KAISER FOUNDATION HEALTH PLAN, INC. AND SUBSIDIARIES AND KAISER FOUNDATION HOSPITALS AND SUBSIDIARIES

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1 (1) Description of Business The accompanying combined financial statements include Kaiser Foundation Health Plan, Inc. and Subsidiaries (Health Plans) and Kaiser Foundation Hospitals and Subsidiaries (Hospitals). Health Plans and Hospitals are primarily not-for-profit corporations whose capital is available for charitable, educational, research and related purposes. Health Plans are primarily health maintenance organizations and are generally exempt from federal and state income taxes. Membership at December 31, 2008 was 8.6 million. The percentage of enrolled membership in California at December 31, 2008 was approximately 76%. The principal operating subsidiary of Kaiser Foundation Hospitals is Kaiser Hospital Asset Management, Inc. (KHAM). The principal operating subsidiaries of Kaiser Foundation Health Plan, Inc. (Health Plan, Inc.) are: Kaiser Foundation Health Plan of Colorado Kaiser Foundation Health Plan of Georgia, Inc. Kaiser Foundation Health Plan of the Mid-Atlantic States, Inc. Kaiser Foundation Health Plan of the Northwest Kaiser Foundation Health Plan of Ohio Kaiser Health Plan Asset Management, Inc. (KHPAM) Independent Medical Groups (Medical Groups) cooperate with Health Plans and Hospitals in conducting the Kaiser Permanente Medical Care Program. Because the Medical Groups are independent, their operations are not included in the combined financial statements. Health Plans contract with Hospitals and the Medical Groups to provide or arrange hospital and medical services for members. Hospitals also contract with Medical Groups for certain services. Contract payments to the Medical Groups represent a substantial portion of the expenses for medical services reported in the combined statements of operations and changes in net worth. The percentages of Health Plans and Hospitals total labor force covered under collective bargaining agreements at December 31, 2008 was approximately 66%. Of those collective bargaining agreements in effect at December 31, 2008, agreements covering approximately 4% of Health Plans and Hospitals total workforce are scheduled to expire within one year. Health Plans and Hospitals strive to improve the health and welfare of the communities they serve through their Direct Community Benefit Investment (DCBI) programs. DCBI expenditures provide funding for community benefit programs that serve communities through research, community-based health partnerships, direct health coverage for low-income families and collaboration with community clinics, health departments and public hospitals. DCBI expenditures for 2008 are estimated at $1,171 million, 2.9% of operating revenue. In addition to its direct expenditures, Health Plans and Hospitals encourage their personnel to be actively involved in community service activities. 1

2 (2) Summary of Significant Accounting Policies (a) Basis of Presentation The financial statements of Health Plans and Hospitals are presented on a combined basis due to the operational interdependence of these organizations and because their governing boards and management are substantially the same. These combined financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. All significant intercompany balances and transactions have been eliminated. (b) (c) For purposes of filing the Financial Report with the Department of Managed Health Care, the following reports and schedules have been prepared on a combined basis for Health Plans and Hospitals. All other reports and schedules in the Reporting Form have been prepared for Health Plan, Inc. only. Report #1 Part A: Assets Report #1 Part B: Liabilities and Net Worth Report #2: Revenue, Expenses and Net Worth Report #3: Statement of Cash Flows Knox-Keene Supplemental Information (Tangible Net Equity calculation only) Cash and Cash Equivalents Cash and cash equivalents include interest-bearing deposits purchased with an original or remaining maturity of three months or less. Cash and investments that are restricted per regulatory requirements are classified as long-term investments and excluded from cash and cash equivalents. Investments Investments include investments in equity, U.S. Treasury, government agencies, and other marketable debt securities and are reported at fair value. Alternative investments are carried at the equity method which approximates fair value. Certain investments are illiquid and are valued based on the most current information available. Interest and dividend income, as well as recognized gains and losses, which are recorded on the specific identification basis, are included in investment income (loss) - net. Health Plans and Hospitals have designated certain investments for the physicians retirement plan. These investments are unrestricted assets of Health Plans and Hospitals. A portion of investment income which represents the expected return on the investments designated for the physicians retirement plan has been recorded as a reduction in the provision for physicians retirement plan benefits and is excluded from investment income (loss) - net. 2

