in the marketplace. Accordingly, termination of the license agreements could have a material adverse effect on our business, financial condition and results of operations.

 

Upon termination of a license agreement, the Blue Cross Blue Shield Association would impose a “Re-establishment Fee” upon us, which would allow the Blue Cross Blue Shield Association to “re-establish” a Blue Cross and or Blue Shield presence in the vacated service area. Through December 31, 2005 the fee was set at $80 per licensed enrollee. As of December 31, 2005, we reported 27.3 million Blue Cross and or Blue Shield enrollees. If the re-establishment fee was applied to our total Blue Cross and or Blue Shield enrollees, we would be assessed approximately $2.2 billion by the Blue Cross Blue Shield Association.

 

Our investment portfolios are subject to varying economic and market conditions, as well as regulation. If we fail to comply with these regulations, we may be required to sell certain investments.

 

The market values of our investments vary from time to time depending on economic and market conditions. For various reasons, we may sell certain of our investments at prices that are less than the carrying value of the investments. In addition, in periods of declining interest rates, bond calls and mortgage loan prepayments generally increase, resulting in the reinvestment of these funds at the then lower market rates. We cannot assure you that our investment portfolios will produce positive returns in future periods. Our regulated subsidiaries are subject to state laws and regulations that require diversification of our investment portfolios and limit the amount of investments in certain riskier investment categories, such as below-investment-grade fixed income securities, mortgage loans, real estate and equity investments, which could generate higher returns on our investments. Failure to comply with these laws and regulations might cause investments exceeding regulatory limitations to be treated as non-admitted assets for purposes of measuring statutory surplus and risk-based capital, and, in some instances, require the sale of those investments.

 

As a Medicare fiscal intermediary, we are subject to complex regulations. If we fail to comply with these regulations, we may be exposed to criminal sanctions and significant civil penalties.

 

Like a number of other Blue Cross and Blue Shield companies, we serve as a fiscal intermediary for the Medicare program, which generally provides coverage for persons who are 65 or older and for persons with end-stage renal disease. Part A of the Medicare program provides coverage for services provided by hospitals, skilled nursing facilities and other health care facilities. Part B of the Medicare program provides coverage for services provided by physicians, physical and occupational therapists and other professional providers. Part B also includes coverage for durable medical equipment such as diabetic supplies and wheelchairs. As a fiscal intermediary, we receive reimbursement for certain costs and expenditures, which is subject to adjustment upon audit by CMS (formerly the Health Care Financing Administration, or HCFA). The laws and regulations governing fiscal intermediaries for the Medicare programs are complex, subject to interpretation and can expose a fiscal intermediary to penalties for non-compliance. If we fail to comply with these laws and regulations, we could be subject to criminal fines, civil penalties or other sanctions.

 

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Regional concentrations of our business may subject us to economic downturns in those regions.

 

Our business operations include or consist of strategic business units located in the Midwest, East and West with most of our revenues generated in the states of California, Colorado, Connecticut, Georgia, Indiana, Kentucky, Maine, Missouri, Nevada, New Hampshire, New York, Ohio, Virginia and Wisconsin. Due to this concentration of business in these states, we are exposed to potential losses resulting from the risk of an economic downturn in these states. If economic conditions in these states deteriorate, we may experience a reduction in existing and new business, which could have a material adverse effect on our business, financial condition and results of operations.

 

Large-scale medical emergencies may have a material adverse effect on our business, financial condition and results of operations.

 

Large-scale medical emergencies can take many forms and can cause widespread illness and death. For example, there have been various incidents of suspected bioterrorist activity in the United States. To date, these incidents have resulted in related isolated incidents of illness and death. However, federal and state law enforcement officials have issued warnings about additional potential terrorist activity involving biological and other weapons. In addition, natural disasters such as the hurricanes experienced in the southeastern part of the United States in 2005 and the potential for a wide-spread pandemic of influenza coupled with the lack of availability of appropriate preventative medicines can have a significant impact on the health of the population of wide-spread areas. If the United States were to experience more widespread bioterrorist or other attacks, large-scale natural disasters in our concentrated coverage areas or a large-scale pandemic, our covered medical expenses could rise and we could experience a material adverse effect on our business, financial condition and results of operations.

 

We have built a significant portion of our current business through mergers and acquisitions and we expect to pursue acquisitions in the future.

 

The following are some of the risks associated with acquisitions that could have a material adverse effect on our business, financial condition and results of operations:

 

    some of the acquired businesses may not achieve anticipated revenues, earnings or cash flow;

 

    we may assume liabilities that were not disclosed to us or which we under-estimated;

 

    we may be unable to integrate acquired businesses successfully and realize anticipated economic, operational and other benefits in a timely manner, which could result in substantial costs and delays or other operational, technical or financial problems;

 

    acquisitions could disrupt our ongoing business, distract management, divert resources and make it difficult to maintain our current business standards, controls and procedures;

 

    we may finance future acquisitions by issuing common stock for some or all of the purchase price, which could dilute the ownership interests of our shareholders;

 

    we may also incur additional debt related to future acquisitions; and

 

    we would be competing with other firms, some of which may have greater financial and other resources, to acquire attractive companies.

 

We have substantial indebtedness outstanding and may incur additional indebtedness in the future. As a holding company, we are not able to repay our indebtedness except through dividends from subsidiaries, some of which are restricted in their ability to pay such dividends under applicable insurance law and undertakings. Such indebtedness could also adversely affect our ability to pursue desirable business opportunities.

 

As of December 31, 2005, we had indebtedness outstanding of approximately $6.8 billion and had available borrowing capacity under our amended and restated revolving credit facility of approximately $898.6 million,

 

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which credit facility expires on November 29, 2010. In January 2006, we incurred additional debt of $2.7 billion which was used to repay our bridge loan and a portion of our commercial paper borrowings that were outstanding at December 31, 2005, and we may also incur additional indebtedness in the future. Our debt service obligations require us to use a portion of our cash flow to pay interest and principal on debt instead of for other corporate purposes, including funding future expansion. If our cash flow and capital resources are insufficient to service our debt obligations, we may be forced to seek extraordinary dividends from our subsidiaries, sell assets, seek additional equity or debt capital or restructure our debt. However, these measures might be unsuccessful or inadequate in permitting us to meet scheduled debt service obligations.

 

As a holding company, we have no operations and are dependent on dividends from our subsidiaries for cash to fund our debt service and other corporate needs. Our subsidiaries are separate legal entities. Furthermore, our subsidiaries are not obligated to make funds available to us, and creditors of our subsidiaries will have a superior claim to certain of our subsidiaries’ assets. State insurance laws restrict the ability of our regulated subsidiaries to pay dividends, and in some states we have made special undertakings that may limit the ability of our regulated subsidiaries to pay dividends. In addition, our subsidiaries’ ability to make any payments to us will also depend on their earnings, the terms of their indebtedness, business and tax considerations and other legal restrictions. We cannot assure you that our subsidiaries will be able to pay dividends or otherwise contribute or distribute funds to us in an amount sufficient to pay the principal of or interest on the indebtedness owed by us.

 

We may also incur future debt obligations that might subject us to restrictive covenants that could affect our financial and operational flexibility. Our breach or failure to comply with any of these covenants could result in a default under our credit agreements. If we default under our credit agreements, the lenders could cease to make further extensions of credit or cause all of our outstanding debt obligations under our credit agreements to become immediately due and payable, together with accrued and unpaid interest. If the indebtedness under our notes or our credit agreements is accelerated, we may be unable to repay or finance the amounts due. Indebtedness could also limit our ability to pursue desirable business opportunities, and may affect our ability to maintain an investment grade rating for our indebtedness.

 

We face intense competition to attract and retain employees.

 

We are dependent on retaining existing employees, attracting and retaining additional qualified employees to meet current and future needs and achieving productivity gains from our investments in technology. We face intense competition for qualified employees, especially information technology personnel and other skilled professionals, and there can be no assurance that we will be able to attract and retain such employees or that such competition among potential employers will not result in increasing salaries. There also can be no assurance that an inability to retain existing employees or attract additional employees will not have a material adverse effect on our business, financial condition and results of operations.

 

The failure to effectively maintain and modernize our operations in an Internet environment could adversely affect our business.

 

Our business depends significantly on effective information systems, and we have many different information systems for our various businesses. Our information systems require an ongoing commitment of significant resources to maintain and enhance existing systems and develop new systems in order to keep pace with continuing changes in information processing technology, evolving industry and regulatory standards, and changing customer preferences. In addition, we may from time to time obtain significant portions of our systems-related or other services or facilities from independent third parties, which may make our operations vulnerable to such third parties’ failure to perform adequately. As a result of our merger and acquisition activities, we have acquired additional systems. Our failure to maintain effective and efficient information systems, or our failure to efficiently and effectively consolidate our information systems to eliminate redundant or obsolete applications, could have a material adverse effect on our business, financial condition and results of operations.

 

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Also, like many of our competitors in the health benefits industry, our vision for the future includes becoming a premier e-business organization by modernizing interactions with customers, brokers, agents, providers, employees and other stakeholders through web-enabling technology and redesigning internal operations. We are developing our e-business strategy with the goal of becoming widely regarded as an e-business leader in the health benefits industry. The strategy includes not only sales and distribution of health benefits products on the Internet, but also implementation of advanced self-service capabilities benefiting customers, agents, brokers, partners and employees. There can be no assurance that we will be able to realize successfully our e-business vision or integrate e-business operations with our current method of operations. The failure to develop successful e-business capabilities could result in competitive and cost disadvantages to us as compared to our competitors.

 

We are dependent on the success of our relationship with a large vendor for a significant portion of our information system resources and certain other vendors for various other services.

 

We have an agreement with International Business Machines Corporation, or IBM, pursuant to which we outsourced a portion of our core applications development as well as a component of our data center operations and help desk to IBM. We are dependent upon IBM for these support functions. If our relationship with IBM is terminated for any reason, we may not be able to find an alternative partner in a timely manner or on acceptable financial terms. As a result, we may not be able to meet the demands of our customers and, in turn, our business, financial condition and results of operations may be harmed. The contract with IBM includes several service level agreements, or SLAs, related to issues such as performance and job disruption with significant financial penalties if these SLAs are not met. We also outsource a component of our data center to another vendor, which could assume much of the IBM work and mitigate business disruption should a termination with IBM occur. We may not be adequately indemnified against all possible losses through the terms and conditions of the agreement. In addition, some of our termination rights are contingent upon payment of a fee, which may be significant.

 

We have also entered into agreements with large vendors pursuant to which we have outsourced certain functions such as data entry related to claims and billing processes and call center operations for member and provider queries as well as certain Medicare Part D sales. If these vendor relationships were terminated for any reason, we may not be able to find alternative partners in a timely manner or on acceptable financial terms. As a result, we may not be able to meet the full demands of our customers and, in turn, our business, financial condition and results of operations may be harmed.

 

The anticipated potential benefits of the merger between Anthem, Inc. and WellPoint Health Networks Inc. may not be realized.

 

We acquired WellPoint Health Networks Inc. in November 2004 because we believed the merger would be beneficial to our companies. Continuing to achieve the anticipated benefits of the merger will depend in part upon whether anticipated synergies are achieved as a result of this merger. Because of the complex nature of the integration process, we cannot provide any assurances regarding the ultimate achievement of anticipated synergies. Any inability of our management to successfully achieve anticipated synergies could have a material adverse effect on our business, results of operations and financial condition.

 

We may experience difficulties integrating the business of WellChoice with our business and may incur substantial costs in connection with the integration, which could cause us to lose many of the anticipated potential benefits of the acquisition.

 

Integrating WellChoice’s operations into our operating platform will be a complex, time-consuming and expensive process. Before the acquisition, we and WellChoice operated independently, each with our own business, products, customers, employees, culture and systems. We may experience unanticipated and material difficulties or expenses in connection with the integration of WellChoice, especially given the relatively large size and complexity of WellChoice’s operations. The time and expense associated with this integration may

 

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exceed management’s expectations and limit or delay the intended benefits of the transaction. Similarly, the process of combining sales and marketing and network management forces, consolidating administrative functions, and coordinating product and service offerings can take longer, cost more, and provide fewer benefits than initially projected. To the extent any of these events occurs, the benefits of the transaction may be reduced.

 

We may face substantial difficulties, costs and delays in integrating WellChoice. These factors may include:

 

    retaining and integrating management and other key employees;

 

    costs and delays in implementing common systems and procedures, where applicable;

 

    perceived adverse changes in product offerings available to customers or customer service standards, whether or not these changes do, in fact, occur;

 

    difficulty comparing financial reports due to differing management systems;

 

    diversion of management resources from our business;

 

    retention of WellChoice’s provider networks;

 

    difficulty in retaining existing customers of each company; and

 

    reduction or loss of customer sales due to the potential for market confusion, hesitation and delay.

 

We may seek to combine certain operations and functions using common information and communication systems, operating procedures, financial controls and human resource practices, including training, professional development and benefit programs. We may be unsuccessful in implementing the integration of these systems and processes. Any one of these factors may cause increased operating costs, worse than anticipated financial performance or the loss of customers and employees.

 

We acquired WellChoice with the expectation that the acquisition will result in various benefits, including, among others, benefits relating to a stronger and more diverse network of doctors and other health care providers, expanded and enhanced affordable health care services, enhanced revenues, a strengthened market position for us across the United States, cross-selling opportunities, technology, cost savings and operating efficiencies. Achieving the anticipated benefits of the acquisition is subject to a number of uncertainties, including whether we integrate WellChoice in an efficient and effective manner, and general competitive factors in the marketplace. Failure to achieve these anticipated benefits could result in increased costs, decreases in the amount of expected revenues and diversion of management’s time and energy and could materially impact our business, financial condition and operating results.

 

Indiana law, and other applicable laws, and our articles of incorporation and bylaws, may prevent or discourage takeovers and business combinations that our shareholders might consider in their best interest.

 

Indiana law and our articles of incorporation and bylaws may delay, defer, prevent or render more difficult a takeover attempt that our shareholders might consider in their best interests. For instance, they may prevent our shareholders from receiving the benefit from any premium to the market price of our common stock offered by a bidder in a takeover context. Even in the absence of a takeover attempt, the existence of these provisions may adversely affect the prevailing market price of our common stock if they are viewed as discouraging takeover attempts in the future.

 

We are regulated as an insurance holding company and subject to the insurance holding company acts of the states in which our insurance company subsidiaries are domiciled, as well as similar provisions included in the health statutes and regulations of certain states where these subsidiaries are regulated as managed care companies or HMOs. The insurance holding company acts and regulations and these similar health provisions restrict the ability of any person to obtain control of an insurance company or HMO without prior regulatory approval.

 

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Under those statutes and regulations, without such approval (or an exemption), no person may acquire any voting security of a domestic insurance company or HMO, or an insurance holding company which controls an insurance company or HMO, or merge with such a holding company, if as a result of such transaction such person would “control” the insurance holding company, insurance company or HMO. “Control” is generally defined as the direct or indirect power to direct or cause the direction of the management and policies of a person and is presumed to exist if a person directly or indirectly owns or controls 10% or more of the voting securities of another person.

 

In addition to the restrictions described above, under the Indiana demutualization law, for a period of five years following November 2, 2001, the effective date of our demutualization, no person may acquire beneficial ownership of 5% or more of the outstanding shares of our common stock without the prior approval of the Indiana Insurance Commissioner and our Board of Directors. Any of our shares acquired in violation of this restriction, without the prior approval of the Indiana Insurance Commissioner and our Board of Directors, may not be voted at any shareholders’ meeting. This restriction does not apply to acquisitions made by us or made pursuant to an employee benefit plan or employee benefit trust sponsored by us. The Indiana Insurance Commissioner has adopted rules under which passive institutional investors could purchase 5% or more but less than 10% of our outstanding common stock with the prior approval of our Board of Directors and prior notice to the Indiana Insurance Commissioner.

 

Further, the Indiana corporation law contains business combination provisions that, in general, prohibit for five years any business combination with a beneficial owner of 10% or more of our common stock unless the holder’s acquisition of the stock was approved in advance by our Board of Directors. The Indiana corporation law also contains control share acquisition provisions that limit the ability of certain shareholders to vote their shares unless their control share acquisition is approved in advance.

 

Our articles of incorporation restrict the beneficial ownership of our capital stock in excess of specific ownership limits. The ownership limits restrict beneficial ownership of our voting capital stock to less than 10% for institutional investors and less than 5% for non-institutional investors, both as defined in our articles of incorporation. Additionally, no person may beneficially own shares of our common stock representing a 20% or more ownership interest in us. These restrictions are intended to ensure our compliance with the terms of our licenses with the Blue Cross Blue Shield Association. By agreement between us and the Blue Cross Blue Shield Association, these ownership limits may be increased. Our articles of incorporation prohibit ownership of our capital stock beyond these ownership limits without prior approval of a majority of our continuing directors (as defined in our articles of incorporation). In addition, as discussed above in the risk factor describing our license agreements with the Blue Cross Blue Shield Association, such license agreements are subject to termination upon a change of control and re-establishment fees would be imposed upon termination of the license agreements.

 

Certain other provisions included in our articles of incorporation and bylaws may also have anti-takeover effects and may delay, defer or prevent a takeover attempt that our shareholders might consider in their best interests. In particular, our articles of incorporation and bylaws: permit our Board of Directors to issue one or more series of preferred stock; divide our Board of Directors into three classes serving staggered three-year terms; restrict the maximum number of directors; limit the ability of shareholders to remove directors; impose restrictions on shareholders’ ability to fill vacancies on our Board of Directors; prohibit shareholders from calling special meetings of shareholders; impose advance notice requirements for shareholder proposals and nominations of directors to be considered at meetings of shareholders; and impose restrictions on shareholders’ ability to amend our articles of incorporation and bylaws.

 

ITEM 1B. UNRESOLVED SEC STAFF COMMENTS.

 

None.

 

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ITEM 2. PROPERTIES

 

We have set forth below a summary of our principal office space (locations greater than 100,000 square feet). We believe that our facilities will be sufficient to meet our needs for the foreseeable future.

 

Location


 

Amount (Square Feet) of
Building Owned or Leased
and Occupied by WellPoint


  

Principal Usage


370 Basset Rd., North Haven, CT

  566,000    Operations

220 Virginia Ave., Indianapolis, IN

  557,000    Operations

21555 Oxnard St., Woodland Hills, CA

  448,000    Operations

11 Corporate Woods, Albany, NY

  375,000    Operations

1831 Chestnut St., St. Louis, MO

  312,000    Operations

DCS, 2015 Staples Mill Rd., Richmond, VA

  295,000    Operations

700 Broadway, Denver, CO

  285,000    Operations

3350 Peachtree Rd., Atlanta, GA

  272,000    Operations

9901 Linn Station Rd., Louisville, KY

  255,000    Operations

DCN, 2015 Staples Mill Rd., Richmond, VA

  249,000    Operations

13550 Triton Office Park Blvd., Louisville, KY

  234,000    Operations

4241 Irwin Simpson Rd., Mason, OH

  224,000    Operations

2000 & 2100 Corporate Center Drive, Newbury Park, CA

  218,000    Operations

401 Michigan St., Milwaukee, WI

  216,000    Operations

15 MetroTech Center, Brooklyn, NY

  217,000    Operations

4361 Irwin Simpson Rd., Mason, OH

  213,000    Operations

2 Gannett Dr., South Portland, ME

  208,000    Operations

400 S. Salina St., Syracuse, NY

  203,000    Operations

120 Monument Circle, Indianapolis, IN

  202,000    Principal executive offices

3000 Goff Falls Rd., Manchester, NH

  201,000    Operations

2221 Edward Holland Drive, Richmond, VA

  193,000    Operations

8115-8125 Knue Road, Indianapolis, IN

  184,000    Operations

6740 N. High St., Worthington, OH

  182,000    Operations

85 Crystal Run, Middletown, NY

  173,000    Operations

1351 Wm. Howard Taft, Cincinnati, OH

  167,000    Operations

5151-5155 Camino Ruiz, Camarillo, CA

  149,000    Operations

2357 Warm Springs Rd., Columbus, GA

  147,000    Operations

233 S. Wacker Drive, Chicago, IL

  146,000    Operations

6737 West Washington St., West Allis, WI

  144,000    Operations

602 S. Jefferson St., Roanoke, VA

  144,000    Operations

4553 La Tienda Drive, Thousand Oaks, CA

  120,000    Operations

3 Huntington Quadrangle, Melville, NY

  110,000    Operations

11 West 42nd St., New York, NY

  107,000    Operations

12433 Olive Blvd., St. Louis, MO

  102,000    Operations

 

Our facilities support our various business segments. We believe that our properties are adequate and suitable for our business as presently conducted.

