Banner Health Management s Discussion and Analysis of Results of Operations and Financial Position

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1 Banner Health Management s Discussion and Analysis of Results of Operations and Financial Position The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make assumptions and estimates that affect the amounts reported in the financial statements, including the notes thereto, and related disclosures of commitments and contingencies, if any. Management relies on historical experience and other assumptions believed to be reasonable under the circumstances in making its judgments and estimates. Actual results could differ materially from those estimates. We recommend that you read this discussion together with our audited consolidated financial statements and related notes of Banner Health ( Banner ) for the year ended December 31, The audited consolidated financial statements are available from the Municipal Securities Rulemaking Board (the MSRB ) on its Electronic Municipal Market Access ( EMMA ) system, found at

2 Banner Health Management s Discussion and Analysis For The Three and Six Months Ended June 30, 2017 Overview Banner is one of the nation s largest nonprofit healthcare systems. Its stated mission is making health care easier, so that life can be better and it seeks to achieve that mission through continuous improvement in clinical and service performance for the patients and members it serves. Headquartered in Phoenix, Arizona, Banner provides a broad range of healthcare and related services concentrated in three geographic areas: the Greater Phoenix metropolitan area, the Greater Tucson metropolitan area, and in northern and northeastern Colorado, with the remaining facilities located in small or rural communities in Wyoming, Nebraska, Arizona, Nevada, and California. Centralized corporate and other support services for these operations are provided from Banner s corporate offices in Phoenix, Arizona. In December, 2015, Banner exercised its right to terminate the Greater Fairbanks Community Hospital Foundation lease with one year advance notice. The termination was effective January 1, Prior year comparisons below have been adjusted to reflect only continuing operations. Performance for the Three Months Ended June 30, 2017 Banner generated operating income of $121.5 million and net income of $178.4 million for the quarter ended June 30, 2017, equating to operating and total margins of 6.1% and 8.6%, respectively. This performance represents an improvement from the $93.5 million and $138.2 million operating and net income and 4.9% and 7.1% operating and total margins for the second quarter of Performance results include three significant elements: Strong community delivery system performance. academic delivery system operations yielded $111.5 million in operating income, the equivalent of an 8.7% operating margin, up significantly from the 4.6% operating margin earned in the second quarter of Community delivery revenue increased 6.6% over the prior year on a 3.3% increase in acute patient encounters (inpatient acute admissions plus observation cases). Weak but improving University Medicine delivery operations. The University Medicine Division, which includes two medical centers and the faculty practice plan in Tucson Arizona, and a medical center and faculty practice plan in Phoenix, Arizona, earned $12.5 million from operations, compared to $1.3 million for the second quarter of Operating margin improved to 2.0% from 0.3% for the three months ended June 30, 2017 and 2016, respectively. Adjusted admissions, adjusted patient days, inpatient surgery, and emergency volumes reflect strong year-over-year growth and while revenue for the division grew 21.7% from second quarter 2016 to 2017, operating expenses grew only 19.6%. The Division has very focused cost reduction efforts underway with further improvements expected in the upcoming quarters. Unprofitable insurance operations. These operations include two Accountable Care Networks which take full risk from Medicare Advantage ( MA ) health plans and an Arizona Medicaid plan and its associated MA/D-SNP plan. These operations generated an operating loss of $19.9 million on $316.7 million in revenue, an operating margin of -6.3%, a significant decline from the $1.2 million operating income and 0.4% operating margin reported for the second quarter of The decrease in operating performance is largely attributable to increased losses on Banner Health Network s Medicare Advantage Plans. The largest of these plans, the BCBS

