Health Net, Inc. Q3 2008 Earnings Call Transcript

| About: Health Net, (HNT)

Health Net, Inc. (NYSE:HNT)

Q3 2008 Earnings Call

November 4, 2008 11:30 am ET

Executives

Angie McCabe - Vice President of Investor Relations

Jay Gellert - Chief Executive Officer

Jim Woys - Chief Operating Officer

Joe Capezza - Chief Financial Officer

Analysts

Charles Boorady - Citi

Matthew Borsch - Goldman Sachs

Joshua Raskin - Barclays Capital

Greg Nersessian - Credit Suisse

Tom Carroll - Stifel Nicolaus

Justin Lake - UBS

John Rex - JP Morgan

Scott Fidel - Deutsche Bank

Brian Wright - Banc of America

Operator

Good day, everyone, and welcome to this Health Net, Inc. Third Quarter 2008 Conference Call. Today’s call is being recorded.

At this time, I would like to turn the call over to Angie McCabe, Vice President of Investor Relations. Please go ahead, ma’am.

Angie McCabe - Vice President of Investor Relations

Thank you, Pam. Good morning. During this call, we will make forward-looking statements that are subject to certain risks and uncertainties. Risk factors that may impact those statements and could cause actual future results to differ materially from currently expected results are described in our filings with the SEC as well as the cautionary statements in our press release issued in advance of this call.

In addition, today’s press release makes and the comments on this call will make reference to certain measurements that are not calculated and presented in accordance with Generally Accepted Accounting Principles. I should note that today’s press release which is available on the company’s website, includes a reconciliation of non-GAAP financial measures with operating results excluding charges related to the company’s operation strategy and the company’s investment holding.

In addition, we included a supplemental schedule showing a breakout of reserves and health care costs per capitation, provider settlements and the impact of Part D. These supplemental items provide the basis for discussion of operating metrics excluding the charges where appropriate and discussion of days claims payable, excluding the costs noted above.

Let me now turn the call over to our CEO, Jay Gellert. Jay?

Jay Gellert – Chief Executive Officer

Thank you, Angie. We are deeply disappointed in our third quarter and year-to-date results. This is a challenging time for us. Considering our year-to-date performance we cannot assume that the adverse trends we’ve seen will abate in the near future.

Our guidance for the fourth quarter and next year incorporates these trends. This in no way is meant to excuse or minimize the fact that this quarter’s performance is unacceptable. Despite the challenges we face, there are several key factors to keep in mind as move forward. Even when you incorporate these trends and assume continued weakness in the economy we have a clear path to earnings with our administrative cost saving effort giving us additional opportunities to address these trends. As a result we have the visibility that will allow us to go forward with our Investor Day as scheduled. Its important for us to have a full exchange with all of you about the current state of our operations and what we see for next year.

The balance sheet remained strong with no exposure to pension liability or other unusual issues. And, in order to streamline and bring an intense focus to our operational challenges all day-to-day operations of the company are now in Jim Woys’ hands. He’s a proven operator that many of you know and trust. Every area of the company he’s worked in has done well.

Tricare is producing excellent results and has over many years under his leadership. In just a short time as a COO, he has made significant progress in reducing our administrative cost and rationalizing our infrastructure. However, we know that is not enough. We must pay attention to the issues many stockholders have raised, including structural, strategic and environmental issues. We are determined to do whatever it takes to address these issues.

In terms of addressing the future, the Board of Directors have directed me to focus my energies entirely on assessing our strategic challenges and pursuing what is ever is necessary to deal with the issues we face.

For now let me turn the call over to Jim Woys, our COO who will review all the operations of the company. Then CFO, Joe Capezza will discuss our financials results. Jim?

Jim Woys – Chief Operating Officer

Thank you, Jay. Have you seen from this morning’s management change press release, I now have an expanded role in the company. In addition to my responsibilities for the government specialty division and administrative functions, all health plans now report to me. I believe this is the positive step for the company as it centralizes all operations in a single management structure. This should help us become more responsive to the changing business, economic and political environments and should lead to a speedier achievement of our targeted G&A savings.