 

ITEM 3. LEGAL PROCEEDINGS.

 

Litigation

 

Multi-District Litigation Settlement Agreement

 

In May 2000, a case titled California Medical Association vs. Blue Cross of California, et. al., was filed in U.S. district court in San Francisco against Blue Cross of California (“BCC”), one of WHN’s subsidiaries at the time and now a Company subsidiary. The lawsuit alleges that BCC violated the Racketeer Influenced and Corrupt Organizations Act (“RICO”) (the “CMA Litigation”).

 

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In August 2000, WHN was added as a defendant to Shane v. Humana, et al., a class-action lawsuit brought on behalf of health care providers nationwide alleging RICO violations (the “Shane Litigation”). Effective upon the November 30, 2004 merger with WHN, WHN became a wholly owned subsidiary of the Company. On September 26, 2002, Anthem was added as a defendant to the Shane Litigation.

 

In May 2003, in a case titled Kenneth Thomas, M.D., et al., v. Blue Cross Blue Shield Association, et al., (the “Thomas Litigation”) several medical providers filed suit in federal district court in Miami, Florida against the Blue Cross Blue Shield Association (“BCBSA”) and Blue Cross and Blue Shield plans across the country, including the Company and WellChoice. The suit alleges that the BCBSA and the Blue Cross and Blue Shield plans violated RICO and challenges many of the same practices as the CMA Litigation and the Shane Litigation.

 

In October 2000, the federal Judicial Panel on Multidistrict Litigation (“MDL”) issued an order consolidating the CMA Litigation, the Shane Litigation and various other pending managed care class-action lawsuits against the Company and other companies before District Court Judge Federico Moreno in the Southern District of Florida for purposes of pretrial proceedings. A mediator was appointed by Judge Moreno and the parties have been conducting court-ordered mediation. On December 9, 2004, Judge Moreno issued a new scheduling order extending the expert discovery deadline to February 7, 2005 and setting trial for September 6, 2005.

 

On July 11, 2005, the Company entered into a settlement agreement (the “Agreement”) with representatives of more than 700,000 physicians nationwide to resolve the CMA Litigation, the Shane Litigation, the Thomas Litigation and certain other similar cases brought by physicians. Under the Agreement, the Company has agreed to make cash payments totaling up to $198.0 million, of which $135.0 million will be paid to physicians and $5.0 million will be contributed to a not-for-profit foundation whose mission is to promote higher quality health care and to enhance the delivery of care to the disadvantaged members of the public. In addition, up to $58.0 million will be paid in legal fees to be determined by the court. The Company also has agreed to implement and maintain a number of operational changes such as standardizing the definition of medical necessity in physician contracts, creating a formalized Physician Advisory Committee and modifying some of the Company’s claims payment and physician contracting provisions. The Agreement is subject to, and conditioned upon, review and approval by the U.S. District Court for the Southern District of Florida. The court preliminarily approved the settlement in an order filed July 15, 2005. The hearing for final approval was held on December 2, 2005 in Miami, Florida. The Court issued a final order approving the settlement on December 22, 2005, and issued an amended final order approving the settlement on January 4, 2006. Appeals have been filed by certain physicians. As a result of the Agreement, the Company incurred a pre-tax expense of $103.0 million, or $0.10 per diluted share after tax, for the year ended December 31, 2005, which represents the final settlement amount of the Agreement that was not previously accrued.

 

The WellChoice transaction was closed on December 28, 2005, after the settlement was reached with the plaintiffs in the CMA Litigation, the Shane Litigation and the Thomas Litigation. The former WellChoice company, now one of our wholly-owned subsidiaries, continues to be a defendant in the Thomas Litigation, and will not be affected by the settlement between the Company and plaintiffs. The Company intends to vigorously defend this proceeding; however, its ultimate outcome cannot be presently determined.

 

Other Litigation

 

On June 27, 2002, in a case titled Academy of Medicine of Cincinnati and Luis Pagani, M.D. v. Aetna Health, Inc., Humana Health Plan of Ohio, Inc., Anthem Blue Cross and Blue Shield, and United Health Care of Ohio, Inc., No. A02004947 filed in the Court of Common Pleas, Hamilton County, Ohio and a case titled Academy of Medicine of Cincinnati and A. Lee Greiner, M.D., Victor Schmelzer, M.D., and Karl S. Ulicny, Jr., M.D. v. Aetna Health, Inc., Humana, Inc., Anthem Blue Cross and Blue Shield, and United Health Care, Inc., No. 02-CI-903 filed in the Boone County, Kentucky Circuit Court, the Academy and certain physicians allege that the defendants acted in combination and collusion with one another to reduce the reimbursement rates paid to physicians in the area. On September 30, 2005, the Company entered into a settlement agreement to resolve

 

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the litigation. The settlement agreement has three components. First, the Company will increase the total annual reimbursement to physicians in the twelve county area (six counties each in Ohio and Kentucky) by $35.0 million in 2005, an additional $20.0 million in 2006 and an additional $15.0 million in 2007. The increases will be measured against the total reimbursement amount for the same area in 2004. Second, the Company will pay $2.8 million to plaintiffs, with approximately $0.6 million for payments to retired doctors and incentive awards to the named plaintiffs and the remainder going to a charitable foundation to improve health care in the affected area. Third, the Company will pay $9.6 million in attorneys’ fees to the plaintiffs’ class counsel. Both the Ohio court and the Kentucky court preliminarily approved the settlement on September 30, 2005. A final fairness hearing was held on November 21, 2005. Both courts issued orders giving final approval of the settlement on November 21, 2005. The attorneys’ fees, incentive awards to plaintiffs, payments to retired doctors and charitable donation were paid out December 27, 2005. The final terms of the settlement agreement did not have a significant impact on the financial results of the Company for the year ended December 31, 2005.

 

Prior to WHN’s acquisition of the group benefit operations (“GBO”) of John Hancock Mutual Life Insurance Company (“John Hancock”), John Hancock entered into a number of reinsurance arrangements, including with respect to personal accident insurance and the occupational accident component of workers’ compensation insurance, a portion of which was originated through a pool managed by Unicover Managers, Inc. Under these arrangements, John Hancock assumed risks as a reinsurer and transferred certain of such risks to other companies. Similar reinsurance arrangements were entered into by John Hancock following WHN’s acquisition of the GBO of John Hancock. These various arrangements have become the subject of disputes, including a number of legal proceedings to which John Hancock is a party. The Company is currently in arbitration with John Hancock regarding these arrangements. The Company believes that it has a number of defenses to avoid any ultimate liability with respect to these matters and believes that such liabilities were not transferred to the Company as part of the GBO acquisition. However, if the Company were to become subject to such liabilities, the Company could suffer losses that might have a material adverse effect on its financial condition, results of operations or cash flows.

 

Other Contingencies

 

From time to time, the Company and certain of its subsidiaries are parties to various legal proceedings, many of which involve claims for coverage encountered in the ordinary course of business. The Company, like HMOs and health insurers generally, excludes certain health care services from coverage under its HMO, PPO and other plans. The Company is, in its ordinary course of business, subject to the claims of its enrollees arising out of decisions to restrict or deny reimbursement for certain services. The loss of even one such claim, if it results in a significant punitive damage award, could have a material adverse effect on the Company. In addition, the risk of potential liability under punitive damage theories may increase significantly the difficulty of obtaining reasonable settlements of coverage claims.

 

In addition to the lawsuits described above, the Company is also involved in other pending and threatened litigation of the character incidental to the business transacted, arising out of its operations and its 2001 demutualization, and is from time to time involved as a party in various governmental investigations, audits, reviews and administrative proceedings. These investigations, audits and reviews include routine and special investigations by state insurance departments, state attorneys general and the U.S. Attorney General. Such investigations could result in the imposition of civil or criminal fines, penalties and other sanctions. The Company believes that any liability that may result from any one of these actions, or in the aggregate, is unlikely to have a material adverse effect on its consolidated financial position or results of operations.

 

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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

 

The Company did not submit any matters to a vote of security holders during the fourth quarter of 2005.

 

PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

 

Market Prices

 

The Company’s Common Stock, par value $0.01 per share, is listed on the NYSE under the symbol “WLP”. On February 15, 2006, the closing price on the NYSE was $78.82. As of February 15, 2006, there were 154,599 shareholders of record of the Common Stock. The following table presents high and low sales prices for the Common Stock on the NYSE for the periods indicated.

 

       High

     Low

2005

                 

First Quarter1

     $ 63.98      $ 54.58

Second Quarter1

       71.23        58.20

Third Quarter

       77.40        65.06

Fourth Quarter

       80.40        70.25

20041

                 

First Quarter

     $ 46.07      $ 36.25

Second Quarter

       47.80        41.93

Third Quarter

       46.95        38.88

Fourth Quarter

       58.85        36.10
 
  1 The market prices for the Company’s stock reflect the two-for-one stock split, which was approved by the Board of Directors on April 25, 2005.

 

Dividends

 

No cash dividends have been paid on our common stock. The declaration and payment of future dividends will be at the discretion of our Board of Directors and must comply with applicable law. Future dividend payments will depend upon our financial condition, results of operations, future liquidity needs, potential acquisitions, regulatory and capital requirements and other factors deemed relevant by our Board of Directors. In addition, we are a holding company whose primary assets are 100% of the capital stock of Anthem Insurance Companies, Inc., Anthem Southeast, Inc., Anthem Holding Corp. and WellPoint Holding Corp. Our ability to pay dividends to our shareholders, if authorized by our Board of Directors, is significantly dependent upon the receipt of dividends from our insurance subsidiaries. The payment of dividends by our insurance subsidiaries without prior approval of the insurance department of each subsidiary’s domiciliary jurisdiction is limited by formula. Dividends in excess of these amounts are subject to prior approval by the respective insurance departments.

 

Securities Authorized for Issuance under Equity Compensation Plans

 

The information required by this Item concerning securities authorized for issuance under the Company’s equity compensation plans is set forth in or incorporated by reference into Part III Item 12 of this Form 10-K.

 

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Issuer Purchases of Equity Securities

 

Period


  Total Number
of Shares
Purchased1


   Average
Price Paid
per Share


   Total Number
of Shares
Purchased as
Part of
Publicly
Announced
Programs2


   Approximate
Dollar Value
of Shares that
May Yet Be
Purchased
Under the
Programs


    (In millions, except share and per share data)

October 1, 2005 to October 31, 2005

  433    $ 74.96    —      $ 1,000.0

November 1, 2005 to November 30, 2005

  1,655      76.45    —        1,000.0

December 1, 2005 to December 31, 2005

  87,655      78.81    —        2,000.0
   
         
      
    89,743      78.75    —         
   
         
      

1 Total number of shares purchased includes 89,743 shares delivered to or withheld by the Company in connection with employee payroll tax withholding upon exercise of stock awards. Stock grants to employees and directors and stock issued for stock option plans and stock purchase plans in the consolidated statements of shareholders’ equity are shown net of these shares purchased.
2 Represents the number of shares repurchased through our repurchase program authorized by our Board of Directors. During the year ended December 31, 2005, the Company repurchased approximately 5.1 million shares at a cost of $333.4 million under the program. Remaining authorization under the program is $2.0 billion as of December 31, 2005.

 

ITEM 6. SELECTED FINANCIAL DATA.

 

The table below provides selected consolidated financial data of WellPoint. The information has been derived from our consolidated financial statements for each of the years in the five year period ended December 31, 2005. You should read this selected consolidated financial data in conjunction with the audited consolidated financial statements and notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this Form 10-K.

 

    As of and for the Years Ended December 31

 
    20051

    20041

    2003

    20021

    2001

 
    (In millions, except where indicated and except per share data)  

Income Statement Data

                                       

Total operating revenue2,3

  $ 44,513.1     $ 20,460.9     $ 16,487.1     $ 13,000.4     $ 10,131.3  

Total revenue3

    45,136.0       20,815.1       16,781.4       13,292.2       10,455.7  

Net income4

    2,463.8       960.1       774.3       549.1       342.2  

Per Share Data4,5

                                       

Basic net income per share

  $ 4.03     $ 3.15     $ 2.80     $ 2.31     $ 1.66  

Diluted net income per share

    3.94       3.05       2.73       2.26       1.65  

Other Data (unaudited)

                                       

Benefit expense ratio6

    80.6 %     82.0 %     80.8 %     82.3 %     84.4 %

Selling, general and administrative expense ratio6

    16.3 %     17.0 %     18.8 %     19.3 %     19.6 %

Income before income taxes as a percentage of total revenue

    8.6 %     6.9 %     7.2 %     6.0 %     5.0 %

Net income as a percentage of total revenue

    5.5 %     4.6 %     4.6 %     4.1 %     3.3 %

Medical membership (In thousands)

    33,856       27,728       11,927       11,053       7,883  

 

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    As of and for the Years Ended December 31

    20051

   20041

   2003

   20021

   2001

    (In millions, except where indicated and except per share data)

Balance Sheet Data

                                 

Cash and investments3

  $ 20,336.0    $ 15,792.2    $ 7,478.2    $ 6,726.4    $ 4,559.8

Total assets3

    51,405.2      39,738.4      13,414.6      12,416.3      6,325.0

Long-term debt3

    6,324.7      4,289.5      1,662.8      1,659.4      818.0

Total liabilities3

    26,412.1      20,279.4      7,414.7      7,054.0      4,265.0

Total shareholders’ equity

    24,993.1      19,459.0      5,999.9      5,362.3      2,060.0

1 The net assets for WellChoice, Inc. and the net assets of and results of operations for Lumenos, Inc., WellPoint Health Networks Inc., and Trigon Healthcare, Inc. are included from their respective acquisition dates of December 28, 2005 (effective December 31, 2005 for accounting purposes), June 9, 2005, November 30, 2004, and July 31, 2002.
2 Operating revenue is obtained by adding premiums, administrative fees and other revenue.
3 Certain prior year amounts have been reclassified to conform to the current year presentation.
4 We adopted FAS 142, Goodwill and Other Intangible Assets, on January 1, 2002. With the adoption of FAS 142, we ceased amortization of goodwill. The intangible assets established for Blue Cross and Blue Shield trademarks are deemed to have indefinite lives, and beginning January 1, 2002, are no longer amortized.

 

Net income and net income per share for the year ended December 31, 2001 on a pro forma basis as if FAS 142 had been adopted January 1, 2001, is as follows:

 

(In millions, except per share data)


 

Net income adjusted for FAS 142

  $ 357.3

Basic net income per share adjusted for FAS 142

    1.73

Diluted net income per share adjusted for FAS 142

    1.72

 

5 There were no shares or dilutive securities outstanding prior to November 2, 2001 (date of Anthem’s, whose name changed to WellPoint, demutualization and initial public offering). Accordingly, amounts prior to 2002 represent pro forma earnings per share. For comparative pro forma earnings per share presentation, the weighted average shares outstanding and the effect of dilutive securities for the period from November 2, 2001 to December 31, 2001, was used to calculate pro forma earnings per share for 2001.
6 The benefit expense ratio represents benefit expenses as a percentage of premium revenue. The selling, general and administrative expense ratio represents selling, general and administrative expenses as a percentage of total operating revenue.

 

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

References to the terms “we”, “our”, or “us” used throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, refer to WellPoint, Inc. (name changed from Anthem, Inc. effective November 30, 2004), an Indiana holding company, and unless the context otherwise requires, its direct and indirect subsidiaries.

 

The structure of our Management’s Discussion and Analysis of Financial Condition and Results of Operations is as follows:

 

I. Executive Summary

 

II. Overview

 

III. Significant Transactions

 

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IV. Membership—December 31, 2005 Compared to December 31, 2004

 

V. Cost of Care

 

VI. Results of Operations—Year Ended December 31, 2005 Compared to the Year Ended December 31, 2004

 

VII. Membership—December 31, 2004 Compared to December 31, 2003

 

VIII. Results of Operations—Year Ended December 31, 2004 Compared to the Year Ended December 31, 2003

 

IX. Critical Accounting Policies and Estimates

 

X. Liquidity and Capital Resources

 

XI. Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995

 

I.    Executive Summary

 

We are the largest health benefits company in terms of membership in the United States, serving approximately 34 million medical members as of December 31, 2005. We are an independent licensee of the Blue Cross Blue Shield Association, or BCBSA, an association of independent health benefit plans. We serve our members as the Blue Cross licensee in California and as the Blue Cross and Blue Shield licensee for: Colorado, Connecticut, Georgia, Indiana, Kentucky, Maine, Missouri (excluding 30 counties in the Kansas City area), Nevada, New Hampshire, New York (as BCBS in 10 New York City metropolitan counties, and as Blue Cross or BCBS in selected upstate counties only), Ohio, Virginia (excluding the immediate suburbs of Washington, D.C.), and Wisconsin. We also serve customers throughout various parts of the country as UniCare. We are licensed to conduct insurance operations in all 50 states through our subsidiaries and in Puerto Rico through an affiliate.

 

No other health benefits company has leading local market presence in so many geographic areas. This market position offers advantages in attracting physicians and hospitals to our networks at attractive rates and in helping to keep our products affordable. While we hold the leading position in these markets, all have additional room for expansion.

 

Operating revenue reached an all-time high of $44.5 billion in 2005, a 118% increase over 2004. Operating revenue increases were driven by the merger with WellPoint Health Networks Inc., which represented approximately 111% of this increase, supplemented by organic revenue growth, particularly in the individual and small group business, known as ISG, Large Group and National Account businesses.

 

We have successfully executed our strategy to deliver on our long-term goal of achieving at least 15% growth in fully diluted earnings per share, or EPS, which was exceeded in 2005 as our EPS increased by 29%. We have accomplished this by focusing on profitable enrollment growth with innovative product offerings, pricing with discipline, implementing initiatives to optimize the cost of care, continuing to leverage administrative costs over a larger membership base, further penetrating our specialty businesses and by using our cash flow effectively.

 

We intend to continue expanding through a combination of organic growth and strategic acquisitions in both existing and new markets. Our growth strategy is designed to enable us to take advantage of the additional economies of scale provided by increased overall membership as well as providing us access to new and evolving technologies and products. In addition, we believe geographic diversity reduces our exposure to local or regional regulatory, economic and competitive pressures and provides us with increased opportunities for growth. While we have achieved strong growth as a result of strategic mergers and acquisitions, we have also achieved organic growth in our existing markets by providing excellent service, offering competitively priced products and effectively capitalizing on the brand strength of the Blue Cross and Blue Shield names and marks.

 

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II.    Overview

 

We manage our operations through three reportable segments: Health Care, Specialty and Other.

 

Our Health Care segment includes strategic business units delineated primarily by geographic areas within which we offer similar products and services, including commercial accounts, individual, senior and government programs such as the Federal Employee Program, or FEP, and Medicaid. We offer a diversified mix of managed care products, including preferred provider organizations or PPOs, health maintenance organizations or HMOs, traditional indemnity benefits, consumer-driven health plans or CDHPs and point of service or POS plans. We also offer a variety of hybrid benefit plans, including consumer directed, hospital only and limited benefit products. Additionally, we provide a broad array of managed care services to self-funded customers, including claims processing, underwriting, stop loss insurance, actuarial services, provider network access, medical cost management and other administrative services.