3 Medicare Advantage Plan, was substantially modified through new contract terms in 2017 and the addition of a new provider network. Although the initial short-term impact of these changes is negative, the long-term potential of the changes is expected to be positive and will improve the Plan s overall financial performance. BHN has initiated several performance improvement plans, which are expected to result in improvements in financial performance as the year progresses. Revenue, Volume and Operating Expense Banner continues to see strong revenue growth, as revenue increased 9.4% from second quarter 2016 to second quarter On a consolidated basis, acute and observation cases increased by 2,646 cases, or 3.3%. Emergency room visits of 256,716 increased 1.6% from 2016, and accounted for 58.4% of Banner s inpatient cases, up from 56.8% in the second quarter of Surgical volumes decreased 0.5% and totaled 40,455. The inpatient percentage of these cases increased to 37.2% in the second quarter of 2017 compared to 36.2% in the same period a year ago. hospital volume growth was strong as a result of continued additions to medical group capacity, the addition of Banner Urgent Care Services in November, 2016, and productivity increases. Clinic encounters grew 15.6% on a consolidated basis, excluding prior year Alaska encounters. Operating expenses totaled $1.9 billion for the quarter with labor and supply costs comprising 54.9% and 18.1% of patient revenue, respectively, compared with 54.7% and 19.6% of net patient revenue for the same period in Banner has embarked on an aggressive cost reduction plan in order to meet its income expectations for 2017 and the early outcomes of these plans are showing net positive results after severance and other costs. operating Performance operating performance for the quarter was strong, with investment earnings of $75.9 million partially offset by mark-to-market losses of $9.0 million from interest rate swaps and income taxes and other non-operating expenses of $3.5 million. Performance for the Six Months Ended June 30, 2017 For the first six months of 2017, Banner Health generated operating income of $189.5 million and net income of $386.8 million on revenue of $3.951 billion. This compares to $200.1 million operating income and $123.0 million net income for the same period in The significant increase in net income is due to the combined effect of improved investment returns and favorable mark-to-market movement in interest rate swaps in This performance equates to operating and total margins of 4.8% and 9.3%, respectively, compared to 5.2% and 3.3% for the same period a year earlier. Operating EBITDA is strong at 11.5%, but declined from 12.2% in the same period in Year-to-date results reflect strong delivery system performance and challenges in insurance operations, as reflected in the table below.

4 Summary of Operating Performance For the Six Months Ended June, 2017 ($ in thousands) Community Delivery University Delivery Insurance Operations Elims/ Other Consolidated Operating Revenue $ 2,565,545 $ 1,189,596 $ 623,263 $ (426,979) $ 3,951,425 Operating Expense 2,347,747 1,203, ,530 ( ) 3,761,902 Operating Income $ 217,798 $ (13,721) $ (43,267) $ 28,713 $ 189,523 Prior Year Operating Income * $ 163,559 $ (17,845) $ (10,382) $ 64,758 $ 200,090 % Change in Operating Income 33.2% 23.1% % -55.7% -5.3% * Prior year Alaska operations in Other Financial support from the University medical centers to the University medical group increased by approximately $90 million from 2016 to This caused a shift in operating income from the obligated group (medical centers) to the non-obligated group (medical group). The accounting change was made to better reflect the integrated nature of the academic medical group with the medical centers, and to facilitate performance measurements required by the Academic Affiliation Agreement beginning two years after the UAHN acquisition, the second anniversary of which was February 27, Capital Structure & Balance Sheet Banner s financial position is shown in the table below: Annualized YTD Annualized YTD Year Ended Year Ended June 30, June 30, December 31, December 31, LT Debt to Capital 34.3% 36.9% Days Cash on Hand Cash to LT Debt 159% 147% MADS Coverage % 38.0% % 151%

5 Banner Health and Subsidiaries Unaudited Financial Statements As of June 30, 2017 Contents Unaudited Consolidated Balance Sheets 2 Unaudited Consolidated Income Statements 4 Unaudited Consolidated Statements of Changes in Net Assets 5 Unaudited Consolidated Statements of Cash Flows 6 Notes to Consolidated Unaudited Financial Statements 7 1

6 ($ in thousands) Obligated Assets Current assets: Cash and cash equivalents 14,416 Banner Health and Subsidiaries Consolidated Balance Sheets Unaudited As of June 30, 2017 As of June 30, 2016 Obligated Eliminations Banner Health Obligated Obligated Eliminations Consolidated Banner Health Consolidated $ $ 111,070 $ - $ 125,486 $ 13,047 $ 70,470 $ - $ 83,517 Short-term investments 223,808 75, , ,131 75, ,365 Collateral held under securities lending program and repurchase agreements 389, , , ,530 Assets limited as to use 43,454 33,774-77,228 38,170 33,675-71,845 Patient receivables, net of allowance for doubtful accounts 721,216 85,325 (33,607) 772, ,385 76,732 (26,653) 797,464 Inventories 170,074 23, , ,925 16, ,930 Estimated current portion of third-party payor settlements 12, ,969 7, ,407 Other receivables 162,712 83,595 (1,366) 244, ,570 77,880 (3,006) 222,444 Other, primarily prepaid expenses 277,865 (213,304) - 64, ,577 (27,715) - 76,862 Total current assets 2,015, ,128 (34,973) 2,179,868 1,728, ,281 (29,659) 2,021,364 Assets limited as to use: Funds designated by: Board of Directors 1,947, ,947,319 1,734, ,734,024 Lease agreements 1, ,900 2, ,317 Funds held by trustees under: Self-insurance funding arrangements 15, , ,806 16, , ,033 Other funds 221, , , ,435 Total assets limited as to use, less current portion 2,186, ,851-2,299,066 2,033, ,505-2,187,809 Assets held for sale 2, ,140 2, ,140 Property and equipment, net of depreciation 3,260,551 90,157-3,350,708 3,059,953 62,348-3,122,301 Leased hospital assets 230, , , ,094 Other assets: Long-term investments 1,938,136 31,018-1,969,154 1,981,750 28,656-2,010,406 Other 401, ,758 83, , , ,772 47, ,468 Total other assets 2,339, ,776 83,269 2,611,826 2,337, ,428 47,249 2,563,874 $ 10,035,232 $ 590,912 $ 48,296 $ 10,674,440 $ 9,419,430 $ 718,562 $ 17,590 $ 10,155,582 2