As Jay noted, we’re all very extremely disappointed with this quarter’s result and the outlook for the balance of this year. We recognized that our commercial health care cost were higher than expected. As we look at the fourth quarter and next year, we’re assuming that the higher cost trends continue. It is a very difficult environment and as such we’re focused on restoring our operational momentum.

As we discussed in the press release we experience higher than anticipated health care cost in the third quarter. The drivers of these unexpected costs were adverse prior period developments for the first and second quarters of 2008 and higher than expected commercial, Medicare and Medicaid costs in the third quarter. The adverse prior period development was primarily the result of higher than expected hospital costs in all three lines of business.

This amounted to approximately $55 million pretax. I should note that more than 70% of the development was in the commercial book. The higher than expected costs in the third quarter were driven by hospital, utilization and unit costs. Due to the higher health care costs that we experienced in the third quarter, and our belief that this trend will continue, we now expect to commercial health care cost trends on a per member per month basis to be approximately 10.9% for the full year 2008 as compared to 8.9% increase from 2007.

2007’s amounts exclude litigation and regulatory charges. A table that reconciles GAAP to non-GAAP financials is included in the press release. While the commercial landscape remains competitive we do expect commercial premium yields to be 8.3% on a per member per month basis for the full year 2008 compared to a 9.2% increase in 2007. Joe will provide more detail of these numbers in his comments.

I would like now to briefly touch on the membership activity in Q3. Total commercial risk enrollment of nearly 2.1 million members at September 30, 2008, declined by 6.5% or 145,000 members from September 30, 2007. Sequentially, commercial risk enrollment declined by 2.9% or 63,000 members. These declines are results of the weakening economy in a competitive commercial environment.

We expect these trends to continue in the near term and as a result we now expect commercial membership declines of 8% to 9% for the full year 2008 compared to our previous expectations of 6% to 7% decline. Our Medicare lines of business experienced membership growth in the third quarter. In Medicare advantage our focus is on growing the network model HMO and PPO plans. MA enrollment grew by 54,000 members are 23% from September 30, 2007, to September 30, 2008. Sequentially, MA enrollment increased by more than 8,000 members or 2.8%.

We continue to expect 20% to 25% membership growth in MA for the full year 2008. Enrollment in our private fee for service business grew by 53% or 8,000 members over the past 12 months to 23,000 members at September 30, 2008. Sequentially, private fee for service membership declined by 1% from the second quarter.

PDP membership, which we continue to expect to grow by 40% to 45% this year stood at 538,000 members at September 30, 2008, an increase of 173,000 members from September 30, 2007. Sequentially, PDP membership grew by 12,000 members or 2.3%.

With regard to claims cost in our Medicare lines of business we continue to experience higher overall utilization across the MA and part D plans. We believe we have taken this into considerations with respect to the 2009 Medicare bids where we have made conservative assumptions.

We believe, our pricing, product design and medical and pharmacy management will successfully overcome the margin deterioration we experienced in 2008. With the competitive bids released we are now able to focus our sales and marketing efforts in areas where we have product and pricing advantage to achieve our membership goals for next year.

Also I’m very pleased with Scott Kelly’s performance in the short time since he became our Chief Government Program Officer in June. Scott and his team are focused on improving the performance of our Medicare business and achieving our expected 2009 improved performance.

On the cost management front, G&A expense ratio is 9%, excluding the impact of the operational strategy charge improved a 130 basis points compared to the third quarter of 2007, as we continue to focus on expense management. There is a table in the earnings press release that reconciles these numbers.

We also are making progress with our operational strategy, which is designed to reduce costs and reposition our business for a competitive advantage. As part of our operation strategy during the third quarter we entered into agreements with two premier outsourcing vendors with proving track records. First, in August we signed an agreement with IBM where they will provide us with IT infrastructure services. At the end of September, we also signed the agreement with Cognizant Technology Solutions to outsource our software application, development and management activities. By outsourcing our IT infrastructure and applications capabilities we expect to save approximately $120 million in the next four years.

