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UnitedHealth Group Incorporated (NYSE:UNH)

Q3 2008 Earnings Call

October 16, 2008 8:45 am ET

Executives

Stephen Hemsley - President and CEO

Mike Mikan - EVP and CFO

Simon Stevens - CEO, Ovations

Gail Boudreaux - EVP and President, UnitedHealthcare

Rick Jelinek - CEO, AmeriChoice

Analysts

Justin Lake - UBS

Josh Raskin - Barclays Capital

Matthew Borsch - Goldman Sachs

Scott Fidel - Deutsche Bank

John Rex - JPMorgan

Carl McDonald - Oppenheimer

Sheryl Skolnick - CRT Capital Group

Charles Boorady - Citigroup

Ana Gupte - Bernstein Research

Peter Costa - FTN Midwest Securities

Doug Simpson - Merrill Lynch

Operator

At this time, I would like to welcome everyone to the UnitedHealth Group third quarter 2008 earnings conference call. (Operator Instructions).

Here are some important introductory information. This call will reference non-GAAP amounts. A reconciliation of non-GAAP to GAAP amounts is available on the financial reports and SEC filings section of the company's Investor page, at www.unitedhealthgroup.com. This call contains forward-looking statements under US Federal Securities Laws. Such statements are subject to risks and uncertainties that could cause actual results to differ materially from historical experience or present expectation. A description of some of the risks and uncertainties can be found in the report that we filed with the Securities and Exchange Commission from time to time, including cautionary statements included in our current and periodic filings.

Information presented on this call is contained in the earnings release we issued this morning and in our Form 8-K dated October 16, 2008, which may be accessed from the Investors page of the company's website, at www.unitedhealthgroup.com.

I would now like to turn the conference over to the President and Chief Executive Officer of UnitedHealth Group, Stephen Hemsley.

Stephen Hemsley

Good morning and thank you for joining us today. We moved our call a few days ahead so we could provide more timely information, given the turbulence in the capital markets these past weeks. This morning, we are pleased to report an improving picture in our business performance in the third quarter.

We reported earnings per share of $0.75 with key financial metrics in line, and in some instances, stronger than our most recent outlook. Our balance sheet is very strong and our investment portfolio is positioned conservatively in highly liquid securities and a high cash position. We've realized a net capital gain of $58 million on this portfolio year-to-date.

Our third quarter earnings per share of $0.75 include the realization of $0.02 per share in net capital losses. The quarter also includes the absorption of $0.03 per share for estimated costs for resolving a legal matter. And finally, we saw a benefit of $0.02 per share from a change in the estimated net cost to settle two class action lawsuits related to our historical stock option practices.

The third quarter performance was influenced by better than projected growth in most enrollment categories and improvements in clinical care and operating cost trend.

Fourth quarter net earnings are projected to be in the range of $0.77 to $0.80 per share. We have not projected any meaningful capital gains or losses on investments in these numbers.

One of the purposes of holding our call earlier is to address questions related to the financial strength of the industry and our enterprise. So we will begin this morning by focusing on our balance sheet, capital base and liquidity, which are strong across the board.

For the third quarter, we generated cash flows from operations on an adjusted basis of $2.4 billion, excluding the settlement payment. This is consistent with our full year cash flow outlook approaching $5 billion as adjusted. This exceptional cash generation allowed us to fully fund previously announced legal settlements and to reduce our debt to debt plus equity ratio from 40.4% to 39.2% over the quarter. We expect that ratio will be lower by yearend depending on market conditions.

We remain regular active participants in the commercial paper market. We ended the quarter with less than $600 million outstanding. Our commercial paper program is backstopped by a $2.5 billion bank credit facility that extends through 2012 and is supported by 26 financial institutions as well as further support from a 364-day credit facility. There are no balances outstanding under these facilities.

With respect to future liquidity and debt refinancing, we have term debt totaling $900 million due before the end of the first quarter of 2009 and approximately $450 million in the third quarter of 2009. We expect to refinance those bonds in the fixed income market by then or could repay them entirely from our cash flows if needed.

Our investment portfolio performed well on a relative basis in the third quarter. We had small positions in issuers, such as Lehman Brothers, Washington Mutual and AIG.

As previously discussed, our net realized losses were $45 million, including net losses of $67 million from sales and other than temporary impairments realized subsequent to September 15 in response to market conditions. This $45 million net loss represents two tenths of 1% of the total of the $20.4 billion cash and investments on our balance sheet.

That brings us to a net realized capital gain of $58 million for the first nine months of 2008, a distinctive accomplishment in this period of capital market turbulence. We had a net unrealized loss position of $282 million on September 30 or 1.4% of the total portfolio value, and the clear expectation and intent to hold these investments to their maturity.

We continued to be well served by the philosophy of having a large fixed income investment portfolio that is highly liquid, with $6 billion in cash and cash equivalents, highly diversified and characterized by strong credit quality with over 80% of the portfolio in securities rated AA or higher.

Our practice is to hold investment grade bonds. More than 99% of the portfolio is investment grade, less than 1% that has not resulted largely from a recent acquisition that has not yet been brought fully into line with our portfolio standards.

With respect to overall capital levels, we have regulated capital of more than $10 billion at September 30. We project this will increase to approximately $11 billion by yearend, which will put us at 580% or $9 billion in excess of the minimum regulatory risk-based capital level at December 31, 2008.