7 ($ in thousands) Obligated Liabilities and net assets Current liabilities: Current portion of long-term debt 156,133 Banner Health and Subsidiaries Consolidated Balance Sheets Unaudited As of June 30, 2017 As of June 30, 2016 Obligated Eliminations Banner Health Consolidated Obligated Obligated Eliminations Banner Health Consolidated $ $ - $ - $ 156,133 $ 154,597 $ 1,535 $ (152) $ 155,980 Current portion of hospital lease obligations 23, ,785 22, ,719 Trade accounts payable 185,423 27, , ,008 28, ,580 Payable under securities lending program and repurchase agreements 389, , , ,530 Estimated current portion of third-party payor settlements - 1,091-1, Accrued expenses: Salaries and benefits 303,563 96,777 (6,423) 393, ,637 70,248 (6,344) 325,541 Claims payable - 141,078 (28,467) 112, ,643 (23,387) 98,256 Other 162,356 60, , ,531 64, ,789 Total current liabilities 1,220, ,493 (34,890) 1,513,062 1,147, ,257 (29,883) 1,403,396 Long-term debt, less current portion 2,735, ,735,648 2,745, ,745,516 Hospital lease obligation, less current portion 222, , , ,966 Estimated third-party payor settlements, less current portion 28, ,842 23, ,423 Estimated self-insurance liabilities, less current portion 73, ,943 (689) 176,514 40, ,987 (545) 161,159 Interest rate swaps 327, , , ,846 Other 215,806 5, , ,059 5, ,404 Total liabilities 4,824, ,284 (35,579) 5,225,932 4,899, ,589 (30,428) 5,281,710 Net assets: Unrestricted 5,135,477 19,138 83,402 5,238,017 4,472, ,611 47,448 4,698,477 Temporarily restricted 75, , ,238 47,463 97, ,757 Total Banner Health net assets 5,211, ,848 83,402 5,415,255 4,519, ,905 47,448 4,843,234 Noncontrolling interests - unrestricted - 32, ,253-30, ,638 Total net assets 5,211, ,628 83,875 5,448,508 4,519, ,973 48,018 4,873,872 $ 10,035,232 $ 590,912 $ 48,296 $ 10,674,440 $ 9,419,430 $ 718,562 $ 17,590 $ 10,155,582 3

8 ($ in thousands) Obligated Banner Health and Subsidiaries Consolidated Income Statements Unaudited For the Six Months Ending June 30, 2017 For the Six Months Ending June 30, 2016 Obligated Eliminations Banner Health Obligated Obligated Eliminations Consolidated Banner Health Consolidated Revenues: Net patient service $ 3,085,960 $ 497,666 $ (234,547) $ 3,349,079 $ 3,007,745 $ 464,488 $ (198,261) $ 3,273,972 Provision for doubtful accounts 130,901 21, , ,953 18, ,366 Net patient service revenue, less provision for doubtful accounts 2,955, ,149 (234,547) 3,196,661 2,877, ,075 (198,261) 3,125,606 Medical insurance premiums - 570, , , ,415 Other revenue 107, ,162 (166,694) 183, , ,157 (126,456) 179,538 Total revenues 3,062,468 1,290,198 (401,241) 3,951,425 2,990,629 1,166,647 (324,717) 3,832,559 Expenses: Salaries and benefits 1,392, ,910 (75,535) 1,911,223 1,364, ,263 (71,619) 1,820,063 Supplies 535,190 98,973 (2,189) 631, ,470 92, ,665 Physician and professional fees 137,670 31,071 (76,875) 91,866 65,338 20,411 (9,390) 76,359 Depreciation and amortization 196,524 5, , ,529 4, ,124 Interest 58,281 2,521-60,802 67,387 2,898 (475) 69,810 Medical claims costs, net of Banner claims - 567,300 (179,257) 388, ,564 (148,865) 345,699 Other 473,675 68,606 (66,723) 475, , ,916 (94,616) 492,749 Total expenses 2,794,188 1,368,293 (400,579) 3,761,902 2,690,592 1,266,842 (324,965) 3,632,469 Operating income (loss) 268,280 (78,095) (662) 189, ,037 (100,195) ,090 Other income (losses): Investment income-realized 77,476 1,830-79,306 26, (475) 25,866 Investment income - unrealized 80,330 1,439-81,769 13, ,626 Income (loss) from alternative investments 49, ,428 12,216 (214) - 12,002 Investment income (loss) 207,589 3, ,503 52, (475) 52,494 Unrealized gain (loss) on interest rate swaps 5, ,079 (110,929) - - (110,929) Other (4,397) (4,357) 2,906 (5,848) (4,059) (4,480) 4,476 (4,063) 208,271 (443) 2, ,734 (62,681) (3,818) 4,001 (62,498) Excess (deficiency) of revenues over expenses 476,551 (78,538) 2, , ,356 (104,013) 4, ,592 Less excess of revenues over expenses attributable to noncontrolling interests - 13, ,448-14, ,637 Excess (deficiency) of revenues over expenses attributable to Banner Health 476,551 (91,983) 2, , ,356 (118,458) 4, ,955 Amortization of cumulative loss on interest rate swaps Equity transfers (19,041) 19, (143,011) 143, Other changes in net assets, primarily distributions of earnings (39,990) 41,656 1,976 3,642 14,082 (15,202) 3,231 2,111 Increase (decrease) in unrestricted net assets $ 417,634 $ (31,286) $ 4,217 $ 390,565 $ 108,541 $ 9,351 $ 7,288 $ 125,180 4