We believe we are still on track to save the $50 million in G&A costs in 2009, and over $100 million in 2010, as we previously communicated. Finally, our Federal services division both Tricare and MHN, our behavioral subsidiary continues to perform very well. Our Federal services division remains focused on meeting the needs of our military families, at this time we have no new news regarding the procurement of the new Tricare contract. In the meantime we continue to explore how we can apply Tricare model to other opportunities.

Also, deliver of services under MHNs five year military and family life consultant program, with BOD continues to grow. This program is expected to contribute over $100 million in total revenue in 2008 compared to approximately $50 million in 2007 and will increase another 40% in 2009.

I continue to be very proud as the work in this division continues to perform everyday in the benefit of our military family. While our 2008 performance has been a disappointment, we believe we are taking the necessary steps to put the company back on track in 2009. My priorities as I assume the expanded role as the Chief Operating Officer of Health Net are first to put the right people in the right chairs. To continue to aggressively pursue and exceed our G&A cost reduction targets. To ensure achievement in 2009 of our improved Medicare margins, to work closely with contracting actuarial underwriting, to carefully view the implications of the higher health care cost trends that we’ve experienced this year and focus my team on improving our margins in 2009.

And finally, make sure this entire organization is focused on improving our performance in every aspect of our business to improve shareholder value. We will provide a more in depth review of our plans on Investor Day which is scheduled for November 18 in New York City.

I’d like now to turn the call over to Joe for a more in-depth discussion of our financials. Joe?

Joe Capezza – Chief Financial Officer

Thanks Jim, and good morning everyone. I don’t think there is any need to add to Jim and Jay’s comments about our collective disappointment with these results. What I want to do this morning is to review our financial condition and discuses our third quarter results.

We will have much more to say about the future at our Investor Day in two weeks. We encourage anyone who can to attend, it will be an important dialogue concerning where Health Net is today and what we can expect to achieve going forward. In the past, I started these calls by going over the P&L.

Given the events in the financial markets over the past several weeks I’m going to start with the balance sheet. I want to demonstrate to all that our balance sheet is sound and our liquidity position is strong. We’ve seen cash and investments remain relatively stable over the past several quarters.

Cash alone was down sequentially however in this quarter by $420 million. This change was primarily due to the reserve fund, which was reclassified from cash to short term investments and paying down the revolver. At the end of the quarter our investment in the reserved fund was $372 million. As of October 31, we had monetized approximately $130 million of this investment, so our cash liquidity today is much stronger than it was at the end of the quarter and is back over $700 million. I’m confident based on the information available that we’d be able to monetize the balance of our exposure in the reserve fund in the near future.

As some of you know, we maintain a very conservative position in our portfolio. We did take a charge for some relatively small investments in Lehman, Freddie and Fannie, which amounted to approximately $15 million pretax. This was less than 1% of our total portfolio of approximately $1.8 billion. We currently have $43 million of net unrealized losses in the portfolio, a relatively insignificant amount. Our conservative portfolio is invested in several key areas, municipals, corporates and agency backed mortgage instruments. We do not own any subprime paper, the duration of our portfolio remains unchanged at approximately 3.9years.

The average credit quality of our portfolio is double A plus with more than 80% of the portfolio rated double A or better. Because of the Fannie and Freddie government takeovers the mortgage backed paper is secure.

On the debt side we have three separate facilities, the first is approximately $400 million in senior notes, the coupon rate on these notes is 6.38% and they mature in June 2017. Second is a low interest amortizing financing with approximately $157 million outstanding. We will complete the full debt amortization in December of 2012. The last is our $900 million credit facility. We currently pay 17 basis points of LIBOR on the revolver. We expect to keep this in place through June 2012. As of September 30, 2008 we have draw down approximately $100 million which is down $45 million from Q2. Our total debt to capital ratio is 27.6%, still under the 30% threshold.

