Form 10-Q for the period ended June 30, 2006
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


Form 10-Q

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2006

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: 1-10864

 


UnitedHealth Group Incorporated

(Exact name of registrant as specified in its charter)

 

Minnesota   41-1321939

(State or other jurisdiction of

incorporation or organization)

  (I.R.S. Employer
Identification No.)

UnitedHealth Group Center

9900 Bren Road East

Minnetonka, Minnesota

  55343
(Address of principal executive offices)   (Zip Code)

(952) 936-1300

(Registrant’s telephone number, including area code)

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  ¨        No  þ

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. (Check one):

Large accelerated filer  þ            Accelerated filer  ¨            Non-accelerated filer  ¨

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

As of February 15, 2007, there were 1,354,320,209 shares of the registrant’s Common Stock, $.01 par value per share, issued and outstanding.

 


 


Table of Contents

UNITEDHEALTH GROUP

TABLE OF CONTENTS

 

              Page

Explanatory Note

   3

Part I. Financial Information

  
 

Item 1.

   Financial Statements (Unaudited)   
  Condensed Consolidated Balance Sheets as of June 30, 2006 and
December 31, 2005 (As Restated)
   9
  Condensed Consolidated Statements of Operations for the three and six months ended
June 30, 2006 and 2005 (As Restated)
   10
  Condensed Consolidated Statements of Cash Flows for the six months ended
June 30, 2006 and 2005 (As Restated)
   11
  Notes to Condensed Consolidated Financial Statements    12
 

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    45
 

Item 3.

   Quantitative and Qualitative Disclosures about Market Risk    69
 

Item 4.

   Controls and Procedures    70

Part II. Other Information

  
 

Item 1.

   Legal Proceedings    74
 

Item 1A.

   Risk Factors    77
 

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds    77
 

Item 4.

   Submission of Matters to a Vote of Security Holders    77
 

Item 6.

   Exhibits    79

Signatures

   80

 

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EXPLANATORY NOTE

In this Form 10-Q, UnitedHealth Group Incorporated (“UnitedHealth Group” or the “Company”) is restating its Condensed Consolidated Balance Sheet as of December 31, 2005 and the Condensed Consolidated Statements of Operations and Cash Flows for the three and six months ended June 30, 2005. This Form 10-Q also reflects the amendment of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” presented in the Company’s Form 10-Q for the quarter ended June 30, 2005 as it related to the period ended June 30, 2005.

Immediately prior to the filing of this Form 10-Q, the Company filed an amended quarterly report on Form 10-Q/A for the quarter ended March 31, 2006 (the “Form 10-Q/A”), and immediately after the filing of this Form 10-Q, the Company will file a quarterly report on Form 10-Q for the quarter ended September 30, 2006 and an annual report on Form 10-K for the year ended December 31, 2006 (the “2006 Form 10-K”). The Form 10-Q/A contains restated financial information for the periods ended March 31, 2005 and March 31, 2006; the Form 10-Q for the quarter ended September 30, 2006 will contain restated financial information for the period ended September 30, 2005. In the 2006 Form 10-K, the Company will restate its Consolidated Balance Sheet as of December 31, 2005, and the related Consolidated Statements of Operations, Changes in Shareholders’ Equity and Cash Flows for each of the fiscal years ended December 31, 2005 and December 31, 2004 and quarterly financial data for the quarter ended December 31, 2005. The 2006 Form 10-K will also reflect the restatement of “Selected Financial Data” in Item 6 for the fiscal years ended December 31, 2005, 2004, 2003 and 2002, and the amendment of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” presented in the Company’s Form 10-K for the fiscal year ended December 31, 2005 as it related to the fiscal years ended December 31, 2005 and December 31, 2004.

Previously filed annual reports on Form 10-K and quarterly reports on Form 10-Q (other than for the quarter ended March 31, 2006, which has been amended by the Form 10-Q/A) have not been amended and should not be relied upon.

Background of the Restatement

In March 2006, media reports questioned whether a number of companies, including UnitedHealth Group, had engaged in backdating stock option grants. Shortly thereafter, the Company was notified that the Securities and Exchange Commission (the “SEC”) had commenced an inquiry into the Company’s historic practices concerning stock option grants.

On April 4, 2006, the Company’s Board of Directors (the “Board”) created an independent committee comprised of three independent directors to review the Company’s option grant practices over the period from 1994 through 2005 (the “Independent Review Period”). The independent committee engaged the law firm of Wilmer Cutler Pickering Hale and Dorr LLP (“WilmerHale”) as counsel for its independent review, and WilmerHale retained independent accounting advisors. WilmerHale has advised that, in the course of its review, it examined physical and electronic documents comprising more than 26 million pages of material and conducted over 80 interviews.

WilmerHale’s report of its findings (the “WilmerHale Report”) was furnished to the Board and publicly issued on October 15, 2006. The complete text of the WilmerHale Report is available on the Company’s Web site, www.unitedhealthgroup.com, and is included as an exhibit to the Company’s Current Report on Form 8-K filed with the SEC on October 16, 2006.

After substantially completing its analysis of the accounting adjustments necessary to reflect the findings of the WilmerHale Report, on November 8, 2006, the Company filed with the SEC a Current Report on Form 8-K reporting management’s conclusion, which the Audit Committee of the Board had approved, that — due solely to the Company’s historic stock option practices — the Company’s financial statements for the fiscal years ended

 

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December 31, 1994 through 2005, the interim periods contained therein, the quarter ended March 31, 2006 and all earnings and press releases, including for the quarters ended June 30, 2006 and September 30, 2006, and similar communications issued by the Company for such periods, and the related reports of the Company’s independent registered public accounting firm, should no longer be relied upon. The Form 8-K also reported that management had re-evaluated its assessment of the Company’s internal controls over financial reporting and had concluded that, as of December 31, 2005, the Company had a material weakness solely relating to stock option plan administration and accounting for and disclosure of stock option grants.

The Form 8-K also disclosed that certain of the Company’s current and former senior executives had agreed to increase the exercise price of all stock options granted to that executive with stated grant dates between 1994 and 2002 to eliminate any financial benefit resulting from what the WilmerHale Report concluded was the likely backdating of grants that they received.

After completing its internal review of the accounting treatment for all option grants, and following consultation on certain interpretive accounting issues with the Office of the Chief Accountant of the SEC, management has concluded, and the Audit Committee of the Board has approved the conclusion, that the Company used incorrect measurement dates and made other errors described below in accounting for stock option grants and, accordingly, that the Company’s previously issued financial statements should be restated.

Summary of the Restatement Adjustments

As of January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (FAS 123R), using the modified retrospective transition method. Under this method, all prior period financial statements are required to be restated to recognize compensation cost in the amounts historically disclosed in our consolidated financial statements under FAS 123. Prior to January 1, 2006, the Company accounted for share-based compensation granted under its stock option plans using the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25). Under APB 25, a company was not required to recognize compensation expense for stock options issued to employees if the exercise price of the stock options was at least equal to the quoted market price of the company’s common stock on the “measurement date.” APB 25 defined the measurement date as the first date on which both the number of shares that an individual employee was entitled to receive and the option or purchase price, if any, were known.

The restatement in this Form 10-Q principally reflects additional stock-based compensation expense and related tax effects as of December 31, 2005 and for the three- and six-month periods ended June 30, 2005 under both FAS 123R, the Company’s current accounting method, and APB 25, the Company’s historical accounting method, relating to the Company’s historic stock option practices. The restatement also reflects certain other accounting adjustments, including adjustments unrelated to historic stock option practices, which are not material either individually or in the aggregate to the periods ended June 30, 2006 or prior periods.

The principal components of the restatement are as follows:

Revised Measurement Dates.    Based on all available evidence, the Company applied the methodologies described below to determine the appropriate measurement dates under both FAS 123 and APB 25 for grants in the following categories: (1) grants of approximately 80 million shares on a split-adjusted basis to Section 16 officers (“Section 16 Grants”); (2) grants of approximately 260 million shares on a split-adjusted basis to middle management and senior management employees (“Broad-Based Grants”); and (3) grants of approximately 50 million shares on a split-adjusted basis in connection with the hiring or promotion of employees (“New Hire and Promotion Grants”). As a result of this analysis, the Company has determined that, in most cases, the stated grant date was not the correct measurement date.

 

 

Section 16 Grants — Section 16 Grants, generally made to eight to twelve officers, required approval by the Compensation and Human Resources Committee of the Board (the “Compensation Committee”).

 

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For the majority of Section 16 Grants, Compensation Committee approval was reflected in Written Actions. The WilmerHale Report concluded that the Written Actions were generally executed subsequent to the stated grant dates. (Under Minnesota corporate law, it is permissible to make a Written Action effective as of a date other than the date on which the last of the required signers affixes his or her signature, even if that effective date is before the last signature affixed.) Based on the available evidence, the Company has determined that the appropriate measurement date for each of these Section 16 Grants is the earlier of (a) the date on which a Form 4 (or other statement of changes in beneficial ownership) was filed with the SEC with respect to a particular officer’s grant or (b) the date on which the written action with respect to that grant was likely executed by a majority of the members of the Compensation Committee.

As to certain other Section 16 Grants, Compensation Committee approval occurred at a meeting or there was general Compensation Committee approval of the Section 16 Grant together with a delegation to the Chairman of the Compensation Committee to determine the final amount of stock options, grant date and exercise price for each Section 16 officer receiving options. The Company has determined, based on available evidence, that the appropriate measurement date for these Section 16 Grants is the earlier of (a) the date on which a Form 4 (or other statement of changes in beneficial ownership) was filed with the SEC with respect to a particular officer’s grant or (b) the date on which a resolution with respect to that grant was adopted at a meeting of the Compensation Committee or a decision was made by the Chairman of the Compensation Committee, if so delegated.

For option grants with stated grant dates in October 1999 that were made in connection with the entry of employment agreements for our former chief executive officer and our current chief executive officer (both of whom had been employed by the Company prior to that date), the Company has determined that the appropriate measurement date is the date on which the employment agreements were executed on behalf of the Company. With respect to stock option grants with a stated grant date in October 1999 that represented the number of additional stock options necessary to equal the minimum annual stock option grant provided for pursuant to each such employment agreement, the Company has determined that the appropriate measurement date is the last day of 1999, the calendar year in which the Company was contractually obligated to make the grants.

 

 

Broad-Based Grants — Between 1,500 and 4,000 middle and senior management employees periodically and customarily received options. As described in the WilmerHale Report, our former chief executive officer, acting pursuant to authority delegated to him by the Compensation Committee, chose the grant dates and overall amounts for Broad-Based Grants and ultimately reflected the Broad-Based Grants in CEO Certificates.

The Company followed separate allocation processes to determine the particular recipients and individual option amounts of grants to middle management employees and senior management employees. In the majority of Broad-Based Grants, the process of allocating stock option grants among individual employees in both middle management and senior management continued beyond the stated grant date. After the date on which substantially all granting activities were completed, there were an insignificant number of changes to option awards attributable to circumstances such as the effective cancellation of a grant because of an employee’s termination, administrative error corrections, promotion or individual performance reassessment.

Based on all available evidence, the Company has determined that the appropriate measurement date for Broad-Based Grants was the later of the following two dates: (a) the date on which the evidence identified by the Company indicated that a communication to or from our former chief executive officer refers to a particular grant, or the grant was presented to the Compensation Committee or (b) the date on which the allocation of the options to individual employees and grant process associated with the Broad-Based Grant was substantially complete. Where information is not available to evidence either (a) or (b) above, the Company has determined the appropriate measurement date to be the date on which the Company determined, based upon all available evidence, that the CEO Certificate for such grant was likely executed. Where option award amounts changed subsequent to the date the allocation process was substantially

 

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complete, the Company has determined that each award that was changed is a separate grant with its own measurement date and should not be considered indicative that the granting process was not complete.

 

 

New Hire and Promotion Grants — During the Independent Review Period, the Company granted stock options to approximately 2,500 employees in connection with their hire or promotion (“New Hire and Promotion Grants”).

For New Hire and Promotion Grants made prior to 2002, the Company typically chose grant dates by determining the lowest closing price of the Company’s common stock between the date of an event in the recruitment of the newly hired employee (e.g., date of first contact, date of an offer letter) or promotion of the employee and the end of the quarter in which the employee started work or was promoted. As a result of this practice, some employees received stock options with grant dates that were earlier than that employee’s start date. In 2002, the Company changed to a practice of determining grant dates for new hires and promotions to be the date of the lowest closing price of the Company’s common stock between the start date of employment or date of promotion and the end of the quarter in which the employee started work or was promoted. The Company historically used these stated grant dates as the measurement dates for accounting purposes.

The Company has concluded that the measurement dates used with respect to nearly all of the New Hire and Promotion Grants during the Independent Review Period were not correct because the Company’s practice was to determine grant dates with the benefit of hindsight. The Company has determined that the appropriate measurement date for each New Hire and Promotion Grant was the date on which the Company set the terms of the award, or, where the Company could not identify such date based on all available evidence, the last date of the fiscal quarter in which a particular New Hire or Promotion Grant was made.

1999 Grant of Supplemental Options.    In the fourth quarter of 1999, following a decline in its stock price, the Company granted “supplemental” stock options to acquire 2.2 million shares of Company common stock (17.6 million shares on a split-adjusted basis) to a broad group of employees, including our former chief executive officer and other Section 16 officers. The supplemental options were granted in connection with the suspension of the vesting and exercisability of an equal number of options with exercise prices above $46.50 ($5.8125 on a split-adjusted basis) that had previously been granted to those employees (the “Suspended Options”). The supplemental options had a stated grant date of October 13, 1999 and an exercise price equal to $40.125 ($5.0156 on a split-adjusted basis).

After taking into account all available evidence regarding the Suspended Options, the Company has concluded that, under APB 25, the grant of the supplemental options constituted an effective re-pricing subject to variable accounting for each option until exercise, forfeiture or expiration. Additionally, the Company has determined that, under FAS 123, the grant of the supplemental options was a modification that required an incremental fair value charge to be recognized over the related vesting period.

2000 Reactivation of Suspended Options.    In 2000, the Company reactivated the vesting and exercisability of the Suspended Options. The Company has determined that, under APB 25 and FAS 123, the reactivation of the vesting and exercisability of the Suspended Options was a new stock option grant that should have had a new measurement date, and the Company has determined that the appropriate measurement date is the date grantees were again permitted to exercise their previously vested awards.

Cliff Vesting Options.    Prior to April 2000, the Company granted to employees certain stock options that vested 100% on the sixth or ninth anniversary of the date of grant (the “Cliff Vesting Options”). Under the terms of the options, the Company could elect to accelerate the vesting of all or a portion of the Cliff Vesting Options at its discretion. The Company followed a policy of accelerating the vesting of a consistent percentage of the Cliff Vesting Options, unless the option holder was subject to disciplinary action or performing at a less than satisfactory level. This resulted in nearly all option holders having their Cliff Vesting Options accelerated so they actually vested as if they had a 20% or 25% per year time-based vesting schedule (i.e., a four-year or five-year vesting period).

 

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Grant of Cliff Vesting Options. Under APB 25, an award should be accounted for as a performance award if its cliff vesting terms are not considered to be substantive. Based on numerous factors, including evaluation of employee turnover rates, the Company has determined that the nine-year vesting term was not substantive in grants after January 1995 to middle management employees. Accordingly, these options should have been subject to variable accounting until each of their vesting dates. With respect to substantially all other Cliff Vesting Options, the Company has concluded that the cliff vesting term is substantive.

 

 

Acceleration of Cliff Vesting Options. In accordance with the provisions of Financial Accounting Standards Board Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation (An Interpretation of APB Opinion No. 25)” (FIN 44), subsequent to July 1, 2000, the acceleration of the six- or nine-year cliff vesting term of a stock option constituted a modification. Accordingly, the Company should have measured the intrinsic value of the award at the date of the modification and recognized this amount as compensation cost on the termination of employment if, absent the acceleration, the award would have been forfeited pursuant to its original terms. Under FAS 123, the performance targets were taken into consideration when determining the expected term of the award and therefore the acceleration of vesting was not considered to be a modification of the terms.

Other Modifications of Option Terms.    The Company has also determined that certain other actions were taken that resulted in the modification of option terms, as follows:

 

 

Options Modified Upon Terminations. On approximately 75 occasions from 1998 to 2005, the Company entered into amended employment or separation agreements with employees that resulted in the modification of vesting or cancellation terms of their stock option agreements. Under APB 25, the potential compensation expense of the modification should have been measured at the date of the modification and recognized if the employee ultimately received a benefit on the termination date. Under FAS 123, the modification should have been recognized at the date of the modification based upon the incremental fair value provided to the employee.

 

 

1999 Cancellation and Reissuance of Options. In the fourth quarter of 1999, the Company issued stock options to acquire an aggregate of 400,000 shares of Company common stock (3.2 million shares on a split-adjusted basis) to approximately 65 employees in exchange for the cancellation of an equal number of stock options that had previously been granted to those employees at various times earlier in 1999. The reissued stock options had a stated grant date of October 13, 1999 and an exercise price equal to $40.125 ($5.0156 on a split-adjusted basis), which was lower than the exercise price of the cancelled options. The Company has determined that, under APB 25, this constituted a “re-pricing,” resulting in variable accounting for each option until exercise, forfeiture or expiration. Additionally, the Company has concluded that, under FAS 123, this would also be viewed as a modification to the award and the incremental fair value in addition to the originally measured fair value should have been recognized over the remaining vesting period.

Related Tax Adjustments.    The restatement in this Form 10-Q also reflects the estimated loss of certain tax deductions and additional interest expense related to the exercise of stock options granted to certain of the Company’s executive officers that — as a result of the revision of measurement dates — no longer qualify as deductible performance-based compensation in accordance with Internal Revenue Code section 162(m).

Additional Information

Note 2 of the Notes to Condensed Consolidated Financial Statements in this Form 10-Q sets forth, for the periods ended June 30, 2005, the impact under FAS 123R and APB 25 of recognizing additional stock-based compensation expense and related tax effects as a result of the Company’s historic stock option practices.

 

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The Company has conducted a sensitivity analysis to assess how the restatement adjustments described in this Form 10-Q would have changed under two alternative methodologies for determining measurement dates for stock option grants made during the Independent Review Period. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” presented in Item 2 of this Form 10-Q, for information regarding the incremental stock-based compensation cost that would result from using alternate measurement date determination methodologies. See “Cautionary Statements” in Item 2 for a discussion of certain risk factors related to the Company’s historic stock option practices.

Item 4 of this Form 10-Q describes management’s conclusion that, although the Company had taken significant remedial actions during the first and second quarters of 2006, the Company continued to have a material weakness in internal control over financial reporting solely relating to stock option plan administration and accounting for and disclosure of stock option grants as of June 30, 2006 and that, solely for this reason, its disclosure controls and procedures were not effective as of June 30, 2006. As Item 4 of this Form 10-Q further describes, the Company had fully remediated the material weakness as of December 31, 2006.