Given the conservative profile of our investment policies, we believe we are more than adequately capitalized, even amid the unprecedented volatility of the broad capital markets.

We'll now shift the discussion to our third quarter performance in two simple sections, our health benefit businesses and our health services businesses. Earnings from operations for our health benefit businesses, which include UnitedHealthcare, Ovations and AmeriChoice, were $1.2 billion. This was an increase of more than $100 million from the second quarter of 2008 and an 80 basis point improvement in the overall operating margin to 6.8%.

UnitedHealthcare's commercial benefits business performed better this quarter. Risk-based enrollment grew on a same-store basis for the first time in a number of quarters. Fee-based business declined by 25,000 people as anticipated in response to employment attrition, which we expect will continue and accelerate.

Sequentially, the traditional UnitedHealthcare medical care ratio increased by 10 basis points to 83%, a performance slightly better than we projected, while operating costs decreased sequentially in response to continuing cost reduction efforts initiated two quarters ago.

While it is still very early, we have made progress in engaging more closely in local markets. Our customers are telling us our service and resolution disciplines are steadily improving. Our regional structure is in place, and stronger leadership teams are focused on improved execution. Further integration efforts across UnitedHealthcare are moving forward steadily.

We are addressing pricing and underwriting in a disciplined fashion and have taken the steps we discussed in our last quarterly call. We brought back a past company leader to resume national underwriting oversight responsibility. We are taking action on a market-by-market basis to address product positioning, reduce new business discounting, hold the line on case level negotiations and work for lower medical costs trends.

We are pricing customer renewals to their expected trends. These improvements will advance steadily and increase their impact as more of 2009 matures. We expect these underwriting disciplines, combined with more locally engaged fundamental care management, will ultimately improve our year-over-year margin trend.

We also continue our focus on care provider relationships. We have put resources back into local markets to better serve those relationships and our local market leaders have been specifically tasked to rebuild our relationship equity on a market-by-market basis. We quantify these efforts on a relative basis through surveys and we align compensation to the performance improvement.

Our medical costs trends have remained stable. We continue to see 2009 commercial trends in a corridor of 8%, plus or minus 50 basis points. Within patient unit costs, our biggest concern is specific markets. While we believe our UnitedHealthcare business is steadily strengthening, we clearly expect first quarter 2009 enrollment levels will be down significantly, comparable to first quarter 2008 and possibly greater.

We are of course addressing enrollment, but our greatest near-term priority is optimizing our product alignment, premium yield and medical cost trend in each market. We are confident profit and growth will quickly follow.

Our Ovations senior health benefits businesses are also steadily improving. This quarter, our Medicare Advantage business grew by 25,000 people, bringing our organic year-to-date increase to 80,000 and the total increase to 110,000 members to-date. Medicare Supplement business also increased 110,000 year-to-date, with 35,000 member growth in the third quarter. And our Medicare Part D business grew by 20,000 members in the third quarter.

These are all encouraging signs. We are much better positioned as we head into 2009. Benefit adjustments have been made across the board and particularly in our special need plans. Our distribution disciplines are improved. Our Part D auto assignment market position is much better.

We obviously cannot predict the ultimate mix we will achieve by the end of the enrollment season, but a realistic perspective on 2009 might have us with growth comparable to 2008, but with a clearly better business mix.

Ovations is committed to much more effective fundamental medical cost management performance across our senior markets. This is a result of consolidating and integrating our in-market care management efforts with our UnitedHealthcare management resources on a regional basis. This will be important to Ovations' 2009 performance.

AmeriChoice continued its strong performance in the quarter. Total Medicaid membership grew by 85,000 people this quarter, bringing year-to-date expansion including Unison to 630,000 people. On an organic basis, we are up 250,000 people this year and accelerating with recent wins positioning us for strong growth and performance in 2009.

We are currently building staff to support growth in markets like Tennessee, where we will provide behavioral medical benefits to more than 0.25 million new people by early 2009. Our services businesses include OptumHealth, Ingenix and Prescription Solutions. They all serve the healthcare marketplace broadly and continue to be an important dimension of growth, diversification and innovation for UnitedHealth Group.

On a combined basis, these businesses posted third quarter revenues of $4.7 billion and a sequential 3.5% increase in earnings from operations to total operating earnings of $323 million. These businesses also realized a modest decrease in overall operating costs in the quarter.

Operating margins improved sequentially for OptumHealth to 13.5% and Ingenix to 14.9%, while Prescription Solutions' margins remained flat at 3% which represents a 60 basis point improvement over the prior year. Key developments include continued progress in health banking, the preparation for launch of an updated consumer portal business and steadily stronger consumer demand for mail service pharmacy and generic drugs.

Medical costs at OptumHealth improved sequentially. We saw improvements in third quarter behavioral cost trends, where we expect the economic climate to remain a factor in behavioral health utilization.

OptumHealth is also significantly impacted by UnitedHealthcare membership trends, which have been the largest factor in OptumHealth 2008 performance. This will also remain a factor in 2009. This higher margin membership is being replaced by lower margin Medicaid and government program business.

Ingenix has actually had an important growth year, advancing meaningfully in its consulting services, government market businesses, lines and data and analytics services. Sales growth of 45% year-to-date across the payer, provider, government and other market segments has been offset by the sharply higher level of CRO project cancellations, as pharma companies respond to their own market pressures and narrowed their development efforts. We have seen this trend at times in the past and expect growth to resume in the future.