Now let me turn to the P&L, cash flow and reserves. Total revenues climbed 3% compared to last year’s third quarter. This was driven by health plan and government contract revenue increases while net investment income fell because of declining interest rates in the impairment charge.

Our [ASOP] and other income were essentially flat. Our commercial revenue PMPM rose 7.7% from last year’s third quarter. Sequentially, premium yields rose by approximately $8, which is more than prior expectations of $5-to-$6.

The problem was commercial health care costs PMPM which rose 12.9% and driven by prior period development from the first half and higher than expected health care costs in the third quarter. Commercial MCR came in at 86.7% for the quarter. There is no escaping the fact that the health care cost environment has been very difficult. We do not expect relentless persistency of the higher trends most especially in hospitals costs. We have now baked in this higher trend into expectations for the fourth quarter and in to our earlier assumptions for next year. Given the past volatility of trends and reserves I called in an outside actuarial firm to provide an independent assessment and to work closely with our internal staff to reviewing IBR and trend data. Together they assessed where we are and produced a best estimate for reserve levels and booked that point estimate. We will continue to use this approach going forward.

Now let me turn to Medicare. The Medicare advantage and PDP enrollment story is very strong. But the performance has not been satisfactory. Same cost issues that they set the commercial book also affected Medicare advantage. Medicare advantage MCR rose more than 400 basis points year-over-year and came in at 90.5%. We are confident that next year this measure will improve. We’ve assessed the competitive bids and we believe we can meet this goal.

Adjusted day claims fell by two days year-over-year, and 3.3 days sequentially. This change in days claims payable is due to using the average reserve levels in calculating the DCP. End of period reserves DCP would have been flat sequentially. I call your attention to the reconciling table that DCP provided with the press release.

A few other comments on the P&L. Selling course are higher as we continue to grow the Medicare advantage book. Depreciation climbed sequentially by approximately $4 million as a result of higher capital expenditures due to the acquisition of assets coming off of long term lease. Amortization was essentially flat and interest expense dropped as a revolver fell and interest rates declined. Average weighted share amount declined as well, resulting of buying back approximately 3.7 million shares in the third quarter for approximately $100 million.

As noted in our earnings release we put the share buyback plan on hold as a consequence of the uncertain economic environment in Jay’s strategic review. Operating cash flow was $92 million in the third quarter or about 1.6 times net income. That’s a sharp rebound for prior quarters and a testament to our ability to generate cash. We currently expect strong cash flow in the fourth quarter as well.

That ends my remarks for this morning. We will have more to say on our future plans in 2009 guidance on Investor Day in two weeks in New York. We know that we must do better. It’s been a tough year so far. I’m heartened by the strength in our balance sheet, our strong cash flow capacity, and the new opportunities provided by the management changes we announced today. Thanks for your time and I will turn it back over to Angie.

Angie McCabe - Vice President of Investor Relations

Pam, we would like to get started with Q&A.

Question-and-Answer Session

Operator

Thank you. [Operator instructions]. And our first question from Charles Boorady at Citi.

Charles Boorady

Thanks, good morning. My question is around health care cost trends that you’re reporting at much higher levels than what we’re seeing for the industry overall. Can you give us more supporting detail behind what the factors are, unit price versus volume trends that you are seeing and also comment on whether you believe you’re adversely selected against, so some of your trend due to a riskier pool considering the losses of enrollment? As part of explaining that, if you have data on the cost trends for the customers you lost versus kept, this year, considering the big drop in enrollment that would be helpful as well? Thanks.

Jim Woys

Thanks, Charles this is Jim. As we look at our increased cost trends, it’s primarily around hospital and it’s primarily around unit. When we looked at this and we looked at what we saw in the latter part of ‘07, and the of Q1 of ‘08, we thought we had a pattern with regards to trend in hospital based on more recent current results we now see it’s probably per percent in lying trend there. We have seen an increase in the non-managed admits, specially admissions through ER to non-contract facilities. As well as increase in more intense cases. We built these underlying trends into Q4 and to ‘09, so it is around hospital, we do think that as some of the membership in the slide business we had and with regard to the economy is impacting the increase in those trends. But we’ve got to find a way to stem work on that issue about the hospital trends going forward. It’s clearly that’s where our biggest area of exposure has been and we’ve adjusted our guidance for that it’s clearly hospital. And, primarily for advance that we are not really managing, so stuff that’s going through the ER that’s ending up in non-contracted facilities at much higher unit rates.