 

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PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements (Unaudited)

UNITEDHEALTH GROUP

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(In millions, except per share data)

 

     June 30,
2006
    December 31,
2005
           (As Restated)

ASSETS

    

Current Assets

    

Cash and Cash Equivalents

   $ 9,472     $ 5,421

Short-Term Investments

     584       590

Accounts Receivable, net 

     1,350       1,207

Assets Under Management

     1,819       1,825

Deferred Income Taxes 

     627       650

Other Current Assets

     1,626       854
              

Total Current Assets 

     15,478       10,547

Long-Term Investments

     8,937       8,971

Property, Equipment and Capitalized Software, net

     1,666       1,647

Goodwill 

     16,619       16,238

Other Intangible Assets, net

     2,005       2,020

Other Assets

     1,932       1,865
              

TOTAL ASSETS 

   $ 46,637     $ 41,288
              

LIABILITIES AND SHAREHOLDERS’ EQUITY

    

Current Liabilities

    

Medical Costs Payable

   $ 8,171     $ 7,262

Accounts Payable and Accrued Liabilities 

     3,803       3,285

Other Policy Liabilities

     3,702       1,845

Commercial Paper and Current Maturities of Long-Term Debt

     939       3,261

Unearned Premiums 

     2,653       1,000
              

Total Current Liabilities 

     19,268       16,653

Long-Term Debt, less current maturities

     6,426       3,834

Future Policy Benefits for Life and Annuity Contracts

     1,799       1,761

Deferred Income Taxes and Other Liabilities 

     1,106       1,225

Commitments and Contingencies (Note 14)

    
              

Shareholders’ Equity

    

Common Stock, $0.01 par value per share — 3,000 shares authorized; 1,338 and 1,358 issued and outstanding

     13       14

Additional Paid-In Capital 

     6,029       7,510

Retained Earnings 

     12,089       10,258

Accumulated Other Comprehensive Income:

    

Net Unrealized (Losses)/Gains on Investments, net of tax effects

     (93 )     33
              

Total Shareholders’ Equity 

     18,038       17,815
              

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY 

   $ 46,637     $ 41,288
              

See notes to condensed consolidated financial statements

 

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UNITEDHEALTH GROUP

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In millions, except per share data)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2006     2005     2006     2005  
           (As Restated)           (As Restated)  

REVENUES

        

Premiums

   $ 16,439     $ 10,327     $ 32,618     $ 20,454  

Services 

     1,065       906       2,103       1,786  

Products 

     165       17       330       43  

Investment and Other Income

     194       129       393       243  
                                

Total Revenues

     17,863       11,379       35,444       22,526  
                                

OPERATING COSTS

        

Medical Costs 

     13,410       8,292       26,693       16,406  

Operating Costs 

     2,475       1,705       5,006       3,415  

Cost of Products Sold 

     143       12       280       28  

Depreciation and Amortization

     168       108       325       217  
                                

Total Operating Costs 

     16,196       10,117       32,304       20,066  
                                

EARNINGS FROM OPERATIONS 

     1,667       1,262       3,140       2,460  

Interest Expense 

     (116 )     (55 )     (198 )     (104 )
                                

EARNINGS BEFORE INCOME TAXES 

     1,551       1,207       2,942       2,356  

Provision for Income Taxes 

     (570 )     (438 )     (1,070 )     (851 )
                                

NET EARNINGS 

   $ 981     $ 769     $ 1,872     $ 1,505  
                                

BASIC NET EARNINGS PER COMMON SHARE

   $ 0.73     $ 0.61     $ 1.39     $ 1.19  
                                

DILUTED NET EARNINGS PER COMMON SHARE 

   $ 0.70     $ 0.58     $ 1.33     $ 1.13  
                                

BASIC WEIGHTED-AVERAGE NUMBER OF COMMON SHARES OUTSTANDING

     1,339       1,258       1,346       1,268  

DILUTIVE EFFECT OF COMMON STOCK EQUIVALENTS 

     56       66       61       66  
                                

DILUTED WEIGHTED-AVERAGE NUMBER OF COMMON SHARES OUTSTANDING 

     1,395       1,324       1,407       1,334  
                                

See notes to condensed consolidated financial statements

 

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UNITEDHEALTH GROUP

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In millions)

 

     Six Months Ended
June 30,
 
     2006     2005  
           (As Restated)  

OPERATING ACTIVITIES

    

Net Earnings 

   $ 1,872     $ 1,505  

Noncash Items: 

    

Depreciation and Amortization 

     325       217  

Deferred Income Taxes and Other

     (293 )     (89 )

Stock-Based Compensation

     184       144  

Net Change in Other Operating Items, net of effects from acquisitions and changes in AARP balances: 

    

Accounts Receivable and Other Current Assets 

     (805 )     (42 )

Medical Costs Payable

     731       263  

Accounts Payable and Other Accrued Liabilities

     991       636  

Unearned Premiums

     1,607       (251 )
                

Cash Flows From Operating Activities

     4,612       2,383  
                

INVESTING ACTIVITIES

    

Cash Paid for Acquisitions, net of cash assumed and other effects

     (647 )     (115 )

Purchases of Property, Equipment and Capitalized Software

     (338 )     (222 )

Proceeds from Disposal of Property, Equipment and Capitalized Software

     9        

Purchases of Investments

     (1,720 )     (3,180 )

Maturities and Sales of Investments

     1,573       2,709  
                

Cash Flows Used For Investing Activities

     (1,123 )     (808 )
                

FINANCING ACTIVITIES

    

Repayments of Commercial Paper, net

     (2,326 )     (273 )

Proceeds from Issuances of Long-Term Debt

     3,000       500  

Repayments of Convertible Subordinated Debt

     (91 )      

Common Stock Repurchases

     (2,345 )     (2,138 )

Proceeds from Common Stock Issuances under Stock-Based Compensation Plan

     246       224  

Stock-Based Compensation Excess Tax Benefits

     190       114  

Customer Funds Administered

     1,983       78  

Dividends Paid

     (41 )     (19 )

Other

     (54 )     (10 )
                

Cash Flows From (Used For) Financing Activities

     562       (1,524 )
                

INCREASE IN CASH AND CASH EQUIVALENTS

     4,051       51  

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

     5,421       3,991  
                

CASH AND CASH EQUIVALENTS, END OF PERIOD

   $ 9,472     $ 4,042  
                

See notes to condensed consolidated financial statements

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited) (As Restated)

 

1. Basis of Presentation and Use of Estimates

Unless the context otherwise requires, the use of the terms the “Company,” “we,” “us,” and “our” in the following refers to UnitedHealth Group Incorporated and its subsidiaries.

The accompanying unaudited condensed consolidated financial statements reflect all adjustments, consisting solely of normal recurring adjustments, except as discussed in Note 2, needed to present the financial results for these interim periods fairly. In accordance with the rules and regulations of the Securities and Exchange Commission, we have omitted certain footnote disclosures that would substantially duplicate the disclosures contained in our annual audited consolidated financial statements. Read together with the disclosures below, we believe the interim financial statements are presented fairly. However, these Unaudited Condensed Consolidated Financial Statements should be read together with the consolidated financial statements and the notes included in our Annual Report on Form 10-K for the year ended December 31, 2006 to be filed with the Securities and Exchange Commission.

These Condensed Consolidated Financial Statements include certain amounts that are based on our best estimates and judgments. These estimates require us to apply complex assumptions and judgments, often because we must make estimates about the effects of matters that are inherently uncertain and will likely change in subsequent periods. The most significant estimates relate to medical costs, medical costs payable, historic stock option measurement dates, revenues, intangible asset valuations, asset impairments, and contingent liabilities. We adjust these estimates each period, as more current information becomes available. The impact of any changes in estimates is included in the determination of earnings in the period in which the estimate is adjusted.

Adoption of FAS 123R

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (FAS) No. 123 (revised 2004), “Share-Based Payment” (FAS 123R). FAS 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25). Under APB 25, no compensation expense was recognized for employee stock option grants if the exercise price of a company’s stock option grant is at or above the fair market value of the underlying stock on the date of grant. FAS 123R requires the determination of the fair value of share-based compensation at the grant date and recognition of the related expense over the period in which the share-based compensation vests. The Company adopted FAS 123R effective January 1, 2006 using the modified retrospective method. All prior periods have been restated to give effect to the fair-value-based method of accounting for awards granted in fiscal years beginning on or after January 1, 1995.

 

2. Restatement of Unaudited Condensed Consolidated Financial Statements

In March 2006, media reports questioned whether a number of companies, including UnitedHealth Group, had engaged in backdating stock option grants. Shortly thereafter, the Company was notified that the Securities and Exchange Commission (the “SEC”) had commenced an inquiry into the Company’s practices concerning stock option grants.

On April 4, 2006, the Company’s Board of Directors (the “Board”) created an independent committee comprised of three independent directors to review the Company’s option grant practices over the period from 1994 through 2005 (the “Independent Review Period”). The independent committee engaged the law firm of Wilmer Cutler Pickering Hale and Dorr LLP (“WilmerHale”) as counsel for its independent review, and WilmerHale retained independent accounting advisors.

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

WilmerHale’s report of its findings (the “WilmerHale Report”) was furnished to the Board and publicly issued on October 15, 2006. WilmerHale’s findings include, among other things, that many of the stock option grants it reviewed were likely backdated, that a 1999 supplemental grant of stock options was not accounted for correctly in the Company’s financial statements and that the Company’s controls with respect to stock option grants were inadequate.

After substantially completing its analysis of the accounting adjustments necessary to reflect the findings of the WilmerHale Report, on November 8, 2006, the Company filed with the SEC a Current Report on Form 8-K reporting management’s conclusion, which the Audit Committee of the Board had approved, that — due solely to the Company’s historic stock option practices — the Company’s financial statements for the fiscal years ended December 31, 1994 through 2005, the interim periods contained therein, the quarter ended March 31, 2006 and all earnings and press releases, including for the quarters ended June 30, 2006 and September 30, 2006, and similar communications issued by the Company for such periods, and the related reports of the Company’s independent registered public accounting firm, should no longer be relied upon. The Form 8-K also reported that management had re-evaluated its assessment of the Company’s internal controls over financial reporting and had concluded that, as of December 31, 2005, the Company had a material weakness solely relating to stock option plan administration and accounting for and disclosure of stock option grants.

After completing its internal review of the accounting treatment for all option grants, management has concluded, and the Audit Committee of the Board has approved the conclusion, that the Company used incorrect measurement dates and made other errors described below in accounting for stock option grants and, accordingly, that the Company’s previously issued financial statements should be restated.

Summary of the Restatement Adjustments

As of January 1, 2006, the Company adopted FAS 123R, using the modified retrospective transition method. Under this method, all prior period financial statements are required to be restated to recognize compensation cost in the amounts historically disclosed in our consolidated financial statements under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (FAS 123). Prior to January 1, 2006, the Company accounted for share-based compensation granted under its stock option plans using the recognition and measurement provisions of APB 25. Under APB 25, a company was not required to recognize compensation expense for stock options issued to employees if the exercise price of the stock options was at least equal to the quoted market price of the company’s common stock on the “measurement date.” APB 25 defined the measurement date as the first date on which both the number of shares that an individual employee was entitled to receive and the option or purchase price, if any, were known.

The restatement principally reflects additional stock-based compensation expense and related tax effects as of December 31, 2005 and for the three- and six-month periods ended June 30, 2005 under both FAS 123R, the Company’s current accounting method, and APB 25, the Company’s historical accounting method, relating to the Company’s historic stock option practices. The restatement also reflects certain other accounting adjustments, including adjustments unrelated to historic stock option practices, which are not material either individually or in the aggregate to the current or prior periods.

The principal components of the restatement are as follows:

Revised Measurement Dates.    Based on all available evidence, the Company applied the methodologies described below to determine the appropriate measurement dates under both FAS 123 and APB 25 for grants in the following categories: (1) grants of approximately 80 million shares on a split-adjusted basis to Section 16 officers (“Section 16 Grants”); (2) grants of approximately 260 million shares on a split-adjusted basis to middle

 

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Table of Contents

UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

management and senior management employees (“Broad-Based Grants”); and (3) grants of approximately 50 million shares on a split-adjusted basis in connection with the hiring or promotion of employees (“New Hire and Promotion Grants”). As a result of this analysis, the Company has determined that, in most cases, the stated grant date was not the correct measurement date.

 

 

Section 16 Grants — Section 16 Grants, generally made to eight to twelve officers, required approval by the Compensation and Human Resources Committee of the Board (the “Compensation Committee”).

For the majority of Section 16 Grants, Compensation Committee approval was reflected in Written Actions. The WilmerHale Report concluded that the Written Actions were generally executed subsequent to the stated grant dates. (Under Minnesota corporate law, it is permissible to make a Written Action effective as of a date other than the date on which the last of the required signers affixes his or her signature, even if that effective date is before the last signature affixed.) Based on the available evidence, the Company has determined that the appropriate measurement date for each of these Section 16 Grants is the earlier of (a) the date on which a Form 4 (or other statement of changes in beneficial ownership) was filed with the SEC with respect to a particular officer’s grant or (b) the date on which the written action with respect to that grant was likely executed by a majority of the members of the Compensation Committee.

As to certain other Section 16 Grants, Compensation Committee approval occurred at a meeting or there was general Compensation Committee approval of the Section 16 Grant together with a delegation to the Chairman of the Compensation Committee to determine the final amount of stock options, grant date and exercise price for each Section 16 officer receiving options. The Company has determined, based on available evidence, that the appropriate measurement date for these Section 16 Grants is the earlier of (a) the date on which a Form 4 (or other statement of changes in beneficial ownership) was filed with the SEC with respect to a particular officer’s grant or (b) the date on which a resolution with respect to that grant was adopted at a meeting of the Compensation Committee or a decision was made by the Chairman of the Compensation Committee, if so delegated.

For option grants with stated grant dates in October 1999 that were made in connection with the entry of employment agreements for our former chief executive officer and our current chief executive officer (both of whom had been employed by the Company prior to that date), the Company has determined that the appropriate measurement date is the date on which the employment agreements were executed on behalf of the Company. With respect to stock option grants with a stated grant date in October 1999 that represented the number of additional stock options necessary to equal the minimum annual stock option grant provided for pursuant to each such employment agreement, the Company has determined that the appropriate measurement date is the last day of 1999, the calendar year in which the Company was contractually obligated to make the grants.

 

 

Broad-Based Grants — Between 1,500 and 4,000 middle and senior management employees periodically and customarily received options. As described in the WilmerHale Report, our former chief executive officer, acting pursuant to authority delegated to him by the Compensation Committee, chose the grant dates and overall amounts for Broad-Based Grants and ultimately reflected the Broad-Based Grants in CEO Certificates.

The Company followed separate allocation processes to determine the particular recipients and individual option amounts of grants to middle management employees and senior management employees. In the majority of Broad-Based Grants, the process of allocating stock option grants among individual employees to both middle management and senior management continued beyond the stated grant date. After the date on which substantially all granting activities were completed, there were an insignificant number of changes to option awards attributable to circumstances such as the effective cancellation of a grant because of an employee’s termination, administrative error corrections, promotion or individual performance reassessment.

 

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Table of Contents

UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Based on all available evidence, the Company has determined that the appropriate measurement date for Broad-Based Grants was the later of the following two dates: (a) the date on which the evidence identified by the Company indicated that a communication to or from our former chief executive officer refers to a particular grant, or the grant was presented to the Compensation Committee or (b) the date on which the allocation of the options to individual employees and grant process associated with the Broad-Based Grant was substantially complete. Where information is not available to evidence either (a) or (b) above, the Company has determined the appropriate measurement date to be the date on which the Company determined, based upon all available evidence, that the CEO Certificate for such grant was likely executed. Where option award amounts changed subsequent to the date the allocation process was substantially complete, the Company has determined that each award that was changed is a separate grant with its own measurement date and should not be considered indicative that the granting process was not complete.

 

 

New Hire and Promotion Grants — During the Independent Review Period, the Company granted stock options to approximately 2,500 employees in connection with their hire or promotion (“New Hire and Promotion Grants”).

For New Hire and Promotion Grants made prior to 2002, the Company typically chose grant dates by determining the lowest closing price of the Company’s common stock between the date of an event in the recruitment of the newly hired employee (e.g., date of first contact, date of an offer letter) or promotion of the employee and the end of the quarter in which the employee started work or was promoted. As a result of this practice, some employees received stock options with grant dates that were earlier than that employee’s start date. In 2002, the Company changed to a practice of determining grant dates for new hires and promotions to be the date of the lowest closing price of the Company’s common stock between the start date of employment or date of promotion and the end of the quarter in which the employee started work or was promoted. The Company historically used these stated grant dates as the measurement dates for accounting purposes.

The Company has concluded that the measurement dates used with respect to nearly all of the New Hire and Promotion Grants during the Independent Review Period were not correct because the Company’s practice was to determine grant dates with the benefit of hindsight. The Company has determined that the appropriate measurement date for each New Hire and Promotion Grant was the date on which the Company set the terms of the award, or, where the Company could not identify such date based on all available evidence, the last date of the fiscal quarter in which a particular New Hire or Promotion Grant was made.

1999 Grant of Supplemental Options.    In the fourth quarter of 1999, following a decline in its stock price, the Company granted “supplemental” stock options to acquire 2.2 million shares of Company common stock (17.6 million shares on a split-adjusted basis) to a broad group of employees, including our former chief executive officer and other Section 16 officers. The supplemental options were granted in connection with the suspension of the vesting and exercisability of an equal number of options with exercise prices above $46.50 ($5.8125 on a split-adjusted basis) that had previously been granted to those employees (the “Suspended Options”). The supplemental options had a stated grant date of October 13, 1999 and an exercise price equal to $40.125 ($5.0156 on a split-adjusted basis).

After taking into account all available evidence regarding the Suspended Options, the Company has concluded that, under APB 25, the grant of the supplemental options constituted an effective re-pricing subject to variable accounting for each option until exercise, forfeiture or expiration. Additionally, the Company has determined that, under FAS 123, the grant of the supplemental options was a modification that required an incremental fair value charge to be recognized over the related vesting period.

2000 Reactivation of Suspended Options.    In 2000, the Company reactivated the vesting and exercisability of the Suspended Options. The Company has determined that, under APB 25 and FAS 123, the reactivation of the vesting and exercisability of the Suspended Options was a new stock option grant that should have had a new

 

15


Table of Contents

UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

measurement date, and the Company has determined that the appropriate measurement date is the date grantees were again permitted to exercise their previously vested awards.

Cliff Vesting Options.    Prior to April 2000, the Company granted to employees certain stock options that vested 100% on the sixth or ninth anniversary of the date of grant (the “Cliff Vesting Options”). Under the terms of the options, the Company could elect to accelerate the vesting of all or a portion of the Cliff Vesting Options at its discretion. The Company followed a policy of accelerating the vesting of a consistent percentage of the Cliff Vesting Options, unless the option holder was subject to disciplinary action or performing at a less than satisfactory level. This resulted in nearly all option holders having their Cliff Vesting Options accelerated so they actually vested as if they had a 20% or 25% per year time-based vesting schedule (i.e., a four-year or five-year vesting period).

 

 

Grant of Cliff Vesting Options. Under APB 25, an award should be accounted for as a performance award if its cliff vesting terms are not considered to be substantive. Based on numerous factors, including evaluation of employee turnover rates, the Company has determined that the nine-year vesting term was not substantive in grants after January 1995 to middle management employees. Accordingly, these options should have been subject to variable accounting until each of their vesting dates. With respect to substantially all other Cliff Vesting Options, the Company has concluded that the cliff vesting term is substantive.

 

 

Acceleration of Cliff Vesting Options. In accordance with the provisions of Financial Accounting Standards Board Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation (An Interpretation of APB Opinion No. 25)” (FIN 44), subsequent to July 1, 2000, the acceleration of the six- or nine-year cliff vesting term of a stock option constituted a modification. Accordingly, the Company should have measured the intrinsic value of the award at the date of the modification and recognized this amount as compensation cost on the termination of employment if, absent the acceleration, the award would have been forfeited pursuant to its original terms. Under FAS 123, the performance targets were taken into consideration when determining the expected term of the award and therefore the acceleration of vesting was not considered to be a modification of the terms.

Other Modifications of Option Terms.    The Company has also determined that certain other actions were taken that resulted in the modification of option terms, as follows:

 

 

Options Modified Upon Terminations. On approximately 75 occasions from 1998 to 2005, the Company entered into amended employment or separation agreements with employees that resulted in the modification of vesting or cancellation terms of their stock option agreements. Under APB 25, the potential compensation expense of the modification should have been measured at the date of the modification and recognized if the employee ultimately received a benefit on the termination date. Under FAS 123, the modification should have been recognized at the date of the modification based upon the incremental fair value provided to the employee.