3 Investments are regularly reviewed for impairment and a charge is recognized when the fair value is below cost basis and is judged to be other-than-temporary. Impairment is included in recognized losses. In its review of assets for impairment that is deemed other-than-temporary, management generally follows the following criteria: For investments managed by outside investment managers who do not need Health Plans or Hospitals management pre-approval for sales, all declines in value relative to book value are recognized as impairment that is other-than-temporary. For other securities, losses are recognized for known matters, such as bankruptcies, regardless of ownership period, and investments that have been continuously below book value for an extended period of time are evaluated for impairment that is other-than-temporary. All other unrealized gains and losses on investments are included as a component of net worth. (d) (e) Securities Lending Collateral and Payable Health Plans and Hospitals enter into Securities Lending agreements whereby certain securities from their portfolios are loaned to other institutions. Securities lent under such agreements remain in the portfolios of Health Plans and Hospitals. Health Plans and Hospitals receive a fee from the borrower under these agreements which is recognized ratably over the period that the securities are lent. Collateral, primarily cash, is required at a rate of 102% of the fair value of securities lent and is carried on the balance sheet as Securities Lending Collateral. The obligation of Health Plans and Hospitals to return the cash collateral is carried on the balance sheet as Securities Lending Payable. The fair value of securities lending collateral is determined using level 1 or 2 inputs as appropriate, as defined by Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements. The fair value of the loaned securities is monitored on a daily basis, with additional collateral obtained or refunded as the fair value of the loaned securities fluctuates. Land, Buildings, Equipment and Software Land, buildings, equipment, and software are stated at the lower of cost less accumulated depreciation and amortization or, for assets deemed impaired, at recoverable value. Interest is capitalized on facilities construction and internally developed software work in process and is added to the cost of the underlying asset, in accordance with SFAS No. 34, Capitalization of Interest Cost. Software, which includes internal and external costs incurred in developing or obtaining computer software for internal use, is capitalized in accordance with Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. Qualifying costs incurred during the application development stage are capitalized and depreciation begins when the project is substantially complete and ready for its intended use. Software is amortized on a straight-line basis over periods generally ranging from 3 to 7 years. Buildings and equipment are depreciated on a straight-line basis over the estimated useful lives of the various classes of assets, generally ranging from 3 to 33 years. Management continually evaluates alternatives for delivering services that may affect the current and future utilization of existing and planned assets and could result in an adjustment to the carrying 3

4 values of such land, buildings, equipment, and software in the future. Management evaluates and records impairment losses based on expected utilization, projected net cash flows, and recoverable values. Maintenance and repairs are expensed as incurred. Major improvements that increase the estimated useful life of an asset are capitalized. Upon the sale or retirement of assets, recorded cost and related accumulated depreciation are removed from the accounts, and any gain or loss on disposal is reflected in operations. Management estimates the fair value of legal asset retirement obligations that are conditional on a future event if the amount can be reasonably estimated, in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 47 (FIN 47), Accounting for Conditional Asset Retirement Obligations, an interpretation of SFAS No Estimates are developed through the identification of applicable legal requirements, identification of specific conditions requiring incremental cost at time of asset disposal, estimation of costs to remediate conditions, and estimation of remaining useful lives or date of asset disposal. (f) (g) (h) Medical Claims Payable The cost of health care services is recognized in the period in which services are provided. Medical claims payable consists of unpaid health care expenses, which include an estimate of the cost of services provided to Health Plans members by third party providers that have been incurred but not reported. The estimate for incurred but not reported claims is based on actuarial projections of costs using historical paid claims and other relevant data. Estimates are continually monitored and reviewed and, as settlements are made or estimates revised, adjustments are reflected in current operations. Such estimates are subject to the impact of changes in the regulatory environment and economic conditions. Given the inherent variability of such estimates, the actual liability could differ significantly from the amounts provided. While the ultimate amount of paid claims is dependent on future developments, management is of the opinion that the reserves for claims are adequate to cover such claims. Due to Associated Medical Groups Due to associated medical groups consists primarily of unpaid medical expenses owed to the Medical Groups for medical services provided to members under Medical Services Agreements with Health Plans. The cost of medical services is recognized by Health Plans in the period in which services are provided and is reflected as a component of medical and hospital services expenses. Self-Insured Risks Costs associated with self-insured risks, primarily for professional, general and workers compensation liabilities, are charged to operations based upon actual and estimated claims. The portion estimated to be paid during the next year is included in current liabilities. The estimate for incurred but not reported self-insured claims is based on actuarial projections of costs using historical claims and other relevant data. Estimates are monitored and reviewed and, as settlements 4