9 ($ in thousands) Banner Health and Subsidiaries Consolidated Statements of Changes in Net Assets Unaudited Obligated For the Six Months Ending June 30, 2017 For the Six Months Ending June 30, 2016 Obligated Eliminations Banner Health Obligated Obligated Eliminations Consolidated Banner Health Consolidated Unrestricted net assets: Excess (deficiency) of revenues over expenses attributable to Banner Health $ 476,551 $ (91,983) $ 2,241 $ 386,809 $ 237,356 $ (118,458) $ 4,057 $ 122,955 Amortization of cumulative loss on interest rate swaps Equity transfers (19,041) 19, (143,011) 143, Other changes in net assets, primarily distributions of earnings (39,990) 41,656 1,976 3,642 14,082 (15,202) 3,231 2,111 Increase (decrease) in unrestricted net assets 417,634 (31,286) 4, , ,541 9,351 7, ,180 Temporarily restricted net assets: Contributions and other 3,576 4,939-8,515 7,869 5,617-13,486 Net unrealized gain on investments Net assets released from restriction (3,021) (7,330) - (10,351) (3,787) (7,937) - (11,724) Increase (decrease) in temporarily restricted net assets 559 (1,765) - (1,206) 4,106 (2,165) - 1,941 Noncontrolling interests: Excess of revenues over expenses attributable to noncontrolling interests - 13, ,448-14, ,637 Other changes, primarily distributions of earnings to noncontrolling interests - (10,780) - (10,780) - (14,699) (383) (15,082) Increase (decrease) in noncontrolling interests - 2, ,668 - (254) (191) (445) Increase (decrease) in net assets 418,193 (30,386) 4, , ,647 6,932 7, ,676 Net assets, beginning of period 4,792, ,014 79,655 5,056,481 4,407, ,041 40,921 4,747,196 Net assets, end of period $ 5,211,005 $ 153,628 $ 83,875 $ 5,448,508 $ 4,519,881 $ 305,973 $ 48,018 $ 4,873,872 5