 

 

1999 Cancellation and Reissuance of Options. In the fourth quarter of 1999, the Company issued stock options to acquire an aggregate of 400,000 shares of Company common stock (3.2 million shares on a split-adjusted basis) to approximately 65 employees in exchange for the cancellation of an equal number of stock options that had previously been granted to those employees at various times earlier in 1999. The reissued stock options had a stated grant date of October 13, 1999 and an exercise price equal to $40.125 ($5.0156 on a split-adjusted basis), which was lower than the exercise price of the cancelled options. The Company has determined that, under APB 25, this constituted a “re-pricing,” resulting in variable accounting for each option until exercise, forfeiture or expiration. Additionally, the Company has concluded that, under FAS 123, this would also be viewed as a modification to the award and the incremental fair value in addition to the originally measured fair value should have been recognized over the remaining vesting period.

 

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Table of Contents

UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Related Tax Adjustments    The restatement in this Form 10-Q also reflects the estimated loss of certain tax deductions and additional interest expense related to the exercise of stock options granted to certain of the Company’s executive officers that — as a result of the revision of measurement dates — no longer qualify as deductible performance-based compensation in accordance with Internal Revenue Code section 162(m).

Restatement Adjustments

The following table sets forth, on a year-by-year basis, the impact under FAS 123R and APB 25 of recognizing additional stock-based compensation expense and related tax effects as a result of historic stock option practices as well as immaterial adjustments unrelated to historic stock option practices that were identified through a review of the Company’s accounting practices. The impact under FAS 123R of all errors is $43 million ($57 million net of tax) in 2005, $40 million ($44 million net of tax) in 2004, and an aggregate of $453 million ($313 million net of tax) for 2003 and all prior years. The impact under APB 25 of all errors is $304 million ($238 million net of tax) in 2005, $200 million ($158 million net of tax) in 2004, and an aggregate of $1,056 million ($738 million net of tax) for 2003 and all prior years.

Additionally, on January 1, 2006, our Uniprise business segment began reporting premiums and expenses on a gross basis for a large account where we have employed third-party reinsurance. Historically, revenues and expenses associated with this account were reported net of amounts ceded to an unaffiliated reinsurer. While the reinsurance contract has been in place for a number of years, recent accounting interpretations suggest this reinsurance arrangement be presented on a gross versus net basis. Prior period amounts have been restated to conform to the 2006 presentation. The restatement has no effect on our net earnings or shareholders’ equity as previously reported.

 

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Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

    FAS 123R - Current Accounting Method
    Decrease (Increase) to Earnings Before Income Taxes     Decrease (Increase) to
Net Earnings

Year

 

Section 16

and
Broad-Based

Grants

  New Hire
and
Promotion
Grants
  1999 Grant
of
Supplemental
Options
  Reactivation
of
Suspended
Options
  Cliff
Vesting
Options
  Option
Modifications
  Other Stock-
Based
Compensation
(1)
  Total Stock-
Based
Compensation
Errors
  Other
Errors
(2)
    Total     Total Stock-
Based
Compensation
Errors
  Other
Errors
(2)
    Total

(in millions)

                                                         

1995 (3)

  $ 4   $   $   $   $   $   $ 2   $ 6   $ 4     $ 10     $ 4   $ 3     $ 7

1996

    5                         1     6     3       9       4     2       6

1997

    10                         3     13     4       17       8     3       11

1998

    14     1                 11     6     32     3       35       22     2       24

1999

    18     1                 2     1     22     4       26       14     3       17

2000

    9     6     25     83         3     3     129     5       134       94     3       97

2001

    22     10     22     25         1     1     81     6       87       53     5       58

2002

    35     9         16         1     1     62     (1 )     61       44     1       45

2003

    30     10         13             1     54     20       74       41     7       48
                                                                                   

Total Impact through 2003

    147     37     47     137         18     19     405     48       453       284     29       313

2004

    27     8         4         2         41     (1 )     40       31     13       44

First Quarter 2005

    10     2                 1         13     (11 )     2       10     (3 )     7

Second Quarter 2005

    10     2                 1     1     14     (27 )     (13 )     12     (11 )     1

Third Quarter 2005

    11     2                 2         15     (26 )     (11 )     13     (13 )    

Fourth Quarter 2005

    11     3                         14     51       65       12     37       49
                                                                                   

2005 Full Year

    42     9                 4     1     56     (13 )     43       47     10       57

Total Impact through 2005

  $ 216   $ 54   $ 47   $ 141   $   $ 24   $ 20   $ 502   $ 34     $ 536     $ 362   $ 52     $ 414
                                                                                   

(1) Includes options converted to UnitedHealth Group options in conjunction with acquisitions that were not fully vested at the acquisition date, options granted to contractors and restricted stock grants for which expense was not recorded at the time of the initial grant.

 

(2) Includes immaterial adjustments unrelated to historic stock option practices that were identified through a review of Company accounting practices.

 

(3) The Company adopted FAS 123R effective January 1, 2006, using the modified retrospective method. All prior periods have been restated to give effect to the fair-value based method of accounting for awards granted in fiscal years beginning on or after January 1, 1995.

 

18


Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

    APB 25 - Historical Accounting Method
    Decrease (Increase) to Earnings Before Income Taxes   Decrease (Increase) to
Net Earnings

Year

 

Section 16

and Broad-
Based

Grants

  New Hire
and
Promotion
Grants
  1999 Grant
of
Supplemental
Options
  Reactivation
of
Suspended
Options
  Cliff
Vesting
Options
(3)
  Option
Modifications
  Other Stock-
Based
Compensation
(1)
    Total Stock
Based
Compensation
Errors
  Other
Errors
(2)
    Total   Total Stock-
Based
Compensation
Errors
  Other
Errors
(2)
    Total

(in millions)

                                                         

pre-1994

  $ 19   $ 4   $   $   $   $   $     $ 23   $     $ 23   $ 16   $     $ 16

1994

    2                               2           2     1           1

1995

    5                 2         19       26     4       30     17     3       20

1996

    8     1             1         18       28     3       31     20     2       22

1997

    15     1             2         5       23     4       27     16     3       19

1998

    20     2             2     23     10       57     3       60     40     2       42

1999

    26     1             9     2     1       39     4       43     27     3       30

2000

    63     10     81     40     35     14     6       249     5       254     177     3       180

2001

    73     17     92     32     21     11     (1 )     245     6       251     172     5       177

2002

    52     12     43     13     17     6     1       144     (1 )     143     100     1       101

2003

    34     11     90     7     25     4     1       172     20       192     123     7       130
                                                                                   

Total Impact through 2003

    317     59     306     92     114     60     60       1,008     48       1,056     709     29       738

2004

    22     10     151     1         16     1       201     (1 )     200     145     13       158

First Quarter 2005

    16     3     37         1     8     (1 )     64     (11 )     53     45     (3 )     42

Second Quarter 2005

    17     3     44         3     5           72     (27 )     45     52     (11 )     41

Third Quarter 2005

    18     3     40             41     1       103     (26 )     77     74     (13 )     61

Fourth Quarter 2005

    14     4     59         1     1     (1 )     78     51       129     57     37       94
                                                                                   

2005 Full Year

    65     13     180         5     55     (1 )     317     (13 )     304     228     10       238

Total Impact through 2005

  $ 404   $ 82   $ 637   $ 93   $ 119   $ 131   $ 60     $ 1,526   $ 34     $ 1,560   $ 1,082   $ 52     $ 1,134
                                                                                   

(1) Includes options converted to UnitedHealth Group options in conjunction with acquisitions that were not fully vested at the acquisition date, options granted to contractors and restricted stock grants for which expense was not recorded at the time of the initial grant.

 

(2) Includes immaterial adjustments unrelated to historic stock option practices that were identified through a review of Company accounting practices.

 

(3) Includes $50 million of stock-based compensation expense associated with performance-based awards granted on certain dates in 1996, 1997 and 1998 which have been accounted for as variable awards.

 

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Table of Contents

UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The following table illustrates the effect of the restatement adjustments on our pro forma net earnings and pro forma net earnings per share if we had recorded compensation costs based on the estimated grant date using the fair value accounting method as defined by FAS 123 for the three and six months ended June 30, 2005.

 

(in millions, except per share data)

  For the Three
Months Ended
June 30, 2005
    For the Six
Months Ended
June 30, 2005
 

Net Earnings

   

APB 25

   

As Reported-APB 25

  $ 809     $ 1,588  

Restatement Adjustments-APB 25:

   

Compensation Expense, net of tax effects

    (52 )     (97 )

Other Adjustments, net of tax effects

    11       14  
               

As Restated-APB 25

  $ 768     $ 1,505  
               

FAS 123 Pro Forma

   

As Restated-APB 25

  $ 768     $ 1,505  

Less: APB 25 Compensation Expense, net of tax effects

    52       97  

FAS 123 Historical Compensation Expense, net of tax effects

    (39 )     (75 )

Restatement Adjustment

   

FAS 123 Compensation Expense, net of tax effects

    (12 )     (22 )
               

As Restated-FAS 123 Pro Forma

  $ 769     $ 1,505  
               

Basic Net Earnings Per Common Share

   

As Reported-APB 25

  $ 0.64     $ 1.25  

As Restated-APB 25

  $ 0.61     $ 1.19  

As Restated-FAS 123 Pro Forma

  $ 0.61     $ 1.19  

Diluted Net Earnings Per Common Share

   

As Reported-APB 25

  $ 0.61     $ 1.19  

As Restated-APB 25

  $ 0.58     $ 1.13  

As Restated-FAS 123 Pro Forma

  $ 0.58     $ 1.13  

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The following tables present the effect of the restatement adjustments by financial statement line item for the Condensed Consolidated Statements of Operations, Balance Sheets and Statements of Cash Flows. The tables have been presented on both a FAS 123R basis, which the Company adopted on January 1, 2006, and on an APB 25 basis, which was used for all periods prior to January 1, 2006.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

 

    For the Three Months Ended June 30, 2005  
    APB 25 — Historical Accounting Method     FAS 123R — Current Accounting Method  
    As Reported     Adjustments (1)     As Restated     Adoption (2)     Adjustments (3)     As Restated  

(in millions, except per share data)

                                   

Revenues

           

Premiums

  $ 10,062     $ 265     $ 10,327     $     $     $ 10,327  

Services

    920       (14 )     906                   906  

Products

          17       17                   17  

Investment and Other Income

    129             129                   129  
                                               

Total Revenues

    11,111       268       11,379                   11,379  
                                               

Operating Costs

           

Medical Costs

    8,061       231       8,292                   8,292  

Operating Costs

    1,632       70       1,702       (11 )     14       1,705  

Cost of Products Sold

          12       12                   12  

Depreciation and Amortization

    108             108                   108  
                                               

Total Operating Costs

    9,801       313       10,114       (11 )     14       10,117  
                                               

Earnings From Operations

    1,310       (45 )     1,265       11       (14 )     1,262  

Interest Expense

    (55 )           (55 )                 (55 )
                                               

Earnings Before Income Taxes

    1,255       (45 )     1,210       11       (14 )     1,207  

Provision for Income Taxes

    (446 )     4       (442 )     2       2       (438 )
                                               

Net Earnings

  $ 809     $ (41 )   $ 768     $ 13     $ (12 )   $ 769  
                                               

Basic Net Earnings per Common Share

  $ 0.64     $ (0.03 )   $ 0.61     $ 0.01     $ (0.01 )   $ 0.61  
                                               

Diluted Net Earnings per Common Share

  $ 0.61     $ (0.03 )   $ 0.58     $ 0.01     $ (0.01 )   $ 0.58  
                                               

Basic Weighted-Average Number of Common Shares Outstanding

    1,258             1,258                   1,258  

Dilutive Effect of Common Stock Equivalents

    63       (2 )     61       2       3       66  
                                               

Diluted Weighted-Average Number of Common Shares Outstanding

    1,321       (2 )     1,319       2       3       1,324  
                                               

(1) Includes $72 million of stock-based compensation expense and $20 million of deferred tax benefit associated with the restatement of our historical APB 25 Condensed Statement of Operations as well as an adjustment to premium revenue of $277 million, medical costs of $253 million and operating costs of $24 million to reflect a reinsurance contract on a gross basis. To conform to our current presentation, we have also reclassified certain service revenues and operating costs to product revenues and cost of products sold, respectively, primarily related to our pharmacy benefit management business acquired as part of the PacifiCare acquisition in December 2005.
(2) Reflects $61 million of stock-based compensation expense and $22 million of deferred tax benefit as recorded under the modified retrospective method of adoption of FAS 123R that would have been recognized based on our original pro forma disclosure under FAS 123 prior to the restatement, net of the restatement adjustments under APB 25.
(3) Represents adjustments made to restate our Condensed Statement of Operations subsequent to the adoption of FAS 123R under the modified retrospective method of adoption to correct the previously presented pro forma disclosures for the effects of the historical stock option practices and includes $14 million of additional stock-based compensation expense and $2 million of related deferred tax benefit.

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

 

    For the Six Months Ended June 30, 2005  
    APB 25 — Historical Accounting Method     FAS 123R — Current Accounting Method  
    As Reported     Adjustments (1)     As Restated     Adoption (2)     Adjustments (3)     As Restated  

(in millions, except per share data)

 

Revenues

           

Premiums

  $ 19,933     $ 521     $ 20,454     $     $     $ 20,454  

Services

    1,822       (36 )     1,786                   1,786  

Products

          43       43                   43  

Investment and Other Income

    243             243                   243  
                                               

Total Revenues

    21,998       528       22,526                   22,526  
                                               

Operating Costs

           

Medical Costs

    15,963       443       16,406                   16,406  

Operating Costs

    3,252       155       3,407       (19 )     27       3,415  

Cost of Products Sold

          28       28                   28  

Depreciation and Amortization

    217             217                   217  
                                               

Total Operating Costs

    19,432       626       20,058       (19 )     27       20,066  
                                               

Earnings From Operations

    2,566       (98 )     2,468       19       (27 )     2,460  

Interest Expense

    (104 )           (104 )                 (104 )
                                               

Earnings Before Income Taxes

    2,462       (98 )     2,364       19       (27 )     2,356  

Provision for Income Taxes

    (874 )     15       (859 )     3       5       (851 )
                                               

Net Earnings

  $ 1,588     $ (83 )   $ 1,505     $ 22     $ (22 )   $ 1,505  
                                               

Basic Net Earnings per Common Share

  $ 1.25     $ (0.06 )   $ 1.19     $ 0.02     $ (0.02 )   $ 1.19  
                                               

Diluted Net Earnings per Common Share

  $ 1.19     $ (0.06 )   $ 1.13     $ 0.02     $ (0.02 )   $ 1.13  
                                               

Basic Weighted-Average Number of Common Shares Outstanding

    1,268             1,268                   1,268  

Dilutive Effect of Common Stock Equivalents

    63       (3 )     60       3       3       66  
                                               

Diluted Weighted-Average Number of Common Shares Outstanding

    1,331       (3 )     1,328       3       3       1,334  
                                               

(1) Includes $136 million of stock-based compensation expense and $39 million of deferred tax benefit associated with the restatement of our historical APB 25 Condensed Consolidated Statement of Operations as well as an adjustment to premium revenue of $554 million, medical costs of $506 million and operating costs of $48 million to reflect a reinsurance contract on a gross basis. To conform to our current presentation, we have also reclassified certain service revenues and operating costs to product revenues and cost of products sold, respectively, primarily related to our pharmacy benefit management business acquired as part of the PacifiCare acquisition in December 2005.
(2) Reflects $117 million of stock-based compensation expense and $42 million of deferred tax benefit as recorded under the modified retrospective method of adoption of FAS 123R that would have been recognized based on our original pro forma disclosure under FAS 123 prior to the restatement, net of the restatement adjustments under APB 25.
(3) Represents adjustments made to restate our Condensed Consolidated Statement of Operations subsequent to the adoption of FAS 123R under the modified retrospective method of adoption to correct the previously presented pro forma disclosures for the effects of the historical stock option practices and includes $27 million of additional stock-based compensation expense and $5 million of related deferred tax benefit.

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

CONSOLIDATED BALANCE SHEETS

 

    As of December 31, 2005
    APB 25 — Historical Accounting Method   FAS 123R — Current Accounting Method
    As Reported   Adjustments (1)     As Restated   Adoption (2)     Adjustments (3)     As Restated

(in millions, except per share data)

Assets

           

Current Assets

           

Cash and Cash Equivalents

  $ 5,421   $     $ 5,421   $     $     $ 5,421

Short-Term Investments

    590           590                 590

Accounts Receivable, net

    1,290     (83 )     1,207                 1,207

Assets Under Management

    1,825           1,825                 1,825

Deferred Income Taxes

    645     5       650                 650

Other Current Assets

    869     (15 )     854                 854
                                         

Total Current Assets

    10,640     (93 )     10,547                 10,547

Long-Term Investments

    8,971           8,971                 8,971

Property, Equipment, and Capitalized Software, net

    1,647           1,647                 1,647

Goodwill

    16,206     32       16,238                 16,238

Other Intangible Assets, net

    2,020           2,020                 2,020

Other Assets

    1,890     (25 )     1,865                 1,865
                                         

Total Assets

  $ 41,374   $ (86 )   $ 41,288   $     $     $ 41,288
                                         

Liabilities and Shareholders’ Equity

           

Current Liabilities

           

Medical Costs Payable

  $ 7,301   $ (39 )   $ 7,262   $     $     $ 7,262

Accounts Payable and Accrued Liabilities

    3,301     (16 )     3,285     (95 )     95       3,285

Other Policy Liabilities

    1,824     21       1,845                 1,845

Commercial Paper and Current Maturities of Long-Term Debt

    3,261           3,261                 3,261

Unearned Premiums

    957     43       1,000                 1,000
                                         

Total Current Liabilities

    16,644     9       16,653     (95 )     95       16,653

Long-Term Debt, less current maturities

    3,850     (16 )     3,834                 3,834

Future Policy Benefits for Life and Annuity Contracts

    1,761           1,761                 1,761

Deferred Income Taxes and Other Liabilities

    1,386     (134 )     1,252     24       (51 )     1,225

Commitments and Contingencies

           
                                         

Shareholders’ Equity

           

Common Stock

    14           14                 14

Additional Paid-In Capital

    6,921     338       7,259     664       (413 )     7,510

Retained Earnings

    10,765     (283 )     10,482     (593 )     369       10,258

Accumulated Other Comprehensive Income:

           

Net Unrealized Gains on Investments, net of tax effects

    33           33                 33
                                         

Total Shareholders’ Equity

    17,733     55       17,788     71       (44 )     17,815
                                         

Total Liabilities and Shareholders’ Equity

  $ 41,374   $ (86 )   $ 41,288   $     $     $ 41,288
                                         

(1) Includes adjustments to increase current income taxes payable by $95 million, decrease non-current deferred tax liabilities by $236 million, increase additional paid-in capital by $372 million and to decrease retained earnings by $231 million associated with the restatement of our historical APB 25 Condensed Consolidated Balance Sheet.
(2) Reflects adjustments to decrease non-current deferred tax liabilities by $212 million, increase additional paid-in capital by $1,036 million and decrease retained earnings by $824 million associated with the adoption of FAS 123R under the modified retrospective method as of December 31, 2005 that would have been recognized based on our original pro forma disclosure under FAS 123 prior to the restatement, net of the restatement adjustments under APB 25.
(3) Represents adjustments made to restate our Condensed Consolidated Balance Sheet subsequent to the adoption of FAS 123R under the modified retrospective method to correct the previously presented pro forma disclosures for the effects of the historic stock option practices and includes adjustments to increase current income taxes payable by $95 million, decrease non-current deferred tax liabilities by $51 million, decrease additional paid-in capital by $413 million and increase retained earnings by $369 million. Includes adjustments to our historic common stock repurchase accounting considering the increase in compensation recognized in relation to the timing of stock repurchase activity and the related impact to period end reclassifications within shareholders’ equity to restore additional paid-in capital.