Charles Boorady

Do you have the components of cost trends, what’s unit cost versus volumes for hospital, in patient, out patient and pharmacy and do you know the loss ratios roughly of the customers you lost versus the ones that you are retaining?

Jim Woys

We don’t have that right in front, we will get back to you with that.

Charles Boorady

Okay, but in terms of addressing to fix the problem, helps to know what the real problem is and I guess considering how much higher your cost trends are than the competition I’m just wondering whether there is a really more of an underwriting and pricing issue than a cost issue per say, and can you really address the high unit cost through re-contracting or any other measures or is it going to require a change in your approach to pricing and underwriting?

Joe Capezza

Charles, this is Joe. I think its going be a double prong approach to that. We have to take a look at our contract costs with facilities to see if we’re at alignment with the competition and work to bring that can back into alignment. In addition, looking at the underwriting side, particularly in the sliced business accounts where because of either employer contribution policies or because of benefit designs we might be adversely selected against.

Charles Boorady

Is this a California issue or you seeing the same trends in the Northeast?

Joe Capezza

It’s pretty much across the board.

Charles Boorady

Does this compromise your ability to hang onto Tricare?

Joe Capezza

No shouldn’t have anything to do with Tricare, Tricare’s a separate contracts with rates.

Charles Boorady

Inability to manage the cost trend is that something that would jeopardize you there? Or is that not some things are going look at in that process.

Jay Gellert

That process if we go through the Tricare contract, that process is evaluation in three areas, probably way along that way. The process is evaluation our past performance which has been very good to evaluate our technical solution with regard to their requirements of their contract. And they evaluate what our price is, our bid price. The Tricare model is much, much different than what we have in the commercial side, we have absolutely no cost problems in our Tricare business, we are hitting through the targets that we believe we would hit in conjunction with our customer. I don’t believe this is at all connected to a any potential of harming our Tricare business.

Charles Boorady

Thanks. I’ll jump back in queue, thanks.

Operator

Our next question is from Matthew Borsch with Goldman Sachs.

Matthew Borsch

Hi, yes. Thank you, good morning. So, could you talk here about whether a sale of the company is on the table, is that something that you are able to openly address in this call?

Jay Gellert

This is Jay. We don’t think it would be appropriate to speculate on that at this time.

Matthew Borsch

Okay. Why is that Jay? I mean, it would seem at this point, at least to indicate to investors that you’re open to that or not, you might actually be helpful at this point?

Jay Gellert

I think that the Board recognizes the need to fix these problems. But, I think that idle speculation won’t help solve the problem. The focus though will be to make sure that we look at everything, consider everything and do whatever it takes to successfully deal with these issues.

Matthew Borsch

Okay. Fair enough. On the question of the outsourcing contracts, just I’m curious, are those contracts ones that if there were to be a change of control for the company, would you be able to exit those contracts in a way that presumably successor wouldn’t be burdened by them?

Jay Gellert

I think every major contract we sign like that as anybody would a vender would, would put provisions in them to in case of change or control.

Matthew Borsch

Okay. And could you talk about what you’re seeing in the northeast in California and even other markets, where you can make a distinction in terms of where you think the industry pricing has been how much of a challenge you think it is? Do you see any signs that it’s been getting better?

Jay Gellert

We haven’t seen any significant signs of improvement one way or other. And in our forecast we are not projecting for any improvement in the environment and should that happen, all the better.

Matthew Borsch

Okay. Last question. Capital and free cash, may not have heard it, but free cash as apparent as of September 30, maybe where you project that to be at year end? And can you give us an idea where you expect your overall RBC ratio will be by now and by year end?

