The condensed consolidated financial statements of Humana Inc. in this document present the Company's financial position, results of operations and cash flows, and should be read in conjunction with the following discussion and analysis. References to "we," "us," "our," "Company," and "Humana" mean Humana Inc. and its subsidiaries. This discussion includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. When used in filings with the SEC, in our press releases, investor presentations, and in oral statements made by or with the approval of one of our executive officers, the words or phrases like "expects," "anticipates," "intends," "likely will result," "estimates," "projects" or variations of such words and similar expressions are intended to identify such forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions, including, among other things, information set forth in Item 1A. - Risk Factors in our Form 10-K for the year ended December 31, 2007 that was filed with the SEC on February 25, 2008 as modified by the changes to these risk factors included in this document and other reports we filed subsequent to February 25, 2008. In making these statements, we are not undertaking to address or update these factors in future filings or communications regarding our business or results. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this document might not occur. There may also be other risks that we are unable to predict at this time. Any of these risks and uncertainties may cause actual results to differ materially from the results discussed in the forward-looking statements.

Overview

Headquartered in Louisville, Kentucky, Humana Inc. is one of the nation's largest publicly traded health and supplemental benefits companies, based on our 2007 revenues of $25.3 billion. We are a full-service benefits solutions company, offering a wide array of health and supplemental benefit products for employer groups, government benefit programs, and individuals. As of September 30, 2008, we had approximately 11.5 million members in our medical benefit plans, as well as approximately 6.7 million members in our specialty products.

We manage our business with two segments: Government and Commercial. The Government segment consists of beneficiaries of government benefit programs, and includes three lines of business: Medicare, Military, and Medicaid. The Commercial segment consists of members enrolled in our medical and specialty products marketed to employer groups and individuals. We identified our segments in accordance with the aggregation provisions of SFAS 131, which aggregates products with similar economic characteristics. These characteristics include the nature of customer groups as well as pricing, benefits, and underwriting requirements. These segment groupings are consistent with information used by our Chief Executive Officer.

The results of each segment are measured by income before income taxes. We allocate all selling, general and administrative expenses, investment and other revenue, interest expense, and goodwill, but no other assets or liabilities, to our segments. Members served by our two segments often utilize the same medical provider networks, enabling us to obtain more favorable contract terms with providers. Our segments also share indirect overhead costs and assets. As a result, the profitability of each segment is interdependent.

Our results are impacted by many factors, but most notably are influenced by our ability to establish and maintain a competitive and efficient cost structure and to accurately and consistently establish competitive premium, ASO fee, and plan benefit levels that are commensurate with our benefit and administrative costs. Benefit costs are subject to a relatively high rate of inflation due to many forces, including new higher priced technologies and medical procedures, new prescription drugs and therapies, an aging population, lifestyle challenges including obesity and smoking, the tort liability system, and government regulation.

Our industry relies on two key statistics to measure performance. The benefits ratio, which is computed by taking total benefit expenses as a percentage of premium revenues, represents a statistic used to measure underwriting profitability. The selling, general, and administrative expense ratio, or SG&A expense ratio, which is computed by taking total selling, general and administrative expenses as a percentage of premium revenues, administrative services fees and other revenues, represents a statistic used to measure administrative spending efficiency.

Government Segment

Our strategy and commitment to the expanded Medicare programs, including new product choices and pharmacy benefits for seniors, has led to significant growth. Medicare Advantage membership increased to 1,368,000 members at September 30, 2008, up 225,000 members, or 19.7%, from 1,143,000 members at December 31, 2007, and up 230,000 members, or 20.2%, from 1,138,000 at September 30, 2007, primarily due to sales of Preferred Provider Organization, or PPO, and Private Fee-For-Service, or PFFS, products. The OSF, SecureHorizons, and Metcare acquisitions also added 48,000 Medicare HMO and PPO members. In addition, recently the mix of sales has shifted increasingly to our network-based PPO offerings. Likewise, Medicare Advantage premium revenues have increased 23.8% to $3.5 billion for the third quarter of 2008 from $2.8 billion in the third quarter of 2007.