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

    For Six Months Ended June 30, 2005  
    APB 25 — Historical Accounting Method     FAS 123R — Current Accounting Method  
    Reported     Adjustments (1)     As Restated     Adoption (2)     Adjustments (3)     As Restated  

(in millions)

 

Operating Activities

           

Net Earnings

  $ 1,588     $ (83 )   $ 1,505     $ 22     $ (22 )   $ 1,505  

Noncash Items:

           

Depreciation and Amortization

    217             217                   217  

Deferred Income Taxes and Other

    63       (29 )     34       (123 )           (89 )

Stock-Based Compensation

          136       136       (19 )     27       144  

Net Change in Other Operating Items, net of effects from acquisitions, and changes in AARP balances

           

Accounts Receivable and Other Assets

    (53 )     11       (42 )                 (42 )

Medical Costs Payable

    289       (26 )     263                   263  

Accounts Payable and Other Accrued Liabilities

    616       19       635             1       636  

Unearned Premiums

    (223 )     (28 )     (251 )                 (251 )
                                               

Cash Flows From Operating Activities

    2,497             2,497       (120 )     6       2,383  
                                               

Investing Activities

           

Cash Paid for Acquisitions, net of cash assumed and other effects

    (115 )           (115 )                 (115 )

Purchases of Property, Equipment and Capitalized Software

    (222 )           (222 )                 (222 )

Purchases of Investments

    (3,180 )           (3,180 )                 (3,180 )

Maturities and Sales of Investments

    2,709             2,709                   2,709  
                                               

Cash Flows Used for Investing Activities

    (808 )           (808 )                 (808 )
                                               

Financing Activities

           

Repayments of Commercial Paper, net

    (273 )           (273 )                 (273 )

Proceeds from Issuance of Long-Term Debt

    500             500                   500  

Common Stock Repurchases

    (2,138 )           (2,138 )                 (2,138 )

Proceeds from Common Stock Issuances under Stock-Based Compensation Plans

    224             224                   224  

Stock-Based Compensation Excess Tax Benefit

                      120       (6 )     114  

Customer Funds Administered

    78             78                   78  

Dividends Paid

    (19 )           (19 )                 (19 )

Other

    (10 )           (10 )                 (10 )
                                               

Cash Flows From (Used For) Financing Activities

    (1,638 )           (1,638 )     120       (6 )     (1,524 )
                                               

Increase in Cash and Cash Equivalents

    51             51                   51  

Cash and Cash Equivalents, Beginning of Period

    3,991             3,991                   3,991  
                                               

Cash and Cash Equivalents, End of Period

  $ 4,042     $     $ 4,042     $     $     $ 4,042  
                                               

(1) Includes adjustments to operating cash flows for stock-based compensation and related tax effects associated with the restatement of our historical APB 25 Condensed Consolidated Statement of Cash Flows, as well as operating cash flow adjustments due to immaterial adjustments, individually and in the aggregate, unrelated to historical stock option practices.
(2) Reflects adjustments to operating cash flows for stock-based compensation and deferred tax assets and to financing cash flows for excess tax benefits as recorded under the modified retrospective method of adoption of FAS 123R that would have been recognized based on our original pro forma disclosure under FAS 123 prior to the restatement, net of the restatement adjustments under APB 25.

(3)

Represents adjustments made to restate our Condensed Consolidated Statement of Cash Flows subsequent to the adoption of FAS 123R under the modified retrospective method to correct the previously presented pro forma disclosures for the effects of the historical stock option practices and includes adjustments to operating cash flows for additional stock-based compensation expense and deferred tax assets and to financing cash flows for excess tax benefits.

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

3. Medicare Part D Pharmacy Benefits Contract

Beginning January 1, 2006, the Company began serving as a plan sponsor offering Medicare Part D prescription drug insurance coverage under contracts with the Centers for Medicare & Medicaid Services (CMS). Under the Medicare Part D program, there are six separate elements of payment received by the Company during the plan year. These payment elements are as follows:

 

 

CMS Premium — CMS pays a fixed monthly premium per member to the Company for the entire plan year.

 

 

Member Premium — Additionally, certain members pay a fixed monthly premium to the Company for the entire plan year.

 

 

Low-Income Premium Subsidy — For qualifying low-income members, CMS pays some or all of the member’s monthly premiums to the Company on the member’s behalf.

 

 

Catastrophic Reinsurance Subsidy — CMS pays the Company a cost reimbursement estimate monthly to fund the CMS obligation to pay approximately 80% of the costs incurred by individual members in excess of the individual annual out-of-pocket maximum of $3,600. A settlement is made based on actual cost experience subsequent to the end of the plan year.

 

 

Low-Income Member Cost Sharing Subsidy — For qualifying low-income members, CMS pays on the member’s behalf some or all of a member’s cost sharing amounts, such as deductibles and coinsurance. The cost sharing subsidy is funded by CMS through monthly payments to the Company. The Company administers and pays the subsidized portion of the claims on behalf of CMS, and a settlement payment is made between CMS and the Company based on actual claims experience, subsequent to the end of the plan year.

 

 

CMS Risk-Share — If the ultimate per member per month benefit costs of any Medicare Part D regional plan varies more than 2.5% above or below the level estimated in the original bid submitted by the Company and approved by CMS, there is a risk-share settlement with CMS subsequent to the end of the plan year. The risk-share adjustment, if any, is recorded as an adjustment to premium revenues and other receivables or liabilities.

The CMS Premium, the Member Premium, and the Low-Income Premium Subsidy represent payments for the Company’s insurance risk coverage under the Medicare Part D program and therefore are recorded as premium revenues in the Condensed Consolidated Statements of Operations. Premium revenues are recognized ratably over the period in which eligible individuals are entitled to receive prescription drug benefits. We record premium payments received in advance of the applicable service period as unearned premiums.

The Catastrophic Reinsurance Subsidy and the Low-Income Member Cost Sharing Subsidy represent cost reimbursements under the Medicare Part D program. The Company is fully reimbursed by CMS for costs incurred for these contract elements and, accordingly, there is no insurance risk to the Company. Amounts received for these subsidies are not reflected as premium revenues, but rather are accounted for as deposits, with the related liability recorded in Other Policy Liabilities in the Condensed Consolidated Balance Sheets. Related cash flows are presented as Customer Funds Administered within financing cash flows in the Condensed Consolidated Statements of Cash Flows.

Pharmacy benefit costs and administrative costs under the contract are expensed as incurred and are recognized in Medical Costs and Operating Costs, respectively, in the Condensed Consolidated Statements of Operations.

As a result of the Medicare Part D product benefit design, the Company incurs a disproportionate amount of pharmacy benefit costs early in the contract year. For example, the Company is responsible for approximately

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

67% of a Medicare Part D beneficiary’s drug costs up to $2,250, while the beneficiary is responsible for 100% of their drug costs from $2,250 up to $5,100 (at the Company’s discounted purchase price). Consequently, the Company incurs a disproportionate amount of benefit costs in the first half of the contract year as compared with the last half of the contract year, when comparatively more members will be incurring claims above the $2,250 initial coverage limit. The uneven timing of Medicare Part D pharmacy benefit claims results in losses in the first half of the contract year that entitle the Company to risk-share adjustment payments from CMS. Accordingly, during the interim periods within the contract year we record a net risk-share receivable from CMS in Other Current Assets in the Condensed Consolidated Balance Sheets and a corresponding retrospective premium adjustment in premium revenues in the Condensed Consolidated Statements of Operations. This represents the estimated amount payable by CMS to the Company under the risk-share contract provisions if the program were terminated based on estimated costs incurred through that interim period. Those losses reverse in the second half of the year and final risk-share amounts due to or from CMS, if any, are settled approximately six months after the contract year-end. The projected net risk-share receivable to be received from CMS as of June 30, 2006 was $344 million.

For the six months ended June 30, 2006, the Company recognized approximately $3.1 billion, or approximately 52% of estimated full year Medicare Part D revenues. For the six months ended June 30, 2006, the Company recognized $2.9 billion or approximately 56% of anticipated full year pharmacy benefit costs associated with active members as of June 30, 2006. The medical care ratio (medical costs as a percentage of premium revenues) for the Medicare Part D product was 94% during the six months ended June 30, 2006.

As a result of these contracts and the December 2005 acquisition of PacifiCare Health Systems, Inc., premium revenues from CMS, which have historically been approximately 10% of total revenues, increased to approximately 25% for the six months ended June 30, 2006.

 

4. Acquisitions

On February 24, 2006, the Company acquired John Deere Health Care, Inc. (JDHC). JDHC serves employers primarily in Iowa, central and western Illinois, eastern Tennessee and southwestern Virginia. This acquisition strengthened our resources and capabilities in these areas. The operations of JDHC reside primarily within our Health Care Services and Uniprise segments. We paid approximately $515 million in cash, including transaction costs, in exchange for all of the outstanding equity of JDHC. The purchase price and costs associated with the acquisition exceeded the preliminary estimated fair value of the net tangible assets acquired by approximately $370 million. Pending completion of a valuation analysis, we have preliminarily allocated the excess purchase price over the fair value of the net tangible assets acquired to finite-lived intangible assets of $60 million and goodwill of $310 million. The finite-lived intangible assets consist primarily of member lists, with an estimated weighted-average useful life of 15 years. The acquired goodwill is deductible for income tax purposes. The results of operations and financial condition of JDHC have been included in our Consolidated Financial Statements since the acquisition date. The pro forma effects of the JDHC acquisition on our Consolidated Financial Statements were not material. Our preliminary estimate of the acquired net tangible assets of $145 million, which is subject to further refinement, consisted mainly of cash, cash equivalents, investments, accounts receivable, property and equipment and other assets partially offset by medical payables and other current liabilities. JDHC has been renamed UnitedHealthcare Services Company of the River Valley, Inc.

On December 20, 2005, the Company acquired PacifiCare Health Systems, Inc. (PacifiCare). PacifiCare provides health care and benefit services to individuals and employers, principally in markets in the western United States. This merger significantly strengthened our resources by enhancing our capabilities on the Pacific Coast and in other western states and broadening the scope of our product offerings for a host of specialized services. The operations of PacifiCare reside primarily within our Health Care Services and Specialized Care Services

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

segments. Under the terms of the agreement, PacifiCare shareholders received 1.1 shares of UnitedHealth Group common stock and $21.50 in cash for each share of PacifiCare common stock they owned. Total consideration issued for the transaction was approximately $8.8 billion, composed of approximately 99.2 million shares of UnitedHealth Group common stock (valued at approximately $5.3 billion based upon the average of UnitedHealth Group’s share closing price for two days before, the day of and two days after the acquisition announcement date of July 6, 2005), approximately $2.1 billion in cash, $960 million cash paid to retire PacifiCare’s existing debt and UnitedHealth Group vested common stock options with an estimated fair value of approximately $420 million issued in exchange for PacifiCare’s outstanding vested common stock options. The purchase price and costs associated with the acquisition exceeded the preliminary estimated fair value of the net tangible assets acquired by approximately $7.1 billion. Pending completion of a valuation analysis, we have preliminarily allocated the excess purchase price over the fair value of the net tangible assets acquired to finite-lived intangible assets of $1.0 billion and associated deferred tax liabilities of $392 million, and goodwill of approximately $6.5 billion. The finite-lived intangible assets consist primarily of member lists, health care physician and hospital networks and trademarks, with an estimated weighted average useful life of 13 years. The acquired goodwill is not deductible for income tax purposes. Our preliminary estimate of acquired net tangible assets and liabilities are categorized as follows: cash and cash equivalents of $810 million; investments of $2.4 billion; accounts receivable and other current assets of $729 million; property, equipment and capitalized software and other assets of $332 million; medical costs payable of $1.4 billion and other liabilities of $1.2 billion.

We record liabilities related to integration activities in connection with business combinations when integration plans are finalized and approved by management within one year of the acquisition date in accordance with the requirements of Emerging Issues Task Force (EITF) Issue No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination.” Liabilities recorded relate to activities that have no future economic benefit to the Company and represent contractual obligations. These liabilities result in an increase to goodwill acquired. At each reporting date, we evaluate our liabilities associated with integration activities and make adjustments as appropriate.

Integration activities finalized prior to June 30, 2006 relate to severance costs for certain workforce reductions primarily in the Health Care Services segment, costs of terminated or vacated leased facilities and other contract termination costs. The following table illustrates the changes in employee termination benefit costs and other integration costs related to the PacifiCare acquisition for the six-month period ended June 30, 2006 (in millions):

 

     Employee
Termination
Benefit Costs
    Other Integration
Activities
   Total  

Accrued integration liabilities at December 31, 2005

   $ 15     $ 30    $ 45  

Additional integration costs accrued and estimate adjustments

     35       20      55  

Payments made against liability

     (24 )          (24 )
                       

Accrued integration liabilities at June 30, 2006

   $ 26     $ 50    $ 76  
                       

The results of operations and financial condition of PacifiCare have been included in our consolidated financial statements since the acquisition date and for the entire three and six months ended June 30, 2006. The unaudited pro forma financial information presented below assumes that the acquisition occurred as of the beginning of each respective period presented below. The pro forma adjustments include the pro forma effect of UnitedHealth Group shares issued in the acquisition, the amortization of finite-lived intangible assets arising from the purchase price allocation, interest expense related to financing the cash portion of the purchase price and the associated income tax effects of the pro forma adjustments. Because the unaudited pro forma financial information has been prepared based on estimates of fair values, the actual amounts recorded as of the completion of the PacifiCare

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

purchase price allocation may differ from the information presented below. The following unaudited pro forma results have been prepared for comparative purposes only and do not purport to be indicative of the results of operations that would have occurred had the PacifiCare acquisition been consummated at the beginning of the period presented.

 

Pro forma — unaudited

   For the Three
Months Ended
June 30, 2005
   For the Six
Months Ended
June 30, 2005
(in millions, except per share data)

Revenues

   $ 14,960    $ 29,543

Net Earnings

   $ 842    $ 1,649

Earnings Per Share:

     

Basic

   $ 0.62    $ 1.20

Diluted

   $ 0.59    $ 1.15

On September 19, 2005, our Health Care Services business segment acquired Neighborhood Health Partnership (NHP). NHP serves local employers primarily in South Florida. This acquisition strengthened our market position in this region and provided expanded distribution opportunities for our other UnitedHealth Group businesses. We paid approximately $185 million in cash in exchange for all of the outstanding equity of NHP. The results of operations and financial condition of NHP have been included in our consolidated financial statements since the acquisition date. The pro forma effects of the NHP acquisition on our consolidated financial statements were not material.

 

5. Cash, Cash Equivalents and Investments

As of June 30, 2006, the amortized cost, gross unrealized gains and losses, and fair value of cash, cash equivalents and investments were as follows (in millions):

 

    

Amortized

Cost

  

Gross

Unrealized

Gains

  

Gross

Unrealized

Losses

   

Fair

Value

Cash and Cash Equivalents

   $ 9,472    $   —    $     $ 9,472

Debt Securities — Available for Sale

     9,178      25      (187 )     9,016

Equity Securities — Available for Sale

     227      19      (2 )     244

Debt Securities — Held to Maturity

     261                 261
                            

Total Cash and Investments

   $ 19,138    $ 44    $ (189 )   $ 18,993
                            

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

In accordance with FASB Staff Position FAS 115-1/124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” the following table shows the gross unrealized losses and fair value of investments with unrealized losses that, in our judgment, are not other-than-temporarily impaired. These investments are aggregated by investment type and length of time that individual securities have been in a continuous unrealized loss position (in millions) (1):

 

     As of June 30, 2006  
     Less Than
12 Months
    12 Months or
Greater
    Total  
     Fair
Value
  

Gross

Unrealized
Losses

    Fair
Value
  

Gross

Unrealized
Losses

    Fair
Value
  

Gross

Unrealized
Losses

 

U.S. Government and Agency obligations

   $ 1,758    $ (47 )   $ 228    $ (8 )   $ 1,986    $ (55 )

State and municipal obligations

     3,178      (58 )     411      (12 )     3,589      (70 )

Corporate obligations

     1,796      (55 )     201      (7 )     1,997      (62 )
                                             

Total Debt Securities — Available for Sale

   $ 6,732    $ (160 )   $ 840    $ (27 )   $ 7,572    $ (187 )
                                             

Total Equity Securities

   $ 11    $ (2 )   $    $     $ 11    $ (2 )
                                             

(1) Debt securities classified as held-to-maturity investments have been excluded from this analysis. These investments are predominantly held in U.S. Government or Agency obligations and the contractual terms do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Additionally, the fair values of these investments approximate their amortized cost.

The unrealized losses on investments in U.S. Government and Agency obligations, state and municipal obligations and corporate obligations at June 30, 2006 were mainly caused by interest rate increases and not by unfavorable changes in the credit ratings associated with these securities. We evaluate impairment at each reporting period for each of the securities where the fair value of the investment is less than its cost. The contractual cash flows of the U.S. Government and Agency obligations are either guaranteed by the U.S. Government or an agency of the U.S. Government. It is expected that the securities would not be settled at a price less than the cost of our investment. We evaluated the credit ratings of the state and municipal obligations and the corporate obligations, noting neither a significant deterioration since purchase nor other factors leading to other-than-temporary impairment.

A portion of the Company’s investments in equity securities consists of investments held by our UnitedHealth Capital business in various public and nonpublic companies concentrated in the areas of health care delivery and related information technologies. Market conditions that affect the value of health care and related technology stocks will likewise impact the value of our equity portfolio. The equity securities were evaluated for severity and duration of unrealized loss, overall market volatility and other market factors.

We analyze relevant factors individually and in combination including the length of time and extent to which market value has been less than cost, the financial condition and near-term prospects of the issuer as well as specific events or circumstances that may influence the operations of the issuer, and our intent and ability to hold the investment for a sufficient time to recover our cost. We revise impairment judgments when new information becomes known or when we do not anticipate holding the investment until recovery. If any of our investments experience a decline in fair value that is determined to be other-than-temporary, based on analysis of relevant factors, we record a realized loss in our Consolidated Statements of Operations. We do not consider the unrealized losses on each of the investments described above to be other-than-temporarily impaired at June 30, 2006.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

During the three and six months ended June 30, we recorded realized gains and losses on the sale of investments, as follows (in millions):

 

     Three Months
Ended June 30,
    Six Months
Ended June 30,
 
     2006     2005     2006     2005  

Gross Realized Gains

   $ 5     $ 13     $ 34     $ 23  

Gross Realized Losses

     (11 )     (6 )     (14 )     (14 )
                                

Net Realized (Losses) Gains

   $ (6 )   $ 7     $ 20     $ 9  
                                

Included in the realized losses above are impairment charges of $2 million for each of the three and six months ended June 30, 2006 and 2005.