5 are made or estimates revised, adjustments are reflected in current operations. Given the inherent variability of such estimates, the actual liability could differ significantly from the amounts provided. While the ultimate payments for self-insured claims are dependent on future developments, management is of the opinion that the reserve for self-insured risks is adequate. Insurance coverage, in excess of the per occurrence self-insured retention, has been secured with insurers or reinsurers for specified amounts for professional, general and workers compensation liabilities. Decisions relating to the limit and scope of the self-insured layer and the amounts of excess insurance purchased are reviewed each year, subject to management s analysis of actuarial loss projections and the price and availability of acceptable commercial insurance. (i) (j) Loss Contract Accruals Loss contract accruals and the related expense are recognized when it is probable that expected future health care and maintenance costs under a group of existing contracts will exceed anticipated future premiums and reinsurance recoveries over the remaining lives of the contracts. The level at which contracts are grouped for evaluation purposes is generally by geographic region. The methods for making such estimates and for establishing the resulting reserves are continually reviewed and updated, and any adjustments resulting therefrom are reflected in current operations. Given the inherent variability of such estimates, the actual liability could differ significantly from the amounts provided. Derivative Financial Instruments Derivative financial instruments are utilized to manage interest costs and the risk associated with changing interest rates. Health Plans and Hospitals enter into interest rate swaps with investment or commercial banks with significant experience with such instruments. In addition, certain investments include simple derivative products. The changes in the fair value of the derivative instruments are included in investment income (loss) - net and settlement costs are recorded as interest expense or investment income (loss) - net. Derivative financial instruments are also utilized to manage public equity risk, primarily to hedge downside volatility risk. Heath Plans and Hospitals enter into simple derivatives such as put-spread collars with similar investment or commercial banks noted above. The changes in fair value for these simple derivatives are included in interest and investment income (loss) - net. (k) Revenue Recognition Members dues revenue includes premiums from employer groups and individuals. Revenue is recognized in the month in which the members are entitled to health care services. The majority of Health Plans and Hospitals Medicare revenue is received from the Medicare Advantage Program (Part C). Revenues for Part C include capitated payments which vary based on health status, demographic status and other factors. Medicare revenues also include accruals for estimates resulting from changes in health risk factor scores. Such accruals are recognized when the 5

6 amounts become determinable and collection is reasonably assured. Part C revenue is finalized after all data is submitted to Medicare, and the final settlement is made after the end of the fiscal year. In addition, Medicare benefits include a voluntary prescription drug benefit (Part D). Revenues for Part D include capitated payments made from Medicare adjusted for health risk factor scores. Revenues also include amounts to reflect a portion of the health care costs for low-income Medicare beneficiaries and a risk sharing arrangement to limit the exposure to unexpected expenses. Related accruals are recognized monthly based on cumulative experience and membership data. Part D revenue is finalized after all data is submitted to Medicare, and the final settlement is made after the end of the fiscal year. Certain Medicare revenues are paid under cost reimbursement plans based on pre-established rates, and the final settlement is made after fiscal year-end. Estimates of final settlements of the cost reports are recorded by the Health Plans. Premiums collected in advance are deferred and recorded as dues or Medicare payments received in advance. Revenue is adjusted appropriately to reflect estimates of collectability, including potential retroactive membership adjustment trends, and such adjustments are routinely monitored by management. Revenue and related receivables are exclusive of charity care which is accounted for as a component of DCBI. A portion of revenues derived under contracts with the United States Office of Personnel Management is subject to audit and possible retroactive adjustments. (l) Pension and Other Postretirement Benefits Health Plans and Hospitals account for their defined benefit pension and postretirement plans within the framework of SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans and, as still applicable, SFAS No. 87, Employers Accounting for Pensions, and SFAS No. 106, Employers Accounting for Postretirement Benefits Other than Pensions, respectively. The plans are actuarially evaluated and involve various assumptions. Critical assumptions include the discount rate and the expected rate of return on plan assets (for pension), which are important elements of expense and/or liability measurement. Other assumptions involve demographic factors such as retirement age, mortality, turnover and the rate of compensation increases. Health Plans and Hospitals evaluate assumptions annually and modify them as appropriate. Pension and postretirement costs are allocated over the service period of the employees in the plan. Health Plans and Hospitals use a discount rate to determine the present value of the future benefit obligations. The discount rate is established based on rates available for high-quality fixed-income debt at the measurement date. To determine the expected long-term rate of return on pension plan assets, Health Plans and Hospitals consider the current and expected asset allocation, as well as historical and expected returns for each plan asset class. Any difference between actual and expected plan experience, including asset return experience, in excess of a 10% corridor around the larger of assets or 6

7 liabilities, is recognized in the net periodic pension calculation over the expected average future service of the current employees, approximately 13 years. (m) (n) (o) Donations and Grants Made or Received Donations and grants made are recognized in the period in which a commitment is made, provided the payment of the donation or grant is probable and the amount is determinable. Donations or grants received, including research grants, are recognized in the period the donation or grant was committed unconditionally by the grantor or in the period the donation or grant requirements are met, if later. Use of Estimates The preparation of the combined financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts. Allowance for uncollectible accounts receivable, investments, Medicare revenue accruals, Medicare reserves, incurred but not reported medical claims, physicians retirement plan liabilities, pension and postretirement benefit liabilities, loss contract accruals, self-insured professional, general and workers compensation liabilities, divestiture reserves, software impairments, investment impairments and other charges represent significant estimates. Actual results could differ materially from those estimates. With respect to employee benefit plans, as occurs from time to time, negotiations with labor partners may result in changes to compensation and benefits. These changes are reflected in the financial statements as appropriate when agreements are finalized. Recently Issued Accounting Standards SFAS No. 157, Fair Value Measurements, and SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities Including an amendment of FASB Statement No. 115, are effective for financial statements with fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Health Plans and Hospitals adopted SFAS Nos. 157 and 159 in Although adoption of SFAS No. 157 resulted in expanded footnote disclosures, there was no other significant effect on the combined financial statements as a result of the adoption of these statements. 7