10 ($ in thousands) Banner Health and Subsidiaries Consolidated Statements of Cash Flows Obligated Unaudited For the Six Months Ending June 30, 2017 For the Six Months Ending June 30, 2016 Obligated Eliminations Banner Health Obligated Obligated Eliminations Consolidated Banner Health Consolidated Operating activities: Increase (decrease) in net assets $ 418,193 $ (30,386) $ 4,220 $ 392,027 $ 112,647 $ 6,932 $ 7,097 $ 126,676 Adjustments to reconcile increase (decrease) in net assets to net cash provided by (used in) operating activities: Depreciation and amortization 196,524 5, , ,529 4, ,124 (Increase) decrease in investments designated as trading (96,770) 2,555 - (94,215) 173,926 2, ,829 Equity transfers 19,041 (19,041) ,011 (143,011) - - Net unrealized (gain) loss on interest rate swaps (5,193) - - (5,193) 110, ,815 Loss (gain) on sale of assets (37) - - (37) Temporarily restricted contributions (3,576) (4,939) - (8,515) (7,869) (5,617) - (13,486) Changes in operating elements, net of acquisitions: Patient receivables (8,837) (6,090) (5,254) (20,181) (27,756) 321 (413) (27,848) Inventories and other current assets 49,437 (31,935) (4,136) 13,366 (27,540) (26,941) (6,434) (60,915) Accounts payable and accrued expenses (56,072) (15,206) 9,303 (61,975) (20,754) (31,692) 6,427 (46,019) Estimated third-party settlements (14,984) 1,091 - (13,893) (11,461) - - (11,461) Estimated self-insurance liabilities 1,427 5, ,613 (4,939) (4,395) Other liabilities 6, ,673 (3,246) (86) - (3,332) Net cash provided by (used in) operating activities 505,758 (92,834) 4, , ,326 (192,474) 7, ,951 Investing activities: Net purchases of property and equipment (294,804) (19,207) - (314,011) (194,827) (6,084) - (200,911) Acquisitions (12,024) (11,077) (Increase) decrease in other assets (14,445) 1,904 (4,226) (16,767) 7,191 1,326 (7,245) 1,272 Net cash used in investing activities (309,249) (17,303) (4,226) (330,778) (199,660) (3,811) (7,245) (210,716) Financing activities: Proceeds from temporarily restricted contributions 3,576 4,939-8,515 7,869 5,617-13,486 Intercompany activity, including equity transfers (145,614) 145, (191,967) 191, Payments of hospital lease obligations (12,035) - - (12,035) (4,430) - - (4,430) Payments of long-term debt (57,761) (23) - (57,784) (252,667) (236) 146 (252,757) Net cash (used in) provided by financing activities (211,834) 150,530 - (61,304) (441,195) 197, (243,701) Net (decrease) increase in cash and cash equivalents (15,325) 40,393-25,068 (9,529) 1,063 - (8,466) Cash and cash equivalents at beginning of period 29,741 70, ,418 22,576 69,407-91,983 Cash and cash equivalents at end of period $ 14,416 $ 111,070 $ - $ 125,486 $ 13,047 $ 70,470 $ - $ 83,517 Capital leases NCMC, Inc. and Washakie Medical Center $ 10,546 $ - $ - $ 10,546 $ 25,432 $ - $ - $ 25,432 6

11 Banner Health and Subsidiaries Notes to Consolidated Unaudited Financial Statements June 30, Description of Business Banner Health is a nonprofit corporation exempt from income taxes under Internal Revenue Code Section 501(c)(3) and applicable state income tax codes. Banner Health and its subsidiaries (Banner) own or lease hospitals, multispecialty physician groups, clinics, nursing homes, clinical laboratories, ambulatory surgery centers, urgent care centers, home health agencies, a captive insurance company, foundations, an accountable health care organization, health insurance plans, and other health care-related organizations in six western states. Banner also holds an interest in several healthcare related organizations, including: A 51% controlling interest in Sonora Quest Laboratories (SQL); the financial results of SQL have been included in Banner s consolidated financial statements. A 50% noncontrolling interest in Veritage LLC (Veritage) which is accounted for under the equity method of accounting. Banner s share of Veritage LLC s net income has been recorded within other operating revenue. In August, 2017 Banner provided its initial funding of $58,914,000 to the Banner Health and Aetna Health Insurance Holding Company LLC joint venture, as described in the notes to Banner s December 31, 2016 audited financial statements. 2. Significant Accounting Policies Basis of Presentation The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial reporting, applied on a basis substantially consistent with that of the 2016 audited financial statements of Banner. They do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included. Operating results for the six months ended June 30, 2017 are not necessarily indicative of the results to be expected for the year ended December 31, For more information, refer to the audited consolidated financial statements and notes thereto as of and for the year ended December 31, Subsequent events have been evaluated through August 25, 2017, the date of the issuance of the unaudited consolidated financial statements. The separate details of the Obligated and Obligated financial statements are presented for purposes of additional analysis and are not a required part of the consolidated financial statements. Basis of Consolidation The accompanying consolidated financial statements reflect the consolidated operations of all owned and leased operating units of Banner and its wholly owned subsidiaries. Banner also holds a controlling interest in several joint ventures, the financial results of which are included in Banner s consolidated financial statements. Banner records the unrelated investors ownership share of these joint ventures as noncontrolling interest. The noncontrolling interest balance as of June 30, 2017 and 2016 primarily relates to Quest s investment in SQL, in which Banner holds a 51% interest and Quest Diagnostics, Inc. holds the remaining 49% interest. 7