 

6. Goodwill and Other Intangible Assets

Changes in the carrying amount of goodwill, by segment, for the six months ended June 30, 2006 and 2005 were as follows:

 

(in millions)

   Health
Care
Services
   Uniprise    Specialized
Care
Services
   Ingenix    Consolidated
Total

Balance at December 31, 2005

   $ 13,864    $ 917    $ 732    $ 725    $ 16,238

Acquisitions and Subsequent Payments/Adjustments

     201      50      68      62      381
                                  

Balance at June 30, 2006

   $ 14,065    $ 967    $ 800    $ 787    $ 16,619
                                  

(in millions)

  

Health
Care

Services

   Uniprise   

Specialized
Care

Services

   Ingenix   

Consolidated

Total

Balance at December 31, 2004

   $ 7,505    $ 903    $ 406    $ 665    $ 9,479

Acquisitions and Subsequent Payments/Adjustments

     103      1      38      57      199
                                  

Balance at June 30, 2005

   $ 7,608    $ 904    $ 444    $ 722    $ 9,678
                                  

The weighted-average useful life, gross carrying value, accumulated amortization and net carrying value of other intangible assets as of June 30, 2006 and December 31, 2005 were as follows ($ in millions):

 

     Weighted-
Average
Useful Life
   June 30, 2006    December 31, 2005
        Gross
Carrying
Value
   Accumulated
Amortization
    Net
Carrying
Value
   Gross
Carrying
Value
   Accumulated
Amortization
    Net
Carrying
Value

Customer Contracts and Membership Lists

   15 years    $ 1,897    $ (175 )   $ 1,722    $ 1,830    $ (106 )   $ 1,724

Patents, Trademarks and Technology

   10 years      230      (75 )     155      221      (62 )     159

Other

   16 years      158      (30 )     128      161      (24 )     137
                                                

Total

   15 years    $ 2,285    $ (280 )   $ 2,005    $ 2,212    $ (192 )   $ 2,020
                                                

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Amortization expense relating to intangible assets was approximately $44 million and $88 million for the three and six months ended June 30, 2006 and approximately $21 million and $44 million for the three and six months ended June 30, 2005. Estimated amortization expense relating to intangible assets for the years ending December 31 are as follows: $181 million in 2006, $175 million in 2007, $170 million in 2008, $161 million in 2009, and $153 million in 2010.

 

7. Medical Costs and Medical Costs Payable

Medical costs and medical costs payable include estimates of our obligations for medical care services that have been rendered on behalf of insured consumers for which we have either not yet received or processed claims, and for liabilities for physician, hospital and other medical cost disputes. We develop estimates for medical costs incurred but not reported using an actuarial process that is consistently applied, centrally controlled and automated. The actuarial models consider factors such as time from date of service to claim receipt, claim backlogs, care provider contract rate changes, medical care consumption and other medical cost trends. We estimate liabilities for physician, hospital and other medical cost disputes based upon an analysis of potential outcomes, assuming a combination of litigation and settlement strategies. Each period, we re-examine previously established medical costs payable estimates based on actual claim submissions and other changes in facts and circumstances. As the liability estimates recorded in prior periods become more exact, we adjust the amount of the estimates, and include the changes in estimates in medical costs in the period in which the change is identified. For example, in every reporting period, our operating results include the effects of more completely developed medical costs payable estimates associated with previously reported periods.

Medical costs for the three months ended June 30, 2006 include approximately $150 million of favorable medical cost development, virtually all related to prior years. Medical costs for the three months ended June 30, 2005 include approximately $120 million of favorable medical cost development related to prior years and approximately $20 million of favorable medical cost development related to the first quarter of 2005. Medical costs for the six months ended June 30, 2006 and 2005 include approximately $370 million and $310 million, respectively, of favorable medical cost development related to prior years. The increase in net favorable medical cost development was partially due to a reduction in estimates for extension of benefit obligations based upon analysis of historical claim submissions. Management believes the amount of medical costs payable is reasonable and adequate to cover the Company’s liability for unpaid claims as of June 30, 2006.

 

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8. Commercial Paper and Debt

Commercial paper and debt consisted of the following (in millions):

 

    June 30, 2006     December 31, 2005  
    Carrying
Value (1)
    Fair
Value (2)
    Carrying
Value (1)
    Fair
Value (2)
 

Commercial Paper

  $ 509     $ 509     $ 2,829     $ 2,829  

3.0% Convertible Subordinated Debentures

    30       30       432       432  

$400 million par, 5.2% Senior Unsecured Notes due January 2007

    399       399       401       402  

$550 million par, 3.4% Senior Unsecured Notes due August 2007

    533       536       535       537  

$500 million par, 3.3% Senior Unsecured Notes due January 2008

    482       482       486       485  

$250 million par, 3.8% Senior Unsecured Notes due February 2009

    238       238       243       242  

Senior Unsecured Floating-Rate Notes due March 2009

    650       650              

$450 million par, 4.1% Senior Unsecured Notes due August 2009

    429       429       439       438  

$750 million par, 5.3% Senior Unsecured Notes due March 2011

    732       731              

$450 million par, 4.9% Senior Unsecured Notes due April 2013

    437       422       445       448  

$250 million par, 4.8% Senior Unsecured Notes due February 2014

    233       230       245       245  

$500 million par, 5.0% Senior Unsecured Notes due August 2014

    469       466       495       498  

$500 million par, 4.9% Senior Unsecured Notes due March 2015

    467       464       493       490  

$750 million par, 5.4% Senior Unsecured Notes due March 2016

    710       709              

$850 million par, 5.8% Senior Unsecured Notes due March 2036

    844       758              

Interest Rate Swaps

    203       203       52       52  
                               

Total Commercial Paper and Debt

    7,365       7,256       7,095       7,098  

Less Current Maturities

    (939 )     (938 )     (3,261 )     (3,261 )
                               

Long-Term Debt, less current maturities

  $ 6,426     $ 6,318     $ 3,834     $ 3,837  
                               

(1) The carrying value of debt has been adjusted based upon the applicable interest rate swap fair values in accordance with the fair value hedge short-cut method of accounting described below.
(2) Estimated based on third-party quoted market prices for the same or similar issues.

As of June 30, 2006, our outstanding commercial paper had interest rates of approximately 5.1%.

In March 2006, we refinanced commercial paper by issuing $650 million of floating-rate notes due March 2009, $750 million of 5.3% fixed-rate notes due March 2011, $750 million of 5.4% fixed-rate notes due March 2016 and $850 million of 5.8% fixed-rate notes due March 2036. The floating-rate notes due March 2009 are benchmarked to the London Interbank Offered Rate (LIBOR) and had an interest rate of 5.3% at June 30, 2006.

In December 2005, we amended and restated our $1.0 billion five-year revolving credit facility supporting our commercial paper program. We increased the credit facility to $1.3 billion and extended the maturity date to December 2010. We have entered into amendments to our $1.3 billion credit facility to provide us with additional time to deliver to the lenders our quarterly reports on Form 10-Q for the quarters ended June 30, 2006 and September 30, 2006 and our annual report on Form 10-K for the year ended December 31, 2006, to obtain our lenders’ agreement and acknowledgement that the delivery of a notice of default or notice of acceleration under any indenture or credit agreement that is being contested by the Company in good faith does not cause a default or event of default under the credit agreement, and to obtain a waiver of any potential default that may arise as a result of our determination that our historical financial information should not be relied upon as a result

 

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of restatement of our historical financial statements. As of June 30, 2006, we had no amounts outstanding under our $1.3 billion credit facility.

In November and December 2005, we issued $2.6 billion of commercial paper primarily to finance the cash portion of the purchase price of the PacifiCare acquisition described in Note 4 and to retire a portion of the PacifiCare debt upon closing of the acquisition, as well as to refinance current maturities of long-term debt.

In March 2005, we issued $500 million of 4.9% fixed-rate notes due March 2015. We used the proceeds from this borrowing for general corporate purposes, including repayment of commercial paper, capital expenditures, working capital and share repurchases.

To more closely align interest costs with floating interest rates received on our cash and cash equivalent balances, we have entered into interest rate swap agreements to convert the majority of our interest rate exposure from fixed rates to variable rates. These interest rate swap agreements have aggregate notional amounts of $4.9 billion as of June 30, 2006 with variable rates that are benchmarked to LIBOR, and are recorded on our Condensed Consolidated Balance Sheets. As of June 30, 2006, the aggregate liability, recorded at fair value, for all existing interest rate swaps was approximately $203 million. These fair value hedges are accounted for using the short-cut method under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (FAS 133), whereby the hedges are reported on our Condensed Consolidated Balance Sheets at fair value, and the carrying value of the long-term debt is adjusted for an offsetting amount representing changes in fair value attributable to the hedged risk. Since these amounts completely offset, we have reported both the swap liability and the debt liability within debt on our Condensed Consolidated Balance Sheets, and there have been no net gains or losses recognized in our Condensed Consolidated Statements of Operations. At June 30, 2006, the rates used to accrue interest expense on these agreements ranged from 5.2% to 5.9%.

Our debt arrangements and credit facilities contain various covenants, the most restrictive of which require us to maintain a debt-to-total-capital ratio (calculated as the sum of commercial paper and debt divided by the sum of commercial paper, debt and shareholders’ equity) below 50%. After giving effect to the credit agreement amendments and waivers that we obtained from our lenders, we believe we were in compliance with the requirements of all debt covenants as of June 30, 2006. On August 28, 2006, we received a purported notice of default from persons claiming to hold certain of our debt securities alleging a violation of our indenture governing our debt securities. This followed our announcement that we would delay filing our quarterly report on Form 10-Q for the quarter ended June 30, 2006. On or about November 2, 2006, we received a purported notice of acceleration from the holders who previously sent the notice of default that purports to declare an acceleration of our 5.8% Senior Unsecured Notes due March 15, 2036. Our indenture requires us to provide to the trustee copies of the reports we are required to file with the SEC, such as our quarterly reports, within 15 days of filing such reports with the SEC. On October 25, 2006, we filed an action in the United States District Court for the District of Minnesota seeking a declaratory judgment that we are not in default under the terms of the indenture. Immediately prior to the filing of this Form 10-Q, we filed a quarterly report on Form 10-Q/A to amend our quarterly report on Form 10-Q for the quarter ended March 31, 2006, and immediately after the filing of this Form 10-Q, we will file our quarterly report on Form 10-Q for the quarter ended September 30, 2006, as well as our annual report on Form 10-K for the year ended December 31, 2006. Should the Company ultimately be unsuccessful in this matter, we may be required to retire all or a portion of the $850 million of Senior Unsecured Notes due March 2036. We intend to prosecute the declaratory judgment action vigorously.

PacifiCare had approximately $100 million par value of 3% convertible subordinated debentures (convertible notes) which were convertible into approximately 5.2 million shares of UnitedHealth Group’s common stock and $102 million of cash as of December 31, 2005. In December 2005, we initiated a consent solicitation to all of the holders of outstanding convertible notes pursuant to which we offered to compensate all holders who elected to

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

convert their notes in accordance with existing terms and consent to an amendment to a covenant in the indenture governing the convertible notes. The compensation consisted of the present value of interest through October 18, 2007, the earliest redemption date, plus a pro rata share of $1 million. On January 31, 2006, approximately 91% of the convertible notes were tendered pursuant to the offer, for which we issued approximately 4.8 million shares of UnitedHealth Group common stock, valued at $282 million, and cash of $93 million.

 

9. Stock Repurchase Program

Under our Board of Directors’ authorization, we maintain a common stock repurchase program. Repurchases may be made from time to time at prevailing prices, subject to restrictions on volume, pricing and timing. During the six months ended June 30, 2006, we repurchased 40.2 million shares at an average price of approximately $56 per share and an aggregate cost of approximately $2.2 billion. As of June 30, 2006, we had Board of Directors’ authorization to purchase up to an additional 136.7 million shares of our common stock.

 

10. Stock-Based Compensation and Other Employee Benefit Plans

As further described in Notes 1 and 2, we adopted FAS 123R as of January 1, 2006. FAS 123R requires all companies to measure compensation expense for all share-based payments (including employee stock options, stock appreciation rights and restricted stock) at fair value and recognize the expense over the related service period. We adopted FAS 123R using the modified retrospective transition method, under which all prior period financial statements are required to be restated to recognize compensation cost in the amounts historically disclosed under FAS 123.

As of June 30, 2006, we had approximately 80.3 million shares available for future grants of stock-based awards under our stock-based compensation plan, including, but not limited to, incentive or non-qualified stock options, stock appreciation rights, restricted stock and restricted stock units. Our existing stock-based awards consist mainly of non-qualified stock options and stock-settled stock appreciation rights (SARs). Stock options and SARs generally vest ratably over four years and may be exercised up to 10 years from the date of grant. Stock option and SAR activity is summarized in the table below (shares in millions):

 

     Three Months Ended
June 30, 2006
   Six Months Ended
June 30, 2006
     Shares     Weighted-
Average
Exercise Price
   Shares     Weighted-
Average
Exercise Price

Outstanding at Beginning of Period

   178.3     $ 24    186.8     $ 23

Granted

   16.5     $ 49    18.6     $ 50

Exercised

   (5.1 )   $ 17    (14.7 )   $ 15

Forfeited

   (1.3 )   $ 39    (2.3 )   $ 36
                         

Outstanding at End of Period

   188.4     $ 26    188.4     $ 26
                         

Exercisable at End of Period

   112.9     $ 16    112.9     $ 16
                         

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

As of June 30, 2006 (shares in millions):

 

     Options Outstanding    Options Exercisable

Range of Exercise Prices

   Number
Outstanding
   Weighted-
Average
Remaining
Option Term
(years)
   Weighted-
Average
Exercise
Price
   Number
Exercisable
   Weighted-
Average
Exercise
Price

$  1.68 – $13.17

   56.3    3.5    $ 7    56.3    $ 7

$13.18 – $26.18

   55.4    6.2    $ 20    41.3    $ 20

$26.40 – $47.34

   47.6    8.3    $ 40    14.7    $ 38

$47.69 – $62.90

   29.1    9.6    $ 52    0.6    $ 54
                            

$  1.68 – $62.90

   188.4    6.4    $ 26    112.9    $ 16
                            

To determine compensation expense related to our stock options and SARs, the fair value of each award grant is estimated on the date of grant using an option-pricing model. For purposes of estimating the fair value of our employee stock option and SAR grants, we utilize a binomial model. The principal assumptions we used in applying the option-pricing models were as follows:

 

     Three Months Ended
June 30
   Six Months Ended
June 30
     2006    2005    2006    2005

Risk Free Interest Rate

   4.7%-5.1%    2.7%-4.2%    4.1%-5.1%    2.4%-4.2%

Expected Volatility

   26.8%    24.3%    25.5%    23.9%

Expected Dividend Yield

   0.1%    0.1%    0.1%    0.1%

Forfeiture Rate

   5.0%    5.0%    5.0%    5.0%

Expected Life in Years

   4.1       4.1       4.1       4.1   

The risk-free interest rate is based on U.S. Treasury yields in effect at the time of grant. Expected volatilities are based on a blend of the implied volatilities from traded options on our common stock and the historical volatility of our common stock. We use historical data to estimate option and SAR exercises and employee terminations within the valuation model. The expected term of options and SARs granted represents the period of time that the awards granted are expected to be outstanding based on historical exercise patterns.

The weighted-average fair value of stock options and SARs granted in each of the three and six months ended June 30, 2006 was $11 per share. The weighted-average fair value of stock options and SARs granted in each of the three and six months ended June 30, 2005 was $13 per share. The aggregate fair value of stock options and SARs that vested during the three and six months ended June 30, 2006 was $55 million and $168 million, respectively. The aggregate fair value of stock options and SARs that vested during the three and six months ended June 30, 2005 was $145 million and $160 million, respectively. As of June 30, 2006, the aggregate intrinsic value of outstanding stock options and SARs was $3.7 billion, with a weighted-average remaining contractual term of 6.4 years. The aggregate intrinsic value of exercisable stock options and SARs at that same date was $3.3 billion, with a weighted-average remaining contractual term of 5.0 years. The total intrinsic value of options and SARs exercised during the three and six months ended June 30, 2006, was $153 million and $576 million, respectively. The total intrinsic value of options and SARs exercised during the three and six months ended June 30, 2005, was $180 million and $437 million, respectively.

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Restricted stock awards generally vest ratably over two to four years. Compensation expense related to restricted stock awards is determined based upon the fair value of each award on the date of grant. Restricted stock award activity is summarized in the table below (shares in millions):

 

     Three Months Ended
June 30, 2006
   Six Months Ended
June 30, 2006
     Shares    Weighted-Average
Grant-Date Fair
Value
   Shares     Weighted-Average
Grant-Date Fair
Value

Outstanding at Beginning of Period

   1.8    $ 58    1.8     $ 58

Granted

           0.1     $ 59

Vested

           (0.1 )   $ 32
                        

Outstanding at End of Period

   1.8    $ 58    1.8     $ 59
                        

We recognize compensation cost for stock-based awards, including stock options, SARs, restricted stock and restricted stock units, on a straight-line basis over the related service period (generally the vesting period) of the award, or to an employee’s eligible retirement date under the award agreement, if earlier. For the three and six months ended June 30, 2006, we recognized compensation expense related to our stock-based compensation plans of $94 million ($40 million net of tax effects) and $184 million ($78 million net of tax effects), respectively. For the three and six months ended June 30, 2005, we recognized compensation expense of $75 million ($45 million net of tax effects) and $144 million ($85 million net of tax effects), respectively. Stock-based compensation expense is recognized within Operating Costs in the Condensed Consolidated Statements of Operations. As of June 30, 2006, there was $826 million of total unrecognized compensation cost related to stock awards that is expected to be recognized as an expense over a weighted-average period of approximately 1.5 years.

For the three and six months ended June 30, 2006, the income tax benefit realized from stock-based awards was $58 million and $219 million, respectively. For the three and six months ended June 30, 2005, the income tax benefit realized from stock-based awards was $57 million and $143 million, respectively.

As further discussed in Note 9, we maintain a common stock repurchase program. The objective of our share repurchase program is to optimize our capital structure, cost of capital and return to shareholders, as well as to offset the dilutive impact of shares issued for stock-based award exercises.

Our Employee Stock Purchase Plan, allows employees to purchase the Company’s stock at a discounted price based on the lower of the price on the first day or the last day of the six-month purchase period. The compensation expense is included in the compensation expense amounts recognized and discussed above. We also offer a 401(k) plan for all employees of the Company.

We have provided Supplemental Executive Retirement Plan benefits (SERPs), which are non-qualified defined benefit plans, for our current Chief Executive Officer (CEO), former CEO and certain nonexecutive officer employees (which were assumed in an acquisition). No additional amounts will accrue under the SERPs to our former CEO and current CEO. The SERPs are non-contributory, unfunded and provide benefits based on years of service and compensation during employment. Pension expense is determined using various actuarial methods to estimate the total benefits ultimately payable to executives, and is allocated to service periods. The actuarial assumptions used to calculate pension costs are reviewed annually.

In addition, the Company maintains non-qualified, unfunded deferred compensation plans, which allow certain members of senior management and executives to defer portions of their salary or bonus and receive certain Company contributions on such deferrals, subject to plan limitations. The deferrals are recorded within Long-Term Investments with an equal offsetting amount in Long-Term Other Liabilities in the Condensed Consolidated Balance Sheets. The total deferrals are distributable based upon termination of employment or other periods as elected under the plans.

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

As discussed in Note 2, the Company has restated its previously filed financial statements to reflect additional stock-based compensation expense and related tax effects following an independent investigation of its historic stock option practices.

 

11. AARP

In January 1998, we entered into a ten-year contract with AARP to provide health insurance products and services to members of AARP. These products and services include benefits which supplement traditional Medicare, hospital indemnity insurance, health insurance focused on persons between 50 and 64 years of age, and other products. Under the terms of the Medicare Supplement Insurance contract, we are compensated for transaction processing and other services as well as for assuming underwriting risk. We are also engaged in product development activities to complement the insurance offerings under this program. Premium revenues from these AARP Medicare Supplement Insurance offerings are approximately $5.0 billion annually.

The underwriting gains or losses related to the AARP Medicare Supplement Insurance business are directly recorded as an increase or decrease to a rate stabilization fund (RSF). The primary components of the underwriting results are premium revenue, medical costs, investment income, administrative expenses, member service expenses, marketing expenses and premium taxes. Underwriting gains and losses are recorded as an increase or decrease to the RSF and accrue to the overall benefit of the AARP policyholders, unless cumulative net losses were to exceed the balance in the RSF. To the extent underwriting losses exceed the balance in the RSF, we would have to fund the deficit. Any deficit we fund could be recovered by underwriting gains in future periods of the contract. To date, we have not been required to fund any underwriting deficits. The RSF balance is reported in Other Policy Liabilities in the accompanying Condensed Consolidated Balance Sheets and changes in the RSF are reported in Medical Costs in the Condensed Consolidated Statements of Operations. We believe the RSF balance at June 30, 2006 is sufficient to cover potential future underwriting and other risks associated with the contract.