8 (3) Investments Investments at December 31 (in millions) include: Investments: Current: Equity - U.S. $ 134 U.S. treasury and government agencies 780 Other debt instruments 4,128 Total $ 5,042 Noncurrent: Equity - U.S. $ 2,001 Equity - international 1,153 Alternative investments 1,018 U.S. treasury and government agencies 670 Other debt instruments 3,646 Total $ 8,488 Investments by level at December 31 (in millions) include: Quoted prices Significant in active other Significant markets for observable unobservable identical assets inputs inputs level 1 level 2 level 3 Total Investments: Current: Equity - U.S. $ 134 $ $ $ 134 U.S. treasury and government agencies Other debt instruments 4,128 4,128 Total $ 842 $ 4,200 $ $ 5,042 Noncurrent: Equity - U.S. $ 2,001 $ $ $ 2,001 Equity - international ,153 Alternative investments ,018 U.S. treasury and government agencies Other debt instruments 67 3, ,646 Total $ 3,379 $ 4,833 $ 276 $ 8,488 8

9 Reconciliation of investments with fair value measurements using significant unobservable inputs (level 3) for the year ended December 31, 2008 is as follows (in millions): Alternative Other investments debt Total Beginning balance $ 110 $ $ 110 Transfers in and/or out of level Total gains or (losses) Realized (6) (11) (17) Unrealized 3 3 Purchases, issuances and settlement Ending balance $ 219 $ 57 $ 276 Total year to date net gains or (losses) (realized and unrealized) related to assets held as of December 31, 2008: $ (6) $ (11) $ (17) Noncurrent investments include specific funds held in construction fund accounts. The values of these funds at December 31, 2008 were $0 million. These funds were held for certain construction projects identified in conjunction with revenue bond issuances. Alternative investments include private equity and absolute return limited partnerships. These investments are carried at the equity method, which approximates fair value. Fair value of alternative investments has been estimated by management based on all available information, including information provided by fund managers or the general partners. Hospitals has original commitments related to private equity investments of $385 million, of which $137 million has been invested, leaving $248 million of outstanding commitments as of December 31,

10 Investment income for the year ended December 31 (in millions) is comprised of the following: Recognized gains and losses net $ (2,428) Interest and dividend income 387 Total investment loss (2,041) Less investment income included in operating income (196) Investment loss net $ (2,237), Health Plans and Hospitals recorded impairment of certain investments., the other-than-temporary impairment totaled $2,180 million and an additional $123 million in impairment was recognized on alternative investments. The net unrealized gains on investments at December 31, 2008 totaled $405 million. Gross unrealized losses at December 31, 2008, were $33 million. At December 31, 2008 Health Plans and Hospitals owned certain fixed income bonds and alternative investments with exposure to the subprime market. Health Plans and Hospitals total investment in fixed income bonds and alternative investments totaled $10.2 billion at December 31, 2008 of which approximately 1% represents the value of subprime investments. (4) Derivative Instruments (a) Interest Rate Swaps At December 31, 2008, Health Plans and Hospitals had fifteen agreements to manage interest rate fluctuations (Interest Rate Swaps) with a total notional amount of $1,240 million. In 2008, Health Plans and Hospitals recorded approximately $2 million in investment loss and $8 million increase in interest expense relating to the Interest Rate Swaps. (b) Put Agreement Third Party Debt In 2002, Hospitals entered into an arrangement with a financial institution whereby that organization has the right, but not the obligation, to put to Hospitals certain bonds with a face amount of $168 million with various maturity dates through 2032 at a fixed interest rate of 8.75%. Hospitals receives a fee for this arrangement, which it records as investment income. The arrangement with the financial institution also contains an embedded derivative element in that the underlying debt is fixed rate but Hospitals has agreed to take interest rate risk through a receive fixed/pay variable interest rate swap, where the variable rate of interest is based on The Securities Industry And Financial Markets Association Municipal Swap Index. The financial organization has the option to terminate the embedded interest rate swap in Hospitals has the option to terminate this arrangement for a period of 120 days beginning November 15, 2012, whereby Hospitals would pay the financial organization an amount equal to 100% of the bonds that have 10

11 not been defeased or redeemed. The right to put the bonds may occur when the bonds are in default. These bonds were used by a third party to construct a new hospital with which a subsidiary of Hospitals has entered into a hospital service agreement for the provision of services to members of an operating subsidiary of Health Plan, Inc. The hospital service agreement provides that in the event of default on the debt subject to the put agreement, the subsidiary of Hospitals or its designee shall have the right to acquire the underlying hospital assets under certain terms. At December 31, 2008, there is no amount on the balance sheet relating to the put agreement. At December 31, 2008, the value of the derivative element of this arrangement, including accrued interest, is $12 million. This amount has been recorded on the balance sheet as an asset and the change in value reflected in nonoperating income. (c) (d) Equity Put Spread Collars At December 31, 2008, Hospitals had entered into two put-spread collars totaling $400 million. The purpose of these derivatives is to protect a portion of the long-term marketable securities portfolio from equity volatility. These put-spread collars reduce exposure to public equity losses in exchange for a cap on public equity gains. The collars are in effect for one year and each mature in Information on Derivative Gain or (Loss) and Fair Value Information on Derivative Gain or (Loss) Mark to Market Valuation Recognized in Income in 2008 (In millions) Gain (loss) Statement of recognized in Derivatives not designated operations income as hedging instruments category on derivatives Interest rate swaps - related to debt Investment income - net $ (194) Interest rate swaps - other Investment income - net (26) Put option agreement Investment income - net 6 Equity put spread collars Investment income - net (2) $ (216) 11