 

Our Specialty segment is comprised of businesses providing pharmacy benefit management, group life and disability insurance benefits, behavioral health benefits, dental, vision, workers’ compensation and long-term care insurance.

 

Our Other segment is comprised of our Medicare processing business, including AdminaStar Federal and United Government Services; Arcus Enterprises, which works to develop innovative means to promote quality care, well being and education; intersegment revenue and expense eliminations; and corporate expenses not allocated to our Health Care or Specialty segments. Effective December 31, 2005, Empire Medical Services, the Medicare processing company of the former WellChoice, was also included in our Other segment.

 

Our operating revenue consists of premiums, administrative fees and other revenue. Premium revenue comes from fully-insured contracts where we indemnify our policyholders against costs for covered health and life benefits. Administrative fees come from contracts where our customers are self-insured, or where the fee is based on either processing of transactions or a percent of network discount savings realized. Additionally, we earn administrative fee revenues from our Medicare processing business and from other health-related businesses including disease management programs. Other revenue is principally generated from member co-payments and deductibles associated with the mail-order sale of drugs by our pharmacy benefit management companies.

 

Our benefit expense includes costs of care for health services consumed by our members, such as outpatient care, inpatient hospital care, professional services (primarily physician care) and pharmacy benefit costs. All four components are affected both by unit costs and utilization rates. Unit costs include the cost of outpatient medical procedures per visit, inpatient hospital care per admission, physician fees per office visit and prescription drug prices. Utilization rates represent the volume of consumption of health services and typically vary with the age and health status of our members and their social and lifestyle choices, along with clinical protocols and medical practice patterns in each of our markets. A portion of benefit expense recognized in each reporting period consists of actuarial estimates of claims incurred but not yet paid by us. Any changes in these estimates are recorded in the period the need for such an adjustment arises.

 

Our selling expense consists of external broker commission expenses, and generally varies with premium volume. Our general and administrative expense consists of fixed and variable costs. Examples of fixed costs are depreciation, amortization and certain facilities expenses. Other costs are variable or discretionary in nature. Certain variable costs, such as premium taxes, vary directly with premium volume. Other variable costs, such as salaries and benefits, do not vary directly with changes in premium, but are more aligned with changes in membership. The acquisition or loss of a significant block of business would likely impact staffing levels, and thus salary and benefit expense. Discretionary costs include professional and consulting expenses and advertising. Other factors can impact our administrative cost structure, including systems efficiencies, inflation and changes in productivity.

 

Our cost of drugs consists of the amounts we pay to pharmaceutical companies for the drugs we sell via mail order through our pharmacy benefit management companies, or PBM. This amount excludes the cost of drugs

 

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related to customers of affiliated health plans, which are recorded in benefit expense. Our cost of drugs can be influenced by the volume of prescriptions at our PBM, as well as cost changes, driven by prices set by pharmaceutical companies and mix of drugs sold.

 

Our results of operations depend in large part on our ability to accurately predict and effectively manage health care costs through effective contracting with providers of care to our members and our medical management programs. Several economic factors related to health care costs, such as regulatory mandates of coverage and direct-to-consumer advertising by providers and pharmaceutical companies, have a direct impact on the volume of care consumed by our members. The potential 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 ability to profitably underwrite our business, and may have a material impact on our results of operations.

 

This MD&A should be read in conjunction with our audited consolidated financial statements for the year ended December 31, 2005 included in this Form 10-K.

 

III.    Significant Transactions

 

Merger with WellChoice, Inc.

 

On December 28, 2005 (December 31, 2005 for accounting purposes), WellPoint and WellChoice, Inc., or WellChoice, completed their previously announced merger. The acquisition of WellChoice strengthened our leadership in providing health benefits to National Accounts and provided us with a strategic presence in New York City, the headquarters of more Fortune 500 companies than any other U.S. city. Under the terms of the merger agreement, the stockholders of WellChoice (other than subsidiaries of WellPoint) received consideration of $38.25 in cash and 0.5191 of a share of WellPoint common stock for each share of WellChoice common stock outstanding. In addition, WellChoice stock options and other awards were converted to WellPoint awards in accordance with the merger agreement. The purchase price including cash, fair value of stock and stock awards and estimated transaction costs was approximately $6.5 billion.

 

Multi-District Litigation Settlement Agreement

 

On July 11, 2005, we announced that an agreement was reached with representatives of more than 700,000 physicians nationwide involved in two multi-district class-action lawsuits against us and other health benefits companies. As part of the agreement, we have agreed to pay $135.0 million to physicians and to contribute $5.0 million to a not-for-profit foundation whose mission is to promote higher quality health care and to enhance the delivery of care to the disadvantaged and underserved. In addition, up to $58.0 million will be paid in legal fees. As a result of the agreement, we incurred a pre-tax expense of $103.0 million during the year ended December 31, 2005, or $0.10 EPS, which represents the final settlement amount of the agreement that was not previously accrued.

 

Acquisition of Lumenos, Inc.

 

On June 9, 2005, we announced the completion of our acquisition of Lumenos, Inc., or Lumenos, for approximately $185.0 million in cash paid to the stockholders of Lumenos. The acquisition of Lumenos provided us with market leading consumer-driven health programs as well as the service experience with such programs and the customer tools that drive consumerism in health care today. Lumenos is recognized as a pioneer and market leader in consumer-driven health programs. Lumenos served approximately 177,000 members as of the date of acquisition.

 

Two-For-One Stock Split

 

On April 25, 2005, WellPoint’s Board of Directors approved a two-for-one split of shares of common stock, which was effected in the form of a 100 percent common stock dividend. All shareholders of record on May 13,

 

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2005 received one additional share of WellPoint common stock for each share of common stock held on that date. The additional shares of common stock were distributed to shareholders of record in the form of a stock dividend on May 31, 2005. All historical weighted average share and per share amounts and all references to stock compensation data and market prices of our common stock for all periods presented in this MD&A have been adjusted to reflect this two-for-one stock split.

 

Merger with WellPoint Health Networks Inc.

 

On November 30, 2004, Anthem, Inc. and WellPoint Health Networks Inc., or WHN, completed their merger. The merger with WHN helped us to create the nation’s leading health benefits company and the largest holder of Blue Cross and/or Blue Shield licenses in the country. Additionally, our merger with WHN increased our presence in several new strategic markets, most notably California. Under the terms of the merger agreement, the stockholders of WHN (other than subsidiaries of WHN) received consideration of $23.80 in cash and one share of Anthem, Inc. common stock for each WHN share outstanding. In addition, WHN stock options and other awards were converted to WellPoint, Inc. awards in accordance with the merger agreement. The purchase price including cash, fair value of stock and stock awards and estimated transaction costs was approximately $15.8 billion. Anthem, Inc., the surviving corporate parent, was renamed WellPoint, Inc. concurrent with the merger.

 

IV.    Membership—December 31, 2005 Compared to December 31, 2004

 

Our medical membership includes six different customer types: Large Group, Individual and Small Group, National Accounts, BlueCard Host, Senior and State Sponsored.

 

    Large Group consists of those employer customers with 51 to 4,999 employees eligible to participate as a member in one of our health plans. In addition, Large Group includes customers with 5,000 or more eligible employees with less than 5% of eligible employees located outside the headquarter’s state. Large Group also includes members in the FEP, which provides health insurance coverage to United States government employees and their dependents within our geographic markets through our participation in the national contract between the BCBSA and the U.S. Office of Personnel Management.

 

    Individual and Small Group, or ISG, consists of individual customers under age 65 as well as those employer customers with one to 50 eligible employees.

 

    National Accounts customers are multi-state employer groups primarily headquartered in a WellPoint service area with 5,000 or more eligible employees, with at least 5% of eligible employees located outside of the headquarter’s state. Service area is defined as the geographic area in which we are licensed to sell BCBS products.

 

    BlueCard host members represent enrollees of non-owned Blue Cross and/or Blue Shield plans who receive health care services in our Blue Cross and Blue Shield licensed markets. BlueCard membership consists of estimated host members using the national BlueCard program. Host members are generally members who reside in or travel to a state in which a WellPoint subsidiary is the Blue Cross and/or Blue Shield licensee and who are covered under an employer sponsored health plan issued by a non-WellPoint controlled Blue Cross Blue Shield licensee (i.e., the “home” plan). We perform certain administrative functions for BlueCard members, for which we receive administrative fees from the BlueCard members’ home plans. Other administrative functions, including maintenance of enrollment information and customer service, are performed by the home plan. Host members are computed using, among other things, the average number of BlueCard claims received per member per month.

 

    Senior members are Medicare-eligible individual members age 65 and over who have enrolled in Medicare Advantage, a managed care alternative for the Medicare program, or who have purchased Medicare Supplement benefit coverage.

 

    State Sponsored membership represents eligible members with state sponsored managed care alternatives in Medicaid and State Children’s Health Insurance programs.

 

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In addition to reporting our medical membership by customer type, we report by funding arrangement according to the level of risk that we assume in the product contract. Our two funding arrangement categories are fully-insured and self-funded. Fully-insured products are products in which we indemnify our policyholders against costs for health benefits. Self-funded products are offered to customers, generally larger employers, who elect to retain some or all of the financial risk associated with their employees’ health care costs. Some employers choose to purchase stop-loss coverage to limit their retained risk. These employers are reported with our self-funded business.

 

The following table presents our medical membership by customer type, funding arrangement and geographical region as of December 31, 2005 and 2004. Also included below are key metrics from our Specialty segment, including prescription volume for our PBM and membership by product. The membership data presented is unaudited and in certain instances includes estimates of the number of members represented by each contract at the end of the period.

 

    WellPoint, Inc.
as Reported
December 31,
20051


  WellChoice
December 31,
20052


    WellPoint
Without
WellChoice
December 31,
20053


  WellPoint, Inc.
as Reported
December 31,
2004


  WellPoint Without WellChoice
as Compared to WellPoint at
December 31, 2004


 
          Change

    % Change

 
    (In thousands)  

Medical Membership

                             

Customer Type

                             

Large Group

  16,362   3,085     13,277   13,073   204     2 %

Individual and Small Group (ISG)

  5,645   349     5,296   5,199   97     2  

National Accounts

  4,776   1,235     3,541   3,212   329     10  

BlueCard

  3,915   (93 )   4,008   3,463   545     16  
   
 

 
 
 

     

Total National

  8,691   1,142     7,549   6,675   874     13  

Senior

  1,224   147     1,077   1,059   18     2  

State Sponsored

  1,934   64     1,870   1,722   148     9  
   
 

 
 
 

     

Total medical membership by customer type

  33,856   4,787     29,069   27,728   1,341     5 %
   
 

 
 
 

     

Funding Arrangement

                             

Self-Funded

  16,234   1,798     14,436   13,039   1,397     11 %

Fully-Insured

  17,622   2,989     14,633   14,689   (56 )   0  
   
 

 
 
 

     

Total medical membership by funding arrangement

  33,856   4,787     29,069   27,728   1,341     5 %
   
 

 
 
 

     

Regional Membership

                             

East

  13,800   5,030     8,770   8,508   262     3 %

Central

  10,970   (125 )   11,095   10,565   530     5  

West

  9,086   (118 )   9,204   8,655   549     6  
   
 

 
 
 

     

Total medical membership by Region

  33,856   4,787     29,069   27,728   1,341     5 %
   
 

 
 
 

     

Specialty Metrics

                             

PBM prescription volume4

  344,621   —       344,621   336,541   8,080     2 %

Behavioral health membership

  15,669   —       15,669   11,753   NM5     NM5  

Life and disability membership

  5,826   —       5,826   5,306   NM5     NM5  

Dental membership

  5,195   265     4,930   5,048   NM5     NM5  

Vision membership

  816   —       816   773   43     6 %

 

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Table of Contents

1 Amounts reported at December 31, 2005, include membership from the WellChoice acquisition that closed on December 28, 2005 and from the Lumenos acquisition that closed on June 9, 2005.
2 Represents membership at December 31, 2005, resulting from the WellChoice acquisition. Medical membership is shown net of overlapping BlueCard host membership.
3 WellPoint without WellChoice membership was calculated by subtracting membership resulting from the WellChoice acquisition from WellPoint, Inc.’s reported membership at December 31, 2005.
4 Represents annual PBM prescription volume for mail order and retail prescriptions for the full years ended December 31, 2005 and 2004.
5 Changes from prior period information are not meaningful due to different counting methodologies used by the former Anthem, Inc. and the former WellPoint Health Networks Inc.

 

During the twelve months ended December 31, 2005, total medical membership increased approximately 6,128,000, or 22%, primarily due to our acquisition of WellChoice and organic growth in all customer types. Excluding the impact of the WellChoice acquisition: BlueCard membership increased 545,000, or 16%, representing membership growth in other Blue Cross and Blue Shield licensees with members who reside in or travel to our licensed areas; National Accounts membership increased 329,000, or 10%, primarily due to new sales, as well as, in-group increases in membership and members acquired from the acquisition of Lumenos; Large Group membership increased 204,000, or 2% primarily due to our acquisition of Lumenos as well as new sales throughout the year; State Sponsored membership increased 148,000, or 9% due to new sales, primarily in the West region; and ISG membership increased 97,000, or 2%, primarily due to the introduction of new, more affordable product designs and an overall increase in consumer awareness of our wide variety of quality products and services as well as efforts to market products to the uninsured.

 

Self-funded medical membership increased 3,195,000 or 25%, primarily due to our merger with WellChoice and increases in our BlueCard, National Accounts and Large Group businesses. Fully-insured membership increased by 2,933,000 or 20%, due to our merger with WellChoice. However, on a comparable basis, fully-insured membership decreased by 56,000 primarily due to a Large Group fully-insured account in the East region, which represented approximately 140,000 medical members, converting to self-funded during the third quarter of 2005. This was partially offset by growth in our ISG and State Sponsored businesses, as well as new sales and positive in-group change in Large Group.

 

Our specialty metrics are derived from membership and activity from our specialty products. These products are often ancillary to our health business, and can therefore be impacted by growth in our medical membership. The membership of these products can also be impacted by our efforts to increase the use of Specialty products by our medical members. Prescription volume at our PBM increased 8,080,000 prescriptions, or 2%, in 2005 primarily due to growth in both our mail order and retail operations. Behavioral Health membership increased 3,916,000, or 33%, in 2005. This growth was primarily due to the transition of 1,900,000 members from an external vendor to our in-house operation, as well as growth within our existing health lines of business, our increased offerings of specialty products to our medical members and a change in counting methodologies contributed to increased Behavioral Health’s membership growth.

 

V.    Cost of Care

 

The following discussion summarizes our aggregate cost of care trends for the full year 2005 for our Large Group and ISG fully-insured businesses only. In order to provide a more meaningful comparison to the current period due to the merger with WHN, cost of care information as discussed below is presented as if pre-merger Anthem, Inc. and WHN were combined for all of 2004 and 2003. Accordingly, cost of care reported previously for pre-merger Anthem, Inc. is not comparable to the information presented below.

 

Our cost of care trends are calculated by comparing the year-over-year change in average per member per month claim costs for which we are responsible, which excludes member co-payments and deductibles. While our cost of care trend varies by geographic location, our aggregate cost of care was less than 8.5% for the full year 2005.

 

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Costs for outpatient and inpatient services are the primary drivers of overall cost trends, with outpatient trends moderating from 2004 levels. Cost trend increases for outpatient services were primarily driven by higher per visit costs as more procedures are being performed during each visit to outpatient providers, particularly emergency room visits, as well as the impact of price increases included within certain provider contracts. However, we are seeing the positive impact of our radiology management programs on our outpatient trends. These programs were implemented over most of our East and Central regions in late 2004 and early 2005 and are designed to ensure appropriate use of radiology services by our members. We are currently expanding these programs to our other regions. Inpatient trends have been driven primarily by unit cost, a reflection of negotiated contract increases with hospitals. Utilization (admissions per 1,000 members) remains flat, while average length of hospital stay and hospital days per 1,000 members have both decreased slightly.

 

Pharmacy benefit cost trend, which previously had been a primary driver of overall trend increases, continues to decline as a result of an increase in generic usage rates, benefit plan design changes, improved pharmaceutical contracting resulting from the merger with WHN, the non-renewal of pharmacy only business from a large state customer with historically high utilization and cost trends effective July 1, 2005 and the impact of lower utilization for the COX 2 Inhibitor therapeutic class of drugs. Late in the third quarter of 2004, the arthritis drug VIOXX® was removed from the market due to concerns about the risk of heart attacks in persons taking this drug for longer than 18 months. We have provided our network physicians with information regarding alternatives to VIOXX and our PBM companies have implemented a process to ensure appropriate usage of the COX 2 Inhibitor therapeutic class of drugs.

 

In response to cost trends, we continue to pursue contracting and plan design changes, promote and implement performance-based contracts that reward clinical outcomes and quality, and expand our radiology management, disease management and advanced care management programs. In addition, we are expanding our specialty pharmacy programs and continuously evaluate our drug formulary to ensure the most effective pharmaceutical therapies are available for our members.

 

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Table of Contents

VI.    Results of Operations—Year Ended December 31, 2005 Compared to the Year Ended December 31, 2004

 

We discuss our operations using “comparable basis” information, which is presented in order to provide a more meaningful prior-year comparison to the current year, due to the merger with WHN. Comparable basis information is not calculated in accordance with U.S. generally accepted accounting principles, or GAAP, and is not intended to represent or be indicative of the results of WellPoint, Inc. had the merger been completed as of January 1, 2004. Comparable basis information for the year ended December 31, 2004 was calculated by adding the reclassified historical statements of income for the former WHN for the 11 months ended November 30, 2004 to the reported results of WellPoint, Inc. for the year ended December 31, 2004, which includes one month of the former WHN. Comparable basis information contains no intercompany eliminations or pro forma adjustments resulting from the November 30, 2004 merger.

 

    WellPoint, Inc.
as Reported
Year Ended
December 31,
2004


    WellPoint
Health
Networks Inc.
Eleven Months
Ended
November 30,
2004


   Reclassification
Adjustments1


   

WellPoint, Inc.
Comparable
Basis

Year Ended
December 31,
2004


 
    (In millions, except per share data)  

Premiums

  $ 18,771.6     $ 19,804.7    $ (9.5 )   $ 38,566.8  

Administrative fees

    1,436.9       1,108.9      (53.1 )     2,492.7  

Other revenue

    252.4       54.1      216.7       523.2  
   


 

  


 


Total operating revenue

    20,460.9       20,967.7      154.1       41,582.7  

Net investment income

    311.7       276.3      (24.9 )     563.1  

Net realized gains on investments

    42.5       8.4      25.0       75.9  
   


 

  


 


Total revenue

    20,815.1       21,252.4      154.2       42,221.7  

Benefit expense

    15,387.8       15,925.5      (32.1 )     31,281.2  

Selling, general and administrative expense:

                              

Selling expense

    537.2       820.8      —         1,358.0  

General and administrative expense

    2,940.5       2,493.4      45.4       5,479.3  
   


 

  


 


Total selling, general and administrative expense

    3,477.7       3,314.2      45.4       6,837.3  

Cost of drugs

    95.0       32.6      142.2       269.8  

Interest expense

    142.3       48.1      —         190.4  

Amortization of other intangible assets

    61.4       7.8      35.3       104.5  

Other expenses

    —         36.6      (36.6 )     —    

Merger-related undertakings

    61.5       —        —         61.5  

Loss on repurchase of debt

    146.1       —        —         146.1  
   


 

  


 


Total expense

    19,371.8       19,364.8      154.2       38,890.8  
   


 

  


 


Income before income taxes

    1,443.3       1,887.6      —         3,330.9  

Income taxes

    483.2       755.1      —         1,238.3  
   


 

  


 


Net income

  $ 960.1     $ 1,132.5    $ —       $ 2,092.6  
   


 

  


 


Benefit expense ratio2

    82.0 %                    81.1 %

Selling, general and administrative expense ratio3

    17.0 %                    16.4 %

1 Represents the reclassification of certain WHN historical amounts to conform to a consistent presentation with WellPoint.
2 Benefit expense ratio = Benefit expense ÷ Premiums.
3 Selling, general and administrative expense ratio = Total selling, general and administrative expense ÷ Total operating revenue.