The following AARP Medicare Supplement Insurance program-related assets and liabilities are included in our Condensed Consolidated Balance Sheets (in millions):

 

     Balance as of
     June 30,
2006
   December 31,
2005

Accounts Receivable

   $ 421    $ 414

Assets Under Management

   $ 1,777    $ 1,792

Medical Costs Payable

   $ 1,050    $ 1,001

Other Policy Liabilities

   $ 855    $ 939

Other Current Liabilities

   $ 293    $ 266

The effects of changes in balance sheet amounts associated with the AARP Medicare Supplement Insurance program accrue to the overall benefit of the AARP policyholders through the RSF balance. Accordingly, we do not include the effect of such changes in our Condensed Consolidated Statements of Cash Flows.

Pursuant to our agreement, AARP assets under management are managed separately from our general investment portfolio and are used to pay costs associated with the AARP Medicare Supplement Insurance program. These assets are invested at our discretion, within investment guidelines approved by AARP. We do not guarantee any rates of investment return on these investments and, upon transfer of the AARP Medicare Supplement Insurance contract to another entity, we would transfer cash equal in amount to the fair value of these investments at the date of transfer to that entity. Interest earnings and realized investment gains and losses on these assets accrue to the overall benefit of the AARP policyholders through the RSF and, thus, they are not included in our earnings. Assets under management are reported at their fair market value, and unrealized gains and losses are included directly in the RSF associated with the AARP Medicare Supplement Insurance program. As of June 30, 2006, the amortized cost, gross unrealized gains and losses, and fair value of cash, cash equivalents and investments

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

associated with the AARP Medicare Supplement Insurance program, included in Assets Under Management, were as follows (in millions):

 

     Amortized
Cost
  

Gross

Unrealized Gains

   Gross
Unrealized Losses
   Fair
Value

Cash and Cash Equivalents

   $ 431    $ —        $ —       $ 431

Debt Securities — Available for Sale

     1,387      2          (43)        1,346
                           

Total Cash and Investments

   $ 1,818    $ 2        $ (43)      $ 1,777
                           

As of June 30, 2006, we had investments with an aggregate fair value of $196 million under the AARP agreement in a continuous unrealized loss position of $10 million for 12 months or greater. These investments are subject to the same processes and reviews as the rest of our investment portfolio, including impairment analyses. As a result of these reviews, as is further discussed in Note 5, we did not identify any other-than-temporary impairments.

Under a separate license agreement with AARP, we sell Medicare Prescription Drug benefit plans under the AARP brand name. We assume all operational and underwriting risks and losses for these plans.

 

12. Comprehensive Income

The table below presents comprehensive income, defined as changes in the equity of our business excluding changes resulting from investments by and distributions to our shareholders, for the three and six months ended June 30 (in millions):

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,
 
     2006     2005    2006     2005  

Net Earnings

   $ 981     $ 769    $ 1,872     $ 1,505  

Change in Net Unrealized (Losses)/Gains on Investments, net of tax effects

     (45 )     81      (126 )     (9 )
                               

Comprehensive Income

   $ 936     $ 850    $ 1,746     $ 1,496  
                               

 

13. Segment Financial Information

The following is a description of the types of products and services from which each of our business segments derives its revenues:

 

 

Health Care Services consists of the UnitedHealthcare, Ovations and AmeriChoice businesses. UnitedHealthcare offers a comprehensive array of consumer-oriented health benefit plans and services for the public sector, small and mid-sized employers and individuals nationwide. Ovations provides health and well-being services to individuals age 50 and older, including the administration of supplemental health insurance coverage on behalf of AARP. AmeriChoice provides network-based health and well-being services to beneficiaries of state Medicaid, Children’s Health Insurance Programs and other government-sponsored health care programs. The financial results of UnitedHealthcare, Ovations and AmeriChoice have been combined in the Health Care Services segment column in the tables presented below because these businesses have similar economic characteristics and have similar products and services, types of customers, distribution methods and operational processes, and operate in a similar regulatory environment, typically within the same legal entity.

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Uniprise provides network-based health and well-being services, business-to-business transaction processing services, consumer connectivity and technology support services nationwide to large employers and health plans, and provides health-related consumer and financial transaction products and services.

 

 

Specialized Care Services offers a comprehensive platform of specialty health, wellness and ancillary benefits, services and resources to specific customer markets nationwide.

 

 

Ingenix offers database and data management services, software products, publications, consulting services, outsourced services and pharmaceutical development and consulting services on a national and international basis.

Transactions between business segments principally consist of customer service and transaction processing services that Uniprise provides to Health Care Services, certain product offerings sold to Uniprise and Health Care Services customers by Specialized Care Services, and sales of medical benefits cost, quality and utilization data and predictive modeling to Health Care Services and Uniprise by Ingenix. These transactions are recorded at management’s estimate of fair value. All intersegment transactions are eliminated in consolidation. Assets and liabilities that are jointly used are assigned to each segment using estimates of pro-rata usage. Cash and investments are assigned such that each segment has minimum specified levels of regulatory capital or working capital for non-regulated businesses.

The following table presents segment financial information for the three and six months ended June 30, 2006 and 2005 (in millions):

 

Three Months Ended June 30, 2006

   Health
Care
Services
   Uniprise    Specialized
Care
Services
   Ingenix    Intersegment
Eliminations
    Consolidated

Revenues — External Customers

   $ 15,889    $ 1,057    $ 575    $ 148    $     $ 17,669

Revenues — Intersegment

          279      405      68      (752 )    

Investment and Other Income

     170      13      11                 194
                                          

Total Revenues

   $ 16,059    $ 1,349    $ 991    $ 216    $ (752 )   $ 17,863
                                          

Earnings from Operations

   $ 1,227    $ 221    $ 189    $ 30    $     $ 1,667
                                          

Three Months Ended June 30, 2005

   Health
Care
Services
   Uniprise    Specialized
Care
Services
   Ingenix    Intersegment
Eliminations
    Consolidated

Revenues — External Customers

   $ 9,700    $ 1,030    $ 402    $ 118    $     $ 11,250

Revenues — Intersegment

          186      270      60      (516 )    

Investment and Other Income

     114      9      6                 129
                                          

Total Revenues

   $ 9,814    $ 1,225    $ 678    $ 178    $ (516 )   $ 11,379
                                          

Earnings from Operations

   $ 924    $ 187    $ 131    $ 20    $     $ 1,262
                                          

Six Months Ended June 30, 2006

   Health
Care
Services
   Uniprise    Specialized
Care
Services
   Ingenix    Intersegment
Eliminations
    Consolidated

Revenues — External Customers

   $ 31,510    $ 2,101    $ 1,148    $ 292    $     $ 35,051

Revenues — Intersegment

          555      802      132      (1,489 )    

Investment and Other Income

     344      27      22                 393
                                          

Total Revenues

   $ 31,854    $ 2,683    $ 1,972    $ 424    $ (1,489 )   $ 35,444
                                          

Earnings from Operations 

   $ 2,284    $ 430    $ 366    $ 60    $     $ 3,140
                                          

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Six Months Ended June 30, 2005 (As Restated)

   Health
Care
Services
   Uniprise    Specialized
Care
Services
   Ingenix    Intersegment
Eliminations
    Consolidated

Revenues — External Customers

   $ 19,225    $ 2,045    $ 784    $ 229    $     $ 22,283

Revenues — Intersegment

          362      530      119      (1,011 )    

Investment and Other Income

     215      17      11                 243
                                          

Total Revenues

   $ 19,440    $ 2,424    $ 1,325    $ 348    $ (1,011 )   $ 22,526
                                          

Earnings from Operations 

   $ 1,815    $ 359    $ 251    $ 35    $     $ 2,460
                                          

 

14. Commitments and Contingencies

Legal Matters Relating to our Historic Stock Option Practices

Regulatory Inquiries

In March 2006, we received an informal inquiry from the SEC relating to our historic stock option practices.

On May 17, 2006, we received a document request from the Internal Revenue Service seeking documents relating to stock option grants and other compensation for the persons who from 2003 to the present were the named executive officers in our annual proxy statements.

On May 17, 2006, we received a subpoena from the U.S. Attorney for the Southern District of New York requesting documents from 1999 to the present relating to our stock option practices.

On June 6, 2006, we received a Civil Investigative Demand from the Minnesota Attorney General requesting documents from January 1, 1997 to the present concerning our executive compensation and stock option practices. After filing an action in Ramsey County Court, State of Minnesota, captioned UnitedHealth Group Incorporated vs. State of Minnesota, by Lori Swanson, Attorney General, we filed a Motion for Protective Order which was denied by the trial court. We are pursuing an appeal of the Order denying the Protective Order.

On December 19, 2006, we received from the Enforcement Division staff of the SEC a formal order of investigation into the Company’s historic stock option practices.

We have also received requests for documents from U.S. Congressional committees relating to our historic stock option practices and compensation of executives. With the exception of the Civil Investigative Demand from the Minnesota Attorney General, we have generally cooperated and will continue to cooperate with the regulatory authorities. At the conclusion of these regulatory inquiries, we could be subject to regulatory or criminal fines or penalties as well as other sanctions or other contingent liabilities, which could be material.

Litigation Matters

On March 29, 2006, the first of several shareholder derivative actions was filed against certain of our current and former officers and directors in the United States District Court for the District of Minnesota. The action has been consolidated with six other actions and is captioned In re UnitedHealth Group Incorporated Shareholder Derivative Litigation. The consolidated amended complaint is brought on behalf of the Company by several pension funds and other shareholders and names certain of our current and former directors and officers as defendants, as well as the Company as a nominal defendant. The consolidated amended complaint generally alleges that defendants breached their fiduciary duties to the Company, were unjustly enriched, and violated the

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

securities laws in connection with our historic stock option practices. The consolidated amended complaint seeks unspecified money damages, injunctive relief and rescission of the options. On June 26, 2006, our Board of Directors created a Special Litigation Committee under Minnesota Statute 302A.241, consisting of two former Minnesota Supreme Court Justices, with the power to investigate the claims raised in the derivative actions and a shareholder demand, and determine whether the Company’s rights and remedies should be pursued. Based on the existence of our Special Litigation Committee, defendants have moved to dismiss or in the alternative to stay the litigation pending resolution of the Special Litigation Committee process. A consolidated derivative action, reflecting a consolidation of two actions, is also pending in Hennepin County District Court, State of Minnesota. The consolidated complaint is captioned In re UnitedHealth Group Incorporated Derivative Litigation. The action was brought by two individual shareholders and names certain of our current and former officers and directors as defendants, as well as the Company as nominal defendant. On February 6, 2007, the State Court Judge entered an order staying the action pending resolution of the Special Litigation Committee process.

On May 5, 2006, the first of seven putative class actions alleging a violation of the federal securities laws was brought by an individual shareholder against certain of our current and former officers and directors in the United States District Court for the District of Minnesota. On December 8, 2006 a consolidated amended complaint was filed consolidating the actions into a single action. The action is captioned In re UnitedHealth Group Incorporated PSLRA Litigation. The action was brought by lead plaintiff California Public Employees Retirement System against the Company and certain of our current and former officers and directors. The consolidated amended complaint alleges that defendants, in connection with the same alleged course of conduct identified in the shareholder derivative actions described above, made misrepresentations and omissions during the period between January 20, 2005 and May 17, 2006, in press releases and public filings that artificially inflated the price of our common stock. The consolidated amended complaint also asserts that during the class period, certain defendants sold shares of our common stock while in possession of material, non-public information concerning the matters set forth in the complaint. The consolidated amended complaint alleges claims under Sections 10(b), 14(a), 20(a) and 20A of the Securities and Exchange Act of 1934 and Sections 11 and 15 of the Securities Act of 1933. The action seeks unspecified money damages and equitable relief. Defendants moved to dismiss the consolidated amended complaint on February 6, 2007. We intend to vigorously defend against the action.

On June 6, 2006, a purported class action captioned Zilhaver v. UnitedHealth Group Incorporated, was filed against the Company and certain of our current and former officers and directors in the United State District Court for the District of Minnesota. This action alleges that the fiduciaries to the Company-sponsored 401(k) plan violated ERISA by allowing the plan to continue to hold Company stock. Defendants filed a motion to dismiss on February 6, 2007. The Company will vigorously pursue the action.

On August 28, 2006, we received a purported notice of default from persons claiming to hold certain of our debt securities alleging a violation of our indenture governing our debt securities. This followed our announcement that we would delay filing our quarterly report on Form 10-Q for the quarter ended June 30, 2006. On October 25, 2006, we filed an action in the United States District Court for the District of Minnesota, captioned UnitedHealth Group Incorporated v. Cede & Co. and the Bank of New York, seeking a declaratory judgment that we are not in default under the terms of the indenture. On or about November 2, 2006, we received a purported notice of acceleration from the holders who previously sent the notice of default that purports to declare an acceleration of our 5.8% Senior Unsecured Notes due March 15, 2036 as a result of our announcement that we would delay filing our quarterly report on Form 10-Q for the quarter ended June 30, 2006. Immediately prior to the filing of this Form 10-Q, we filed a quarterly report on Form 10-Q/A to amend our quarterly report on Form 10-Q for the quarter ended March 31, 2006, and immediately after the filing of this Form 10-Q, we will file our quarterly report on Form 10-Q for the quarter ended September 30, 2006, as well as our annual report on Form 10-K for the year ended December 31, 2006. Should the Company ultimately be unsuccessful in this matter, we

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

may be required to retire all or a portion of the $850 million of Senior Unsecured Notes due March 2036. We intend to vigorously prosecute the declaratory judgment action.

In addition, we may be subject to additional litigation or other proceedings or actions arising out of the Independent Committee’s review, the Special Litigation Committee’s review and the related restatement of our historical financial statements. Litigation and any potential regulatory proceeding or action may be time consuming, expensive and distracting from the conduct of our business. The adverse resolution of any specific lawsuit or any potential regulatory proceeding or action could have a material adverse effect on our business, financial condition and results of operations.

In addition, other adjustments for non-operating cash charges may be required in connection with the resolution of stock option-related matters arising under litigation, and regulatory reviews by the SEC, IRS, U.S. Attorney, U.S. Congressional committees and Minnesota Attorney General, the amount and timing of which are uncertain but which could be material.

Other Legal Matters

Because of the nature of our businesses, we are routinely made party to a variety of legal actions related to the design and management of our service offerings. We record liabilities for our estimates of probable costs resulting from these matters. These matters include, but are not limited to, claims relating to health care benefits coverage, medical malpractice actions, contract disputes and claims related to disclosure of certain business practices.

Beginning in 1999, a series of class action lawsuits were filed against both UnitedHealthcare and PacifiCare, and virtually all major entities in the health benefits business. In December 2000, a multidistrict litigation panel consolidated several litigation cases involving the Company and our affiliates in the Southern District Court of Florida, Miami division. Generally, the health care provider plaintiffs allege violations of ERISA and the Racketeer Influenced Corrupt Organization Act (RICO) in connection with alleged undisclosed policies intended to maximize profits. Other allegations include breach of state prompt payment laws and breach of contract claims for failure to timely reimburse providers for medical services rendered. The consolidated suits seek injunctive, compensatory and equitable relief as well as restitution, costs, fees and interest payments. The trial court granted the health care providers’ motion for class certification and that order was reviewed by the Eleventh Circuit Court of Appeals. The Eleventh Circuit affirmed the class action status of the RICO claims, but reversed as to the breach of contract, unjust enrichment and prompt payment claims. During the course of the litigation, there have been co-defendant settlements. On January 31, 2006, the trial court dismissed all remaining claims against PacifiCare, and on June 19, 2006, the trial court dismissed all remaining claims against UnitedHealthcare brought by the lead plaintiff. The tag-along lawsuits remain outstanding. On July 27, 2006, the plaintiffs filed a notice of appeal to the Eleventh Circuit Court of Appeals challenging the dismissal of the claims against UnitedHealthcare. We intend to vigorously defend against the action.

On March 15, 2000, the American Medical Association filed a lawsuit against the Company in the Supreme Court of the State of New York, County of New York. On April 13, 2000, we removed this case to the United States District Court for the Southern District of New York. The suit alleges causes of action based on ERISA, as well as breach of contract and the implied covenant of good faith and fair dealing, deceptive acts and practices, and trade libel in connection with the calculation of reasonable and customary reimbursement rates for non-network providers. The suit seeks declaratory, injunctive and compensatory relief as well as costs, fees and interest payments. An amended complaint was filed on August 25, 2000, which alleged two classes of plaintiffs, an ERISA class and a non-ERISA class. After the Court dismissed certain ERISA claims and the claims brought by the American Medical Association, a third amended complaint was filed on January 11, 2002. On October 25,

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

2002, the court granted in part and denied in part our motion to dismiss the third amended complaint. On May 21, 2003, we filed a counterclaim complaint in this matter alleging antitrust violations against the American Medical Association and asserting claims based on improper billing practices against an individual provider plaintiff. On May 26, 2004, we filed a motion for partial summary judgment seeking the dismissal of certain claims and parties based, in part, due to lack of standing. On July 16, 2004, plaintiffs filed a motion for leave to file an amended complaint, seeking to assert RICO violations. On December 29, 2006, the trial court granted plaintiffs’ motion to amend the complaint. We intend to vigorously defend against the action.

Government Regulation

Our business is regulated at federal, state, local and international levels. The laws and rules governing our business and interpretations of those laws and rules are subject to frequent change. Broad latitude is given to the agencies administering those regulations. State legislatures and Congress continue to focus on health care issues as the subject of proposed legislation. Existing or future laws and rules could force us to change how we do business, restrict revenue and enrollment growth, increase our health care and administrative costs and capital requirements, and increase our liability in federal and state courts for coverage determinations, contract interpretation and other actions. Further, we must obtain and maintain regulatory approvals to market many of our products.

We typically have been and are currently involved in various governmental investigations, audits and reviews. These include routine, regular and special investigations, audits, and reviews by CMS, state insurance and health and welfare departments, state attorneys general, the Office of the Inspector General, the Office of Personnel Management, the Office of Civil Rights, U.S. Congressional committees, the U.S. Department of Justice and U.S. Attorneys. Such government actions can result in assessment of damages, civil or criminal fines or penalties, or other sanctions, including loss of licensure or exclusion from participation in government programs. We also are subject to a formal investigation of our historic stock option practices by the SEC, the Internal Revenue Service, U.S. Attorney for the Southern District of New York, Minnesota Attorney General, and a related review by the Special Litigation Committee of the Company, and we have received requests for documents from U.S. Congressional committees as described in Item 1 — “Legal Proceedings.” With the exception of the Civil Investigative Demand from the Minnesota Attorney General, we have generally cooperated and will continue to cooperate with the regulatory authorities. At the conclusion of these regulatory inquiries, we could be subject to regulatory or criminal fines or penalties as well as other sanctions or other contingent liabilities, which could be material.

Due to the financial restatements reflected in the 2006 Form 10-K to be filed with the SEC on the date hereof, we have determined that certain options exercised by our nonexecutive officer employees in 2006 were discount options subject to Section 409A of the Internal Revenue Code. We notified the Internal Revenue Service (IRS) on February 28, 2007 that we would participate in the IRS’s resolution program which allows us to pay our employees’ tax costs under Section 409A. As such, we will take a charge, net of tax benefit, of approximately $55 million in the first quarter of 2007.