12 Information on Derivative Settlement Costs Recognized in Income in 2008 (In millions) Gain (loss) Statement of recognized in Derivatives not designated operations income as hedging instruments category on derivatives Interest rate swaps - related to debt Interest expense $ (8) Interest rate swaps - other Investment income - net (2) Put option agreement Investment income - net 8 Equity put spread collars Investment income - net 69 $ 67 The values of derivatives at December 31, 2008 are as follows: Information on Fair Values of Derivative Instruments - Assets (In millions) Derivatives not designated Balance sheet Fair value as hedging instruments category (gross) Put option agreement Other long-term assets $ 11 12

13 Information on Fair Values of Derivative Instruments - Liabilities (In millions) Derivatives not designated Balance sheet Fair value as hedging instruments category (gross) Interest rate swaps - related to debt Other long-term liabilities $ (241) Interest rate swaps - other Other long-term liabilities (33) Equity put spread collars Other long-term liabilities (2) $ (276) These derivatives contain reciprocal provisions whereby if Health Plans and Hospitals or the counterparties credit rating were to decline to certain levels, provisions would be triggered requiring Health Plans and Hospitals or the counterparties to provide certain collateral. At December 31, 2008, no collateral was required to be posted by either Health Plans and Hospitals or the counterparties. Additional information on derivatives is contained in the following notes, Summary of Significant Accounting Policies - Derivative Financial Instruments and Fair Value of Financial Instruments. (5) Other Health Care Receivable - Net Other Health Care Receivable - Net at December 31 (in millions) include: Patient services $ 1,659 Medicare 340 Other 196 2,195 Valuation allowances (1,630) Total $

14 (6) Property and Equipment Property and Equipment at December 31 (in millions) include: Land $ 1,426 Construction and software development in progress 2,249 Buildings and improvements 17,280 Furniture, equipment and software 7,063 28,018 Accumulated depreciation and amortization (12,186) Total $ 15,832 For 2008 net gains on disposition of land, building and improvements and furniture, equipment and software were $80 million. Health Plans and Hospitals capitalize interest costs on borrowings incurred during the construction, upgrade or development of qualifying assets. Capitalized interest is added to the cost of the underlying assets and is depreciated or amortized over the useful lives of the assets. For 2008, Health Plans and Hospitals capitalized $83 million of interest in connection with various capital projects. The fair value of legal asset retirement obligations that are conditional on a future event has been estimated in accordance with FIN 47. Legal obligations to perform asset retirement obligations relate primarily to the following: asbestos containing building materials; leaded wall shielding; storage tanks (above ground and below ground); chillers or cooling tower chemicals; mercury in large fixed components; PCB containing ballasts and equipment; and hard drives requiring data wiping prior to disposal. As of December 31, 2008, the liability for asset retirement obligations was $58 million. Amortization of the associated assets for the year ended December 31, 2008 totaled $1 million. The unamortized balance of this retirement obligation as of December 31, 2008 is $13 million. 14

15 (7) Medical Claims Payable Activity in the liability for medical claims payable is summarized as follows (in millions): Balances at January 1 $ 1,139 Incurred related to: Current year 5,499 Prior years (29) Total incurred 5,470 Paid related to: Current year 4,551 Prior years 866 Total paid 5,417 Balances at December 31 $ 1,192 Amounts incurred related to prior years vary from previously estimated liabilities as the claims are ultimately adjudicated and paid. Liabilities at any year-end are continually reviewed and re-estimated as information regarding actual claims payments becomes known. Negative amounts reported for incurred related to prior years result from claims being adjudicated and paid for amounts less than originally estimated. 15

16 (8) Loans and Notes Payable (Not Subordinated) Loans and Notes Payable (not subordinated) at December 31 (in millions): Tax-exempt revenue bonds: 0.25% to 4.70% variable rate due through 2041 $ 2, % to 7.15% fixed rate due through ,421 Others at various rates due through Total $ 3,949 Current portion of long-term debt $ 12 Long-term debt subject to short-term remarketing arrangements - net 1,213 Long-term debt classified as a long-term liability 2,724 Total $ 3,949 At the holder s option, repurchase of variable rate revenue bonds, totaling $2,488 million at December 31, 2008, may be required at earlier than stated maturity. These bonds may be remarketed rather than repurchased. To date, all such bonds have been remarketed. Health Plans and Hospitals have provided self liquidity for the variable rate putable bonds. Additionally, as of December 31, 2008, management has the ability to finance the acquisition of up to $800 million of any unremarketed bonds that are put, using available long-term credit facilities. As of December 31, 2008, $1,213 million of these variable bonds have been classified in current liabilities. This amount is net of $800 million of available long-term credit facilities. Variable rates for these bonds are determined by market rates for similar obligations. As of December 31, 2008, $19 million of the above tax-exempt fixed-rate revenue bonds represents a net unamortized premium balance. Management believes Health Plans and Hospitals are in compliance with covenants in financing agreements, which generally relate to liquidity, total indebtedness and asset dispositions. 16