 

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Table of Contents

Our consolidated results of operations for the years ended December 31, 2005 and 2004 are discussed in the following section.

 

    Years Ended December 31

   

% Change


   

Comparable
Basis2,3

Year Ended

December 31,
2004


   

$ Change


   

% Change


 
    2005

    20041

         
    (In millions, except per share data)  

Premiums

  $ 41,216.7     $ 18,771.6     120 %   $ 38,566.8     $ 2,649.9     7 %

Administrative fees

    2,729.9       1,436.9     90       2,492.7       237.2     10  

Other revenue

    566.5       252.4     124       523.2       43.3     8  
   


 


       


 


     

Total operating revenue

    44,513.1       20,460.9     118       41,582.7       2,930.4     7  

Net investment income

    633.1       311.7     103       NM4       NM4     NM4  

Net realized (losses) gains on investments

    (10.2 )     42.5     (124 )     75.9       (86.1 )   (113 )
   


 


       


 


     

Total revenue

    45,136.0       20,815.1     117       NM4       NM4     NM4  

Benefit expense

    33,219.9       15,387.8     116       31,281.2       1,938.7     6  

Selling, general and administrative expense:

                                           

Selling expense

    1,474.2       537.2     174       1,358.0       116.2     9  

General and administrative expense

    5,798.5       2,940.5     97       5,479.3       319.2     6  
   


 


       


 


     

Total selling, general and administrative expense

    7,272.7       3,477.7     109       6,837.3       435.4     6  

Cost of drugs

    288.0       95.0     203       269.8       18.2     7  

Interest expense

    226.2       142.3     59       NM4       NM4     NM4  

Amortization of other intangible

                                           

assets

    238.9       61.4     289       NM4       NM4     NM4  

Merger-related undertakings

    —         61.5     (100 )     NM4       NM4     NM4  

Loss on repurchase of debt securities

    —         146.1     (100 )     NM4       NM4     NM4  
   


 


       


 


     

Total expense

    41,245.7       19,371.8     113       NM4       NM4     NM4  
   


 


       


 


     

Income before income taxes

    3,890.3       1,443.3     170       NM4       NM4     NM4  

Income taxes

    1,426.5       483.2     195       NM4       NM4        
   


 


       


 


     

Net income

  $ 2,463.8     $ 960.1     157 %     NM4       NM4     NM4  
   


 


       


 


     

Average diluted shares outstanding

    625.8       314.6     99 %     NM4       NM4     NM4  

Diluted net income per share

  $ 3.94     $ 3.05     29 %     NM4       NM4     NM4  

Benefit expense ratio5

    80.6 %     82.0 %   (140 )bp6     81.1 %           (50 )bp6

Selling, general and administrative

                                           

expense ratio7

    16.3 %     17.0 %   (70 )bp6     16.4 %           (10 )bp6

Income before income taxes as a percentage of total revenue

    8.6 %     6.9 %   170 bp6     NM4             NM4  

Net income as a percentage of total revenue

    5.5 %     4.6 %   90 bp6     NM4             NM4  

Certain of the following definitions are also applicable to all other results of operations tables in this discussion:

 

1 Financial results for 2004 include operations of the former WellPoint Health Networks Inc. for the one month period ended December 31, 2004 and the former Anthem, Inc. for the year ended December 31, 2004.
2 See “Comparable Basis Information” above for additional information.

 

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Table of Contents
3 For certain line items impacted by the merger of Anthem and WHN, comparable basis is not meaningful due to related capitalization and purchase accounting.
4 NM = Not meaningful.
5 Benefit expense ratio = Benefit expense ÷ Premiums.
6 bp = basis point; one hundred basis points = 1%.
7 Selling, general and administrative expense ratio = Total selling, general and administrative expense ÷ Total operating revenue.

 

Premiums increased $22,445.1 million, or 120%, to $41,216.7 million in 2005. On a comparable basis, premium increased $2,649.9 million, or 7%, primarily due to premium rate increases in our Large Group, ISG and Senior businesses and membership gains in our ISG, State Sponsored and Senior membership types. Partially offsetting the impact of premium rate increases was the conversion of some Large Group customers from fully-insured contracts to self-funded arrangements and the non-renewal of certain fully-insured accounts.

 

Administrative fees increased $1,293.0 million, or 90%, to $2,729.9 million in 2005. On a comparable basis, administrative fees increased $237.2 million, or 10%, primarily due to increased self-funded membership in our National and Large Group businesses. These membership gains are driven by the popularity of the BlueCard program, as well as successful efforts to attract large self-funded accounts and the continuing trend towards self-funded arrangements over fully-insured contracts among our Large Group customers.

 

Other revenue is comprised principally of co-payments and deductibles associated with the sale of mail-order drugs by our PBM companies, which provides services to members of our Health Care segment and third party clients. Other revenue increased $314.1 million, or 124%, to $566.5 million in 2005. On a comparable basis, other revenue increased $43.3 million, or 8%, primarily due to additional mail-order prescription revenue and increased prices of prescription drugs sold by our PBM companies. Increased mail-order prescription volume resulted from both membership increases and additional utilization of our PBM’s mail-order pharmacy option.

 

Net investment income increased $321.4 million, or 103%, to $633.1 million in 2005 primarily resulting from invested assets acquired with the WHN merger (net of cash used in the merger) and from growth in invested assets from reinvestment of cash generated from operations.

 

A summary of our net realized (losses) gains on investments for the years ended December 31, 2005 and 2004 is as follows:

 

    Years Ended
December 31


       
    2005

    20041

    $ Change

 
    (In millions)        

Net realized (losses) gains from the sale of fixed maturity securities

  $ (25.3 )   $ 40.6     $ (65.9 )

Net realized gains from the sale of equity securities

    22.0       3.3       18.7  

Other-than-temporary impairments

    (14.8 )     (0.8 )     (14.0 )

Other realized gains (losses)

    7.9       (0.6 )     8.5  
   


 


 


Net realized (losses) gains

  $ (10.2 )   $ 42.5     $ (52.7 )
   


 


 


 
  1 Includes operations of the former WellPoint Health Networks Inc. for the one month period ended December 31, 2004 and the former Anthem, Inc. for the year ended December 31, 2004.

 

In 2005, net realized gains and losses from the sale of fixed maturity and equity securities was primarily due to restructuring of our portfolio as a result of integration activities related to our merger with WHN. Net gains or losses on investments are influenced by market conditions when an investment is sold, and will vary from year to year.

 

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Table of Contents

During 2004, we reallocated securities in our fixed maturity portfolio, primarily to optimize future after-tax income by investing in a higher mix of tax-exempt fixed maturity securities. The sale of fixed maturity securities associated with this reallocation resulted in the majority of the net realized gains reported during the year ended December 31, 2004.

 

Other-than-temporary impairments in 2005 were approximately equal between equity securities and fixed maturity securities, while in 2004, other-than-temporary impairments were substantially related to equity securities. Other-than-temporary impairments in both 2005 and 2004 are primarily due to the length of time that such securities’ fair value had been less than cost.

 

Benefit expense increased $17,832.1 million, or 116%, to $33,219.9 million in 2005. On a comparable basis, benefit expense increased $1,938.7 million, or 6%, primarily due to increased cost of care, which was driven primarily by higher costs in outpatient and inpatient services. In addition, our benefit expense included $35.0 million in 2005 related to the multi-district litigation settlement agreement discussed in “Significant Transactions” above. On a comparable basis, our benefit expense ratio decreased 50 basis points from 81.1% in 2004 to 80.6% in 2005. The decrease in our benefit expense ratio is driven by moderating cost of care trends coupled with disciplined underwriting practices.

 

Selling, general and administrative expense increased $3,795.0 million, or 109%, to $7,272.7 million in 2005. On a comparable basis, selling, general and administrative expense increased $435.4 million, or 6%, primarily due to increases in volume-sensitive costs such as higher commissions, premium taxes and other expenses associated with growth in our business; increased incentive compensation, including merger-related stay bonuses; and costs associated with the transition of information technology infrastructure services to IBM. In addition, we incurred expenses related to the multi-district litigation settlement agreement discussed in “Significant Transactions” above; and start-up costs related to Medicare Part D. On a comparable basis, our selling, general and administrative expense ratio decreased 10 basis points to 16.3% in 2005, primarily due to growth in operating revenue and the leveraging of costs over a larger membership base, partially offset by the factors noted above.

 

Cost of drugs increased $193.0 million, or 203%, to $288.0 million in 2005. On a comparable basis cost of drugs increased $18.2 million, or 7%, primarily due to higher retail and mail-order prescription volume at our PBM companies.

 

Interest expense increased $83.9 million, or 59%, to $226.2 million in 2005, primarily due to additional interest expense on the debt incurred in conjunction with the WHN merger, partially offset by reduced interest expense from the repurchase of debt securities in December of 2004.

 

Amortization of other intangible assets increased $177.5 million, or 289%, to $238.9 million in 2005, primarily due to a full year of additional amortization expense related to identifiable intangible assets with finite lives resulting from the WHN merger.

 

Income tax expense increased $943.3 million, or 195%, to $1,426.5 million in 2005. Included in 2005 was $28.4 million in tax benefits associated with a refund claim, recognizing the deductibility of capital losses on the sale of certain subsidiaries that occurred in prior years. Included in 2004 was $44.8 million in tax benefits associated with a change in Indiana laws governing the state’s high-risk health insurance pool.

 

Our net income as a percentage of total revenue increased 90 basis points, from 4.6% in 2004 to 5.5% in 2005. The increase in this metric reflects a combination of all factors discussed above.

 

Reportable Segments

 

We manage our operations through three reportable segments: Health Care, Specialty and Other.

 

We use operating gain to evaluate the performance of our reportable segments, as described in FAS 131, Disclosure About Segments of an Enterprise and Related Information. Operating gain is calculated as total

 

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operating revenue less benefit expense, selling, general and administrative expense and cost of drugs. It does not include net investment income, net realized gains (losses) on investments, interest expense, amortization of other intangible assets, merger-related undertakings, loss on repurchase of debt or income taxes, as these items are managed in a corporate shared service environment and are not the responsibility of operating segment management. For additional information, see Note 19 to our audited consolidated financial statements included in this Form 10-K. The discussions of segment results for the years ended December 31, 2005 and 2004 presented below are based on operating gain, as described above, and operating margin, which is calculated as operating gain divided by operating revenue. Our definitions of operating gain and operating margin may not be comparable to similarly titled measures reported by other companies.

 

Our segments’ operating revenue and operating gain for the year ended December 31, 2004 on a comparable basis are as follows. Comparable basis information was calculated as discussed above and is presented in order to provide investors with a more meaningful prior-year comparison to the current year, due to the merger with WHN. Comparable basis information is not calculated in accordance with GAAP and is not intended to represent or be indicative of the results of WellPoint, Inc. had the merger been completed as of January 1, 2004.

 

    WellPoint, Inc.
as Reported
Year Ended
December 31,
2004


    WellPoint
Health
Networks Inc.
Eleven Months
Ended
November 30,
2004


    Reclassification
Adjustments


   

WellPoint, Inc.
Comparable
Basis

Year Ended
December 31,
2004


 
    (In millions)              

Operating Revenue:

                               

Health Care

  $ 19,754.5     $ 20,014.8     $ (118.2 )   $ 39,651.1  

Specialty

    1,235.2       976.0       423.0       2,634.2  

Other:

                               

External customers

    212.8       37.4       117.4       367.6  

Elimination of intersegment revenue

    (741.6 )     (60.5 )     (268.1 )     (1,070.2 )
   


 


 


 


Total Other

    (528.8 )     (23.1 )     (150.7 )     (702.6 )
   


 


 


 


Total operating revenue

  $ 20,460.9     $ 20,967.7     $ 154.1     $ 41,582.7  
   


 


 


 


Operating Gain (Loss)

                               

Health Care

  $ 1,505.3     $ 1,507.7     $ (9.9 )   $ 3,003.1  

Specialty

    100.9       226.0       6.0       332.9  

Other

    (105.8 )     (38.3 )     2.5       (141.6 )

 

Health Care

 

Our Health Care segment’s summarized results of operations for the year ended December 31, 2005 and 2004 are as follows:

 

     Years Ended December 31

    % Change

  

Comparable
Basis

Year Ended
December 31,

2004


    $ Change

   % Change

     2005

    2004

           
     (In millions)                      

Operating revenue

   $ 42,597.5     $ 19,754.5     116%    $ 39,651.1     $ 2,946.4    7%

Operating gain

   $ 3,459.0     $ 1,505.3     130%    $ 3,003.1     $ 455.9    15%

Operating margin

     8.1 %     7.6 %   50bp      7.6 %          50bp

 

Operating revenue increased $22,843.0 million, or 116%, to $42,597.5 million. On a comparable basis, operating revenue increased $2,946.4 million, or 7%, primarily due to growth in premium income as a result of premium rate increases in our Large Group and ISG businesses resulting from underwriting discipline. Also

 

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contributing to premium revenue growth was higher membership, primarily in our ISG and State Sponsored businesses. Administrative fees also increased primarily due to additional self-funded membership in National Accounts and Large Group businesses.

 

Operating gain increased $1,953.7 million, or 130%, to $3,459.0 million. On a comparable basis, operating gain increased $455.9, or 15%, primarily due to premium rate increases mentioned above along with membership growth and lower than expected cost of care within our ISG, Senior and Large Group businesses. Partially offsetting this increase was the impact of the $103.0 million pre-tax expense recognized in connection with the multi-district litigation settlement agreement in 2005.

 

Specialty

 

Our Specialty segment’s summarized results of operations for the years ended December 31, 2005 and 2004 are as follows:

 

    

Years Ended

December 31


    % Change

   

Comparable
Basis

Year Ended
December 31,
2004


    $ Change

   % Change

 
   2005

    2004

          
     (In millions)                         

Operating revenue

   $ 2,863.1     $ 1,235.2     132 %   $ 2,634.2     $ 228.9    9 %

Operating gain

   $ 388.1     $ 100.9     285 %   $ 332.9     $ 55.2    17 %

Operating margin

     13.6 %     8.2 %   540 bp     12.6 %          100 bp

 

Operating revenue increased $1,627.9 million, or 132%, to $2,863.1 million. On a comparable basis operating revenue increased $228.9 million or 9%, primarily due to increases in PBM operating revenue driven by improved pharmaceutical contracting and increased script volume, particularly due to mail-order script volume. This increase was partially offset by decreases in behavioral health revenue due to the standardization in funding arrangements between Health Care and Specialty segments.

 

Operating gain increased $287.2 million, or 285%, to $388.1 million. On a comparable basis operating gain increased $55.2 million or 17%, primarily due to an increase in PBM, behavioral health and dental businesses. On a comparable basis, PBM operating gain increased due to higher script volume and improved pharmaceutical contracting. In addition, operating gain from behavioral health increased as we standardized funding arrangements between the Health Care and Specialty segments. Finally, membership growth, driven primarily by the transition of 1.9 million behavioral health members from an outside vendor, also contributed to the improved results in Specialty segment. These gains are partially offset by decreased rates on workers’ compensation insurance in California driven by unfavorable legislation.

 

Other

 

Our summarized results of operations for our Other segment for the years ended December 31, 2005 and 2004 are as follows:

 

    Years Ended
December 31


    % Change

   

Comparable
Basis

Year Ended
December 31,
2004


    $ Change

    % Change

 
  2005

    2004

         
    (In millions)                          

Operating revenue from external customers

  $ 350.4     $ 212.8     65 %   $ 372.8     $ (22.4 )   (6 )%

Elimination of intersegment revenue

  $ (1,297.9 )   $ (741.6 )   75 %   $ (1,075.4 )   $ (222.5 )   21 %
   


 


       


 


     

Total operating revenue

  $ (947.5 )   $ (528.8 )   79 %   $ (702.6 )   $ (244.9 )   35 %

Operating loss

  $ (114.6 )   $ (105.8 )   8 %   $ (141.6 )   $ 27.0     19 %

 

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Operating revenue from external customers increased $137.6 million, or 65%, to $350.4 million. On a comparable basis, operating revenue from external customers decreased $22.4 million, or 6% primarily due to the movement of certain businesses from the Other segment to the Health Care segment. The elimination of intersegment revenue increased $556.3 million, or 75%. On a comparable basis, the elimination of intersegment revenue increased $222.5 million or 21%, reflecting additional sales by our PBM companies to our Health Care segment.

 

Operating loss increased $8.8 million, or 8%, to $114.6 million. On a comparable basis, operating loss decreased $27.0 million or 19%, primarily due to expenses not allocated to the Health Care or Specialty segments.

 

VII.    Membership—December 31, 2004 Compared to December 31, 2003

 

The following table presents our medical membership by customer type, funding arrangement and geographical region as of December 31, 2004 and 2003. Also included below are key metrics from our Specialty segment, including prescription volume for our PBM and membership by product. The membership data presented is unaudited and in certain instances includes estimates of the number of members represented by each contract at the end of the period, rounded to the nearest thousand.

 

    December 31

  

Comparable

Basis2

December 31,

2003


  

Change


   

%


 
    2004

   20031

       
    (In thousands)  

Medical Membership

                          

Customer Type

                          

Large Group

  13,073    4,708    12,740    333     3 %

Individual and Small Group (ISG)

  5,199    1,954    4,867    332     7  

National Accounts

  3,212    1,640    2,668    544     20  

BlueCard

  3,463    2,816    2,931    532     18  
   
  
  
  

 

Total National

  6,675    4,456    5,599    1,076     19  

Senior

  1,059    599    1,063    (4 )   —    

State Sponsored

  1,722    210    1,781    (59 )   (3 )
   
  
  
  

 

Total medical membership by customer type

  27,728    11,927    26,050    1,678     6 %
   
  
  
  

 

Funding Arrangement

                          

Self-Funded

  13,039    6,412    11,750    1,289     11 %

Fully-Insured

  14,689    5,515    14,300    389     3  
   
  
  
  

 

Total medical membership by funding arrangement

  27,728    11,927    26,050    1,678     6 %
   
  
  
  

 

Regional Membership

                          

East

  8,508    5,300    7,839    669     9 %

Central

  10,565    5,688    10,032    533     5  

West

  8,655    939    8,179    476     6  
   
  
  
  

 

Total medical membership by region

  27,728    11,927    26,050    1,678     6 %
   
  
  
  

 

Specialty Metrics

                          

PBM prescription volume3

  336,541    76,871    299,630    36,911     12 %

Behavioral health membership

  11,753    3,171    10,384    NM4     NM4  

Life and disability membership

  5,306    2,230    5,240    NM4     NM4  

Dental membership

  5,048    2,529    5,291    NM4     NM4  

Vision membership

  773    423    431    342     79  

 

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  1 Represents the former Anthem, Inc. only.
  2 “Comparable Basis” data were calculated by adding historical data for the former WellPoint Health Networks Inc. to historical data for the former Anthem, Inc., and adjusting the combined totals to ensure a consistent approach for calculating membership and volume statistics and to eliminate overlapping BlueCard membership.
  3 Represents prescription volume for mail order and retail prescriptions for the full years ended 2004 and 2003, respectively. Prescription volume for 2004 and 2003 is shown on a “comparable” basis.
  4 Changes from prior period information are not meaningful due to different counting methodologies used by the former Anthem, Inc. and the former WellPoint Health Networks Inc.