We offer three Medicare stand-alone prescription drug plans, or PDPs, the Standard, Enhanced, and Complete products, with varying degrees of coverage. During the nine months ended September 30, 2008, we experienced prescription drug claim expenses for our Medicare stand-alone PDPs that were higher than we had originally assumed in our bids. These higher claim levels for our Medicare stand-alone PDPs are reflective of a combination of several variances between our actuarial bid assumptions versus our year-to-date experience. These variances result from differences in utilization assumptions by drug tier for our Enhanced plans, as well as an increase in the percentage of higher cost members in both our Standard and Enhanced plans. Primarily due to the lower than expected stand-alone PDP operating results, we are expecting a decrease in consolidated earnings for full year 2008 as compared to 2007. We believe we have addressed these issues for 2009, based on our enhancements made to our bid development and review processes. In September 2008, we received the final approvals from CMS for our PDP benefit plans for 2009.

The enactment of the Medicare Improvements for Patients and Providers Act of 2008, or the Act, in July 2008 could affect our Medicare operations. Principally, beginning in 2011 sponsors of Medicare Advantage PFFS plans will be required to contract with providers to establish adequate networks, except in geographic areas that CMS determines have fewer than two network-based Medicare Advantage plans. Additionally, the Act prohibits several different kinds of marketing activities by Medicare plan sponsors and their brokers beginning in 2009, and will phase out indirect medical education (IME) costs beginning in 2010. We are implementing various operational and strategic initiatives that are intended to answer the challenges presented by the Act. In addition, most of our PFFS enrollees reside in geographies where we have developed a PPO network and offer a PPO plan. We will continue to develop our PPO network and build network-based plan offerings to address the network restriction. Nonetheless, there can be no assurance that we will be able to successfully implement those initiatives. Failure to implement this strategy may result in a material adverse effect on our results of operations, financial position, and cash flows.

Our quarterly Government segment earnings and operating cash flows are particularly impacted by the Medicare Part D benefit design and changes in the composition of our membership. The Medicare Part D benefit design results in coverage that varies as a member's cumulative out-of-pocket costs pass through successive stages of a member's plan period which begins January 1 for renewals. These plan designs generally result in us sharing a greater portion of the responsibility for total pharmacy costs in the early stages and less in the latter stages. As a result the Government segment's benefits ratio generally improves as the year progresses. In addition, the number of low-income senior members as well as year over year changes in the mix of membership in our stand-alone PDP products, Standard, Enhanced, and Complete, affect the quarterly benefits ratio pattern.

Commercial Segment

We continue to increase the diversification of our Commercial segment membership base and continue to exercise pricing discipline relative to our fully-insured accounts. Commercial segment medical membership increased 254,900 members from September 30, 2007 to 3,554,000 members at September 30, 2008, primarily as a result of the acquisitions of OSF Health Plans, Inc., or OSF, and KMG America Corporation, or KMG, discussed more fully below, which together added approximately 159,000 members, primarily ASO. The remaining increase primarily was due to enrollment gains in strategic areas of commercial growth. Individual membership increased 42%, Smart plans and other consumer offerings membership grew 20%, and small group membership was up 4% at September 30, 2008 compared to September 30, 2007. Membership changes from sales focused on strategic growth areas, exercising pricing discipline, and the acquisition of CompBenefits Corporation, or CompBenefits, and KMG resulted in a decline in the benefits ratio to 79.4% for the nine months ended September 30, 2008 compared to 80.4% for the nine months ended September 30, 2007 and 80.5% for the year ended December 31, 2007.

In addition, we are diversifying our Commercial segment revenues through expanded and new specialty product offerings with the acquisitions of CompBenefits Corporation, or CompBenefits, and KMG in the fourth quarter of 2007. These acquisitions significantly increased our dental membership and added new product offerings including vision and other voluntary employee benefits including supplemental health products such as cancer, critical illness, and accident policies. Along with our 2005 acquisition of Corphealth, Inc., a behavioral health care management company, these specialty acquisitions are anticipated to enhance our Commercial segment margins and our ability to appeal to more customers seeking benefit providers who offer full-service solutions.