17 Scheduled principal payments for each of the next five years and thereafter (in millions): 2009 $ Thereafter 3,872 Total $ 3,944 In 2008, Hospitals purchased $213 million of its bonds issued in 2007 through open market activities. Hospitals reported a gain on the extinguishment of this debt of $83 million in (a) Credit Facilities Hospitals credit facilities totaling $800 million consist of a $450 million credit facility which terminates in May 2011 and a $350 million credit facility which terminates in October Various interest rate options are available under these facilities. Any revolving borrowings mature on the termination date of the applicable credit facility. Hospitals pay facility fees on each facility which range from 0.05% to 0.15% per annum, depending upon Hospitals long-term senior unsecured debt rating. At December 31, 2008, the facility fee is at an annual rate of 0.06% for both credit facilities. At December 31, 2008, no amounts are outstanding under these facilities. Hospitals revolving credit facilities contain financial covenants. Under the terms of these facilities, Hospitals is required to maintain a minimum ratio of net cash flow, as defined, to all principal payments of debt plus all interest with respect to funded debt accrued or capitalized during each quarter. Hospitals are also required to maintain a ratio of total debt to capital consisting of debt plus net worth. Management believes that Hospitals met these requirements at December 31, Hospitals maintain a commercial paper program providing for the issuance of up to $800 million in aggregate maturity value of short-term indebtedness. The commercial paper is issued in denominations of $100,000 and will bear such interest rates, if interest-bearing, or will be sold at such discount from their face amounts, as agreed upon by Hospitals and the dealer acting in connection with the commercial paper program. The commercial paper may be issued with varying maturities up to a maximum of 270 days from the date of issuance. At December 31, 2008, no commercial paper was outstanding. (9) Fair Value of Financial Instruments The carrying amounts reported in the balance sheet for cash and equivalents, accounts receivable, accounts payable and accrued expenses, medical claims payable, payroll and related charges, and due to associated medical groups approximate fair value. 17

18 Investments, other than alternative investments, as discussed in the Investments note, are reported at fair value. Alternative investments are carried at the equity method which approximates fair value. Valuation is primarily determined by external pricing agencies, over which management exercises oversight to ensure materially accurate valuations. The fair values of investments are based on quoted market prices, if available, or estimated using quoted market prices for similar investments. If listed prices or quotes are not available, fair value is based upon models that primarily use as inputs market-based or independently sourced market parameters. In addition to market information, models also incorporate transaction details, such as maturity. Fair value adjustments, including credit, liquidity and other factors are included, as appropriate, to arrive at a fair value measurement. Certain investments are illiquid and are valued based on the most current information available, which may be less current than the date of these financial statements. On January 1, 2008 Health Plans and Hospitals adopted SFAS No. 157 Fair Value Measurements, which established a three-level valuation hierarchy for fair value measurements. An instrument's categorization within the hierarchy is based upon the lowest level of input that is significant to the fair value measurement. For instruments classified in level 1 of the hierarchy, valuation inputs are quoted prices in active markets as of the measurement date for identical instruments. For instruments classified in level 2 of the hierarchy, valuation inputs are directly observable but do not qualify as level 1 inputs. Examples of level 2 inputs include: quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in nonactive markets; other observable inputs such as interest rates and yield curves observable at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks, and default rates; and market-correlated inputs that are derived principally from or corroborated by observable market data. Level 3 inputs are unobservable inputs for the instrument. Level 3 inputs incorporate assumptions about the factors that market participants would use in pricing the instrument. The fair value of long-term debt is based on level 2 inputs, such as interest rates currently available to Health Plans and Hospitals for debt with similar terms and remaining maturities. The carrying amount of long-term debt totaled $3.9 billion at December 31, The estimated fair value of long-term debt was approximately $3.7 billion at December 31, The estimated fair values of derivative instruments have been determined using level 2 inputs including available market information and valuation methodologies, primarily discounted cash flows. At December 31, 2008 the fair values of these derivatives were recorded on the balance sheet at a net $265 million liability. Of this amount, a $274 million liability pertains to interest rate swaps, a $2 million liability pertains to the put-spread collars and an $11 million asset pertains to the Put Agreement discussed in the Derivative Instruments note. Changes in the fair value are recorded in investment income (loss) - net. (10) Pension Plans (a) Defined Benefit Plan Health Plans and Hospitals have a defined benefit pension plan covering substantially all their employees. Benefits are based on age at retirement, years of credited service, and average compensation for a specified period prior to retirement. Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. 18