12 Banner Health and Subsidiaries Notes to Consolidated Unaudited Financial Statements June 30, Significant Accounting Policies (continued) Short-Term Investments Short-term investments primarily include debt securities with maturity dates of one year or less from the balance sheet date, US Treasury government obligations and actively traded equity securities. These investments are stated at fair value (Refer to Note 3). Investments Banner invests in alternative investments, mainly hedge funds, through limited partnerships. Banner accounts for its ownership share in these alternative investments under the equity method based on the hedge funds net asset value per share of the fund held by Banner. The hedge fund net asset value is provided to Banner by each of the hedge fund managers. The net asset value is determined based on the estimated fair value of each of the underlying investments held in the hedge fund. However, the hedge fund investment holdings may include investment in private investment funds whose values have been estimated by the hedge fund manager in the absence of readily ascertainable fair values. Due to the inherent uncertainty of these estimates, these values may differ from the values that would have been used had a ready market for these investments existed. Banner s share of the alternative investments unrestricted realized and unrealized gains approximated $50,428,000 and $12,002,000 for the six months ended June 30, 2017 and 2016, respectively. The restricted share of alternative investment realized and unrealized gains is approximately $688,000 and $270,000 for the six months ended June 30, 2017 and 2016, respectively. Banner uses derivative financial instruments in its investment portfolio to moderate changes in value due to fluctuations in the financial markets. Banner has not designated its derivatives related to marketable securities as hedged financial instruments. Banner offsets the fair value for various derivative instruments including forwards, interest rate swaps, currency swaps, options and other conditional or exchange contracts, if they are executed with the same counterparty under a master netting arrangement. Banner invests in a variety of derivative instruments through fixed income managers that have executed a master netting arrangement with each of its forward and future purchase and sale contracts, interest and credit swap agreements and option agreements, whereby the financial instruments are held by the same counterparty and are legally offset as the instrument is settled. Banner's derivative contracts in a net loss position were immaterial at June 30, 2017 and 2016 and were reported on the accompanying consolidated balance sheets on a net basis. As of June 30, 2017 and 2016, the gross derivative assets and liabilities held and netted together within the investment accounts amounted to assets of approximately $493,122,000 and $372,142,000 and liabilities of approximately $486,959,000 and $379,597,000, respectively. (See Note 3 for a more complete description of derivative assets and liabilities.) Banner has entered into repurchase agreements amounting to approximately $139,005,000 and $167,713,000 as of June 30, 2017 and 2016, respectively, which are included in long-term investments on the accompanying consolidated balance sheets. In connection with the repurchase agreements, Banner has loaned cash to certain financial institutions in exchange for collateral. Collateral provided by the financial institutions amounted to approximately $139,412,000 and $174,154,000 as of June 30, 2017 and 2016, respectively, and is recorded in the unaudited consolidated balance sheets within collateral held under securities lending program and repurchase agreements as of June 30, 2017 and

13 Banner Health and Subsidiaries Notes to Consolidated Unaudited Financial Statements June 30, Significant Accounting Policies (continued) Banner participates in securities lending transactions through its custodian whereby Banner lends a portion of its investments to various brokers in exchange for collateral for the securities loaned, usually on a short-term basis. Collateral provided by the brokers consists of cash and securities and is maintained at levels approximating 102% of the fair value of the securities on loan, adjusted for market fluctuations. Banner maintains effective control of the loaned securities through its custodian during the term of the arrangement in that they may be recalled at any time. Under the terms of the agreement, the borrower must return the same, or substantially the same, investments that were borrowed. The value of collateral held for loaned securities is reported in current assets as collateral held under securities lending program and repurchase agreements, and a corresponding obligation is reported in current liabilities as a payable under securities lending program and repurchase agreements in the accompanying consolidated balance sheets. At June 30, 2017 and 2016, the fair value of the collateral provided on behalf of Banner was approximately $249,786,000 and $207,376,000, respectively. At June 30, 2017 and 2016, the fair market value of securities on loan was approximately $243,095,000 and $200,892,000, respectively, and is included in assets limited as to use on the accompanying consolidated balance sheets. Premium Revenues and Claims Costs Premium revenues and claims costs of BHN and the University Health Plans are as follows (in thousands): 6/30/2017 6/30/2016 Net premium revenue $ 570,887 $ 527,415 Net claims cost 388, ,699 BHN and University Health Plans elimination 208, ,210 Gross claims cost, including claims paid to Banner facilities and providers $ 596,929 $ 524,909 Claims cost as a percent of premiums 104.6% 99.5% Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements. Estimates also affect the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates are made in the areas of patient accounts receivable, accruals for settlements with third-party payors, risk pool and insurance settlements, medical claim liabilities, contingent liabilities, and accrued liabilities resulting from self-insurance programs. In the six months ended June 30, 2017 and 2016, Banner Health Network recorded prior plan year income of $12,006,000 and $19,495,000, respectively, related to the Medicare Pioneer ACO savings, which is recorded as an increase to other revenue. Banner Health Network also recognized an increase to other operating revenue amounting to $15,361,000 and $1,541,000 in 2017 and 2016 for adjustments to prior year risk sharing agreements. The 2017 adjustment is due to an actuarial adjustment in the Blue Alliance loss projections by Blue Cross and Blue Shield of Arizona, including an anticipated reinsurance settlement. Net patient services revenue was increased by $17,204,000 and $14,523,000 in the first six months of 2017 and 2016 for prior year third party settlements, and by $23,728,000 and $38,626,000 for changes in reimbursement for graduate medical education programs. GME distribution amounts are not finalized until near the end of the fiscal year covered, so there are often changes in estimates relative to this program. Professional and general liability insurance expense decreased $5,000,000 and $17,500,000 in the first six months of 2017 and 2016 due to actuarial adjustments. 9