 

During the twelve months ended December 31, 2004, total comparable medical membership increased approximately 1,678,000, or 6%, primarily in our National Accounts, BlueCard, and ISG businesses. Our National Accounts comparable membership increased 544,000, or 20%, primarily due to recognition of the value of Blue Cross and Blue Shield networks and the discounts we can secure, the breadth of our product offerings, and our distinctive customer service. BlueCard comparable membership increased 532,000, or 18%, representing increased sales by other Blue Cross and Blue Shield licensees to accounts with members who reside in or travel to our licensed areas. ISG comparable membership increased 332,000, or 7%, primarily due to the introduction of new, more affordable product designs and an overall increase in consumer awareness of our wide variety of quality products and services as well as efforts to market products to the uninsured.

 

Self-funded comparable medical membership increased 1,289,000, or 11%, primarily due to increases in our National Accounts and BlueCard businesses. Fully-insured comparable membership increased by 389,000 members, or 3%, primarily in our ISG business.

 

Prescription volume at our PBM increased 36,911,000 prescriptions, or 12%, on a comparable basis in 2004 primarily due to the integration of our Virginia health membership to our internal PBM, as well as increased mail-order utilization and growth within our other existing health lines of business.

 

Vision comparable membership increased 342,000, or 79%, due to the integration of internal health members, as well as increased sales.

 

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VIII.    Results of Operations—Year Ended December 31, 2004 Compared to the Year Ended December 31, 2003

 

Our consolidated results of operations for the years ended December 31, 2004 and 2003 are as follows:

 

    Years Ended
December 31


            
    20041

    20031

    $ Change

   % Change

 
    (In millions, except per share data)  

Premiums

  $ 18,771.6     $ 15,167.7     $ 3,603.9    24 %

Administrative fees

    1,436.9       1,160.2       276.7    24  

Other revenue

    252.4       159.2       93.2    59  
   


 


 

  

Total operating revenue

    20,460.9       16,487.1       3,973.8    24  

Net investment income

    311.7       278.1       33.6    12  

Net realized gains on investments

    42.5       16.2       26.3    NM2  
   


 


 

  

Total revenue

    20,815.1       16,781.4       4,033.7    24  

Benefit expense

    15,387.8       12,254.5       3,133.3    26  

Selling, general and administrative expense:

                            

Selling expense

    537.2       411.2       126.0    31  

General and administrative expense

    2,940.5       2,686.3       254.2    9  
   


 


 

  

Total selling, general and administrative expense

    3,477.7       3,097.5       380.2    12  

Cost of drugs

    95.0       38.7       56.3    NM2  

Interest expense

    142.3       131.2       11.1    8  

Amortization of other intangible assets

    61.4       47.6       13.8    29  

Merger-related undertakings

    61.5       —         61.5    NM2  

Loss on repurchase of debt securities

    146.1       —         146.1    NM2  
   


 


 

  

Total expense

    19,371.8       15,569.5       3,802.3    24  
   


 


 

  

Income before income taxes

    1,443.3       1,211.9       231.4    19  

Income taxes

    483.2       437.6       45.6    10  
   


 


 

  

Net income

  $ 960.1     $ 774.3     $ 185.8    24 %
   


 


 

  

Average diluted shares outstanding

    314.6       284.0       30.6    11 %

Diluted net income per share

  $ 3.05     $ 2.73     $ 0.32    12 %

Benefit expense ratio3

    82.0 %     80.8 %          120 bp4  

Selling, general and administrative expense ratio5

    17.0 %     18.8 %          (180) bp4  

Income before income tax as a percentage of total revenue

    6.9 %     7.2 %          (30) bp4  

Net income as a percentage of total revenue

    4.6 %     4.6 %          - bp4  

Certain of the following definitions are also applicable to all other results of operations tables in this discussion:

 

  1 Financial results for 2004 include operations of the former WellPoint Health Networks Inc. for the one month period ended December 31, 2004 and the former Anthem, Inc. for the year ended December 31, 2004. Financial results for 2003 represent the results of the former Anthem, Inc. only and have been reclassified to conform to current presentation.
  2 NM = Not meaningful
  3 Benefit expense ratio = Benefit expense ÷ Premiums.
  4 bp = basis point; one hundred basis points = 1%.
  5 Selling, general and administrative expense ratio = Total selling, general and administrative expense ÷ Total operating revenue.

 

Premiums increased $3,603.9 million, or 24%, to $18,771.6 million in 2004, due to the impact of the merger with WHN, and premium rate increases in our Large Group and ISG businesses. Also contributing to premium

 

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growth was higher fully-insured membership, primarily in our ISG business. Partially offsetting the growth were shifts by certain customers to self-funding arrangements, resulting in lower revenues. Included in 2003 were premium refunds of $40.4 million issued to policyholders from our Health Care segment, as claims costs in certain lines of business were much lower than expected. Our premium yields, net of buy-downs, for our fully-insured Large Group and ISG businesses were just less than 10% on a rolling 12-month basis as of December 31, 2004, including the business of pre-merger WHN for all periods.

 

Administrative fees increased $276.7 million, or 24%, to $1,436.9 million in 2004, primarily due to increased revenues from self-funded membership, principally in National businesses, and also due to the impact of the merger with WHN. These increases were partially offset by decreased administrative fees from AdminaStar Federal’s 1-800 Medicare Help Line contract with Centers for Medicare & Medicaid Services, or CMS, which was substantially completed by June 30, 2003.

 

Other revenue is comprised principally of co-payments and deductibles associated with the sale of mail-order drugs by our PBM, which provides its services to members of our Health Care segment and third party clients. Other revenue increased $93.2 million, or 59%, to $252.4 million in 2004, primarily due to additional mail-order prescription volume and increased prices of prescription drugs sold by our PBM, and also due to the impact of the merger with WHN. Increased mail-order prescription volume resulted from both membership increases and additional utilization of our PBM’s mail-order pharmacy option. Effective January 1, 2004, our PBM began to provide pharmacy benefit management services to Virginia customers of our Health Care segment.

 

Net investment income increased $33.6 million, or 12%, to $311.7 million in 2004 primarily due to the merger with WHN. Our investment income also increased in 2004 due to the growth in invested assets from reinvestment of cash generated from operations, partially offset by a decrease in yields from new investments. Yields were lower in 2004 due in part to the impact of a portion of our fixed maturity portfolio being invested in shorter duration investments in anticipation of the WHN merger and the use of cash upon completion of the WHN merger on November 30, 2004. Yields were also lower in part due to an increased allocation of tax exempt securities in 2004, which is expected to enhance after tax income.

 

A summary of our net realized gains on investments for the years ended December 31, 2004 and 2003 is as follows:

 

    Years Ended
December 31


       
    2004

    2003

    $ Change

 
    (In millions)        

Net realized gains from the sale of fixed maturity securities

  $ 40.6     $ 41.7     $ (1.1 )

Net realized gains from the sale of equity securities

    3.3       0.5       2.8  

Other-than-temporary impairments

    (0.8 )     (24.4 )     23.6  

Other realized losses

    (0.6 )     (1.6 )     1.0  
   


 


 


Net realized gains

  $ 42.5     $ 16.2     $ 26.3  
   


 


 


 

Other-than-temporary impairments recognized in 2003 were substantially related to our equity security investments, primarily due to the length of time that the securities’ fair value had been less than cost.

 

Benefit expense increased $3,133.3 million, or 26%, to $15,387.8 million in 2004. Benefit expense increased due to the impact of the merger with WHN, and also due to increased cost of care, which was driven primarily by higher costs in outpatient services and drug costs. Included in the 2003 results was a $31.7 million net favorable prior year reserve development recorded during the second quarter of 2003 and a $24.5 million favorable adjustment for resolution of a litigation matter in our Health Care segment in the first quarter of 2003. Our benefit expense ratio increased 120 basis points from 80.8% in 2003 to 82.0% in 2004, increasing from lower than anticipated cost of care trends in 2003 and returning to more sustainable levels.

 

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Selling, general and administrative expense increased $380.2 million, or 12%, to $3,477.7 million in 2004, primarily due to the impact of the merger with WHN, and also due to increases in volume-sensitive costs such as higher commissions, premium taxes and other expenses associated with growth in our business and higher salary and benefits costs. These increases were partially offset by a decrease in incentive compensation in 2004, and $20.0 million of contributions to our charitable foundation made by our Health Care segment in 2003 which did not recur in 2004. Our selling, general and administrative expense ratio decreased 180 basis points to 17.0% in 2004, primarily due to our growth in operating revenue and the leveraging of costs over these higher revenues.

 

Cost of drugs increased $56.3 million, or 145%, to $95.0 million in 2004, primarily due to higher mail-order prescription volume at our PBM.

 

Interest expense increased $11.1 million, or 8%, to $142.3 million in 2004, primarily due to additional interest expense on the $2.8 billion of debt initially incurred in conjunction with the WHN merger. Debt of $2.8 billion initially incurred in conjunction with the WHN merger was reduced to approximately $1.9 billion at December 31, 2004. Interest expense for this merger-related debt was incurred in December 2004.

 

Amortization of other intangible assets increased $13.8 million, or 29%, to $61.4 million in 2004, primarily due to additional amortization expense on identifiable intangible assets resulting from the WHN merger.

 

Merger-related undertakings were expenses recorded in 2004 related to certain obligations under our agreements with the California Department of Insurance, the California Department of Managed Health Care and the Georgia Department of Insurance. These agreements were related to the merger with WHN.

 

The loss on repurchase of debt incurred in 2004 related to our tender offer for our high coupon surplus notes. Due to the high coupon on this debt and time remaining until stated maturity, the debt was repurchased at a significant premium over book value, which was the driver of the loss.

 

Income tax expense increased $45.6 million, or 10%, to $483.2 million in 2004. Included in 2004 was $44.8 million in tax benefits associated with a change in Indiana laws governing the state’s high-risk health insurance pool recorded during the first quarter of 2004.

 

Health Care

 

Our Health Care segment’s summarized results of operations for the years ended December 31, 2004 and 2003 are as follows:

 

    Years Ended
December 31


            
    2004

    2003

    $ Change

   % Change

 
    (In millions)             

Operating revenue

  $ 19,754.5     $ 16,000.1     $ 3,754.4    23 %

Operating gain

  $ 1,505.3     $ 1,174.6     $ 330.7    28 %

Operating margin

    7.6 %     7.3 %          30 bp  

 

Operating revenue increased $3,754.4 million, or 23%, to $19,754.5 million in 2004, due to the impact of the merger with WHN, as the results of the acquired health business is included effective November 30, 2004. Operating revenue also increased due to premium rate increases in our Large Group, ISG, and Senior businesses. Also contributing to this growth were membership increases in our ISG and National Accounts businesses.

 

Operating gain increased $330.7 million, or 28%, to $1,505.3 million, due to our merger with WHN, improved underwriting results in our Large Group business, and growth in our National Accounts businesses. Included in the 2003 results was a $31.7 million net favorable prior year reserve development recorded during the second quarter of 2003 and a $24.5 million favorable adjustment for resolution of a litigation matter in the

 

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first quarter of 2003. Also included in 2003 were premium refunds of $40.4 million issued to policyholders as claims costs in certain lines of business were much lower than expected. Additionally, our Health Care segment made contributions of $20.0 million to our charitable foundation in 2003 that did not occur in 2004.

 

Specialty

 

Our Specialty segment’s summarized results of operations for the years ended December 31, 2004 and 2003 are as follows:

 

    Years Ended
December 31


            
    2004

    2003

    $ Change

   % Change

 
    (In millions)             

Operating revenue

  $ 1,235.2     $ 732.0     $ 503.2    69 %

Operating gain

  $ 100.9     $ 69.1     $ 31.8    46 %

Operating margin

    8.2 %     9.4 %          (120) bp  

 

Operating revenue increased $503.2 million, or 69%, to $1,235.2 million in 2004, due to the impact of the merger with WHN, as the results of the acquired specialty business is included effective November 30, 2004. Operating revenue also increased due to increased mail-order prescription volume, including more specialty pharmacy prescriptions and increased wholesale drug costs which are passed through to customers of our PBM. Specialty pharmacy prescriptions include higher cost transactions for biopharmaceutical and injectable medications, which are complex in design and administration, and are costly to ship and store. The increased mail-order prescription volume resulted from both membership increases and additional utilization of our PBM’s mail-order pharmacy option. Effective January 1, 2004, our PBM began providing pharmacy benefit management services to our Virginia health members.

 

Operating gain increased $31.8 million, or 46%, to $100.9 million in 2004, due to the impact of the merger with WHN, and increased mail-order prescription volume at our PBM. This improvement was partially offset by operating results in our other specialty businesses.

 

Other

 

Our summarized results of operations for our Other segment for the years ended December 31, 2004 and 2003 are as follows:

 

    Years Ended
December 31


             
    2004

    2003

    $ Change

    % Change

 
    (In millions)              

Operating revenue from external customers

  $ 212.8     $ 197.8     $ 15.0     8 %

Elimination of intersegment revenue

    (741.6 )     (442.8 )     (298.8 )   67 %
   


 


 


     

Total operating revenue

  $ (528.8 )   $ (245.0 )   $ (283.8 )   NM  

Operating loss

  $ (105.8 )   $ (147.3 )   $ 41.5     28 %

 

Operating revenue from external customers increased $15.0 million, or 8%, to $212.8 million in 2004, due to the impact of the merger with WHN, as well as an increase in revenues from our Medicare customer service software development contract with CMS. These were partially offset by the loss of our 1-800 Medicare Help Line contract with CMS, which was substantially completed by June 30, 2003. Elimination of intersegment revenues increased $298.8 million, or 67%, reflecting additional sales by our pharmacy benefit management company to our Health Care segment.

 

Operating loss decreased $41.5 million, or 28%, to $105.8 million in 2004, primarily due to lower incentive compensation expenses.

 

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IX.    Critical Accounting Policies and Estimates

 

We prepare our consolidated financial statements in conformity with U.S. generally accepted accounting principles, or GAAP. Application of GAAP requires management to make estimates and assumptions that affect the amounts reported in our consolidated financial statements and accompanying notes and within this Management’s Discussion and Analysis. We consider some of our most important accounting policies that require estimates and management judgment to be those policies with respect to liabilities for medial claims payable, income taxes, goodwill and other intangible assets, investments and retirement benefits, which are discussed below. Our significant accounting policies are summarized in Note 2 to our audited consolidated financial statements for the year ended December 31, 2005 included in this Form 10-K.

 

Medical Claims Payable

 

The most judgmental accounting estimate in our consolidated financial statements is our liability for medical claims payable. At December 31, 2005, this liability was $4,923.4 million and represented 19% of our total consolidated liabilities. We record this liability and the corresponding benefit expense for pending claims and claims that are incurred but not reported, including the estimated costs of processing such claims. Pending claims are those received by us but not yet processed through our systems. Liabilities for both incurred but not reported and reported but not yet paid claims are determined employing actuarial methods that are commonly used by health insurance actuaries and meet Actuarial Standards of Practice. Actuarial Standards of Practice require that the claim liabilities be adequate under moderately adverse circumstances. We determine the amount of the liability for incurred but not reported claims by following a detailed actuarial process that entails using both historical claim payment patterns as well as emerging medical cost trends to project our best estimate of claim liabilities. Under this process, historical data of paid claims is formatted into “claim triangles,” which compare claim incurred dates to the dates of claim payments. This information is analyzed to create “completion factors” that represent the average percentage of total incurred claims that have been paid through a given date after being incurred. Completion factors are applied to claims paid through the financial statement date to estimate the ultimate claim expense incurred for the current period. Actuarial estimates of claim liabilities are then determined by subtracting the actual paid claims from the estimate of the ultimate incurred claims.

 

For the most recent incurred months, the percentage of claims paid for claims incurred in those months is generally low. This makes the completion factor methodology less reliable for such months. Therefore, incurred claims for recent months are not projected from historical completion and payment patterns; rather they are projected by estimating the claims expense for those months based on recent claims expense levels and health care trend levels, or “trend factors”.

 

Because the reserve methodology is based upon historical information, it must be adjusted for known or suspected operational and environmental changes. These adjustments are made by our actuaries based on their knowledge and their estimate of emerging impacts to benefit costs and payment speed. Circumstances to be considered in developing our best estimate of reserves include changes in utilization levels, unit costs, mix of business, benefit plan designs, provider reimbursement levels, processing system conversions and changes, claim inventory levels, claim processing patterns and claim submission patterns. A comparison of prior period liabilities to re-estimated claim liabilities based on subsequent claims development is also considered in making the liability determination. In the actuarial process, the methods and assumptions are not changed as reserves are recalculated, rather the availability of additional paid claims information drives our changes in the re-estimate of the unpaid claim liability. To the extent appropriate, changes in such development are recorded as a change to current period benefit expense.

 

In addition to the pending claims and incurred but not reported claims, the liability for medical claims payable includes reserves for premium deficiencies, if appropriate. Premium deficiencies are recognized when it is probable that expected claims and administrative expenses will exceed future premiums on existing medical insurance contracts without consideration of investment income. Determination of premium deficiencies for

 

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longer duration life and disability contracts includes consideration of investment income. For purposes of premium deficiencies, contracts are grouped in a manner consistent with our method of acquiring, servicing and measuring the profitability of such contracts.

 

We regularly review our assumptions regarding claim liabilities and make adjustments to benefit expense when necessary. If it is determined that our assumptions regarding cost trends and utilization are significantly different than actual results, our income statement and financial position could be impacted in future periods. Adjustments of prior year estimates may result in additional benefit expense or a reduction of benefit expense in the period an adjustment is made. Further, due to the considerable variability of health care costs, adjustments to claim liabilities occur each quarter and are sometimes significant as compared to the net income recorded in that quarter. Prior year development is recognized immediately upon the actuary’s judgment that a portion of the prior year liability is no longer needed or that additional liability should have been accrued. That determination is made when sufficient information is available to ascertain that the re-estimate of the liability is accurate and will not fluctuate significantly with future development.

 

As described above, the completion factors and trend factors can have a significant impact on the claim liability. The following example provides the estimated impact to our December 31, 2005 unpaid claims liability assuming hypothetical changes in the completion and trend factors:

 

Completion Factor1


 

Claims Trend Factor2


(Decrease) Increase in
Completion Factor


 

Increase (Decrease) in

Unpaid Claims Liabilities


 

(Decrease) Increase in Claims
Trend Factor


 

(Decrease) Increase in

Unpaid Claims Liabilities


    (In millions)       (In millions)

(3)%

  $751.0     (3)%   $(195.0)

(2)%

  489.0   (2)%     (130.0)

(1)%

  239.0   (1)%       (65.0)

  1%

  (229.0)     1%       65.0

  2%

  (448.0)     2%     130.0
  3 %   (659.0)     3 %     195.0

1 Assumes (decrease) increase in the completion factors for the most recent four months
2 Assumes (decrease) increase in the claims trend factors for the most recent two months

 

In addition, assuming a hypothetical 1% total difference between our December 31, 2005 estimated claims liability and the actual claims paid, net income for the year ended December 31, 2005 would increase or decrease by $32.0 million, while basic and diluted net income per share would increase or decrease by $0.05 per share.

 

As summarized below, Note 10 to our audited consolidated financial statements for the year ended December 31, 2005 included in this Form 10-K provides historical information regarding the accrual and payment of our medical claims liability. Components of the total incurred claims for each year include amounts accrued for current year estimated claims expense as well as adjustments to prior year estimated accruals. In Note 10 to our audited consolidated financial statements, the line labeled “incurred related to prior years” accounts for those adjustments made to prior year estimates. The impact of any reduction of “incurred related to prior years” claims may be offset as we establish the estimate of “incurred related to current year”. Our reserving practice is to consistently recognize the actuarial best estimate of our ultimate liability for our claims. When we recognize a release of the redundancy, we disclose the amount that is not in the ordinary course of business, if material. We believe we have consistently applied our methodology in determining our best estimate for unpaid claims liability at each reporting date.