In conjunction with the PacifiCare acquisition we committed to make $50 million in charitable contributions to the benefit of California health care consumers, which has been accrued on our Consolidated Balance Sheets. Additionally, we agreed to invest $200 million in California’s health care infrastructure to further health care services to the underserved populations of the California marketplace. The timing and amount of individual contributions and investments are at our discretion, subject to the advice and oversight of local regulatory authorities; however, our goal is to have the investment commitment fully funded by the end of 2010. The investment commitment remains in place for 20 years after full funding. We have committed to specific projects totaling $12 million of the $50 million charitable commitment at this time.

 

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UNITEDHEALTH GROUP

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

15. Recent Accounting Standards

Recently Adopted Accounting Standards

Effective January 1, 2006, we adopted FAS 123R, “Share-Based Payment,” which revises FAS No. 123, “Accounting for Stock-Based Compensation.” See Note 2 for details on its impact to our Condensed Consolidated Financial Statements.

Accounting Standards Issued Subsequent to June 30, 2006

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (FIN 48), which clarifies the accounting for uncertain tax positions. FIN 48 provides that the tax effects from an uncertain tax position are recognized only if it is more likely than not that the position will be sustained upon examination based on the technical merits of the position. The provisions of FIN 48 are effective for our 2007 fiscal year. We are currently evaluating the impact of adopting FIN 48 on our Consolidated Financial Statements. The cumulative effect of adopting this Interpretation will be recorded as a charge to retained earnings. We do not expect that the adoption of FIN 48 will have a material impact on our Consolidated Financial Statements.

In September 2006, the FASB issued FAS No. 157, “Fair Value Measurements” (FAS 157), which establishes a framework for reporting fair value and expands disclosures about fair value measurements. FAS 157 is effective for our 2008 fiscal year. We are currently evaluating the impact of this standard on our condensed consolidated financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (SAB 108). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. Under SAB 108, registrants should quantify errors using both a balance sheet and income statement approach (“dual approach”) and evaluate whether either approach results in a misstatement that is material, when all relevant quantitative and qualitative factors are considered. We will adopt SAB 108 on December 31, 2006.

In September 2006, the FASB issued FAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (FAS 158). This statement requires (a) balance sheet recognition of the overfunded or underfunded status of pension and postretirement benefit plans and (b) recognition, as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost. FAS 158 also requires additional disclosures in the notes to the consolidated financial statements. We will adopt FAS 158 on December 31, 2006. The adoption of this standard is not expected to have a material impact on our Condensed Consolidated Financial Statements.

In February 2007, the FASB issued FAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (FAS 159). FAS 159 permits an entity to elect fair value as the initial and subsequent measurement attribute for many financial assets and liabilities. Entities electing the fair value option would be required to recognize changes in fair value in earnings. Entities electing the fair value option are required to distinguish on the face of the statement of financial position, the fair value of assets and liabilities for which the fair value option has been elected and similar assets and liabilities measured using another measurement attribute. FAS 159 is effective for our fiscal year 2008. The adjustment to reflect the difference between the fair value and the carrying amount would be accounted for as a cumulative-effect adjustment to retained earnings as of the date of initial adoption. We are currently evaluating the impact, if any, of FAS 159 on our Consolidated Financial Statements.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read together with the accompanying unaudited condensed consolidated financial statements and notes. In addition, the following discussion should be considered in light of a number of factors that affect the Company, the industry in which we operate, and business generally. These factors are described in the Cautionary Statements section of this Quarterly Report.

Financial Restatements

All of the financial information presented in this Item 2 has been adjusted to reflect the restatement of the Company’s financial results, which is more fully described in the “Explanatory Note” immediately preceding Part I, Item 1 and in Note 2, “Restatement of Unaudited Condensed Consolidated Financial Statements” of the Notes to Condensed Consolidated Financial Statements in this Form 10-Q. The impact under Statement of Financial Accounting Standard No. 123 (revised 2004), “Share-Based Payment” (FAS 123R) of recognizing additional stock-based compensation expense and related tax effects as a result of historic stock option practices as well as immaterial adjustments unrelated to historic stock option practices that were identified through a review of the Company’s accounting practices is $43 million ($57 million net of tax) in 2005, $40 million ($44 million net of tax) in 2004, and an aggregate of $453 million ($313 million net of tax) for 2003 and all prior years. The impact under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) of all errors is $304 million ($238 million net of tax) in 2005, $200 million ($158 million net of tax) in 2004, and an aggregate of $1,056 million ($738 million net of tax) for 2003 and all prior years. The Company also conducted a sensitivity analysis to assess how the restatement adjustment would have changed under two alternative methodologies for determining measurement dates. See “— Critical Accounting Policies and Estimates — Stock Option Measurement Dates” for details.

Summary highlights of our second quarter 2006 results include:

 

 

Diluted net earnings per common share of $0.70, an increase of 21% from $0.58 per share reported in the second quarter of 2005.

 

 

Consolidated revenues of $17.9 billion increased $6.5 billion, or 57%, over the second quarter of 2005. Excluding the impact of acquisitions, consolidated revenues increased by approximately 21% over the prior year.

 

 

Earnings from operations of $1.7 billion, up $405 million, or 32%, over the prior year and up $194 million, or 13%, sequentially over the first quarter of 2006.

 

 

Cash flows from operations of $4.6 billion for the six months ended June 30, 2006, an increase of $2.2 billion, or 94% compared to $2.4 billion for the six months ended June 30, 2005, due in part to a $1.5 billion July CMS payment received in June 2006.

 

 

The consolidated medical care ratio of 81.6% increased from 80.3% in the second quarter of 2005, primarily due to the impact of the acquisition of PacifiCare Health Systems, Inc. (PacifiCare) in December 2005 and the launch of the Medicare Part D program beginning January 1, 2006.

 

 

The operating cost ratio of 13.9% for the second quarter of 2006 improved from 15.0% in the second quarter of 2005.

 

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Summary Operating Information

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
      2006     2005     Percent
Change
    2006     2005     Percent
Change
 

(In millions, except per share data)

      

Revenues

   $ 17,863     $ 11,379     57 %   $ 35,444     $ 22,526     57 %

Earnings from Operations

   $ 1,667     $ 1,262     32 %   $ 3,140     $ 2,460     28 %

Net Earnings

   $ 981     $ 769     28 %   $ 1,872     $ 1,505     24 %

Diluted Net Earnings Per Common Share

   $ 0.70     $ 0.58     21 %   $ 1.33     $ 1.13     18 %

Medical Care Ratio

     81.6 %     80.3 %       81.8 %     80.2 %  

Operating Cost Ratio

     13.9 %     15.0 %       14.1 %     15.2 %  

Return on Equity (annualized)

     22.1 %     29.0 %       21.0 %     28.2 %  

Operating Margin

     9.3 %     11.1 %       8.9 %     10.9 %  

UnitedHealth Group acquired PacifiCare in December 2005 for total consideration of approximately $8.8 billion. The results of operations and financial condition of PacifiCare have been included in UnitedHealth Group’s consolidated financial statements since the respective acquisition date. On January 1, 2006, UnitedHealth Group began providing Medicare Part D prescription drug insurance coverage. The acquisition of PacifiCare and the new Medicare Part D product offering impact the comparability of results for the three and six months ended June 30, 2006 financial information to the prior year. We adopted FAS 123R, as of January 1, 2006 using the modified retrospective transition method, under which all prior period financial statements are required to be restated to recognize compensation cost in the amounts historically disclosed in our Consolidated Financial Statements under FAS 123, “Accounting for Stock-Based Compensation” (FAS 123).

 

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Results of Operations

Consolidated Financial Results

Revenues

Revenues consist of premium revenues from risk-based products; service revenues, which primarily include fees for management, administrative and consulting services and product revenues; and investment and other income.

Premium revenues are primarily derived from risk-based health insurance arrangements in which the premium is fixed, typically for a one-year period, and we assume the economic risk of funding our customers’ health care services and related administrative costs. Service revenues consist primarily of fees derived from services performed for customers that self-insure the medical costs of their employees and their dependents. For both premium risk-based and fee-based customer arrangements, we provide coordination and facilitation of medical services; transaction processing; customer, consumer and care provider services; and access to contracted networks of physicians, hospitals and other health care professionals. Through our Prescription Solutions pharmacy benefit management (PBM) business, revenues are derived from both products sold and administrative services. Product revenues are recognized upon sale or shipment because the price is fixed and the member cannot return the drugs or receive a refund. Service revenues are recognized when the prescription claim is adjudicated. Product revenues also include sales of Ingenix syndicated content products, which are recognized as revenue upon shipment.

Consolidated revenues for the three and six months ended June 30, 2006 of $17.9 billion and $35.4 billion, respectively, increased by $6.5 billion, or 57%, and $12.9 billion, or 57%, over the comparable 2005 periods. Excluding the impact of businesses acquired since the beginning of 2005, consolidated revenues increased by approximately $2.4 billion, or 21%, and $4.9 billion, or 22%, respectively, for the three and six months ended June 30, 2006 principally driven by the successful launch of the Medicare Part D program on January 1, 2006, rate increases on premium-based and fee-based services, and growth in the total number of individuals served. Following is a discussion of second quarter consolidated revenue trends for each of our revenue components.

Premium Revenues

Consolidated premium revenues for the three and six months ended June 30, 2006 of $16.4 billion and $32.6 billion, respectively, increased by $6.1 billion, or 59%, and $12.2 billion, or 59% over the comparable 2005 periods. Excluding the impact of acquisitions, consolidated premium revenues increased by approximately $2.3 billion, or 22%, and $4.6 billion, or 22%, over the comparable prior periods.

UnitedHealthcare premium revenues for the three and six months ended June 30, 2006 increased by $2.0 billion, or 31%, and $4.0 billion, or 31%, to $8.4 billion and $16.7 billion, respectively, over the comparable 2005 periods. Excluding premium revenues from businesses acquired since the beginning of 2005, UnitedHealthcare premium revenues were essentially flat for both the three and six months ended June 30, 2006. This was primarily due to average net premium rate increases of approximately 8% or above on UnitedHealthcare’s renewing commercial risk-based products offset by lower premium yields from new business due primarily to a larger portion of new customer sales coming from high-deductible lower-premium products (with correspondingly lower medical costs), as well as a decrease in the number of individuals served by UnitedHealthcare’s commercial risk-based products, excluding the impact of acquisitions. Ovations premium revenues for the three and six months ended June 30, 2006 increased by $3.9 billion and $7.8 billion to $6.1 billion and $12.1 billion, respectively, over the comparable 2005 periods. Excluding the impact of acquisitions, Ovations premium revenues for the three and six months ended June 30, 2006 increased by $2.1 billion, or 96%, and $4.3 billion, or 98%, respectively. The increases were driven primarily by the successful launch of the Medicare Part D program which had premium revenues of $1.5 billion and $3.1 billion for the three and six months ended June 30, 2006, respectively, and an increase in the number of individuals served by Medicare Advantage and Medicare supplement products, as well as rate increases on these products. Specialized Care

 

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Services premium revenues for the three and six months ended June 30, 2006 of $791 million and $1.6 billion increased by approximately $270 million and $550 million, respectively, over comparable 2005 periods. This was primarily due to the PacifiCare acquisition and strong growth in the number of individuals served under premium-based arrangements. The remaining premium revenue increase was from AmeriChoice’s Medicaid programs primarily driven by rate increases and a slight increase in the number of individuals served.

Service Revenues

Service revenues for the three and six months ended June 30, 2006 totaled $1.1 billion and $2.1 billion, respectively, an increase of $159 million, or 18%, and $317 million, or 18%, respectively over the comparable 2005 periods. Excluding the impact of acquisitions, service revenues increased by approximately 12% and 13%, respectively. The increase in service revenues was driven primarily by aggregate growth of 8% in the number of individuals served by Uniprise and UnitedHealthcare under fee-based arrangements during the six months ended June 30, 2006, as well as annual rate increases. In addition, Ingenix service revenues increased by approximately 22% for both the three and six months ended June 30, 2006 due to new business growth in the health information and contract research businesses and from businesses acquired since the beginning of 2005.

Product Revenues

Product revenues for the three and six months ended June 30, 2006 totaled $165 million and $330 million, respectively, an increase of $148 million and $287 million over the comparable 2005 periods. This was primarily due to pharmacy revenues at our PBM business, which was acquired in December 2005 with the purchase of PacifiCare.

Investment and Other Income

Investment and other income during the three and six months ended June 30, 2006 totaled $194 million and $393 million, respectively, representing increases of $65 million and $150 million, respectively, over the comparable periods in 2005. Interest income for the three and six months ended June 30, 2006 increased by $78 million and $139 million, respectively, over the comparable periods in 2005, principally due to the impact of increased levels of cash and fixed-income investments, due in part to the acquisition of PacifiCare as well as higher yields on fixed-income investments. Sales of investments resulted in net capital losses of $6 million for the three month period ended June 30, 2006 and capital gains of $20 million for the six month period ended June 30, 2006 compared with net capital gains of $7 million and $9 million for the three and six months ended June 30, 2005.

Medical Costs

The combination of pricing, benefit designs, consumer health care utilization and comprehensive care facilitation efforts is reflected in the medical care ratio (medical costs as a percentage of premium revenues). The consolidated medical care ratio for the three and six months ended June 30, 2006 of 81.6% and 81.8%, respectively, increased from 80.3% and 80.2% in the comparable 2005 periods. The medical care ratio increase resulted primarily from the impact of the acquisition of PacifiCare and the Medicare Part D program, both of which carry a higher medical care ratio than the historic UnitedHealth Group businesses.

For each period, our operating results include the effects of revisions in medical cost estimates related to all prior periods. Changes in medical cost estimates related to prior periods, resulting from more complete claim information and other changes in facts and circumstances, identified in the current period are included in total medical costs reported for the current period. Medical costs for the three months ended June 30, 2006 include approximately $150 million of favorable medical cost development, virtually all related to prior years. Medical costs for the three months ended June 30, 2005 include approximately $120 million of favorable medical cost development related to prior years and approximately $20 million of favorable medical cost development related

 

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to the first quarter of 2005. Medical costs for the six months ended June 30, 2006 and 2005 include approximately $370 million and $310 million, respectively, of favorable medical cost development related to prior years. The increase in net favorable medical cost development was partially due to a reduction in estimates for extension of benefit obligations based upon analysis of historical claim submissions.

Medical costs for the three months and six months ended June 30, 2006 increased $5.1 billion, or 62%, and $10.3 billion, or 63%, to $13.4 billion and $26.7 billion, respectively, due to the impact of businesses acquired since the beginning of 2005, medical costs associated with the new Medicare Part D program, and a medical cost trend of 7% to 8% on commercial risk-based business. Medical costs associated with the new Medicare Part D program for the three months and six months ended June 30, 2006 were $1.4 billion and $2.9 billion, respectively. Medical trend was due to both medical inflation and increases in health care consumption.

Operating Costs

The operating cost ratio (operating costs as a percentage of total revenues) for the three and six months ended June 30, 2006 of 13.9% and 14.1%, respectively, improved from 15.0% and 15.2% in the comparable 2005 periods. This decrease was primarily driven by revenue mix changes, with premium revenues growing at a faster rate than service revenues primarily due to the new Medicare Part D program and the PacifiCare acquisition. Operating costs as a percentage of premium revenues are generally considerably lower than operating costs as a percentage of fee-based revenues. Additionally, the decrease in the operating cost ratio reflected productivity gains from technology deployment and other cost management initiatives, including cost savings associated with the PacifiCare acquisition integration.

Operating costs for the three and six months ended June 30, 2006 increased $770 million, or 45%, and $1.6 billion, or 47%, to $2.5 billion and $5.0 billion, respectively, over the comparable 2005 periods. Excluding the impact of acquisitions, operating costs increased by approximately 15% and 16%, respectively, for the three and six months ended June 30, 2006. These increases were primarily due to the new Part D Program as well as a 4% increase in the total number of individuals served by Health Care Services and Uniprise during the six months ended June 30, 2006 over the comparable 2005 periods, (excluding the impact of acquisitions) growth in Specialized Care Services and Ingenix and general operating cost inflation, partially offset by productivity gains from technology deployment and other cost management initiatives.

Cost of Products Sold

Cost of products sold for the three and six months ended June 30, 2006 totaled $143 million and $280 million, respectively, an increase of $131 million and $252 million over the comparable 2005 periods. This was primarily due to pharmacy sales at our PBM business, which was acquired in December 2005 with the purchase of PacifiCare.

Depreciation and Amortization

Depreciation and amortization for the three and six month periods ended June 30, 2006 of $168 million and $325 million, respectively, increased from $108 million and $217 million in the comparable 2005 periods. The increases were primarily related to separately identifiable intangible assets acquired in business acquisitions since the beginning of 2005 and higher levels of computer equipment and capitalized software as a result of technology enhancements, business growth and businesses acquired since the beginning of 2005.

Income Taxes

Our effective income tax rate for the three and six months ended June 30, 2006 was 36.8% and 36.4%, respectively, compared to 36.3% and 36.1% in the comparable 2005 periods. The increase was mainly driven by the acquisition of PacifiCare which increased our business and income mix in states with higher income tax rates.

 

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Business Segments

The following summarizes the operating results of our business segments for the three and six months ended June 30 (in millions):

Revenues

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,
     2006     2005    

Percent

Change

   2006     2005    

Percent

Change

           (As Restated)     (As Restated)          (As Restated)     (As Restated)

Health Care Services

   $ 16,059     $ 9,814     64%    $ 31,854     $ 19,440     64%

Uniprise

     1,349       1,225     10%      2,683       2,424     11%

Specialized Care Services

     991       678     46%      1,972       1,325     49%

Ingenix

     216       178     21%      424       348     22%

Eliminations

     (752 )     (516 )   nm         (1,489 )     (1,011 )   nm   
                                         

Consolidated Revenues

   $ 17,863     $ 11,379     57%    $ 35,444     $ 22,526     57%
                                         

nm - not meaningful

Earnings from Operations

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,
     2006    2005   

Percent

Change

   2006    2005   

Percent

Change

          (As Restated)    (As Restated)         (As Restated)    (As Restated)

Health Care Services

   $ 1,227    $ 924    33%    $ 2,284    $ 1,815    26%

Uniprise

     221      187    18%      430      359    20%

Specialized Care Services

     189      131    44%      366      251    46%

Ingenix

     30      20    50%      60      35    71%
                                     

Consolidated Earnings from Operations

   $ 1,667    $ 1,262    32%    $ 3,140    $ 2,460    28%
                                     

Health Care Services

The Health Care Services segment, comprised of the UnitedHealthcare, Ovations and AmeriChoice businesses, had revenues for the three and six months ended June 30, 2006 of $16.1 billion and $31.9 billion, respectively, representing increases of $6.2 billion, or 64%, and $12.4 billion, or 64%, over the comparable 2005 periods. Excluding the impact of acquisitions, Health Care Services revenues for the three and six months ended June 30, 2006 increased by approximately $2.3 billion, or 23%, and $4.7 billion, or 24%, respectively.