Recent Turmoil in the Financial Markets

Recently, the securities and credit markets have been experiencing severe volatility and disturbance, increasing risk with respect to our financial assets. At September 30, 2008, cash, cash equivalents and our investment and securities lending portfolios totaled $6.9 billion, or 55% of total assets, with 23% invested in cash and cash equivalents. Investment securities consist primarily of debt securities of investment-grade quality with an average credit rating by S&P of AA+ at September 30, 2008 and an average duration of approximately 4.5 years. Including cash and cash equivalents, the average duration of our investment portfolio was approximately 3.4 years. We have $8.4 million of mortgage-backed securities associated with Alt-A or subprime loans, or 0.1% of total investment securities, at September 30, 2008 and no collateralized debt obligations.

Gross unrealized losses of $286.7 million, including $20.7 million related to our securities lending portfolio, at September 30, 2008 primarily were caused by an increase in interest rates from a widening of credit spreads. All issuers of securities trading at an unrealized loss remain current on all contractual payments, and we believe it is probable that we will be able to collect all amounts due according to the contractual terms of the debt securities. After taking into account these and other factors, including severity, length of time of the decline, and our ability and intent to hold these securities until recovery or maturity, we determined the unrealized losses on these investment securities were temporary and, as such, no impairment was required.

During the third quarter of 2008, we realized losses of $108.3 million ($68.7 million after tax, or $0.40 per diluted common share) primarily associated with other-than-temporary impairments in our investment portfolios as well as realized losses associated with sales of distressed financial institution securities during September 2008. Realized losses of $68.7 million relate to other-than-temporary impairments of investments in Lehman Brothers Holdings Inc. or its subsidiaries (Lehman). Lehman Brothers Holdings Inc. filed for bankruptcy protection on September 15, 2008, and certain of its subsidiaries have also filed for bankruptcy protection. Of this $68.7 million in realized losses, $10.4 million results from terminating an interest rate swap agreement with Lehman. The other impairments primarily relate to declines in values of securities, primarily associated with the financial services industry, for which we are uncertain of our intent to hold until recovery or maturity. Of the $108.3 million, $51.9 million was allocated to the Government segment and $56.4 million was allocated to the Commercial segment.

We continuously review our investment portfolios. Given current market conditions, there is a continuing risk that further declines in fair value may occur and additional material realized losses from sales or other-than-temporary impairments may be recorded in future periods.

On October 7, 2008, we terminated all interest rate swap agreements outstanding associated with our senior notes based on recent changes in the credit market environment. In exchange for terminating these interest rate swap agreements, we received cash of $93.0 million for the fair value of the swap assets and $15.3 million for accrued interest. This transaction also fixes the interest rate on our senior notes to a weighted average rate of 6.08%. We may enter into swap agreements in the future.

The availability of liquidity and credit capacity in general has been impacted by the current conditions in the financial markets. We believe our cash balances, investment securities, operating cash flows, and funds available under our credit agreement or from other public or private financing sources, taken together, provide adequate resources to fund ongoing operating and regulatory requirements, future expansion opportunities, and capital expenditures in the foreseeable future, and refinance debt as it matures. Our long-term debt, consisting primarily of senior notes, of $1,668.2 million represented 28.1% of total capitalization at September 30, 2008. The earliest maturity of our senior notes is in June 2016. In addition, we have available a 5-year, $1.0 billion unsecured revolving credit agreement which expires in July 2011. As of September 30, 2008, there were no borrowings outstanding under this credit agreement. On October 30, 2008, we borrowed approximately $250 million under the revolving credit agreement at a floating rate based on LIBOR in order to fund the acquisition of Cariten Healthcare described below.

Certain of our subsidiaries operate in states that regulate the payment of dividends, loans or other cash transfers to Humana Inc., our parent company, and require minimum levels of equity as well as limit the investments to approved securities. The amount of dividends that may be paid to the parent company by these subsidiaries, without prior approval by state regulatory authorities, is limited based on the entity's level of statutory income and statutory capital and surplus.

Based on the most recently filed statutory financial statements as of June 30, 2008, we maintained aggregate statutory capital and surplus of $3,048.9 million in our state regulated subsidiaries, $1,101.4 million above the aggregate $1,947.5 million in applicable statutory requirements which would trigger any regulatory action by the respective states. We anticipate at least maintaining the current excess capital levels when statutory filings for the third quarter of 2008 are completed in November 2008, since aggregate operating subsidiary earnings exceeded investment losses realized during the third quarter of 2008.