 

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A reconciliation of the beginning and ending balance for medical claims payable for the years ended December 31, 2005, 2004 and 2003 is as follows:

 

    Years Ended December 31

 
    2005

    2004

    2003

 
    (In millions)  

Gross medical claims payable, beginning of period

  $ 4,202.0     $ 1,841.7     $ 1,800.0  

Ceded medical claims payable, beginning of period

    (31.9 )     (8.7 )     (2.8 )
   


 


 


Net medical claims payable, beginning of period

    4,170.1       1,833.0       1,797.2  
   


 


 


Business combinations and purchase adjustments

    784.5       2,394.4       (20.6 )

Net incurred medical claims:

                       

Current year

    33,471.0       15,452.6       12,374.2  

Prior years (redundancies)

    (655.6 )     (172.4 )     (226.2 )
   


 


 


Total net incurred medical claims

    32,815.4       15,280.2       12,148.0  
   


 


 


Net payments attributable to:

                       

Current year medical claims

    29,532.5       12,556.3       10,598.3  

Prior years medical claims

    3,341.8       2,781.2       1,493.3  
   


 


 


Total net payments

    32,874.3       15,337.5       12,091.6  
   


 


 


Net medical claims payable, end of period

    4,895.7       4,170.1       1,833.0  

Ceded medical claims payable, end of period

    27.7       31.9       8.7  
   


 


 


Gross medical claims payable, end of period

  $ 4,923.4     $ 4,202.0     $ 1,841.7  
   


 


 


Current year medical claims paid as a percent of current year net incurred medical claims

    88.2 %     81.3 %     85.6 %
   


 


 


Prior year redundancies in the current period as a percent of prior year net incurred medical claims

    4.2 %     1.4 %     2.3 %
   


 


 


 

Amounts incurred related to prior years vary from previously estimated liabilities as the claims are ultimately settled. Liabilities at any year end are continually reviewed and re-estimated as information regarding actual claims payments, or runout, becomes known. This information is compared to the originally established year end liability. Negative amounts reported for incurred related to prior years result from claims being settled for amounts less than originally estimated. The prior year redundancy of $655.6 million shown in the table above and in Note 10 to our audited consolidated financial statements for the year ended December 31, 2005, represents an estimate based on paid claim activity from January 1, 2005 to December 31, 2005. Medical claim liabilities are usually described as having a “short tail”, which means that they are generally paid within several months of the member receiving service from the provider. Accordingly, the majority, or approximately 87%, of the $655.6 million redundancy relates to claims incurred in calendar year 2004, with the remaining 13% related to claims incurred in 2003 and prior.

 

The ratio of current year paid as a percent of current year incurred was 88.2% for 2005, 81.3% for 2004, and 85.6% for 2003. The 2004 ratio was impacted by having only one month of medical claims incurred and paid during 2004 for the former WHN. If the former WHN had not been included during 2004, current year medical claims paid would have been $12,170.8 million, current year net incurred medical claims would have been $13,942.8 million and the adjusted ratio would have been approximately 87.3% for 2004. Comparison of the 2005 ratio of 88.2%, the adjusted 2004 ratio of 87.3% and the 2003 ratio of 85.6% indicate that we are paying claims faster. The increase is primarily attributable to improved processes and electronic connectivity with our provider networks. The result of these changes is an enhanced ability to adjudicate and pay claims more quickly.

 

We calculate the percentage of prior year redundancies in the current period to net incurred medical claims recorded in each prior year in order to demonstrate the development of the prior year reserves. This metric was

 

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4.2% for 2005, 1.4% for 2004 and 2.3% for 2003. This ratio is calculated using the redundancy of $655.6 million, shown above, which represents an estimate based on paid claim activity from January 1, 2005 to December 31, 2005. The 2005 ratio is impacted by having only one month of net incurred medical claims for WHN in 2004. If WHN had been included for the full year 2004 estimated prior year net incurred medical claims would have been $31,281.2 million, and the adjusted ratio would have been approximately 2.1% for the year ended December 31, 2005. The 2.3% ratio for 2003 was impacted by having only five months of net incurred medical claims in 2002 related to the former Trigon Healthcare, Inc. If the former Trigon Healthcare, Inc. had been included for the full year 2002, the ratio would have been approximately 2.0% for 2003.

 

The following table shows the variance between total net incurred medical claims as reported in the above table for each of 2004 and 2003 and the incurred claims for such years had it been determined retrospectively (computed as the difference between “net incurred medical claims—current year” for the year shown and “net incurred medical claims – prior years (redundancies)” for the immediately following year):

 

    Years Ended December 31

 
    2004

    2003

 
    (In millions)  

Total net incurred medical claims, as reported

  $ 15,280.2     $ 12,148.0  

Retrospective basis, as described above

    14,797.0       12,201.8  
   


 


Variance

  $ 483.2     $ (53.8 )
   


 


Variance to total net incurred medical claims, as reported

    3.2 %     (0.4 )%
   


 


 

The 2004 variance of $483.2 million and variance to total incurred medical claims, as reported of 3.2% are impacted by having only one month of total incurred as reported for WHN during 2004. The adjusted variance would be approximately $146.7 million and the variance to total incurred would be approximately 1.0% if the impact of WHN is removed. We expect that substantially all of the development of the 2005 estimate of medical claims payable will be known during 2006. This table, adjusted for the impact of WHN, shows that our estimates of this liability have approximated the actual development.

 

Income Taxes

 

We account for income taxes in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. This standard requires, among other things, the separate recognition of deferred tax assets and deferred tax liabilities. Such deferred tax assets and deferred tax liabilities represent the tax effect of temporary differences between financial reporting and tax reporting measured at tax rates enacted at the time the deferred tax asset or liability is recorded. A valuation allowance must be established for deferred tax assets if it is “more likely than not” that all or a portion may be unrealized. Our judgment is required in determining an appropriate valuation allowance.

 

At each financial reporting date, we assess the adequacy of the valuation allowance by evaluating each of our deferred tax assets based on the following:

 

    the types of temporary differences that created the deferred tax asset;

 

    the amount of taxes paid in prior periods and available for a carry-back claim;

 

    the forecasted future taxable income, and therefore, likely future deduction of the deferred tax item; and

 

    any significant other issues impacting the likely realization of the benefit of the temporary differences.

 

During 2004 and 2003, the valuation allowance decreased by $33.8 million and $81.9 million, respectively. The 2004 and 2003 reductions resulted from utilizing alternative minimum tax, or AMT, credits and net operating losses on our federal income tax return for which we had a deferred tax asset with a corresponding

 

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valuation allowance. As deferred tax assets related to those deductions are available for use in the tax return, a valuation was no longer required and was reduced. The decrease in the valuation allowance in 2004 was partially offset by an additional $5.6 million related to Indiana state taxes, as discussed below.

 

During 2004 and 2003, we recorded additional tax liabilities of $44.1 million and $81.9 million, respectively, offsetting the reduction in valuation allowances discussed above. These additional liabilities were recorded for uncertainty on several tax issues, including the lack of clear guidance from the Internal Revenue Service, or IRS, on various tax issues relating to our conversion in 1986 from tax exempt to tax paying status.

 

During 2005, a refund claim we filed in 2003 was approved by the Congressional Joint Committee on Taxation. The claim relates to initially disallowed losses on the sale of certain subsidiaries in the late 1990s. A tax benefit of $28.4 million related to this claim was recorded in the first quarter of 2005. Net income related to this claim was $0.04 per basic and diluted share for the year ended December 31, 2005.

 

As a result of legislation enacted in Indiana on March 16, 2004, we recorded deferred tax assets and liabilities, with a corresponding net tax benefit in our income statement of $44.8 million, or $0.15 per basic share and $0.14 per diluted share, for the year ended December 31, 2004. The legislation eliminated the creation of tax credits resulting from the payment of future assessments to the Indiana Comprehensive Health Insurance Association, or ICHIA. ICHIA is Indiana’s high-risk health insurance pool. Our historical ICHIA assessment payments far exceeded our Indiana income tax liability. Thus, the recognition of a state deferred tax asset was not warranted, as a future Indiana tax liability was unlikely. Under the new legislation, ICHIA tax credits are limited to any unused ICHIA assessment paid prior to December 31, 2004. FAS 109 requires that deferred assets or liabilities be established in the period a change in law is enacted. These deferred tax assets and liabilities reflect temporary differences, net operating loss carryforwards and tax credits relating to our Indiana income tax filings. Following guidance in FAS 109, a valuation allowance of $5.6 million was established for the portion of the deferred tax asset, which we believe will likely not be utilized. There is no carryforward limitation on the tax credits and the net operating loss carryforwards do not begin to expire until 2018. We believe we will have sufficient taxable income in future years to offset these carryforwards; therefore, no additional valuation allowance was recorded.

 

We, like other companies, frequently face challenges from tax authorities regarding the amount of taxes due. These challenges include questions regarding the timing and amount of deductions that we have taken on our tax returns. In evaluating any additional tax liability associated with various positions taken in our tax return filings, we record additional tax liability for potential adverse tax outcomes. Based on our evaluation of our tax positions, we believe we have appropriately accrued for tax exposures. To the extent we prevail in matters we have accrued for, our future effective tax rate would be reduced and net income would increase. If we are required to pay more than accrued, our future effective tax rate would increase and net income would decrease. Our effective tax rate and net income in any given future period could be materially impacted.

 

In the ordinary course of business, we are regularly audited by federal and state authorities, and from time to time, these audits result in proposed assessments. We believe our tax positions comply with applicable tax law and intend to defend our positions vigorously through the IRS appeals process. We believe we have adequately provided for any reasonable foreseeable outcome related to these matters. Accordingly, although their ultimate resolution may require additional tax payments, we do not anticipate any material impact to earnings from these matters. As of December 31, 2005, the IRS concluded its examination of our 2001 and 2002 tax years and has initiated its examination of our 2003 and 2004 tax years. Various tax examinations and proceedings also continue for pre-consolidation periods of subsidiaries.

 

For additional information, see Note 14 to our audited consolidated financial statements as of and for the year ended December 31, 2005 included in this Form 10-K.

 

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Goodwill and Other Intangible Assets

 

Our consolidated goodwill at December 31, 2005 was $13,469.1 million and other intangible assets were $9,686.4 million. The sum of goodwill and intangible assets represents 45% of our total consolidated assets and 93% of our consolidated shareholders’ equity at December 31, 2005.

 

We follow Statement of Financial Accounting Standards No. 141, Business Combinations, and Statement of Accounting Standards No. 142, Goodwill and Other Intangible Assets. FAS 141 specifies the types of acquired intangible assets that are required to be recognized and reported separately from goodwill. Under FAS 142, goodwill and other intangible assets (with indefinite lives) are not amortized but are tested for impairment at least annually. We completed our annual impairment tests of existing goodwill and other intangible assets (with indefinite lives) for each of the years ended December 31, 2005, 2004 and 2003 and based upon these tests we have not incurred any impairment losses related to any goodwill and other intangible assets (with indefinite lives).

 

On December 28, 2005, we completed our merger with WellChoice and purchased 100% of the outstanding common stock of WellChoice. In accordance with FAS 141, we allocated the purchase price to the fair value of assets acquired, including intangible assets, and liabilities assumed. This allocation process included the review of relevant information about the assets and liabilities, independent appraisals and other valuations to determine the fair value of assets acquired and liabilities assumed. The preliminary allocation resulted in $3.4 billion of non-tax deductible goodwill and $1.7 billion of identifiable intangible assets. The purchase price allocation is preliminary and additional refinements may occur.

 

On November 30, 2004, we completed our merger with WHN and purchased 100% of the outstanding common stock of WHN. In accordance with FAS 141, we allocated the purchase price to the fair value of assets acquired, including intangible assets, and liabilities assumed. This allocation process included the review of relevant information about the assets and liabilities, independent appraisals and other valuations to determine the fair value of assets acquired and liabilities assumed. The allocation resulted in $7.6 billion of non-tax deductible goodwill and $7.0 billion of identifiable intangible assets.

 

While we believe we have appropriately allocated the purchase price of our acquisitions, this allocation requires many assumptions to be made regarding the fair value of assets and liabilities acquired. In addition, the annual impairment testing required under FAS 142 requires us to make assumptions and judgments regarding the estimated fair value of our goodwill and intangibles. Such assumptions include the discount factor used to determine the fair value of a reporting unit, which is ultimately used to identify potential goodwill impairment. Such estimated fair values might produce significantly different results if other reasonable assumptions and estimates were to be used. If we are unable to support a fair value estimate in future annual goodwill impairment tests or if significant impairment indicators are noted relative to other intangible assets subject to amortization, we may be required to record impairment losses against future income.

 

For additional information, see Note 4 to our audited consolidated financial statements as of and for the year ended December 31, 2005 included in this Form 10-K.

 

Investments

 

Current and long term available-for-sale investment securities were $17,388.0 million at December 31, 2005 and represented 34% of our total consolidated assets at December 31, 2005. In accordance with Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, our fixed maturity and equity securities are classified as “available-for-sale” securities and are reported at fair value. We have determined that all available-for-sale investments in our portfolio, with the exception of certain securities held for contractual or regulatory purposes, are available to support current operations, and accordingly, have classified such securities as current assets. Investment income is recorded when earned, and realized gains or losses, determined by specific identification of investments sold, are included in income when the securities are sold.

 

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In addition to available-for-sale investment securities, we held other long-term investments of $207.8 million, or 0.4% of total consolidated assets, at December 31, 2005. These long-term investments consist primarily of real estate and certain other investments. Due to their less liquid nature, these investments are classified as long-term.

 

An impairment review of securities to determine if declines in fair value below cost are other-than-temporary is subjective and requires a high degree of judgment. We evaluate our investment securities on a quarterly basis, using both quantitative and qualitative factors, to determine whether a decline in value is other-than-temporary. Such factors considered include the length of time and the extent to which a security’s market value has been less than its cost, financial condition and near term prospects of the issuer, recommendations of investment advisors, and forecasts of economic, market or industry trends. If any declines are determined to be other-than-temporary, we charge the losses to income when that determination is made. We have a committee made up of certain accounting and investment associates and management responsible for managing the impairment review process. The current economic environment and recent volatility of securities markets increase the difficulty of determining fair value and assessing investment impairment. The same influences tend to increase the risk of potential impairment of these assets. We recorded charges for other-than-temporary impairment of securities of $14.8 million, $0.8 million and $24.4 million, respectively, for the years ended December 31, 2005, 2004 and 2003. The $24.4 million impairment for the year ended December 31, 2003 included a $22.3 million charge for other-than-temporary impairment of our equity securities; primarily due to the length of time that such securities’ fair value had been less than cost.

 

Management believes it has adequately reviewed the Company’s investment securities for impairment and that its investment securities are carried at fair value. However, over time, the economic and market environment may provide additional insight regarding the fair value of certain securities, which could change management’s judgment regarding impairment. This could result in realized losses relating to other-than-temporary declines being charged against future income.

 

A summary of available-for-sale investments with unrealized losses as of December 31, 2005 along with the related fair value, aggregated by the length of time that investments have been in a continuous unrealized loss position, is as follows:

 

   

Less than

Twelve Months


   

Twelve Months

or More


    Total

 
    Fair
Value


   Gross
Unrealized
Losses


    Fair
Value


   Gross
Unrealized
Losses


   

Fair

Value


   Gross
Unrealized
Losses


 
    (In millions)  

Fixed maturity securities

  $ 9,164.7    $ (134.2 )   $ 1,115.1    $ (26.9 )   $ 10,279.8    $ (161.1 )

Equity securities

    403.9      (27.6 )     4.8      (0.4 )     408.7      (28.0 )
   

  


 

  


 

  


Total

  $ 9,568.6    $ (161.8 )   $ 1,119.9    $ (27.3 )   $ 10,688.5    $ (189.1 )
   

  


 

  


 

  


 

The Company’s fixed maturity investment portfolio is sensitive to interest rate fluctuations, which impact the fair value of individual securities. Unrealized losses reported above were primarily caused by the effect of a rising interest rate environment on certain securities with stated interest rates currently below market rates. The Company currently has the ability and intent to hold these securities until their full cost can be recovered. Therefore, the Company does not believe the unrealized losses represent an other-than-temporary impairment as of December 31, 2005.

 

The Company participates in securities lending programs whereby marketable securities in its investment portfolio are transferred to independent brokers or dealers based on, among other things, their creditworthiness in exchange for collateral initially equal to at least 102% of the value of the securities on loan and is thereafter maintained at a minimum of 100% of the market value of the securities loaned. The market value of the securities on loan to each borrower is monitored daily and the borrower is required to deliver additional collateral if the

 

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market value of the collateral falls below 100% of the market value of the securities on loan. The fair value of the collateral amounted to $1,389.9 million and $658.5 million, which represents 102% and 102% of the carrying value at December 31, 2005 and 2004, respectively. Under the guidance provided in FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, the Company recognizes the collateral as an asset, which is reported as “securities lending collateral” on its balance sheet and the Company records a corresponding liability for the obligation to return the collateral to the borrower, which is reported as “securities lending payable”. The securities on loan are reported in the applicable investment category on the balance sheet.

 

Through our investing activities, we are exposed to financial market risks, including those resulting from changes in interest rates and changes in equity market valuations. We manage the market risks through our investment policy, which establishes credit quality limits and limits of investments in individual issuers. Ineffective management of these risks could have an impact on our future earnings and financial position.

 

We have evaluated the impact on the fixed maturity portfolio’s fair value considering an immediate 100 basis point change in interest rates. A 100 basis point increase in interest rates would result in an approximate $573.0 million decrease in fair value, whereas a 100 basis point decrease in interest rates would result in an approximate $534.9 million increase in fair value. An immediate 10% decrease in each equity investment’s value, arising from market movement, would result in a fair value decrease of $144.8 million. Alternatively, an immediate 10% increase in each equity investment’s value, attributable to the same factor, would result in a fair value increase of $144.8 million.

 

For additional information, see Part II, Item 7A of this Form 10-K, “Quantitative and Qualitative Disclosures about Market Risk” and Note 5 to our audited consolidated financial statements as of and for the year ended December 31, 2005 included in this Form 10-K.

 

Retirement Benefits

 

Pension Benefits

 

We sponsor defined benefit pension plans for our employees, including plans sponsored by WellChoice and WHN prior to the related mergers. These plans are accounted for in accordance with FAS 87, Employers’ Accounting for Pensions, which requires that amounts recognized in financial statements be determined on an actuarial basis. As permitted by FAS 87, we calculate the value of plan assets described below. Further, the effects on our computation of pension expense from the performance of the pension plans’ assets and changes in pension liabilities are amortized over future periods. Other than the former WellChoice plans, for each of our defined benefit pension plans, we use a September 30 measurement date for determining benefit obligations and fair value of plan assets. Plans sponsored by the former WellChoice use a December 31 measurement date. Prior to 2005 plans sponsored by pre-merger WHN used a December 31 measurement date. The effective rates discussed below are based on a weighted average of all the plans and include the effect of using two measurement dates.

 

An important factor in determining our pension expense is the assumption for expected long-term return on plan assets. As of our last measurement dates, we selected an expected weighted average rate of return on plan assets of 7.80% for all plans (compared to a weighted average 8.16% for 2005 expense recognition). We use a total portfolio return analysis in the development of our assumption. Factors such as past market performance, the long-term relationship between fixed maturity and equity securities, interest rates, inflation and asset allocations are considered in the assumption. The assumption includes an estimate of the additional return expected from active management of the investment portfolio. Peer data and historical returns are also reviewed for appropriateness of the selected assumption. The expected long-term rate of return is calculated by the geometric averaging method, which calculates an expected multi-period return, reflecting volatility drag on compound returns. We believe our assumption of future returns is reasonable. However, if we lower our expected long-term return on plan assets, future contributions to the pension plan and pension expense would likely increase.