Jay Gellert

Currently, our free cash parent company is approximately $140 million. I don’t expect to see that change that much from the quarter-to-quarter. And our RBC targets have always been around the 350% range.

Matthew Borsch

Okay. So you’re at those targets and you don’t think that would change by year end?

Jay Gellert

That’s what we are talking for year end, 300% to 350% has been our target range. And, we are making assessment now as to what sort of stats are completed as to what our RBC position is and will determine how to reallocate capital when needed.

Matthew Borsch

So I’m sorry, is there do you think it might be materially different from the 300% to 350% range?

Jay Gellert

No, no, no. It’s just a question with regards to our subsidiaries; we have some subsidiaries that are overly capitalized and we’ll be looking to redistribute to have a more even balance between all our divisions.

Matthew Borsch

Got it. Okay. Thank you.

Operator

And next we have Joshua Raskin with Barclays Capital.

Joshua Raskin

Hi. Thanks, first question, I didn’t hear you talk about the guidance in the call but looking at the press release. It looks like you got an ‘09 expectation of $225 to $240, if I think about the first half of the year, sort of $0.90 and adjusted to -- if you do $0.35, third quarter, maybe $0.44 mid point of the fourth quarter, even if I exclude sort of that first half, and I just say look you did $0.79 in the second half, you’re looking at $0.79 in the second half. Historically you’ve done about 55%, 56% in the second half. It gets me a run rate of say $1.41 or so. So, I’m just curious how do we get sort of from $1.40ish run rate to $2.25 to $2.40. And then, why did you sort of in the first place provide the guidance for ‘09 at this point?

Joe Capezza

Okay. This is Joe. Well, first of all our guidance right now for Q4 is $0.60 to $0.64. So, it’s all higher than the $0.45 that you’re using. If you actually take out the one timers, the PPIA related to prior years, which we believe we won’t have going forward especially since we utilizing an independent actuary to validate the reserved position that we are taking, if you take out the significant misses in the Medicare bids for both Medicare Advantage and PDP, take out those one timers, we expect to be earnings -- to have earnings that are relatively flat on adjusted basis for EPS. And then, throw an additional G&A savings that we expect to obtain and its really easy to get to those numbers.

Joshua Raskin

Okay. So, it’s really easy to get to those numbers. And then, I guess, on the bids it sounds like you feel confident you caught the Medicare portion of that? It would seem that a lot of the issues sort of post June or at least the magnitude of the issues. I’m curious what gives you confidence that Medicare is fixed?

Joe Capezza

Again we had an independent actuary help us with the bid and set the pricing. We got the pricing we wanted. And PDP area we exited the states that we wanted to exit because those were the states that were giving us the biggest problems and the biggest losses.

We evaluated our bid on a competitive basis versus the published bid of our competitors and we then went back and deferred to our adjusted projections based on, what we were seeing on health care cost trends and we still believe that there is significant upside that we are going to achieve in the Medicare program, and a lot of these questions that you’re raising we will have more detail on that on Investor Day in two weeks.

Joshua Raskin

Got you. And, then just lastly follow up on the cash flow, it looked like the unearned premium and receivables lines was a big source $130 million of cash. Was there any timing of state received or CMS payments?

Joe Capezza

No. Not really.

Joshua Raskin

Okay. Thank you.

Operator

And we have Greg Nersessian with Credit Suisse.

Greg Nersessian

Excuse me, good morning. Just a -- my first question was just on the time line. It just seems pretty unusually late in the quarter and in the year to be identifying the escalation of some of these issues. So, I just wanted to get a since for, maybe the sort of time line for when you started to rely identify that these issues were developing as negatively as they did and then a sense for why it took you so long to identify them. Is a systems problem, mix problem or cost reporting problem or anything else?

Joe Capezza

Well, as Jim mentioned in his comments, the fourth quarter of 2007, had unusually high historically high trends that we believe were apparent, Q1 and going into Q2 we had significant increase in hospitalizations, which we believed were attributable to the flu and related illnesses.