Prescription Solutions continues to grow steadily and mature its operation. It has made significant progress towards insourcing specialty pharma services for all of UnitedHealth Group. Organic membership growth outside the UnitedHealth businesses exceeded 400,000 people year-to-date, as Prescription Solutions steadily emerges as a full line, large scale national pharmacy benefits manager. We were gratified that JD Power & Associates gave Prescription Solutions its highest rating among mail order pharmacies for 2008.

Looking forward, the negative economic climate and outlook severely limits our visibility for 2009. We are assuming employment levels will be challenging and will accelerate member attrition. We are seeing selective examples of price discipline strengthening for commercial risk products in local markets, although it is too early to conclude this forms any real trend.

We will continue to be vigilant in our pricing disciplines in both risk and non-risk benefit products and are assuming lower membership in both categories as we enter 2009. While we are better positioned in Medicare and Medicaid entering 2009, we can't know the membership mix we will ultimately achieve in Medicare or what state level rate actions will impact our growing Medicaid business during 2009.

We are comfortable with our commercial medical cost trend outlook for 2009 at 8% plus or minus 50 basis points. We continue to view our consolidated 2008 medical care ratio as within a range of 82.5% plus or minus 50 basis points.

Clearly, there are real scenarios where that range could move slightly higher in 2009, driven most significantly by our ultimate product and business mix across our healthcare benefit businesses, including the level of growth achieved in public and senior market products.

Our comments focus only on the full year because the growth in offerings that have quarter-to-quarter swings and benefit usage, like high deductible consumer products and Part D benefit offerings, has increased quarterly volatility in these ratios over the last two years.

We are confident our operating cost performance in 2009 will continue to improve meaningfully and better match our business levels than in 2008. We've already implemented actions to achieve more than $400 million in run-rate operating costs, and there are substantially more opportunities. Areas for additional savings include benefits from merger integration, reductions in administrative staff and overhead areas and further repositioning in our technology organization to increase efficiency and reduce capital spending.

We will continue to size our staffing to match the growth profile in our benefits businesses for January 1, 2009, while continuing to advance customer service, market level responsiveness and our innovation agenda.

Our overall financial position is strong with a conservatively constructed investment portfolio and capital positioned significantly in excess of any regulatory company action level. Our operating cash flow capacities will further fortify that strong capital and liquidity outlook for 2009.

We can expect 2009 investment income will be less than 2008, particularly in the first quarter, while scheduled debt replacements will be at higher overall interest costs. Given those basic themes from this business, we see 2009 at an operating earnings level prior to investment income that plays out relatively flat to 2008 with clear room for upside if we perform to our plan.

While this mix translates into a positive per share earnings scenario, given currently projected share count levels, the performance range in this environment should be quite wide. We see an overall revenue range of $84 billion to $86 billion and a per share earnings outlook that could range from $2.90 per share to $3.15 per share.

Cash flow from operations should continue to be very strong in relationship to net earnings. Share repurchase activity will clearly be an important component of overall result, but market factors will influence the specific level and timing of repurchases in 2009.

In 2009 we will begin to match the practices of many Fortune 50 companies and move to annual rather than quarterly financial guidance. This should serve to create a conservation better aligned with long-term trends of the business and is consistent with the many reforms we've embraced.

Finally, many have asked about healthcare reform and its implications for our business in 2009 and beyond. On balance, our perspective on this is that we are an important enabler of reform and a committed participant in the reform process.

We support universal healthcare coverage as a broad policy goal and have a proven record of working with the federal government and many state governments to implement existing Medicare and Medicaid programs. The expansion of health insurance to those Americans who currently lack coverage will present additional opportunities for public-private collaboration.

The number of commentators now believe that the pace and magnitude of change will be less than some had previously anticipated. Their reasoning is very basic. There are now meaningfully fewer financial resources to dedicate to this important effort than just a few months ago, and the priority of this issue has been overshadowed by even greater public concern about economic security issues among the current turmoil.

First generation efforts will likely focus on reforms that do not require near-term funding or significant disruption, such as information and transparency, children's health initiatives, coverage policies for individuals and the like. In fact, we think Medicaid/SCHIP expansion may well be the first major funded priority for healthcare for a new administration, and that is an undertaking we can enable very effectively.

We ultimately anticipate pressure on Medicare advantage and Medicaid rates, but we are well along in preparing to respond with more effective care management practices and network strategies that will allow us to advance a better cost structure and thereby continue to diversify and grow in Medicare and Medicaid in a measured and profitable fashion.

We remain flexible and adaptable to changes in the market and are more engaged than ever before in a rational and staged change agenda as a partner in making reform work.

Before taking questions, let me briefly sum up the key points of this morning. The third quarter performance improved from a core earnings perspective with very early signs that actions we are taking across the business should translate to steadily improving results, quarter-by-quarter.

Our financial position is strong and we are committed to keeping it that way. Our business model does not rely on investment income or excessive leverage. We focus on earnings from the products and services we offer and seek to maintain a capital structure that is both prudent and efficient.

We are managing our capital and our operating resources conservatively, focused on retooling our benefit businesses along fundamental performance themes and creating higher growth in our services business. Our goal remains driving broader solutions and innovation across the healthcare landscape.

We are understandably cautious entering 2009, given the economic and political climate, but at the same time our internal improvement momentum is building, and we believe we are better positioned as an enabler of national healthcare agenda than any other enterprise in the marketplace.