 

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This assumed long-term rate of return on assets is applied to a calculated value of plan assets, which recognizes changes in the fair value of plan assets in a systematic manner over three years producing the expected return on plan assets that is included in the determination of pension expense. The difference between this expected return and the actual return on plan assets is deferred and amortized over the average remaining service of the workforce as a component of pension expense. The net deferral of past asset gains or losses affects the calculated value of plan assets and, ultimately, future pension expense.

 

The discount rate reflects the current rate at which the pension liabilities could be effectively settled at the end of the year based on our measurement dates. The weighted average discount rate for all plans is 5.31%, which was developed using a yield curve approach with consideration of a benchmark rate of the Moody’s Aa Corporate Bonds index. Using yields available on high-quality fixed maturity securities with various maturity dates, the yield curve approach provides a “customized” rate, which is meant to better match the expected cash flows of our specific benefit plans. Changes in the discount rates over the past three years have not materially affected pension expense, and the net effect of changes in the discount rate, as well as the net effect of other changes in actuarial assumptions and experience, have been deferred and amortized as a component of pension expense in accordance with FAS 87.

 

In managing the plan assets, our objective is to be a responsible fiduciary while minimizing financial risk. Plan assets include a diversified mix of investment grade fixed maturity securities and equity securities across a range of sectors and levels of capitalization to maximize the long-term return for a prudent level of risk. In addition to producing a reasonable return, the investment strategy seeks to minimize the volatility in the Company’s expense and cash flow.

 

As of our measurement dates, we had approximately 56% of plan assets invested in equity securities, 37% in fixed maturity securities and 7% in other assets. Approximately $13.1 million, or less than 1% of plan assets, were invested in WellPoint common stock as of the measurement date.

 

We funded our cash balance pension plans in the amount of $117.8 million during 2005 and $10.0 million during 2004. For the year ending December 31, 2006, the Company does not expect any required contributions under ERISA. The Company may elect to make discretionary contributions up to the maximum amount deductible for income tax purposes.

 

For the years ended December 31, 2005, 2004 and 2003, we recognized consolidated pretax pension expense of $48.6 million, $40.8 million, and $21.3 million, respectively.

 

Effective January 1, 2006, we curtailed the benefits under the Anthem Cash Balance Pension Plan, or the Plan. Most participants will no longer have pay credits added to their accounts, but will continue to earn interest on existing account balances. Participants will continue to earn years of pension service for vesting. Employees hired on or after January 1, 2006, will not be eligible to participate in the Plan. Certain participants will be “grandfathered” into the Plan based on age and years of service in previously merged plans. Grandfathered participants will continue to receive pay credits under the Plan formula. Expected savings that should be generated by the curtailment of benefits under the Plan will be mostly offset by increased matching contributions to certain defined contribution plans.

 

Other Postretirement Benefits

 

We provide most employees certain life, medical, vision and dental benefits upon retirement. We use various actuarial assumptions including a discount rate and the expected trend in health care costs to estimate the costs and benefit obligations for our retiree benefits. We recognized a postretirement benefit liability of $472.3 million at December 31, 2005.

 

At our last measurement dates, the weighted average discount rate for all plans was 5.29%. We developed this rate using a yield curve approach with consideration of a benchmark rate of the Moody’s Aa Corporate Bonds index.

 

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The assumed health care cost trend rates used to measure the expected cost of other benefits at our last measurement dates was 9.00% for 2006 with a gradual decline to 4.9% by the year 2011. These estimated trend rates are subject to change in the future. The health care cost trend assumption has a significant effect on the amounts reported. For example, an increase in the assumed health care cost trend rate of one percentage point would increase the postretirement benefit obligation as of December 31, 2005 by $51.5 million and would increase service and interest costs by $3.5 million. Conversely, a decrease in the assumed health care cost trend rate of one percentage point would decrease the postretirement benefit obligation by $43.5 million as of December 31, 2005 and would decrease service and interest costs by $2.9 million.

 

For additional information regarding retirement benefits, see Note 17 to our audited consolidated financial statements as of and for the year ended December 31, 2005 included in this Form 10-K.

 

New Accounting Pronouncements

 

In December 2004, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“FAS 123R”). FAS 123R eliminates the alternative to use the intrinsic method of accounting under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. Subsequent to the issuance of FAS 123R, in April 2005, the U.S. Securities and Exchange Commission (“SEC”) issued an amendment to Rule 4-01(a) of Regulation S-X regarding the compliance date for FAS 123R. Under this amendment, the effective date of FAS 123R was extended to January 1, 2006, for most public companies with calendar year ends. The impact of adoption, effective January 1, 2006, on our consolidated results of operations is expected to amount to approximately 3% to 5% of net earnings and is not expected to have a significant impact on our consolidated financial position. See Note 2 to our audited consolidated financial statements included in this Form 10-K for our current disclosures of pro forma stock compensation expense.

 

On March 29, 2005, the SEC staff issued Staff Accounting Bulletin No. 107 (“SAB 107”), which expresses the SEC staff’s view on FAS 123R. SAB 107 provides guidance regarding certain matters important to selecting and applying valuation models. We will consider SAB 107 in our implementation of FAS 123R.

 

In November 2005, the FASB issued FASB Staff Position (“FSP”) FAS Nos. 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. In 2004, the Emerging Issues Task Force (“EITF”) issued EITF 03-1, The Meaning of Other-than-Temporary Impairment and its Application to Certain Investments to provide detailed guidance on when an investment is considered impaired, whether that impairment is other-than-temporary, how to measure the impairment loss and disclosures related to impaired securities. Because of concerns about the application of the guidance of EITF 03-1 that described whether an impairment is other-than-temporary, the FASB deferred the effective date of that portion of the guidance. This FSP nullifies EITF 03-1 guidance on determining whether an impairment is other-than-temporary, and effectively retains the previous guidance in this area, which requires a careful analysis of all pertinent facts and circumstances. (In addition, the FSP generally carries forward EITF 03-1 guidance for determining when an investment is impaired, how to measure the impairment loss and what disclosures should be made regarding impaired securities. The FSP is effective for reporting periods subsequent to December 15, 2005. Our current analysis of impaired investments is consistent with the provisions of this FSP (see “Critical Accounting Policies and Estimates—Investments”). Therefore, the adoption of this FSP is not expected to have a significant impact on our consolidated financial position and results of operations.

 

There were no other new accounting pronouncements issued during 2005 that had a material impact on our financial position, operating results or disclosures.

 

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X.     Liquidity and Capital Resources

 

Introduction

 

Our cash receipts result primarily from premiums, administrative fees, investment income, other revenue, proceeds from the sale or maturity of our investment securities, proceeds from borrowings, and proceeds from exercise of stock options and our employee stock purchase plan. Cash disbursements result mainly from claims payments, administrative expenses, taxes, purchase of investment securities, interest expense, payments on long-term borrowings, capital expenditures and repurchase of our common stock. Cash outflows fluctuate with the amount and timing of settlement of these transactions. Any future decline in our profitability would likely have some negative impact on our liquidity.

 

We manage our cash, investments and capital structure so we are able to meet the short and long-term obligations of our business while maintaining financial flexibility and liquidity. We forecast, analyze and monitor our cash flows to enable investment and financing within the overall constraints of our financial strategy.

 

A substantial portion of the assets held by our regulated subsidiaries are in the form of cash and cash equivalents and investments. After considering expected cash flows from operating activities, we generally invest cash that exceeds our near term obligations in longer term marketable fixed maturity securities, to improve our overall investment income returns. Our investment strategy is to make investments consistent with insurance statutes and other regulatory requirements, while preserving our asset base. Our investments are available-for-sale to meet liquidity and other needs. Excess capital at our subsidiaries is paid annually by subsidiaries in the form of dividends to their respective parent companies for general corporate use, as permitted by applicable regulations.

 

The availability of financing in the form of debt or equity is influenced by many factors including our profitability, operating cash flows, debt levels, debt ratings, contractual restrictions, regulatory requirements and market conditions. We have access to a $2.0 billion commercial paper program supported by a $2.5 billion senior credit facility, which allows us to maintain further operating and financial flexibility.

 

Liquidity—Year Ended December 31, 2005 Compared to Year Ended December 31, 2004

 

During 2005, net cash provided by operating activities was $3,256.7 million, as compared to $1,303.2 million in 2004, an increase of $1,953.5 million. The increase resulted from improved net income, including the impact of our merger with WHN. Net cash provided by operating activities for 2005 included a full year of WHN cash flow activity following the merger.

 

Net cash used in investing activities was $4,420.2 million in 2005, compared to cash used of $2,373.9 million in 2004, an increase in cash used of $2,046.3 million. The table below outlines the changes in investing cash flow between the two years:

 

    Change in
Cash Used in
Investing
Activities


 
    (In millions)  

Increase in net purchases of investments

  $ 1,749.7  

Increase in net purchases of subsidiaries

    349.8  

Increase in net sale of subsidiaries

    (92.8 )

Decrease in proceeds from settlement of a cash flow hedge

    15.7  

Increase in net purchases of property and equipment

    23.9  
   


Net increase in cash used in investing activities

  $ 2,046.3  
   


 

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The purchase of investment securities in 2005 increased from 2004 resulting from increased cash flows from operations driven by improved net income, including the impact of our merger with WHN. The increase in 2005 subsidiary purchases resulted primarily from the use of cash for the WellChoice merger and Lumenos acquisition, as compared to cash used for the WHN merger in 2004. The increase in 2005 sale of subsidiaries resulted primarily from the receipt of cash for the sale of certain subsidiaries, as compared to no activity in 2004.

 

Net cash flow provided by financing activities was $2,446.5 million in 2005 compared to cash provided by financing activities of $2,063.4 million in 2004. The table below outlines the increase in cash flow provided by financing activities of $383.1 million between the two years:

 

   

Change in
Cash Provided
by

Financing
Activities


 
    (In millions)  

Increase in proceeds from exercise of employee stock options and employee stock purchase plan

  $ 270.3  

Increase in repurchases of common stock

    (251.1 )

Net increase in proceeds from commercial paper borrowings

    15.0  

Decrease in repayment of long-term borrowings

    643.4  

Decrease in long-term borrowings

    (70.2 )

Decrease in proceeds from issuance of common stock under Equity Security Units stock purchase contracts

    (230.0 )

Other

    5.7  
   


Net increase in cash provided by financing activities

  $ 383.1  
   


 

The increase in proceeds from the exercise of employee stock options reflects the significant increase in employees with vested options due to our merger with WHN. The increase in repurchases of common stock reflects the activity in our Board-approved common stock repurchase program. The decrease in repayments of long-term debt resulted primarily from the significant amount of repayments in 2004 as new long-term debt was issued to partially pay off outstanding long-term debt and fund the WHN merger. The decrease in proceeds from the issuance of common stock under Equity Security Units stock purchase contracts reflects the maturity of these instruments in 2004.

 

On January 10, 2006, we issued $700.0 million of 5.000% notes due 2011; $1,100.0 million of 5.250% notes due 2016; and $900.0 million of 5.850% notes due 2036 under a registration statement filed on December 28, 2005. The proceeds from this debt issuance were used to repay a bridge loan of $1,700.0 million and approximately $1,000.0 million in commercial paper borrowed to partially fund the WellChoice merger.

 

Liquidity—Year Ended December 31, 2004 Compared to Year Ended December 31, 2003

 

During 2004, net cash provided by operating activities was $1,303.2 million, as compared to $1,159.0 million in 2003, an increase of $144.2 million. The increase resulted from improved net income, including the impact of our merger with WHN, partially offset by a decline in cash from changes in operating assets and liabilities. Our decline in cash from changes in operating assets and liabilities included the impact of long-term compensation payments of approximately $113.0 million made during 2004 that had been accrued in prior years. Net cash provided by operating activities for 2004 included one month of WHN cash flow activity following the merger.

 

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Net cash used in investing activities was $2,373.9 million in 2004, compared to cash used of $1,129.2 million in 2003, an increase in cash used of $1,244.7 million. The table below outlines the changes in investing cash flow between the two years:

 

    Change in
Cash Used in
Investing
Activities


 
    (In millions)  

Decrease in net purchases of investments

  $ (999.3 )

Increase in net purchases of subsidiaries

    2,233.3  

Decrease in proceeds from settlement of a cash flow hedge

    (15.7 )

Increase in net purchases of property and equipment

    26.4  
   


Net increase in cash used in investing activities

  $ 1,244.7  
   


 

The purchase of investment securities in 2004 decreased from 2003 as operating cash was retained for the WHN merger. The increase in 2004 subsidiary purchases resulted primarily from the use of cash for the WHN merger, as compared to minimal activity in 2003. The increase in net property and equipment purchases included one month of cash outflows for the pre-merger WHN companies.

 

Net cash provided by financing activities was $2,063.4 million in 2004 compared to cash used in financing activities of $260.2 million in 2003. Financing activity related to the merger with WHN, as described below, contributed to the increase in cash provided by financing activities.

 

Effective with the WHN merger, the Board of Directors authorized an increase in our commercial paper program from $1,000.0 million to $2,000.0 million. In December 2004, we initially borrowed $1,500.0 million under this commercial paper program, which was used to repay a portion of our senior credit facilities which were used at the date of the WHN merger to complete the transaction.

 

On December 9, 2004, we issued $300.0 million of 3.750% Notes due 2007, $300.0 million of 4.250% Notes due 2009, $500.0 million of 5.000% Notes due 2014 and $500.0 million of 5.950% Notes due 2034. Net proceeds from this offering were approximately $1,583.7 million after deducting the initial purchasers’ discount and estimated offering expenses. Proceeds from these notes were used to repay borrowings outstanding under our bridge loan and five year credit facility, which were used at the date of the WHN merger to complete the transaction. In addition, a portion of the proceeds were used to fund the tender offer to purchase subsidiary surplus notes. The remainder of the proceeds was used to repay amounts outstanding under our commercial paper program described above.

 

During 2004, we received $159.0 million of proceeds from the issuance of common stock related to the exercise of stock options and our employee stock purchase program. These proceeds were offset by $82.2 million of cash used to repurchase our common stock.

 

During 2003, $217.2 million was used to repurchase our common stock. In addition, $100.0 million was used to fund the payment of senior guaranteed notes, which matured on July 15, 2003. These payments were offset by $57.0 million of proceeds from the issuance of common stock related to the exercise of stock options and our employee stock purchase program.

 

Financial Condition

 

We maintained a strong financial condition and liquidity position, with consolidated cash, cash equivalents and investments, including long-term investments, of $20.3 billion at December 31, 2005. Since December 31, 2004, total cash, cash equivalents and investments, including long-term investments, increased by $4.5 billion, primarily resulting from the merger with WellChoice, as well as, improved net income driven by the merger with WHN.

 

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Many of our subsidiaries are subject to various government regulations that restrict the timing and amount of dividends and other distributions that may be paid to their respective parent companies. Also, in connection with the WHN merger, the Company and certain of our subsidiaries in California and Georgia executed undertakings with the California Department of Managed Health Care, the California Department of Insurance and the Georgia Department of Insurance which contained various commitments, including the commitment to provide $61.5 million of support for health benefit programs in those states. Additional undertakings include the requirement to maintain certain capital levels at those subsidiaries. During 2005, we received $3.0 billion of dividends from our subsidiaries. At December 31, 2005, we held at the parent company approximately $2.5 billion of our consolidated $20.3 billion of cash, cash equivalents and investments, which is available for general corporate use, including investment in our businesses, acquisitions, share and debt repurchases and interest payments.

 

Our consolidated debt-to-total capital ratio (calculated as the sum of debt divided by the sum of debt plus shareholders’ equity) was 21.4% as of December 31, 2005 and 18.6% as of December 31, 2004.

 

Our senior debt is rated “BBB+” by Standard & Poor’s, “A-” by Fitch, Inc., “Baa1” by Moody’s Investor Service, Inc. and “a-” by AM Best Company, Inc. We intend to maintain our senior debt investment grade ratings. A significant downgrade in our debt ratings could adversely affect our borrowing capacity and costs.

 

Future Sources and Uses of Liquidity

 

On December 28, 2005, we filed a shelf registration with the Securities and Exchange Commission to register an unlimited amount of any combination of debt or equity securities in one or more offerings. Specific information regarding terms of an offering and the securities being offered will be provided at the time of that offering. Proceeds from future offerings are expected to be used for general corporate purposes, including the repayment of debt, capitalization of our subsidiaries or the financing of possible acquisitions or business expansion. On January 10, 2006, we issued $700.0 million of 5.000% notes due 2011; $1.1 billion of 5.250% notes due 2016; and $900.0 million of 5.850% notes due 2036 under this registration statement. The proceeds from this debt issuance were used to repay a bridge loan of $1,700.0 million and $1,000.0 million in commercial paper borrowed to partially fund the WellChoice merger.

 

On November 29, 2005, we entered into a senior revolving credit facility, or the facility, with certain lenders for general corporate purposes. The facility provides credit up to $2.5 billion (reduced for any commercial paper issuances) and matures on November 29, 2010. The interest rate on this facility is based on either (i) the LIBOR rate plus a predetermined percentage rate based on our credit rating at the date of utilization, or (ii) a base rate as defined in the facility agreement. Our ability to borrow under this facility is subject to compliance with certain covenants. Commitment fees for the facility amounted to $1.4 million in 2005. There were no amounts outstanding under this facility as of December 31, 2005. At December 31, 2005, we had $898.6 million available under this facility.

 

We have Board of Directors’ approval to borrow up to $2.0 billion under our commercial paper program. Proceeds from any issuance of commercial paper may be used for general corporate purposes, including the repurchase of our debt and common stock. Commercial paper notes are short-term senior unsecured notes, with a maturity not to exceed 270 days from date of issuance. When issued, the notes bear interest at current market rates. There were $1.6 billion of borrowings outstanding under this commercial paper program as of December 31, 2005, The borrowings outstanding as of December 31, 2005 are classified as long-term debt as our intent is to replace short-term commercial paper for an uninterrupted period extending for more than one year or with borrowings under our senior credit facilities.

 

As discussed in “Financial Condition” above, many of our subsidiaries are subject to various government regulations that restrict the timing and amount of dividends and other distributions that may be paid. Based upon these requirements, we are currently estimating approximately $2.1 billion of dividends to be paid to the parent company during 2006.

 

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During December 2004, we completed a tender offer to purchase subsidiary surplus notes from the holders, and purchased $258.0 million of 9.125% notes due 2010 and $174.9 million of 9.000% notes due 2027. Future interest payments on these portions of the notes will be paid by the subsidiary to the parent company, and are expected to be approximately $39.2 million annually.

 

Under our Board of Directors’ authorization, we maintain a common stock repurchase program. Repurchases may be made from time to time at prevailing market prices, subject to certain restrictions on volume, pricing and timing. As of December 31, 2005, we had Board of Directors’ authorization to purchase up to an additional $2.0 billion of common stock. Our stock repurchase program is discretionary as we are under no obligation to repurchase shares. We repurchase shares because we believe it is a prudent use of surplus capital. As previously disclosed, we were restricted from repurchasing shares in connection with WellChoice acquisition. Subsequent to the closing of the acquisition on December 28, 2005, we resumed the repurchase of our common stock in January 2006. Given our liquidity and current market conditions, we have been able to execute repurchases under our program in accordance with our strategic plan.

 

Our current pension funding strategy is to fund an amount at least equal to the minimum required funding as determined under ERISA with consideration of factors such as the minimum pension liability requirement and maximum tax deductible amounts. During the year ended December 31, 2005, no contributions under ERISA were required, however, the Company made tax deductible discretionary contributions of $117.8 million.