UnitedHealthcare revenues for the three and six months ended June 30, 2006 increased by $2.1 billion, or 31%, and $4.2 billion, or 31% to $8.8 billion and $17.5 billion, respectively, over comparable 2005 periods. Excluding revenues from businesses acquired since the beginning of 2005, UnitedHealthcare revenues increased by approximately 1% and 2% for the three and six months ended June 30, 2006, respectively, over the comparable 2005 periods. This increase was primarily due to average net premium rate increases of approximately 8% or above on UnitedHealthcare’s renewing commercial risk-based products and an increase in the number of individuals served by UnitedHealthcare’s fee-based products offset by lower premium yields from new business due primarily to a larger portion of new customer sales generated from high-deductible lower-premium products (with correspondingly lower medical costs), as well as a decrease in the number of individuals served by UnitedHealthcare’s commercial risk-based products, excluding the impact of acquisitions. Ovations revenues increased by $4.1 billion and $8.1 billion to $6.4 billion and $12.6 billion, respectively, for the three and six months

 

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ended June 30, 2006. Excluding the impact of acquisitions, Ovations revenues for the three and six months ended June 30, 2006 increased by $2.2 billion, or 95%, and $4.3 billion, or 96%, respectively, over comparable 2005 periods. The increases were driven primarily by the successful launch of the Medicare Part D program, which contributed $1.5 billion and $3.1 billion, respectively, of premium revenues for the three and six months ended June 30, 2006, and an increase in the number of individuals served by Medicare Advantage and Medicare supplement products, as well as rate increases on these products. The remaining increases in Health Care Services revenues were attributable to a 6% and 7% increase in AmeriChoice’s revenues for the three and six month periods ended June 30, 2006, respectively, driven primarily by rate increases and an increase in the number of individuals served by Medicaid products.

The Health Care Services segment had earnings from operations of $1.2 billion and $2.3 billion, respectively, for the three and six months ended June 30, 2006, representing increases of $303 million, or 33%, and $469 million, or 26%, over the comparable 2005 periods. This increase was principally driven by acquisitions and increases in the number of individuals served by Ovations’ Medicare products and UnitedHealthcare’s fee-based products. The segment also benefited from productivity gains from technology deployment and other cost management initiatives, including cost savings associated with the PacifiCare acquisition integration. UnitedHealthcare’s commercial medical care ratio increased to 79.9% in the second quarter from 78.8% in the second quarter of 2005. The increase was mainly due to the impact of the acquisition of PacifiCare and changes in product, business and customer mix. Health Care Services’ operating margin for the three and six months ended June 30, 2006 was 7.6% and 7.2%, respectively, representing decreases of 180 basis points and 210 basis points over the comparable 2005 periods driven by the acquisition of PacifiCare and the new Medicare Part D program which have lower operating margins than historic Health Care Services businesses.

The following table summarizes individuals served by Health Care Services, by major market segment and funding arrangement, as of June 30 (in thousands) (1):

 

     2006    2005

Commercial

     

Risk-based

   9,945    7,700

Fee-based

   4,640    3,455
         

Total Commercial

   14,585    11,155

Medicare Advantage

   1,395    355

Medicare Part D Stand-alone

   4,450   

Medicaid

   1,360    1,265
         

Total Health Care Services

   21,970    12,775
         

(1) Excludes individuals served by Ovations’ Medicare supplement products provided to AARP members as well as Medicare institutional and Medicaid long-term care members.

The number of individuals served by UnitedHealthcare’s commercial business as of June 30, 2006 increased 3.4 million, or 31%, over the second quarter of 2005. Excluding the impact of acquisitions, commercial business increased by 345,000, or 3%, over the prior year. This included an increase of approximately 750,000 in the number of individuals served with commercial fee-based products, driven by new customer relationships and customers converting from risk-based products to fee-based products, offset by a decrease of approximately 405,000 in the number of individuals served with commercial risk-based products due primarily to the Company’s internal pricing decisions in a competitive commercial risk-based pricing environment and the conversion of individuals to fee-based products.

Excluding acquisitions, the number of individuals served by Ovations’ Medicare Advantage products increased by 255,000, or 72%, from the second quarter of 2005 due primarily to new customer relationships. Excluding the impact of acquisitions, AmeriChoice’s Medicaid enrollment increased 15,000, or 1%, primarily due to new customer gains partially offset by the withdrawal of participation in one market during 2005.

 

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Uniprise

Uniprise revenues for the three and six months ended June 30, 2006 were $1.3 billion and $2.7 billion, respectively, representing increases of $124 million, or 10%, and $259 million, or 11% over the comparable 2005 periods. Excluding revenues from businesses acquired since the beginning of 2005, Uniprise revenues increased by 5% and 6% for the three and six months ended June 30, 2006, respectively, over the comparable 2005 periods. This increase was driven primarily by growth of 4% in the number of individuals served by Uniprise during the six months ended June 30, 2006 over the comparable period of 2005, excluding the impact of acquisitions, and annual service fee rate increases for self-insured customers. Uniprise served 11.0 million and 10.5 million individuals as of June 30, 2006 and 2005, respectively.

Uniprise earnings from operations for the three and six months ended June 30, 2006 were $221 million and $430 million, respectively, representing increases of $34 million, or 18%, and $71 million, or 20%, over the comparable 2005 periods. Operating margins improved to 16.4% and 16.0%, respectively, for the three and six months ended June 30, 2006 from 15.3% and 14.8% in the comparable 2005 periods. Uniprise has expanded its operating margin through operating cost efficiencies derived from process improvements, technology deployment and cost management initiatives that have reduced labor and occupancy costs in its transaction processing and customer service, billing and enrollment functions. Additionally, Uniprise’s infrastructure can be scaled efficiently, allowing its business to grow revenues at a proportionately higher rate than the associated growth in operating expenses.

Specialized Care Services

Specialized Care Services had revenues of $991 million and $2.0 billion, respectively, for the three and six months ended June 30, 2006, representing increases of $313 million, or 46%, and $647 million, or 49%, respectively, over the comparable 2005 periods. Excluding the impact of acquisitions, revenues increased by 23% and 26% over the prior year periods. This increase was principally driven by an increase in the number of individuals served and rate increases.

Earnings from operations for the three and six months ended June 30, 2006 of $189 million and $366 million, respectively, represent increases of $58 million, or 44%, and $115 million, or 46%, over the comparable 2005 periods. Specialized Care Services’ operating margins decreased to 19.1% and 18.6%, respectively, for the three and six months ended June 30, 2006 from 19.3% and 18.9% in the comparable 2005 periods. This decrease was due to a business mix shift toward higher revenue, lower margin products including the impact of the PacifiCare acquisition, partially offset by operational and productivity improvements within Specialized Care Services’ businesses.

Ingenix

Ingenix revenues for the three and six months ended June 30, 2006 of $216 million and $424 million, respectively, increased by $38 million, or 21%, and $76 million, or 22% over the comparable 2005 periods due primarily to new business growth in the health information and contract research businesses, as well as businesses acquired since the beginning of 2005.

Earnings from operations were $30 million and $60 million, respectively, for the three and six months ended June 30, 2006, up $10 million, or 50%, and $25 million, or 71%, from the comparable 2005 periods. Ingenix’s operating margins were 13.9% and 14.2% for both of the three and six months ended June 30, 2006, up from 11.2% and 10.1% in the comparable 2005 periods. These increases were driven by growth in the health information and pharmaceutical services businesses, cost management initiatives and businesses acquired since the beginning of 2005. Ingenix typically generates higher revenues and operating margins in the second half of the year due to seasonally strong demand for higher margin health information products.

 

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Financial Condition and Liquidity at June 30, 2006

Liquidity and Capital Resources

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 strong financial flexibility and liquidity. We forecast, analyze and monitor our cash flows to enable prudent investment management and financing within the confines of our financial strategy.

Our regulated subsidiaries generate significant cash flows from operations. A majority of the assets held by our regulated subsidiaries are in the form of cash, cash equivalents and investments. After considering expected cash flows from operating activities, we generally invest cash of regulated subsidiaries that exceed our short-term obligations in longer term, investment-grade, marketable debt securities to improve our overall investment return. Factors we consider in making these investment decisions include our Board of Directors’ approved investment policy, regulatory limitations, return objectives, tax implications, risk tolerance and maturity dates. Our long-term investments are also available for sale to meet short-term liquidity and other needs. Cash in excess of the capital needs of our regulated subsidiaries is paid to non-regulated parent companies, typically in the form of dividends, for general corporate use, when and as permitted by applicable regulations.

Our non-regulated businesses also generate significant cash from operations for general corporate use. Cash flows generated by these entities, combined with the issuance of commercial paper, long-term debt and the availability of committed credit facilities, further strengthen our operating and financial flexibility. We generally use these cash flows to reinvest in our businesses in the form of capital expenditures, to expand the depth and breadth of our services through business acquisitions, and to repurchase shares of our common stock, depending on market conditions.

Cash flows generated from operating activities, our primary source of liquidity, are principally from net earnings, prior to depreciation and amortization and other non-cash expenses. As a result, any future decline in our profitability may have a negative impact on our liquidity. The level of profitability of our risk-based insured business depends in large part on our ability to accurately predict and price for health care and operating cost increases. This risk is partially mitigated by the diversity of our other businesses, the geographic diversity of our risk-based business and our disciplined underwriting and pricing processes, which seek to match premium rate increases with future health care costs. In 2005, a hypothetical unexpected 1% increase in commercial insured medical costs would have reduced net earnings by approximately $130 million.

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, debt covenants and other contractual restrictions, regulatory requirements and market conditions. We believe that our strategies and actions toward maintaining financial flexibility mitigate much of this risk.

Cash and Investments

We maintained a strong financial condition and liquidity position, with cash and investments of $19.0 billion at June 30, 2006. Total cash and investments increased by $4.0 billion since December 31, 2005, primarily due to strong operating cash flows, increased debt levels and funds received from CMS under the Medicare Part D program in advance of required benefit payments, partially offset by common stock repurchases, cash paid for business acquisitions and capital expenditures.

As further described under Regulatory Capital and Dividend Restrictions, 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 parent companies. At June 30, 2006, approximately $750 million of our $19.0 billion of cash and investments was held by non-regulated subsidiaries and was available for general corporate use, including acquisitions and share repurchases.

 

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Cash flows from operating activities were $4.6 billion for the six months ended June 30, 2006, representing an increase over the comparable 2005 period of $2.2 billion, or 94%. The increase in operating cash flows resulted primarily from an increase in unearned premiums due to the receipt of the $1.5 billion July 2006 Medicare premium payment from CMS in June 2006. The remainder of the increase was due to $407 million in other working capital improvements and an increase of $311 million in net income excluding depreciation, amortization and other noncash items.

Financing and Investing Activities

In addition to our strong cash flows generated by operating activities, we use commercial paper and debt to maintain adequate operating and financial flexibility. As of June 30, 2006 and December 31, 2005, we had commercial paper and debt outstanding of approximately $7.4 billion and $7.1 billion, respectively. Our debt-to-total-capital ratio was 29% and 28.5% as of June 30, 2006 and December 31, 2005, respectively. We believe the prudent use of debt optimizes our cost of capital and return on shareholders’ equity, while maintaining appropriate liquidity.

As of June 30, 2006, our outstanding commercial paper had interest rates of approximately 5.1%.

On February 24, 2006, our Health Care Services business segment acquired John Deere Health Care, Inc. (JDHC). Under the terms of the purchase agreement, we paid approximately $515 million in cash, including transaction costs, in exchange for all of the outstanding equity of JDHC. We issued commercial paper to finance the JDHC purchase price. JDHC has been renamed UnitedHealthcare Services Company of the River Valley, Inc.

On December 20, 2005, the Company acquired PacifiCare Health Systems, Inc. (PacifiCare). Under the terms of the agreement, PacifiCare shareholders received 1.1 shares of UnitedHealth Group common stock and $21.50 in cash for each share of PacifiCare common stock they owned. Total consideration issued for the transaction was approximately $8.8 billion, comprised of approximately 99.2 million shares of UnitedHealth Group common stock (valued at approximately $5.3 billion based upon the average of UnitedHealth Group’s share closing price for two days before, the day of and two days after the acquisition announcement date of July 6, 2005), approximately $2.1 billion in cash, $960 million cash paid to retire PacifiCare’s existing debt and UnitedHealth Group vested common stock options with an estimated fair value of approximately $420 million issued in exchange for PacifiCare’s outstanding vested common stock options.

On September 19, 2005, our Health Care Services business segment acquired Neighborhood Health Partnership (NHP). Under the terms of the purchase agreement, we paid approximately $185 million in cash in exchange for all of the outstanding equity of NHP. We issued commercial paper to finance the NHP purchase price.

In March 2006, we refinanced commercial paper by issuing $650 million of floating-rate notes due March 2009, $750 million of 5.3% fixed-rate notes due March 2011, $750 million of 5.4% fixed-rate notes due March 2016 and $850 million of 5.8% fixed-rate notes due March 2036. The floating-rate notes due March 2009 are benchmarked to the London Interbank Offered Rate (LIBOR) and had an interest rate of 5.3% at June 30, 2006.

In December 2005, we amended and restated our $1.0 billion five-year revolving credit facility supporting our commercial paper program. We increased the credit facility to $1.3 billion and extended the maturity date to December 2010. We entered into amendments to our $1.3 billion credit facility to provide us with additional time to deliver to the lenders our quarterly reports on Form 10-Q for the quarters ended June 30, 2006 and September 30, 2006 and our annual report on Form 10-K for the year ended December 31, 2006, to obtain our lenders’ agreement and acknowledgement that the delivery of a notice of default or notice of acceleration under any indenture or credit agreement that is being contested by the Company in good faith does not cause a default or event of default under the credit agreement, and to obtain a waiver of any potential default that may arise as a result of our determination that our historical financial information should not be relied upon and as a result of our restatement of our historical financial statements.

In November and December 2005, we issued $2.6 billion of commercial paper primarily to finance the cash portion of the purchase price of the PacifiCare acquisition described above and to retire a portion of the PacifiCare debt upon closing of the acquisition, as well as to refinance maturing long-term debt.

 

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In March 2005, we issued $500 million of 4.9% fixed-rate notes due March 2015. We used the proceeds from this borrowing for general corporate purposes including repayment of commercial paper, capital expenditures, working capital and share repurchases.

To more closely align interest costs with the floating interest rates received on our cash and cash equivalent balances, we have entered into interest rate swap agreements to convert the majority of our interest rate exposure from fixed rates to variable rates. These interest rate swap agreements have aggregate notional amounts of $4.9 billion as of June 30, 2006 with variable rates that are benchmarked to LIBOR, and are recorded on our Condensed Consolidated Balance Sheets. As of June 30, 2006, the aggregate liability, recorded at fair value, for all existing interest rate swaps was approximately $203 million. These fair value hedges are accounted for using the short-cut method under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” whereby the hedges are reported on our Condensed Consolidated Balance Sheets at fair value, and the carrying value of the long-term debt is adjusted for an offsetting amount representing changes in fair value attributable to the hedged risk. Since these amounts completely offset, we have reported both the swap liability and the debt liability within debt on our Condensed Consolidated Balance Sheets and there have been no net gains or losses recognized in our Condensed Consolidated Statements of Operations. At June 30, 2006, the rates used to accrue interest expense on these agreements ranged from 5.2% to 5.9%.

Our debt arrangements and credit facilities contain various covenants, the most restrictive of which require us to maintain a debt-to-total-capital ratio (calculated as the sum of commercial paper and debt divided by the sum of commercial paper, debt and shareholders’ equity) below 50%. After giving effect to the credit agreement amendments and waivers that we obtained from our lenders, we believe we are in compliance with the requirements of our debt covenants. On August 28, 2006 we received a purported notice of default from persons claiming to hold certain of our debt securities alleging a violation of our indenture governing our debt securities. This followed our announcement that we would delay filing our quarterly report on Form 10-Q for the quarter ended June 30, 2006. On or about November 2, 2006, we received a purported notice of acceleration from the holders who previously sent the notice of default that purports to declare an acceleration of our 5.8% Senior Unsecured Notes due March 15, 2036 as a result of our not filing our quarterly report on Form 10-Q for the quarter ended June 30, 2006. Our indenture requires us to provide to the trustee copies of the reports we are required to file with the SEC, such as our quarterly reports, within 15 days of filing such reports with the SEC. On October 25, 2006, we filed an action in the United States District Court for the District of Minnesota seeking a declaratory judgment that we are not in default under the terms of the indenture. Immediately prior to the filing of this Form 10-Q, we filed a quarterly report on Form 10-Q/A to amend our quarterly report on Form 10-Q for the quarter ended March 31, 2006, and immediately after the filing of this Form 10-Q, we will file our quarterly report on Form 10-Q for the quarter ended September 30, 2006, as well as our annual report on Form 10-K for the year ended December 31, 2006. Should the Company ultimately be unsuccessful in this matter, we may be required to retire all or a portion of the $850 million of Senior Unsecured Notes due March 2036. We intend to prosecute the declaratory judgment action vigorously.

PacifiCare had approximately $100 million par value of 3% convertible subordinated debentures (convertible notes) which were convertible into approximately 5.2 million shares of UnitedHealth Group’s common stock and $102 million of cash as of December 31, 2005. In December 2005, we initiated a consent solicitation to all of the holders of outstanding convertible notes pursuant to which we offered to compensate all holders who elected to convert their notes in accordance with existing terms and consent to an amendment to a covenant in the indenture governing the convertible notes. The compensation consisted of the present value of interest through October 18, 2007, the earliest mandatory redemption date, plus a pro rata share of $1 million. On January 31, 2006, approximately 91% of the convertible notes were tendered pursuant to the offer, for which we issued approximately 4.8 million shares of UnitedHealth Group common stock, valued at $282 million, and cash of $93 million.

Our senior debt is rated “A” with a negative outlook by Standard & Poor’s (S&P), “A” with a negative watch by Fitch, and “A3” with a negative outlook by Moody’s. Our commercial paper is rated “A-1” with a negative outlook by S&P, “F-1” with a negative watch by Fitch, and “P-2” with a negative outlook by Moody’s. Moody’s

 

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downgraded our rating in October 2006 citing concerns about corporate governance following the release of the WilmerHale Report (See Note 2 of the Notes to the Consolidated Financial Statements). We do not expect this Moody’s downgrade to significantly affect our borrowing capacity or costs. A significant downgrade in our debt or commercial paper ratings could adversely affect our borrowing capacity and costs. See “— Cautionary Statements Relating to Our Historic Stock Option Practices — Credit Ratings” for additional information.

Under our Board of Directors’ authorization, we maintain a common stock repurchase program. Repurchases may be made from time to time at prevailing prices, subject to certain restrictions on volume, pricing and timing. During the six months ended June 30, 2006, we repurchased 40.2 million shares at an average price of approximately $56 per share and an aggregate cost of approximately $2.2 billion. As of June 30, 2006, we had Board of Directors’ authorization to purchase up to an additional 136.7 million shares of our common stock. Our common 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 capital. A decision by the Company to discontinue share repurchases would significantly increase our liquidity and financial flexibility.

We currently have $1.0 billion remaining under our universal S-3 shelf registration statement (for common stock, preferred stock, debt securities and other securities), although we will be unable to issue securities on Form S-3 on a primary basis until we have timely filed all reports required to be filed with the SEC for a twelve-month period. We may offer securities from time to time at prices and terms to be determined at the time of offering. Under our S-4 acquisition shelf registration statement, we have remaining issuing capacity of 48.6 million shares of our common stock in connection with acquisition activities. We filed a separate S-4 registration statement for the 99.2 million shares issued in connection with the December 2005 acquisition of PacifiCare described previously.

Contractual Obligations, Off-Balance Sheet Arrangements And Commitments

An updated summary of future obligations under our various contractual obligations, off-balance sheet arrangements and commitments as of December 31, 2006 will be disclosed in our 2006 Form 10-K to be filed with the Securities and Exchange Commission on the date hereof. During the quarter ended June 30, 2006, there were no significant changes to the amounts of these obligations other than those items disclosed under the “Financial Condition and Liquidity at June 30, 2006” section. Additionally, we do not have any other material contractual obligations, off-balance sheet arrangements or commitments that require cash resources; however, we continually evaluate opportunities to expand our operations. This includes internal development of new products, programs and technology applications, and may include acquisitions.

In conjunction with the PacifiCare acquisition we committed to make $50 million in charitable contributions to the benefit of California health care consumers, which has been accrued on our Consolidated Balance Sheets. Additionally, we agreed to invest $200 million in California’s health care infrastructure to further health care services to the underserved populations of the California marketplace. The timing and amount of individual contributions and investments are at our dis