This is a first look at 2009. We are holding our Investor Conference on December 2 in New York, at which we can discuss further our progress and what we see for 2009 and beyond.

At this time, I'd like to open up for questions. I'm joined in this room by many of our senior business colleagues. And John Penshorn, Brett Manderfeld, Mike Mikan, as well as Gail Boudreaux, Bill Munsell, Tony Welters and others, who will continue to be available after this call to respond to any additional questions you may have.

And now, we turn this to the moderator and take questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Justin Lake with UBS.

Justin Lake - UBS

Thanks. Good morning. I would like to just get a little bit more color on the prior period development you reported in the quarter, the $130 million. Can you tell us what drove that and what impact it had specifically on the commercial MLR?

And then, Steve, I think you mentioned the initiatives that are going on within the company to improve the trajectory of commercial margins as you move into '09. Could you give us some idea of where you expect that commercial margin to or the commercial MLR to come out in '09, just down, flat, up, and what initiatives exactly are taking place there and how they are going?

Stephen Hemsley

Absolutely, Justin. Your first question on development, Mike, do you want to respond?

Mike Mikan

Justin, it's pretty much split evenly between the government businesses and the commercial business. It had about a 60 basis point impact on the quarter for the commercial business. There was slight development in the other businesses as well, but most of the development came from the government and commercial businesses.

And what's driving it mostly in the commercial business is coming out of the West Coast. We've seen some improvements there. And in the government business, it's spread pretty evenly in the Medicaid business and we're seeing some favorable development out of the Evercare institutional business, which we saw significant trends earlier in the year. But that should summarize it for you.

Stephen Hemsley

And then, Justin, this is early so we're really not offering guidance on the 2009 MLR. We just offered themes. We grounded you in the consolidated care ratio for 2008. And I think when we meet in December, we'll have more to say about the more specific care ratios for 2009.

Justin Lake - UBS

Okay. And just, Mike, when you said the West Coast helped the prior period development in the commercial space, can you tell us specifically what happened on the West Coast, was it inpatient utilization or was it pricing getting better?

Mike Mikan

Yes, I would say vis-à-vis what our trends were that were embedded in our reserves, they've come out quite favorably and it's come across the board. We took significant actions around bed day management, strong contracting efforts as well, and those actions that we've been taking have improved our outlook now.

Justin Lake - UBS

Okay. Great. Thank you very much.

Stephen Hemsley

Next question please.

Operator

Your next question comes from the line of Josh Raskin with Barclays Capital.

Josh Raskin - Barclays Capital

Thanks. Good morning. Steve, I don't want to put words in your mouth, but it sounds like sort of the biggest area of concern or unknown is the economy in terms of the impact on your business. So I'm curious if we look back to sort of that last downturn, 2000/2002 period, several of the UnitedHealth Group businesses performed particularly well.

So I'm curious, what's different? Can we use that period as a proxy or which businesses specifically, other than membership attrition, obviously, would you expect to be impacted by the downturn?

Stephen Hemsley

Well, Josh, I'm going to keep this broad, but I think if you just stand back and look at the economic climate in total in this country and you look at the trends of employment levels, et cetera, we just think it is prudent to make sure that we are responding to those trends. We're seeing evidence of that in a day-to-day basis in our businesses. And to be cautious with respect to positioning for 2009, given the fact that I think this economic climate has moved swiftly, and that we are exercising that caution.

I don't want anybody to get the impression that we aren't intensely focused on our businesses that we don't see areas of clear executional improvement across the spectrum of our businesses and that we could perform better than what I'm suggesting in this, and I will tell you our clear focus and intent is to perform better.

But I think in terms of establishing kind of very early themes with respect to '09 outlook, I think that it's very appropriate for us to kind of set a grounding in this range.

Josh Raskin - Barclays Capital

Okay, I think I get the gist. Then if I can just sneak in an MLR question, it sounds like the biggest negative drivers this year have been the SNPs, the PDP and the behavioral health. Is it fair to say that the SNPs and PDP were fixed to the bidding process?

Stephen Hemsley

Simon, do you want to respond to that?

Simon Stevens

Yes. Josh, so all the chronic special needs plans, we substantially adjusted the 2009 benefits to put their economics on a more sustainable basis. So while overall performance will still be affected by the risk profile of our legacy chronic SNP members, 2009 chronic SNP benefits have largely been aligned with those of our core HMO products.

Josh Raskin - Barclays Capital

Okay. And the PDP, so obviously the bids were up again.

Simon Stevens

Yeah.

Josh Raskin - Barclays Capital

Okay, thanks.

Stephen Hemsley

Thank you. Next question?

Operator

Your next question comes from the line of Matthew Borsch with Goldman Sachs.

Matthew Borsch - Goldman Sachs

Yeah. If I could just ask a question, just again on the 2009 outlook and the discussion that you just had earlier, if we look back to the last recession year or sort of quasi-recession, 2001-2002, you actually grew EPS by 40% in that two year period.

I mean, isn't it fair to say that what's different here is that you do have a deeper economic downturn, but the primary headwind is the industry cycle itself and the pressure on pricing and the downward pressure that that's putting on underwriting margins? And I guess on that front, my question is do you have a line of sight that that will improve materially in 2009?

Stephen Hemsley

Well, I would agree that pressure in the marketplace plays into our thinking and that in combination with a troubling 2009 economic outlook is clearly what's part of our broad calculus. So I would agree with your basic premise there, Matthew.