19 For financial reporting and funding purposes, the projected unit credit method is used. Most pension fund assets are invested in fixed-income and equity securities, with approximately 2% invested in alternative investments, principally private equity and absolute return limited partnerships. Funded status of the plan at December 31 (in millions): Change in projected benefit obligation (PBO): Benefit obligation at beginning of year $ 5,770 Service cost 456 Interest cost 371 Plan amendments 28 Net actuarial gain (310) Benefits paid (233) Benefit obligation at end of year $ 6,082 Accumulated benefit obligation at end of year $ 4,545 Change in plan assets: Fair value of plan assets at beginning of year $ 4,657 Actual return on plan assets (1,289) Company contributions 414 Benefits paid (233) Fair value of plan assets at end of year $ 3,549 Funded status $ (2,533) Amounts recognized in the balance sheet consist of: Other long-term assets $ Current liabilities Pension and other retirement liabilities (2,533) $ (2,533) Amounts recognized in net worth: Net actuarial loss $ 1,949 Prior service cost 128 $ 2,077 19

20 Pension expense for the year ended December 31 (in millions): Service cost $ 456 Interest cost 371 Expected return on plan assets (372) Amortization of net actuarial loss 23 Amortization of prior service cost 20 Net pension expense $ 498 Other changes in plan assets and projected benefit obligations recognized in other comprehensive income (in millions): Net actuarial (gain)/loss $ 1,351 Prior service cost 28 Amortization of net actuarial loss (23) Amortization of prior service cost (20) Total recognized in other comprehensive income 1,336 Total recognized in net periodic benefit cost and other comprehensive income $ 1,834 The estimated net actuarial (gain) loss and prior service cost that will be amortized from net worth into net periodic benefit cost over the next fiscal year are $0 million and $17 million, respectively. Actuarial assumptions used were as follows: Weighted average discount rate at January 1 for calculating pension expense 6.50% Weighted average discount rate for calculating December 31 PBO 6.90% Weighted average salary scale for calculating pension expense and December 31 PBO 4.60% Expected long-term rate of return on plan assets 8.00% Explanation of Investment Strategies and Policies Health Plans and Hospitals employ a total return investment approach whereby investing in a mix of equity, fixed-income and alternative (including real assets) asset classes is used to maximize the long-term return of plan assets for a prudent level of risk. The intent of this strategy is to minimize 20

21 plan expenses by outperforming plan liabilities over the long run. Risk tolerance is established through careful consideration of plan liabilities, plan funded status, and corporate financial condition. The investment portfolio will consist over time of a varying but diversified blend of equity, fixedincome and alternative investments. Diversification includes such factors as geographic location, equity capitalization size and style, placement in the capital structure, and security type. Investment risk is measured and monitored on an ongoing basis through annual liability measurements, periodic asset/liability studies, and quarterly investment portfolio reviews. Capital Market Assumption Methodology To determine the long-term rate of return assumption for plan assets, management incorporates historical relationships among the various asset classes and sub-classes to be accessed over the investment horizon. Management s intent is to maximize portfolio efficiency. This will be accomplished by seeking the highest returns prudently available among the available asset classes. Overall portfolio volatility will be managed through diversification among asset classes. Current market factors such as inflation and interest rates are evaluated before long-term capital market assumptions are determined. Management has established an expected long-term rate of return on assets (ELTRA) of 8.00%, which reflects a lower return expectation for both equity and fixed income than the plans have experienced historically, in recognition that future returns may not be as strong as past returns. Asset Allocations, Target Allocation and Expected Long-Term Rate of Return on Assets % of plan assets Target ELTRA Equity securities 59% 45%-55% 9.60% Debt securities 39% 30%-40% 5.50% Alternative investments 2% 10%-20% 8.40% Cash and cash equivalents % % 3.00% Total 100% 100% 8.00% Management expects to contribute approximately $438 million to its pension plan in

22 Following are the projected benefit cash flows used in determining the projected benefit obligation (in millions): Year(s): 2009 $ ,361 (b) (c) Defined Contribution Plans Health Plans and Hospitals have defined contribution plans for eligible employees. Employer contributions and costs are based on a percentage of covered employees qualified compensation. There were no required employee contributions in Plan expense, primarily employer contributions, for 2008 was $165 million. Multi-employer Plans Health Plans and Hospitals participate in defined benefit and defined contribution multi-employer union-administered pension plans that provide benefits to some union employees. Plan expense, primarily employer contributions, for 2008 was $22 million. (11) Postretirement Benefits Other than Pensions Certain employees may become eligible for health care and life insurance benefits if they reach retirement while working for Health Plans and Hospitals. 22