14 Banner Health and Subsidiaries Notes to Consolidated Unaudited Financial Statements June 30, Significant Accounting Policies (continued) Reclassifications Prior year amounts have been reclassified to conform to the current year presentation. Prior year third party settlements have been reclassified between current portion and non-current portion to conform to the 2016 audited and 2017 interim presentation. 3. Fair Value of Financial Instruments Fair value is defined as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, Banner utilizes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows: Level 1. Pricing inputs into the determination of fair value are generally observable inputs such as quoted prices in active markets. Level 2. Pricing inputs are based on quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities Level 3. Pricing inputs are generally unobservable and include situations where there is little, if any, market activity for the investment. The inputs into the determination of fair value require management s judgment or estimation of assumptions that market participants would use in pricing the assets or liabilities. The fair values are therefore determined using factors that involve considerable judgment and interpretations, including but not limited to private and public comparables, third party appraisals, discounted cash flow models, and fund manager estimates. Assets and liabilities measured at fair value are based on one or more of three valuation techniques identified in the tables below. Where more than one technique is noted, individual assets or liabilities were valued using one or more of the noted techniques. The valuation techniques are as follows: (a) Market approach. Prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. (b) Cost approach. Amount that would be required to replace the service capacity of an asset (replacement cost). (c) Income approach. Techniques to convert future amounts to a single present amount based on market expectations (including present value techniques, option-pricing and excess earnings models). Banner s investment in alternative investments, amounting to approximately $1,166,474,000 and $1,410,387,000 as of June 30, 2017 and 2016, respectively, are accounted for using the equity method of accounting. Accordingly, the alternative investments are omitted from the following schedule of financial instruments measured at fair value. Also, included in assets limited as to use are premium payments to be received from Banner s split dollar life insurance policies amounting to $6,728,000 and $12,179,000 as of June 30, 2017 and 2016, respectively, which are not measured at fair value. The decrease in split dollar receivables is due to the program winding down and policies being surrendered. Further decreases are expected over the next several years. 10

15 Banner Health and Subsidiaries Notes to Consolidated Unaudited Financial Statements June 30, Fair Value of Financial Instruments (continued) June 30, 2017 (In Thousands) Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Valuation Technique (a, b, c) Cash and cash equivalents $ 319,782 $ 281,991 $ 37,791 $ - a Collateral held under securities lending and repurchase agreement (primarily cash and debt securities) 389, , ,412 - a Mutual funds: a Mutual funds U.S. funds 1,017,038 1,017, a Mutual funds International 760, , a Total mutual funds 1,777,995 1,777, Debt securities: U.S. Treasury/government obligations 295, ,127 - a Corporate bonds/u.s. government bonds 244, ,258 - a Asset-backed securities 132, ,127 - a Commercial mortgage-backed securities 12,629-12,629 - a government-backed collateralized mortgages 21,263-21,263 - a Government mortgage-backed securities 345, ,985 - a Government commercial backed 6,631-6,631 - a Total debt securities $ 1,058,020 $ - $ 1,058,020 $ - Repurchase agreements $ 139,005 $ - $ 139,005 $ - a Equity securities: U. S. equity securities $ 103,352 $ 103,352 $ - $ - a International equity securities 141, , a Total equity securities 244, , Derivative securities Future contracts 72,804 72, a Forward contracts 410, ,685 - a Interest rate swap agreements 3,642-3,642 - a Option agreements a Net credit swaps 5,986-5,986 - a Subtotal derivative assets $ 493,122 $ 72,804 $ 420,318 $ - Future contracts (72,804) (72,804) - - a Forward contracts (410,869) - (410,869) - a Interest rate swap agreements (1,580) - (1,580) - a Option agreements (122) - (122) - a Net credit swaps (1,584) - (1,584) - a Subtotal derivative liabilities $ (486,959) $ (72,804) $ (414,155) $ - Total fair value Investments $ 3,934,946 $ 2,554,555 $ 1,380,391 $ - Short-term investments 299,416 Collateral held under securities lending and repurchase agreements 389,199 Assets limited as to use 2,376,294 Long-term investments 1,969,154 Other assets Banner Foundation restricted funds 74,085 Less: alternative investments 1,166,474 Less: split dollar life insurance 6,728 Total fair value investments $ 3,934,946 Interest rate swaps $ (327,645) $ $ (327,645) $ c 11