Gail, do you want to respond?

Gail Boudreaux

Sure. Let me address the pricing question. As we discussed in our last call, we've taken a very disciplined approach to pricing and our strategy remains what we said before, which is to price to our forward view of cost. I think we've got a pretty good handle on our costs. So I guess the answer I'd say is we've got a pretty disciplined cost structure. We've already taken the actions that we talked about.

One is increasing our renewal pricing. We've been holding the line on our case-by-case negotiations and we've reduced our new business pricing. And I think another important part of it, we're also continuing to work at the market level on managing our medical costs and ensuring that we've got our products appropriately positioned through our regional local structure. So from that perspective, I think we've taken the actions that we've talked about, and while we are cautious in our outlook, feel that we've got some good momentum there.

Matthew Borsch - Goldman Sachs

And if I could just sneak in one more there on the outlook for January and as you think about commercial enrollment maybe being down comparably to what you experienced coming into this year. I mean coming into this year, if my numbers are right, I think you lost about 550,000 commercial risk-based lives and the fee-based enrollment was approximately flat. Are you looking at a change in the composition of where you may see an enrollment drain going into 2009?

Stephen Hemsley

We are not trying to give you first quarter membership direction. I think we tried to suggest that we are seeing that it could be at a level with 2008 or it could be worse than that. I would say there will be more fee in that mix and I think that will be safe to say. But I think given direction beyond that right now, Matt, is something we're just not prepared to do.

Matthew Borsch - Goldman Sachs

Okay. Fair enough. Thank you.

Operator

Your next question comes from the line of Scott Fidel with Deutsche Bank.

Scott Fidel - Deutsche Bank

Thanks. Good morning. I'm just wondering if you could elaborate a bit just on the comment you made about seeing some select improvement in commercial risk pricing so far, maybe if you can elaborate whether you're seeing that more from select blues or more on the public MCO competitor side.

Stephen Hemsley

Gail?

Gail Boudreaux

Sure. Overall, the pricing environment is still competitive, but we believe it's pretty rational. When we take a broad based perspective on the market, we haven't seen any intensification in the competitive environment, but we are seeing some firming in selected markets. And I would use the example of the Southeast and as well as the Midwest. The West certainly remains competitive.

I think it's too early to tell in terms of small group pricing because those renewals are in the process of occurring right now and those rates are being filed. But again, overall, we think that the environment is pretty stable and we do see some examples of firming. We've been very disciplined in our pricing, as I said before.

Scott Fidel - Deutsche Bank

Okay. And if I could just slip in a quick follow-up just around Medicare advantage rates, and Steve, maybe just to get a sense of your thinking on how significant cuts would have to be for you to maybe think about pulling back on the level of focus or attention that you would have on MA, maybe thinking about relative to traditional FFS, if we went back to 100% of FFS, would you still be comfortable or if we took it all the way back down to 95%, have you thought about some ranges relative to FFS where you could see the business just becoming much less attractive or still staying attractive?

Stephen Hemsley

Well, we are very focused on that marketplace and the needs of that marketplace. And if you look at the demographics and the response that is required, the assets of this organization are just ideally positioned to respond to that in the near-term and the long-term.

Whether we calibrate at what particular stages we may take a different view in terms of how we mix that business, I don't think we're prepared to respond. But I will tell you we're positive about that business, we recognize that there will be rate pressure. We have been anticipating that for some time in terms of how we generally manage and position our product alignment and our rates and how we're going after the care management dynamics and the cultivation of networks to respond to that on a long-term basis.

So there's been a great deal of positioning in terms of that business for some time. And we are beginning to see early evidence of how that can be effective. I will let Simon respond in terms of what we might see, in terms of how quickly rate pressure might come on us

Simon Stevens

Yes, so Scott, just building on what Steve has said, we are obviously planning on the assumption that there will be further rate pressure from 2010 and beyond, but in some ways it's worth remembering that's not new. For several years now, this industry has had to deal with annual gap between Medicare rate uplift and Medicare and medical cost trends. Those happened every year.

There are four main dials on our control panel that you can adjust. The first your annual benefits, and no doubt that large reimbursement cuts would mean significant cuts to Medicare benefits for 10 million vocal and politically engaged seniors.

Secondly, there's the effectiveness and intensity of your medical cost management, as Steve talked about. And we think we've got further scope for gains here.

Third, your operating costs, and scale efficiencies are going to be particularly important there.

And then fourth, yes, you margins, and we've made selective adjustments for 2009, where we feel there's a justified growth opportunity.

So I think, as Steve said, the question is what sort of companies are going to be most durable in this environment. It's going to be those with strong network purchasing power and a well-developed clinical care model for seniors, those who can harness operating scale efficiencies, those who are well diversified, both geographically and across the full range of Medicare services.

Remember, we are the market leader in products in the traditional parts of Medicare, not with Medicare Advantage. So if the market moves back in that direction we would expect to see faster growth in our Medicare supplement and our Part D businesses.

And then finally, as Steve said, it's going to be about how organizations can evolve and adapt. We think we can retool our underlying care management competencies and our consumer engagement platforms for whatever the evolving Medicare financing platform looks like, because regardless of how the policy evolves, the underlying demographics aren't changing. The fact is Medicare spending is going to double over the next decade. And the rising chronic condition is going to increase the demand for the kind of services we offer, not reduce them.