Other Highlights

• Our 2009 Medicare PDP bids were above the benchmark in all 34 regions, which will result in the loss of approximately 308,000 dual-eligible Medicare PDP members in 2009. The bid results were not unexpected.

• In September 2008, we received final approval from CMS for our Medicare benefit plans for 2009.

• Cash flows from operations decreased $728.4 million to $685.7 million for the nine months ended September 30, 2008 compared to $1,414.1 million for the nine months ended September 30, 2007. We expect the year over year unfavorable comparison to improve in the fourth quarter due to a substantially lower payment to CMS associated with the settlement of the risk corridor payable. We expect to pay $78.7 million during the fourth quarter of 2008 compared to $725.5 million paid in the fourth quarter of 2007 related to the risk corridor settlement.

We intend for the discussion of our financial condition and results of operations that follows to assist in the understanding of our financial statements and related changes in certain key items in those financial statements from year to year, including the primary factors that accounted for those changes.

Recent Acquisitions

On October 31, 2008 we acquired PHP Companies, Inc. (d/b/a Cariten Healthcare), or Cariten, for cash consideration of approximately $252.9 million. The Cariten acquisition will increase our presence in Tennessee adding approximately 51,400 and 22,100 fully-insured and ASO commercial members, respectively, and approximately 46,900 Medicare Advantage members, primarily in an HMO product. This acquisition was funded through borrowings under our credit agreement in October 2008.

On August 29, 2008, we acquired Metcare Health Plans, Inc., or Metcare, for cash consideration of approximately $14.9 million. The acquisition added approximately 7,300 Medicare HMO members in central Florida.

On May 22, 2008, we acquired OSF Health Plans, Inc., or OSF, a managed care company serving both Medicare and commercial members in central Illinois, for cash consideration of approximately $82.9 million. This acquisition, which expanded our presence in Illinois, broadening our ability to serve multi-location employers with a wider range of products including our specialty offerings, added approximately 33,400 and 29,700 fully-insured and ASO commercial members, respectively, as well as approximately 14,000 Medicare PPO and HMO members.

On April 30, 2008, we acquired UnitedHealth Group's Las Vegas, Nevada individual SecureHorizons Medicare Advantage HMO business, or SecureHorizons, for cash consideration of approximately $185.3 million, plus subsidiary capital and surplus requirements of $40 million. The SecureHorizons acquisition expanded our presence into the rapidly growing Las Vegas market, adding approximately 26,700 Medicare HMO members.

We acquired KMG on November 30, 2007, and CompBenefits on October 1, 2007. We paid cash consideration of $369.6 million for CompBenefits, and cash consideration of $155.2 million, plus the assumption of $36.1 million of long-term debt for KMG. These acquisitions supplemented our Commercial segment's product offerings, with CompBenefits providing dental and vision insurance benefits and KMG providing long-duration insurance benefits including supplemental health and life products.

On March 1, 2007, we acquired DefenseWeb Technologies, Inc., or DefenseWeb, a company responsible for delivering customized software solutions for the Department of Defense, for cash consideration of $27.5 million.

Recently Issued Accounting Pronouncements

In December 2007, the Financial Accounting Standards Board, or FASB, issued FASB Statement No. 141 (Revised 2007), Business Combination, or SFAS 141R. SFAS 141R will significantly change the accounting for business combinations. Under SFAS 141R, an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. SFAS 141R will change the accounting treatment for certain specific items including expensing transaction and restructuring costs and adjusting earnings in periods subsequent to the acquisition for changes in deferred tax asset valuation allowances and income tax uncertainties as well as changes in the fair value of acquired contingent liabilities. SFAS 141R also includes a substantial number of new disclosure requirements. SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after January 1, 2009 with early adoption prohibited. Accordingly, we are required to record and disclose business combinations in accordance with existing GAAP until January 1, 2009. The effect of these new requirements on our financial position and results of operations will depend on the volume and terms of acquisitions in 2009 and beyond, but will likely increase the amount and change the timing of recognizing expenses related to acquisition activities.