23 The accrued liability for postretirement benefits at year-end is as follows (in millions): Change in benefit obligation: Benefit obligation at beginning of year $ 2,819 Service cost 154 Interest cost 187 Plan amendments 52 Benefits paid (59) Net actuarial gain (460) Benefit obligation at end of year $ 2,693 Change in plan assets: Fair value of plan assets at beginning of year $ Company contributions 59 Benefits paid (59) Fair value of plan assets at end of year $ Funded status $ (2,693) Amounts recognized in the balance sheet consist of: Noncurrent assets $ Current liabilities (68) Pension and other retirement liabilities (2,625) $ (2,693) Amounts recognized in net worth: Net actuarial (gain) loss $ (302) Prior service cost 61 Transition obligation 28 $ (213) 23

24 Postretirement benefits expense for the year ended December 31 (in millions): Service cost $ 154 Interest cost 187 Amortization of prior service cost 5 Plan amendment 6 Amortization of net actuarial (gain) loss (8) Amortization of transition obligation 7 Postretirement benefits expense 351 Other changes in plan assets and benefit obligations recognized in other comprehensive income for the year ended December 31 (in millions): Amortization of transition obligation (7) Prior service cost 39 Amortization of prior service cost (5) Net actuarial gain (460) Amortization of net actuarial loss 8 Total recognized in other comprehensive income (425) Total recognized in net periodic benefit cost and other comprehensive income $ (74) The estimated net actuarial (gain) loss, prior service cost, and transition obligation that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year are $(15) million, $7 million, and $7 million, respectively. The unrecognized transition obligation represents the excess of the benefit obligation at January 1, 1993 over amounts previously accrued for this liability. Health Plans and Hospitals have elected to recognize the liability for the transition obligation over a twenty-year period. The employer contributions and benefits paid during 2008 were $59 million. There were no participant contributions from active employees in

25 Actuarial assumptions used were as follows: Weighted average discount rate at January 1 for calculating postretirement benefits expense 6.75% Weighted average discount rate for calculating December 31 benefit obligation 6.80% The following are the assumed health care cost trend rates: Basic and Prescription supplemental drug and Part B Medicare medical Part D Dental premium Part A & B Initial trend rate % 8.0% 5.0% 5.0% 4.4% Initial trend rate % 8.0% 5.0% 5.0% 4.6% Ultimate trend rate 5.0% 5.0% 5.0% 5.0% 5.0% First year at ultimate trend rate A 1% increase in the Medical Trend Rate would increase the benefit obligation by $511 million and the service cost plus interest by $72 million. A decrease of 1% in the Medical Trend Rate would decrease the benefit obligation by $403 million and the service cost plus interest by $56 million. Following are the projected benefit cash flows used in determining the benefit obligation (in millions): (12) Physicians Retirement Plan Year(s): 2009 $ Kaiser Foundation Health Plan, Inc. provides defined retirement and disability benefits for physicians associated with certain Medical Groups. Benefits are determined based on the length of service and level of compensation of each participant. The plan is unfunded and is not subject to the Employee Retirement Income Security Act of Although this plan does not qualify as an employee benefit plan, the liability has been substantially calculated in accordance with the provisions of SFAS No. 158, and net worth has been debited 25

26 accordingly. For purpose of this calculation, assets designated by management for liabilities of the physicians retirement plan are treated as if they were qualified plan assets. Summary of changes in the physicians retirement plan liability (in millions): Physicians retirement plan liability at January 1 $ 2,429 Service cost 113 Interest cost 154 Net gain in net worth (129) Benefits paid (97) Physicians retirement plan liability at December 31 $ 2,470 Accumulated benefit obligation at end of year $ 1,816 Change in plan assets: Fair value of plan assets at the beginning of year $ Actual return on plan assets Company contributions 97 Benefits paid (97) Fair value of plan assets at end of year $ Funded status $ (2,470) Amounts recognized in the balance sheet consist of: Other long-term assets $ Current liabilities (95) Noncurrent liability (2,375) $ (2,470) Amounts recognized in net worth: Net actuarial gain $ 187 Health Plans classifies a portion of the physicians retirement plan obligation as current. As of December 31, 2008, $95 million of the liability is included in current liabilities. 26

27 Provision for physicians retirement plan for the year ended December 31 (in millions): Service cost $ 113 Interest cost 154 Amortization of net actuarial loss 5 Total benefit expense 272 Expected return on assets investment income included in operating expenses (196) Net benefit expense 76 Other changes in projected benefit obligations recognized in other comprehensive income (in millions): Net gain (129) Amortization of net actuarial loss (5) Total recognized in other comprehensive income (134) Total recognized in net periodic benefit cost and other comprehensive income $ (58) Actuarial assumptions used were as follows: Weighted average discount rate at January 1 for calculating benefit expense 6.50% Weighted average discount rate for calculating December 31 benefit obligation 6.85% Weighted average salary scale for calculating pension expense and December 31 benefit obligation 4.90% Expected rate of return on plan assets 8.00% The expected return on assets is the portion of investment income that represents the expected return on investments designated for the physicians retirement plan. This amount is recorded as a reduction in the expense for physicians retirement plan and is excluded from investment income (loss) - net. 27