We started seeing an improvement in the latter part of Q2 with May and June initially coming in at what we thought was very favorable compared to the prior four months, and we believe we are returning to historical trend patterns.

And this was supported by the preliminary hospital data we were receiving. As Jay mentioned, and Jim mentioned, the hospital data was masked because of the emergency room increases and admissions that would go outside of our normal approval pattern.

We started seeing these patterns change in the data we were receiving during the month of September, late August, early September; this caused us to do an in-depth review as to what was going on with the trends. We brought in the independent actuary at that time to help us evaluate the trends and track the trends going forward.

Greg Nersessian

I got it.

Joe Capezza

And that’s why it occurred so late.

Greg Nersessian

Okay. So, it sounds like the nature of the cost trend, just the nature of where the costs were coming from, they were at a network providers prevented you from identifying them earlier, is that sort of the explanation as opposed to your having data in-house and not, I guess I was a little confused, you said it looked like things were improving then you were baking in a continuation of that improvement and then you got some late cost trend, late cost reporting is that it?

Joe Capezza

Based on the hospital data we were seeing for the initial assets, we felt there was improvement in the trends that we were seeing in the admits. As the admits actually developed because of the admits coming in outside of the pre-approval process, such as emergency room admissions and non-managed care products, those admits actually spiked when the development came through, when the hospitals actually started sending the build in. So, and there was about a two month, three month delays on some of those.

Greg Nersessian

Okay. And then, just moving on the role of the independent actuary that you are now using I’m trying to get a sense for how your approach to reserves has changed. Wondering if there is metrics you can give us on maybe your IB&R per member per commercial member some like that, that would give us a sense for how much reserve strengthening you have committed to with this quarter versus maybe the last quarter?

Joe Capezza

Well, this quarter we had approximately $55 million of reserves that we strengthened for prior periods. And what the actuary is doing is basically he’s reviewed all our practices, made recommendations with regards to how we are developing all those reserves, evaluating the trends that we are seeing to bring us to what we believe and what the actuary believes is best practices within the industry. We have asked them to do an independent evaluation of the reserves, to help us validate the best estimates depicted where we are using when setting the reserves and we expect that the reserves that we are setting are going to be inline with the actuaries are telling us. And as a result of the study would see that the base baseline of the trend now is up, because we’ve asked them to validate the trends that we’re using and also help us evaluate the run rate going forward.

Greg Nersessian

My question is, days claims payable dropped pretty significantly on a sequential basis in the quarter which would not be supportive of the notion that you’re actually have booked the full higher medical cost training to your current reserves. So, I guess, maybe if you can give us some color that would give us some greater comfort around that?

Joe Capezza

Right. So, what happens is when you use that with technique based claims payable and I will try to explain it in alignment insurance the actuaries actually calculate this and but what we do is we use an average based on the beginning and ending claims value. Because the PPIA that we took, the prior period development we took, all occurred on the last day of the quarter, that reduces that average significantly. If you took the prior period development and put it back into the prior quarter you would see the days claims payable go flat or up.

Greg Nersessian

Okay. And then, this is last what is your target M&A medical loss ratio for 2009?

Joe Capezza

Yeah, I don’t have that -- I’m sorry you said 2009, I will speak, I was looking at 2008, that look into that on Investor Day.

Greg Nersessian

Okay, thank you.

Operator

Our next question is from Tom Carroll with Stifel Nicolaus.

Tom Carroll

Hi, good morning. I have two quick questions here, first one is on just the management change. Yes, Joe I’m confused by your new role, and what will you will be doing differently in your new strategic role that perhaps you didn’t or haven’t been doing in your prior role? And then, secondly as we look at the Medicare book and I realize its not the bulk of your challenges here today but if you could dive into that for us and maybe give us a sense of where the higher cost are coming from especially since most of your book is network based?