In December 2007, the FASB issued FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements-An Amendment of ARB No. 5, or SFAS 160. SFAS 160 establishes new accounting and reporting standards for a noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, SFAS 160 requires the recognition of a noncontrolling interest (minority interest) as equity and separate from the parent's equity. The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning January 1, 2009. Like SFAS 141R discussed above, earlier adoption is prohibited. We do not expect the adoption of SFAS 160 to have a material impact on our financial position or results of operations.

In March 2008, the FASB issued FASB Statement No. 161, Disclosures about Derivative Instruments and Hedging Activities, or SFAS 161. SFAS 161 requires expanded disclosures regarding the location and amounts of derivative instruments in an entity's financial statements, how derivative instruments and related hedged items are accounted for under SFAS 133, Accounting for Derivative Instruments and Hedging Activities, and how derivative instruments and related hedged items affect an entity's financial position, operating results and cash flows. SFAS 161 is effective on January 1, 2009. Since SFAS 161 affects only disclosures, it will not impact our financial position or results of operations upon adoption.

In June 2008, the FASB issued FASB Staff Position EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities, or FSP EITF 03-6-1. FSP EITF 03-6-1 clarifies that share-based payment awards that entitle their holders to receive nonforfeitable dividends before vesting should be considered participating securities. As participating securities, these instruments should be included in the calculation of basic EPS. We currently are evaluating the provisions of FSP EITF 03-6-1 which will be effective beginning January 1, 2009.

In October 2008, the FASB issued FASB Staff Position No. FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active, or FSP FAS 157-3. FSP FAS 157-3 clarifies the application of FASB Statement No. 157, Fair Value Measurements, or SFAS 157, in a market that is not active and amends SFAS 157 by adding an illustrative example of key considerations used in determining the fair value of a financial asset when the market for that financial asset is not active. FSP FAS 157-3 was effective upon issuance and did not have a material impact on our financial position or results of operations.

Comparison of Results of Operations for 2008 and 2007

The following discussion primarily deals with our results of operations for the three months ended September 30, 2008, or the 2008 quarter, the three months ended September 30, 2007, or the 2007 quarter, the nine months ended September 30, 2008, or the 2008 period, and the nine months ended September 30, 2007, or the 2007 period.

The following table presents certain financial data for our two segments:

                                              For the three months ended
                                                     September 30,                       Change
                                                 2008              2007          Dollars       Percentage
                                                            (in thousands, except ratios)
Premium revenues:
Medicare Advantage                          $    3,497,568      $ 2,825,587     $  671,981           23.8 %
Medicare stand-alone PDP                           782,855          890,420       (107,565 )        (12.1 )%

Total Medicare                                   4,280,423        3,716,007        564,416           15.2 %
Military services                                  771,560          714,173         57,387            8.0 %
Medicaid                                           152,069          135,609         16,460           12.1 %

Total Government                                 5,204,052        4,565,789        638,263           14.0 %

Fully-insured                                    1,559,120        1,418,884        140,236            9.9 %
Specialty                                          228,397          108,168        120,229          111.2 %

Total Commercial                                 1,787,517        1,527,052        260,465           17.1 %

Total                                       $    6,991,569      $ 6,092,841     $  898,728           14.8 %

Administrative services fees:
Government                                  $       21,169      $    19,840     $    1,329            6.7 %
Commercial                                          93,232           81,691         11,541           14.1 %

Total                                       $      114,401      $   101,531     $   12,870           12.7 %

Income before income taxes:
Government                                  $      271,701      $   416,299     $ (144,598 )        (34.7 )%
Commercial                                          11,159           62,203        (51,044 )        (82.1 )%

Total                                       $      282,860      $   478,502     $ (195,642 )        (40.9 )%

Benefit ratios (a):
Government                                            84.1 %           81.4 %                         2.7 %
Commercial                                            80.2 %           81.0 %                        (0.8 )%

Total                                                 83.1 %           81.3 %                         1.8 %

SG&A expense ratios (b):
Government                                            10.2 %           10.2 %                         0.0 %
Commercial                                            23.0 %           21.8 %                         1.2 %
. . .