16 3. Fair Value of Financial Instruments (continued) Banner Health and Subsidiaries Notes to Consolidated Unaudited Financial Statements June 30, 2017 June 30, 2016 (In Thousands) Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Valuation Technique (a, b, c) Cash and cash equivalents $ 463,996 $ 434,612 $ 29,384 $ - a Collateral held under securities lending and repurchase agreement (primarily cash and debt securities) 381, , ,154 - a Mutual funds: Mutual funds U.S. funds 932, , a Mutual funds International 406, , a Total mutual funds 1,338,844 1,338, Debt securities: U.S. Treasury/government obligations 249, ,598 - a Corporate bonds/u.s. government bonds 144, ,134 - a Asset-backed securities 68,859-68,859 - a Commercial mortgage-backed securities 13,225-13,225 - a government-backed collateralized mortgages 12,411-12,411 - a Government mortgage-backed securities 239, ,923 - a Government commercial backed 5,096-5,096 - a Total debt securities $ 733,246 $ - $ 733,246 $ - Repurchase agreements $ 167,713 $ - $ 167,713 $ - a Equity securities: U. S. equity securities $ 173,794 $ 173,794 $ - $ - a International equity securities 239, , a Total equity securities 413, , Derivative securities Future contracts 68,334 68, a Forward contracts 297, ,145 - a Interest rate swap agreements 3,937-3,937 - a Net credit swaps 2,726-2,726 - a Subtotal derivative assets $ 372,142 $ 68,334 $ 303,808 $ - Future contracts (68,335) (68,335) - - a Forward contracts (298,921) - (298,921) - a Interest rate swap agreements (11,147) - (11,147) - a Option agreements (76) - (76) - a Net credit swaps (1,118) - (1,118) - a Subtotal derivative liabilities $ (379,597) $ (68,335) $ (311,262) $ - Total Fair Value Investments $ 3,491,038 $ 2,393,995 $ 1,097,043 $ - a Short-term investments 193,365 Collateral held under securities lending and repurchase agreements 381,530 Assets limited as to use 2,259,654 Long-term investments 2,010,406 Other assets Banner Foundation restricted funds 68,649 Less: alternative investments 1,410,387 Less: split dollar life insurance 12,179 Total fair value investments $ 3,491,038 Interest rate swaps $ (471,846) $ - $ (471,846) $ - c 12

17 Banner Health and Subsidiaries Notes to Consolidated Unaudited Financial Statements June 30, Fair Value of Financial Instruments (continued) Investment income consisted of the following for the six months ended June 30: ($ in thousands) Interest and dividend Income $ 22,834 $ 26,389 Net realized gain on sales of investments 57,451 4,789 Gain from alternative investments 51,116 12,272 Net realized gain (loss) on sales of future contracts 1,145 (2,122) Net realized gain (loss) on sales of interest rate swap agreements 676 (948) Net realized gain on sales of option agreements Net realized loss on sales of net credit swaps (1,150) (277) Net unrealized gain on investments 78,904 17,169 Net unrealized loss on interest rate swap agreements (282) (4,455) Net unrealized gain on option agreements Net unrealized gain on net credit swaps 3, ,796 54,146 Less: Investment income credited to other revenue, restricted funds, and capitalized bond project funds 3,293 1,652 Investment income $ 211,503 $ 52, Interest Rate Swap Agreements Banner entered into multiple interest rate swaps that currently do not qualify for hedge accounting. For the six months ended June 30, 2017 and 2016, the mark-to-market adjustment resulted in an unrealized gain of $5,079,000 and an unrealized loss $(110,929,000) respectively, recorded in excess of revenue over expenses. The net effect of the interest rate swaps, recorded in interest expense, was to increase the overall cost of borrowing for the six months ended June 30, 2017 and 2016, by $19,597,000 and $21,812,000, respectively. Each of the interest rate swap agreements has collateral posting thresholds based on the counterparties bond ratings. At the AA- rating level, Banner and its counterparties must post collateral when the mark-to-market adjustment exceeds between $35,000,000 and $75,000,000 depending on the counterparty. At June 30, 2017 and 2016, Banner had $127,348,000 and $173,793,000 of collateral outstanding with its counterparties, respectively. The fair value of the collateral is reported as other funds under the assets limited as to use category in the accompanying consolidated balance sheets. 13