Stephen Hemsley

And with that said, I'm going to let Simon answer more of these questions. Could we go to our next question?

Operator

Your next question comes from the line of John Rex with JPMorgan.

John Rex - JPMorgan

Thanks. A couple questions on the investment portfolio. I will just focus on that for a minute here. So could you update us on the performance of the portfolio, as current as you can get us through October, given the market conditions, just some broad comments on that?

And then maybe also update us on the mix, if you could break down for us treasuries, munis, and then corporates, equities and private equity or VC, just kind of broad mix where it stands today.

Mike Mikan

Well, I would be giving you an estimate. As you know, John, it's changing every day, if you use any one of the indices that are out there, they would say that the market is down roughly another 2 or 3 points month-to-date. If you extrapolate that across our portfolio, our unrealized position may be down another 1% or so. And if I break out the portfolio, I will try to do that for you, we've got as Steve said $6 billion of cash and cash equivalents; it's roughly 30% of our portfolio.

We've got $1.5 billion in US government and agencies which is roughly 7% of our portfolio, mortgage debt securities of $3 billion, roughly 15% of our portfolio. All three of those categories are average AAA quality $6.6 billion of municipals, roughly 32% of our portfolio. And the balance is made up of corporate debt securities of $2.7 billion, roughly 14%. And then some venture investments and our employees' savings plan is the delta.

John Rex - JPMorgan

Okay. So you are saying net unrealized positioned down 1%, so that netted against, probably I assume the treasuries gave you some unrealized gain that you are netting against that. Is that the right way to think about it?

Mike Mikan

Yes. I think the area to focus in on is that where the market is, I think, rightfully focusing is the corporate debt securities. We feel confident in our position there. We are right in line with the indices that have been quoted of down 6.4% of that $2.7 billion, which is roughly $172 million of the $280 million unrealized gains, and we are tracking it closely, but yes, I would agree with your statement.

John Rex - JPMorgan

Okay. And just a follow-up on the guidance that you provided for us; can you bracket for us what you are incorporating your EPS outlook in terms of share repurchase activity in '09, just so we can kind of get high end/low end, just the broad range?

Mike Mikan

Roughly comparable to this year.

John Rex - JPMorgan

Great, thank you.

Stephen Hemsley

Next question please?

Operator

Your next question comes from the line of Carl McDonald with Oppenheimer.

Carl McDonald - Oppenheimer

Thank you. I'm interested in what you've seen medical cost trend do historically in the tough economy, and how you think this environment may be different. I'm particularly thinking about the greater level of cost-sharing that members have today.

Stephen Hemsley

Mike, do you want to start?

Mike Mikan

Well, I think we've stated before that we believe that there is a correlation with the economy, especially employment and health expenditures. We think there is roughly a two to four-year, call it a three-year lag in health expenditures from the economy. So as the economy enters into a recession, we believe that utilization or health expenditures, we will see that decline roughly three years after that.

We do believe that our products are appropriately matched to that type of economy. And we think that in the short term you may see some differences in utilization, depending on the market actions that we've seen in the marketplace today and this tumultuous time, but we really haven't seen anything different from what we've expected, so overall we expect utilization to be roughly comparable to what we've been seeing to date.

Carl McDonald - Oppenheimer

Great, thank you.

Stephen Hemsley

Next question please?

Operator

Your next question comes from the line of Sheryl Skolnick with CRT Capital Group.

Sheryl Skolnick - CRT Capital Group

Thanks very much for taking the question. I guess given I only have one, I need to go back to understand what you're talking about, Steve, I'm sorry to press you on this point, when you say that membership could be flat with 2008 first quarter or maybe worse, are you talking about the number reported at March or are you talking about the number you've reported on January 1, because there could have been attrition or gains within the quarter that we don't know about, and it may make or say 12/31/07.In other words, do we go back to the end of '07 to start our counting, or do we go back to the end of first quarter '08 to start our counting?

Stephen Hemsley

Well, I think what we intended was to suggest that basically it is what we experienced in the first quarter of last year. That is the first quarter of 2008. And I would compare that, we really speak largely in quarters to what we expect from the first quarter of 2009.

Sheryl Skolnick - CRT Capital Group

So end of quarter - end of quarter. Thank you for that clarification. And can I follow-up on the comments that you've made. I think Mike made a comment about this and so did Gail about the correct positioning of the product mix, the focus on the refocusing on local and regional expertise that the company abandoned when it went national, standardized, efficient, et cetera?

Can you give me an update on where you are and why you think your products are well positioned for today, how much of that transition has taken place? And just how different the company is at the regional and local level today than it was using product mix, for example, as a proxy, or any other that you might choose?

Stephen Hemsley

I would be happy. I would suggest that it is early, but I think there has been some nice progress made, even the fact that we are in the very early stages of it. Gail?

Gail Boudreaux

Hi Sheryl. Let me give you a quick update on where we stand on the regional structure. First the structure and leadership is already in place, and we've aligned our organization to support the model, and that includes our network, our clinical and our provider relations resources. And as Steve said, it is still early. We are already seeing more engagement in local decision-making and better execution of our strategies at the market level.

And as you know, that's where healthcare purchasing decisions are made. So what does that translate into? It translates into stronger sales, better relationships with our distribution partners, and more effective positioning. An example of the more effective positioning, we launched two products this year, Simply Engaged and our Edge products. And those products are actually very well positioned, given the focus on affordability at the employer level.