 

Contractual Obligations and Commitments

 

Our estimated contractual obligations and commitments as of December 31, 2005 are as follows:

 

         Payments Due by Period

    Total

   Less than
1 Year


   1-3 Years

   3-5 Years

   More than
5 Years


    (In millions)

Long-term debt, including capital leases1

  $ 8,606.6    $ 3,966.9    $ 825.6    $ 640.9    $ 3,173.2

Operating lease commitments

    1,098.8      145.0      240.5      208.5      504.8

Projected other postretirement benefits

    987.7      35.8      201.3      205.1      545.5

Purchase obligations:

                                 

IBM outsourcing agreements2

    1,022.8      185.2      326.3      302.3      209.0

Other purchase obligations3

    74.0      57.0      16.1      0.9      —  

Other long-term liabilities

    899.9      19.3      356.4      345.2      179.0

Venture capital commitments

    22.5      8.7      9.7      4.1      —  
   

  

  

  

  

Total contractual obligations and commitments

  $ 12,712.3    $ 4,417.9    $ 1,975.9    $ 1,707.0    $ 4,611.5
   

  

  

  

  


1 Includes estimated interest expense.
2 Relates to agreements with International Business Machines Corporation to provide information technology infrastructure services. See Note 18 to the audited consolidated financial statements for the year ended December 31, 2005 for further information.
3 Includes obligations related to IT service agreements and telecommunication contracts.

 

In addition to the contractual obligations and commitments discussed above, we have a variety of other contractual agreements related to acquiring materials and services used in our operations. However, we do not believe these other agreements contain material noncancelable commitments.

 

We believe that funds from future operating cash flows, cash and investments and funds available under our credit agreements or from public or private financing sources will be sufficient for future operations and commitments and for capital acquisitions and other strategic transactions.

 

For additional information on our debt and lease commitments, see Notes 7 and 16, respectively, to our audited consolidated financial statements for the year ended December 31, 2005 included in this Form 10-K.

 

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Off-Balance Sheet Arrangements

 

We have agreed to guarantee up to $37.0 million of debt incurred by an unaffiliated entity to partially finance the purchase of a hospital.

 

In connection with an investment in a joint venture to develop and operate a well-being center in California, we may be required, based on specific targets, to make an additional $18.0 million contribution following completion of the well-being center. We anticipate the well-being center will be completed during 2006.

 

In connection with the formation of a joint venture providing Medicaid services in Puerto Rico, we agreed under certain circumstances to provide additional funding to the joint-venture entity. As of December 31, 2005, our maximum potential liability pursuant to this guarantee was $30.3 million. We have not been required to make any payments under this guarantee and we do not currently expect any such payments will be made.

 

For additional information on these off-balance sheet arrangements, see Note 18 to our audited consolidated financial statements for the year ended December 31, 2005 included in this Form 10-K.

 

Risk-Based Capital

 

Our regulated subsidiaries’ states of domicile have statutory risk-based capital, or RBC, requirements for health and other insurance companies largely based on the NAIC’s RBC Model Act. These RBC requirements are intended to measure capital adequacy, taking into account the risk characteristics of an insurer’s investments and products. The NAIC sets forth the formula for calculating the RBC requirements, which are designed to take into account asset risks, insurance risks, interest rate risks and other relevant risks with respect to an individual insurance company’s business. In general, under this Act, an insurance company must submit a report of its RBC level to the state insurance department or insurance commissioner, as appropriate, at the end of each calendar year. Our risk-based capital as of December 31, 2005, which was the most recent date for which reporting was required, was in excess of all mandatory RBC thresholds. In addition to exceeding the RBC requirements, we are in compliance with the liquidity and capital requirements for a licensee of the Blue Cross Blue Shield Association and with the tangible net worth requirements applicable to certain of our California subsidiaries.

 

XI.     Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995

 

This document contains certain forward-looking information about WellPoint, Inc. (“WellPoint”) that is intended to be covered by the safe harbor for “forward-looking statements” provided by the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that are not historical facts. Words such as “expect(s)”, “feel(s)”, “believe(s)”, “will”, “may”, “anticipate(s)” and similar expressions are intended to identify forward-looking statements. These statements include, but are not limited to, financial projections and estimates and their underlying assumptions; statements regarding plans, objectives and expectations with respect to future operations, products and services; and statements regarding future performance. Such statements are subject to certain risks and uncertainties, many of which are difficult to predict and generally beyond the control of WellPoint, that could cause actual results to differ materially from those expressed in, or implied or projected by, the forward-looking information and statements. These risks and uncertainties include: those discussed and identified in public filings with the U.S. Securities and Exchange Commission (“SEC”) made by WellPoint, WellPoint Health Networks Inc. (“WHN”) and WellChoice, Inc. (“WC”); trends in health care costs and utilization rates; our ability to secure sufficient premium rate increases; competitor pricing below market trends of increasing costs; increased government regulation of health benefits and managed care; significant acquisitions or divestitures by major competitors; introduction and utilization of new prescription drugs and technology; a downgrade in our financial strength ratings; litigation and investigations targeted at health benefits companies; and our ability to resolve litigation and investigations within estimates; our ability to contract with providers consistent with past practice; our ability to achieve expected synergies and operating efficiencies in the WHN merger within the expected time-frames or at all and to successfully integrate our operations; such integration may be more difficult, time-consuming or costly than expected; revenues following the transaction may be lower than expected; operating costs, customer loss

 

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and business disruption, including, without limitation, difficulties in maintaining relationships with employees, customers, clients or suppliers, may be greater than expected following the transaction; our ability to achieve expected synergies and operating efficiencies in the WC merger within the expected time-frames or at all, to meet expectations regarding repurchases of shares of our common stock and to successfully integrate our operations; such integration may be more difficult, time-consuming or costly than expected; revenues following the transaction may be lower than expected; operating costs, customer loss and business disruption, including, without limitation, difficulties in maintaining relationships with employees, customers, clients or suppliers, may be greater than expected following the transaction; our ability to meet expectations regarding the accounting and tax treatments of the transaction and the value of the transaction consideration; future bio-terrorist activity or other potential public health epidemics; and general economic downturns. Readers are cautioned not to place undue reliance on these forward-looking statements that speak only as of the date hereof. WellPoint does not undertake any obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Readers are also urged to carefully review and consider the various disclosures in WellPoint’s and WC’s various SEC reports.

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

 

As a result of our investing and borrowing activities, we are exposed to financial market risks, including those resulting from changes in interest rates and changes in equity market valuations. Potential impacts discussed below are based upon sensitivity analyses performed on WellPoint’s financial position as of December 31, 2005. Actual results could vary from these estimates. Our primary objectives with our investment portfolio are to provide safety and preservation of capital, sufficient liquidity to meet cash flow requirements, the integration of investment strategy with the business operations and an attainment of a competitive after-tax total return.

 

Investments

 

Our investment portfolio is exposed to three primary sources of risk: credit quality risk, interest rate risk and market valuation risk.

 

The primary risks associated with our fixed maturity securities are credit quality risk and interest rate risk. Credit quality risk is defined as the risk of a credit downgrade to an individual fixed maturity security and the potential loss attributable to that downgrade. Credit quality risk is managed through our investment policy, which establishes credit quality limitations on the overall portfolio as well as diversification and percentage limits on securities of individual issuers. The result is a well-diversified portfolio of fixed maturity securities, with an average credit rating of approximately AA. Interest rate risk is defined as the potential for economic losses on fixed maturity securities, due to a change in market interest rates. Our fixed maturity portfolio is invested primarily in U.S. government securities, corporate bonds, asset-backed bonds, mortgage-related securities and municipal bonds, all of which represent an exposure to changes in the level of market interest rates. Interest rate risk is managed by maintaining asset duration within a band based upon our liabilities, operating performance and liquidity needs. Additionally, we have the capability of holding any security to maturity, which would allow us to realize full par value.

 

Our portfolio includes corporate securities (approximately 38% of the total fixed maturity portfolio at December 31, 2005), which are subject to credit/default risk. In a declining economic environment, corporate yields will usually increase prompted by concern over the ability of corporations to make interest payments, thus causing a decrease in the price of corporate securities, and the decline in value of the corporate fixed maturity portfolio. This risk is managed through fundamental credit analysis, diversification of issuers and industries and an average credit rating of the corporate fixed maturity portfolio of approximately A.

 

Our equity portfolio is comprised of large capitalization and small capitalization domestic equities, foreign equities and index mutual funds. Our equity portfolio is subject to the volatility inherent in the stock market,

 

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driven by concerns over economic conditions, earnings and sales growth, inflation, and consumer confidence. These systematic risks cannot be managed through diversification alone. However, more routine risks, such as stock/industry specific risks, are managed by investing in a diversified equity portfolio.

 

As of December 31, 2005, approximately 90% of our available-for-sale investments were fixed maturity securities. Market risk is addressed by actively managing the duration, allocation and diversification of our investment portfolio. We have evaluated the impact on the fixed maturity portfolio’s fair value considering an immediate 100 basis point change in interest rates. A 100 basis point increase in interest rates would result in an approximate $573.0 million decrease in fair value, whereas a 100 basis point decrease in interest rates would result in an approximate $534.9 million increase in fair value. While we classify our fixed maturity securities as “available-for-sale” for accounting purposes, we believe our cash flows and duration of our portfolio should allow us to hold securities to maturity, thereby avoiding the recognition of losses should interest rates rise significantly.

 

Our available-for-sale equity securities portfolio, as of December 31, 2005, was approximately 10% of our investments. An immediate 10% decrease in each equity investment’s value, arising from market movement, would result in a fair value decrease of $144.8 million. Alternatively, an immediate 10% increase in each equity investment’s value, attributable to the same factor, would result in a fair value increase of $144.8 million.

 

Long-Term Debt

 

Our total long-term debt at December 31, 2005 was $6.8 billion, and included $1.6 billion of commercial paper and $1.7 billion under a senior bridge facility. The carrying value of the commercial paper and bridge facility approximates fair value as the underlying instruments have variable interest rates at market value. The remainder of the debt is subject to interest rate risk as these instruments have fixed interest rates and the fair value is affected by changes in market interest rates.

 

At December 31, 2005, we had $3.4 billion of senior unsecured notes with fixed interest rates. These notes, at par value, included $450.0 million at 6.375% due 2006, $200.0 million at 3.50% due 2007, $300.0 million at 3.75% due 2007, $300.0 million at 4.25% due 2009, $350.0 million at 6.375% due 2012, $800.0 million at 6.80% due 2012, $500.0 million at 5.00% due 2014 and $500.0 million at 5.95% due 2034. These notes had combined carrying and estimated fair value of $3.4 billion and $3.5 billion, respectively, at December 31, 2005.

 

Our subordinated debt includes surplus notes issued by one of our insurance subsidiaries. Par value of amounts outstanding at December 31, 2005 included $42.0 million of 9.125% surplus notes due 2010 and $25.1 million of 9.000% surplus notes due 2027. Any payment of interest or principal on the surplus notes may be made only with the prior approval of the Indiana Department of Insurance. The combined carrying value of the surplus notes was $66.5 million and $66.4 million at December 31, 2005 and 2004, respectively. The estimated fair value of the surplus notes exceeded the carrying value by $16.7 million and $22.4 million at December 31, 2005 and 2004, respectively.

 

Should interest rates increase or decrease in the future, the estimated fair value of our fixed rate debt would decrease or increase accordingly.

 

Derivatives

 

We use derivative financial instruments, specifically interest rate swap agreements, to hedge exposure in interest rate risk on our borrowings. Our derivative use is generally limited to hedging purposes and we generally do not use derivative instruments for speculative purposes.

 

During the year ended December 31, 2005, we entered into two fair value hedges with a total notional value of $660.0 million. The first hedge is a $360.0 million notional amount interest rate swap agreement to exchange a fixed 6.8% rate for a LIBOR-based floating rate and expires on August 1, 2012. The second hedge is a $300.0 million notional amount interest rate swap agreement to exchange a fixed 5.00% rate for LIBOR-based floating

 

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rate and expires December 15, 2014. During the year ended December 31, 2004, we entered into a $300.0 million notional amount interest rate swap agreement to exchange a fixed 3.75% rate for a LIBOR-based floating rate. This swap agreement expires on December 14, 2007.

 

During the year ended December 31, 2005, we entered into a floating to fixed rate cash flow hedge with a total notional value of $480.0 million. The purpose of this hedge is to offset the variability of the cash flows due to the rollover of our variable-rate one-month commercial paper issuance. This swap agreement expires in December 2007. During the year ended December 31, 2005, no gain or loss from hedged ineffectiveness was recorded in earnings and the commercial paper borrowings remain outstanding at December 31, 2005. The unamortized fair value included in accumulated comprehensive income at December 31, 2005 was $3.6 million.

 

During the year ended December 31, 2005, we entered into forward starting pay fixed swaps with an aggregate notional amount of $875.0 million. The objective of these hedges was to eliminate the variability of cash flows in the interest payments on the debt securities to be issued to partially fund the cash portion of the WellChoice merger. The unamortized fair value included in accumulated comprehensive income at December 31, 2005 was $12.5. As of December 31, 2005, the total amount of amortization over the next twelve months is expected to increase interest expense by approximately $0.6 million.

 

During the year ended December 31, 2004, we entered into forward starting pay fixed swaps and treasury lock swaps with an aggregate notional amount of $2.0 billion. The objective of these hedges was to eliminate the variability of cash flows in the interest payments on the debt securities to be issued to partially fund the cash portion of the WHN merger. Upon termination of these swaps in 2004, we received a net $15.7 million, the net fair value at the times of termination. In addition, we recorded an unrealized gain of $10.2 million, net of tax, as accumulated other comprehensive income. Prior to the WHN merger, we reclassified $0.7 million ($0.5 million, net of tax) to net realized gains on investment for the portion of the hedges that were deemed not probable of occurring. Following the completion of the WHN merger on November 30, 2004, we issued debt securities, and the unamortized fair value of the forward starting pay fixed swaps included in balances in accumulated other comprehensive income began amortizing into earnings, as a reduction of interest expense, over the life of the debt securities. The unamortized fair value included in accumulated comprehensive income at December 31, 2005 was $8.9 million. As of December 31, 2005, the total amount of amortization over the next twelve months will decrease interest expense by approximately $1.3 million.

 

Changes in interest rates will affect the estimated fair value of these swap agreements. As of December 31, 2005, we recorded an asset of $5.6 million and a liability of $44.9 million, the estimated fair value of the swaps at that date. We have evaluated the impact on the interest rate swap’s fair value considering an immediate 100 basis point change in interest rates. A 100 basis point increase in interest rates would result in an approximate $61.6 million increase in fair value, whereas a 100 basis point decrease in interest rates would result in an approximate $78.0 million decrease in fair value.

 

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

 

WELLPOINT, INC.

 

CONSOLIDATED FINANCIAL STATEMENTS

 

Years ended December 31, 2005, 2004 and 2003

 

Contents

 

Report of Independent Registered Public Accounting Firm

  75

Audited Consolidated Financial Statements:

   

Consolidated Balance Sheets

  76

Consolidated Statements of Income

  77

Consolidated Statements of Cash Flows

  78

Consolidated Statements of Shareholders’ Equity

  79

Notes to Consolidated Financial Statements

  80

 

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Report of Independent Registered

Public Accounting Firm

 

Shareholders and Board of Directors

WellPoint, Inc.

 

We have audited the accompanying consolidated balance sheets of WellPoint, Inc. as of December 31, 2005 and 2004, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of WellPoint, Inc. at December 31, 2005 and 2004, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of WellPoint, Inc.’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 15, 2006 expressed an unqualified opinion thereon.

 

/S/ ERNST & YOUNG LLP

 

Indianapolis, Indiana

February 15, 2006

 

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WellPoint, Inc.

Consolidated Balance Sheets

 

(In millions, except share data)   December 31

 
    2005

    2004

 

Assets

               

Current assets:

               

Investments available-for-sale, at fair value:

               

Fixed maturity securities (amortized cost of $15,444.5 and $12,286.7)

  $ 15,332.2     $ 12,413.7  

Equity securities (cost of $1,388.4 and $1,089.3)

    1,448.2       1,173.2  

Cash and cash equivalents

    2,740.2       1,457.2  

Accrued investment income

    156.8       144.6  

Premium and self-funded receivables

    2,295.2       1,574.6  

Other receivables

    831.4       731.8  

Securities lending collateral

    1,389.9       658.5  

Deferred tax assets, net

    728.2       434.0  

Other current assets

    1,022.7       769.9  
   


 


Total current assets

    25,944.8       19,357.5  

Long-term investments available-for-sale, at fair value:

               

Fixed maturity securities (amortized cost of $238.1 and $219.3)

    234.7       220.8  

Equity securities (cost of $346.1 and $359.4)

    372.9       360.8  

Other invested assets, long-term

    207.8       166.5  

Property and equipment, net

    1,078.6       1,045.2  

Goodwill

    13,469.1       10,017.9  

Other intangible assets

    9,686.4       8,211.6  

Other noncurrent assets

    410.9       358.1  
   


 


Total assets

  $ 51,405.2     $ 39,738.4  
   


 


Liabilities and shareholders’ equity

               

Liabilities

               

Current liabilities:

               

Policy liabilities:

               

Medical claims payable

  $ 4,923.4     $ 4,202.0  

Reserves for future policy benefits

    82.1       145.0  

Other policyholder liabilities

    1,761.1       1,209.5  
   


 


Total policy liabilities

    6,766.6       5,556.5  

Unearned income

    1,057.1       1,046.6  

Accounts payable and accrued expenses

    2,860.4       2,222.1  

Income taxes payable

    833.4       418.8  

Security trades pending payable

    181.8       84.4  

Securities lending payable

    1,389.9       658.5  

Current portion of long-term debt

    481.2       160.9  

Other current liabilities

    1,286.8       1,433.4  
   


 


Total current liabilities

    14,857.2       11,581.2  

Long-term debt, less current portion

    6,324.7       4,289.5  

Reserves for future policy benefits, noncurrent

    679.9       727.2  

Deferred tax liability, net

    3,306.3       2,596.4  

Other noncurrent liabilities

    1,244.0       1,085.1  
   


 


Total liabilities

    26,412.1       20,279.4  
   


 


Commitments and contingencies—Note 18

               

Shareholders’ equity

               

Preferred stock, without par value, shares authorized—100,000,000; shares issued and outstanding—none

    —         —    

Common stock, par value $0.01, shares authorized—900,000,000; shares issued and outstanding: 660,424,174 and 302,626,708

    6.6       3.0  

Additional paid-in capital

    20,915.4       17,433.6  

Retained earnings

    4,173.5       1,960.1  

Unearned stock compensation

    (82.1 )     (83.5 )

Accumulated other comprehensive (loss) income

    (20.3 )     145.8  
   


 


Total shareholders’ equity

    24,993.1       19,459.0  
   


 


Total liabilities and shareholders’ equity

  $ 51,405.2     $ 39,738.4  
   


 


 

See accompanying notes.

 

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WellPoint, Inc.

Consolidated Statements of Income

 

(In millions, except per share data)   Years ended December 31

    2005

    2004

   2003

Revenues

                    

Premiums

  $ 41,216.7     $ 18,771.6    $ 15,167.7

Administrative fees

    2,729.9       1,436.9      1,160.2

Other revenue

    566.5       252.4      159.2
   


 

  

Total operating revenue

    44,513.1       20,460.9      16,487.1

Net investment income

    633.1       311.7      278.1

Net realized (losses) gains on investments

    (10.2 )     42.5      16.2
   


 

  

Total revenues

    45,136.0       20,815.1      16,781.4

Expenses

                    

Benefit expense

    33,219.9       15,387.8      12,254.5
Selling, general and administrative expense:                     

Selling expense

    1,474.2       537.2      411.2

General and administrative expense

    5,798.5       2,940.5      2,686.3
   


 

  

Total selling, general and administrative expense

    7,272.7       3,477.7      3,097.5

Cost of drugs

    288.0       95.0      38.7

Interest expense

    226.2       142.3      131.2

Amortization of other intangible assets

    238.9       61.4      47.6

Merger-related undertakings

    —         61.5