Simply Engaged is an example of a product that incents our members to engage in health and wellness activities. And the other product is focused on getting members to premium designation. The issue on positioning is a great one, because the Simply Engaged product is extremely popular in the Southwest. It's been positioned appropriately against the market dynamics there, whereas Edge is probably our top product in the Florida market and again based on the competitive dynamics there.

And the other piece of our regional structure that we put in place and I think we talked about in the last call is we moved to four consistent geographic regions across our benefits businesses. That's both for UnitedHealth Care, Ovations and our AmeriChoice business. And what we're seeing there is better coordination and the good sharing of resources. And how that translates, again, is, as we face out to the provider community it allows us to better leverage all of our UnitedHealth Group assets. And that's in our clinical management and our affordability programs, which Simon talked a bit about in Ovations but, clearly, our focus, again, as we enter a market where clinical care management is going to be continually important.

I guess the last piece that I just want to point out, in terms of early momentum on this model, is this gives our regional leaders a real clear line of sight and I think accountability for these programs and results with the market. So that is how I see the regional model playing and what we think are some good early indicators of good execution at the market level.

Sheryl Skolnick - CRT Capital Group

Okay. And what impact have you had on your premium trend? When you say the pricing, can you characterize it as what your premiums are equal to at cost trend, slightly below 50 basis points below, et cetera?

Gail Boudreaux

In terms of premium trends, we are, again, focused on pricing to our forward view of costs for 2009. We've got to look at that. In terms of 2008 we are essentially inline with the guidance we gave in the second quarter on premium trend.

Sheryl Skolnick - CRT Capital Group

Okay. Great. Thank you.

Stephen Hemsley

Next question please?

Operator

Your next question comes from the line of Charles Boorady with Citigroup.

Charles Boorady - Citigroup

Hi, thanks. Most have been asked, but with respect to Medicare for next year, when and at what point will you be able to assess, based on evaluating your competitor's product offering and pricing, what the risk of selection bias is in 2009?

Stephen Hemsley

Simon, do you want to respond?

Simon Stevens

What's it selection bias for a particular product you were thinking of, Charles?

Charles Boorady - Citigroup

Well, Medicare Advantage and the PDP would be the most important ones. For example, this year, as you know, Humana wound up with about 180,000 very high drug users, they weren't expecting last year this time. And the year before it was Sierra who was hit. So each year as you see what your competition's product offering and pricing looks like, I assume you compare your's side by side and assess whether you or somebody else will attract an unusually risky pool of customers. And so I'm just wondering at what point you go through that process and are better able to size up the potential risk going into '09?

Simon Stevens

Yes, so taking the two in turn then, on Part D, we have had modest premium increases in the zero dollar range on our most popular plans. So, we think we are in headline terms probably in the middle of the pack there. We don't think we are likely to be spreadsheeted, as we were.

On the auto-assigned elements of Part D, which gave rise to a significant part of the selection, the fact that you were talking about earlier in 2008, you'll see from our fitting that we took a very selective approach to which regions we thought could be economically viable for us in 2009.

Eight new regions fell into that category, but in certain other large regions such as New York, California, or Florida, our assessment was that the economics weren't viable. So, we didn't fit to come below the auto-assigned benchmark.

As for Medicare Advantage, we have in selected markets improved some of our benefits on our HMO product. We have adjusted downwards some of our chronic SNP benefits that we talked about. And one of the main dynamics I suspect will be the impact of the decision of some competitors to put premiums on some of their products they have. Whether that will create risk selection effects for other plans, I don't know. But we don't see why that should be a main consideration or a main issue for our MA.

Charles Boorady - Citigroup

At what point would you know? Is there a way to predict by actually evaluating your product and pricing up against your competition now and have a team of actuaries kind of assess how the populations might behave and whether you would attract a healthier or sicker population or do you need to actually wait and see the behavior in the first two quarters of '09 to make that assessment?

Simon Stevens

I mean we do that continually as the information available to us evolves. So, obviously in the course of the last few days, we've been able to assess how we are positioned competitively on a county-by-county basis or product. Then towards the end of the year or at the beginning of January, we will get CMS risk scores for some of the new auto-assigned Part D members, for example.

And we will also see some risk adjustment catch-up for some of the chronic special needs plan members, for whom we were under-compensated in the first year, this year. So, we will continue to monitor this very closely as information becomes available.

Charles Boorady - Citigroup

Okay, thanks. Maybe at your December investor day, this would be a great thing to follow up on as you get more information, just to give us greater comfort on MA and PDP going into '09.

Stephen Hemsley

Yes, I guess I might comment that actually as we develop these, our proposal positions, kind of going back in the middle of the year, we actually do what I will call kind of 'game theory' in terms of what will likely happen in the marketplace, what could happen in the marketplace, and it influences our proposals going right in from the beginning.

So, we are kind of doing this, I would say, even in advance of actually knowing. And I would suggest that nothing has necessarily played out differently than we anticipated. And our goal is not adverse selection. So I think that we are pretty comfortable with where we are at the moment. And as more information becomes available, if that view changes, we will update and we will clearly address this in December.

Charles Boorady - Citigroup

Great, thank you.

Operator

Your next question comes from the line of Ana Gupte with Bernstein Research.

Ana Gupte - Bernstein Research

Good morning. My question is about the pipeline for Medicaid opportunities in context of the economy. And I was wondering there is two competing factors, states being pressured fiscally because of the economy, but then it is being offset by a growing pool of Medicaid and SCHIP-eligible lives as the unemployment goes up.

Are states looking to manage care for solutions or is that likely to be more difficult given the budgetary challenges now?

Stephen Hemsley

Rick, do you want to touch on that?

Rick Jelinek

Ana, Rick Jelinek.

Ana Gupte - Bernstein Research

Hi.

Rick Jelinek

We see obviously that Medicaid business long term is a good value proposition for states as they look at health plan programs as a more efficient option than fee-for-service. And in the short run, there may be some challenges around the budget and eligibility cutbacks on an overall basis, but we think that there will be additional opportunity.

And we are actually seeing our customers engage with us in the discussion around adding beneficiary types that are not yet in managed care programs, such as dual eligibles, people with disabilities and the long-term care business, which typically have higher margins in the early years. So, we see this as a great opportunity.

We also, across UnitedHealth Group businesses, see that areas such as behavioral health and other carve-out or consolidation opportunities around prescription drugs is a great area that we are positioned very well for in our sister businesses.

So, long term, we see that this business will continue to grow and provide positive opportunity on the margin side for our business overall.

Ana Gupte - Bernstein Research

Okay, thanks. Just to follow up, are they looking more for risk-based offerings or are they still sticking with the fee-based services?

Rick Jelinek

Ana, sorry, you cut out at the --.

Ana Gupte - Bernstein Research

Are they looking more to move to products that you take on the risks, so that way they get an immediate savings, assuming that they can pass on that risk to you and you manage it adequately through medical management and so on?

Rick Jelinek

Well, yes, the answer on that is yes. The managed-care risk-based programs have shown that that's a more efficient and cost-effective mechanism for states to utilize. And we see that more and more of the eight categories that are not in managed care today will move to a risk-based product in the future.

Ana Gupte - Bernstein Research

Okay, thank you.

Stephen Hemsley

We'll take a couple of more questions, and then as I said, we will have a number of our management available throughout the course of the day. So next one, please.

Operator

Your next question comes from the line of Peter Costa with FTN Midwest Securities.

Peter Costa - FTN Midwest Securities

Hi. In terms of the $2.90 to $3.15 estimate, did you take into account any changes in medical utilization, perhaps more in-network utilization or higher generics from the weaker economy?

And then secondly, if you could go through the components of healthcare cost trend as you see them today and what changes you see going into 2009?

Stephen Hemsley

So, I'll just start in terms of the broad strokes is that, obviously, we have presented a very wide range in our outlook, and therefore that translates obviously to a similar variation in terms of what could occur in terms of utilization and so forth. So, I think if those scenarios are incorporated and is exactly for those kinds of reasons that we have established kind of the breadth of it.

And so, I think we have considered them and that's why we have kind of signaled the scenario and ranges that we are suggesting and suggesting that some of them could actually increase. The ones you are actually talking about generally would mitigate those trends.

And Mike, do you want to go through the components?

Mike Mikan

Well, you know, broadly speaking, I'll go back to my earlier comments. In the near term, we're not expecting really any different behavior in terms of utilization. Now to speak to generics, we do think that our products and especially in the senior space that seniors will, in a downturn that we are seeing, use more generics, which is good for everyone.

With respect to medical trend components, as I laid it out again in the first quarter, we wouldn't come off those trend assumptions for 2009. We are prudently anticipating an uptick in unit costs, but outside of that, I would expect again utilization to be comparable to 2008.

Stephen Hemsley

Thank you. One more question, please.

Operator

Your next question comes from the line of Doug Simpson with Merrill Lynch.

Doug Simpson - Merrill Lynch

Hey, good morning. A lot of my questions have obviously been answered at this point. But just could you give us some color on your comments, expanding your comments relative to cash flow and net income levels next year, just in light of the enrollment pressure you're talking about as well as investment income and interest expense?

You know, as we are thinking about cash to net income next year, cash flow to net income, where do you expect that level to sort of settle out?

Mike Mikan

I believe it will be in the range of where it will end up this year, around 1.3 times net income.

Doug Simpson - Merrill Lynch

Okay. So, the enrollment losses wouldn't really impact that in any way from lapsed claims?

Mike Mikan

It does, but as you know, we've had enrollment losses this year. I think you've seen it for some time, Doug, that we think over the long term this business will generate somewhere around 1.3 times net income, and I don't see any reason that would be any different next year. We'll continue to manage cash flow tightly, and we think there is opportunities to do better.

Doug Simpson - Merrill Lynch

Okay, great. Thanks.

Stephen Hemsley

So, we'd like to thank you for your interest this morning and particularly your flexibility in terms of participating on short notice. I'll just leave you with a couple of thoughts.

We are encouraged by the early signs we see in the third quarter and that the actions that we are taking are improving the performance of our businesses, particularly in our benefit businesses and expect those actions will continue.

We are committed to a very strong financial position, have been for many years. We really don't look to the investment portfolio as the source of earnings. We really look to our products and services, and we're going to continue that position and continue to focus on our balance sheet and our financial strength.

And while we are appropriately cautious about 2009, given current market conditions, we have very good momentum and we are well-positioned as we continue to drive execution in our businesses. And we are beginning to see some of those results. And we are hoping to then see you in December, and thank you very much for your participation.

Operator

Thank you for participating in today's conference call. You may now disconnect.

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Source: UnitedHealth Group Incorporated Q3 2008 Earnings Call
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