Jay Gellert

Let me add into the first question. The intent of the change is to put all of the operating responsibility in the company in Jim Woys’ hands. The view is as I earlier indicated that everything Jim has participated in this company has hit its numbers and one of the concerns everyone has valuably rated desiring consistent performance. So, the goal is for Jim to build an, he’s has already completed doing it, build the team that will report directly to him. So, he is a single person on the line for operating performance within the company. At the same time I think many people have raised the issue of business mix, scale, certain of our operations and the like and in the process of them spending time with operations, I think the Board’s view is we haven’t given adequate heed and attention to the issues that many of you raised and that have been raised, fairly consistently in terms of just kind of the fundamental. So, while Jim is taking singular responsibility for making sure that the numbers come in as we project them, as we identify them that will free me to be specifically directed to handle all of those issues and present to the Board of Directors specific plans and analysis to address all of those kind of issues that have been raised consistently on this call. So that’s very precise direction that we’ve been given in terms of this management structure. It’s clear, it’s down the middle. It’s bright lined, and it will allow us to address both the performance issues that we’re talking about today as well as kind of the fundamental structural issues that have been raised on this call in the past. Regarding Medicare I think Joe is going to comment on that.

Joe Capezza

I’m sorry, what’s the Medicare question again?

Tom Carroll

The Medicare question really is we have heard about some Medicare challenges this quarter across basically across the spectrum of companies. I’m wondering if you would just maybe dive a little deeper into the source of where you are seeing higher costs in your Medicare book specifically, especially because most of your Medicare book is network based as opposed to private fee?

Joe Capezza

Well, we are seeing major deterioration in private fee for service, particularly on the hospital side. PDP is still a significant disappointment with additional deterioration anticipated in Q4. We have not seen the recovery in the PDP that we’ve hoped. Those are the two biggest areas.

Tom Carroll

Okay. So, you’re roughly 22,000 private fee for service members are just really the ones that are giving you most of the problem to the point that you’re talking about raising your costs on Medicare?

Joe Capezza

Well, the private fee for services is a significant part of the problem, we’ve seen the hospital utilization up for Medicare population similar to commercial.

Tom Carroll

I’ll just sneak one last one in on this. On your PDP business, how much of your book there, what you mentioned about 529,000 how much is that is dual eligible?

Joe Capezza

Something to 70% to 80% dual eligible.

Tom Carroll

Okay, thank you.

Operator

[Operator Instruction]. And, we will take our next question from Justin Lake with UBS.

Justin Lake

Thanks, good morning. The couple of questions, first around the capital and liquidity. I just want to kind of walk through these numbers in a little more detail and get your expectation. For instance, what are you thinking about as far as losses for the fourth quarter is on the portfolio and maybe the cash flow from the subs for 2009?

Joe Capezza

Okay. Well, right now we haven’t projected or forecasted any losses in Q4 from the portfolio. As I mentioned we have approximately $143 million of net unrealized losses that’s in the portfolio right now. The $143 million, you know I’m sorry, we have $43 million of net unrealized losses here in the portfolio, I was giving you the cash number, the cash number is 143 at the apparent company.

Justin Lake

Right.

Joe Capezza

And, we haven’t forecasted any realized capital losses for the fourth quarter and at this point considering where exit rates are going and well positioned in the -- our conservative position in the portfolio, I don’t expect to have anything significant to report in Q4 right now.

Justin Lake

Okay. What’s the cash flow you expect to get from the subs?

Joe Capezza

That we will get into on Investor Day as well.

Justin Lake

Is that being typically, I guess just trying to walk through at here, is the cash flow from the subs typically is kind of prior year net income, is that kind of a correct proxy?

Joe Capezza

Well, we tend to talk in a percentage of prior year’s net income.

Justin Lake

Where has it typically been?

Joe Capezza

Where has it typically been? Anywhere between 85% anywhere between 85% and sometimes even in excess of 100% of net income.

Justin Lake

Okay.

Joe Capezza

Depending on what the capital position of the subsidiaries are, if the subsidiary’s though that we capitalized we look to take more out, if it’s adequately capitalized what look to take it out well we allowed to under statutory guidelines. So, it varies by subsidiary.

Justin Lake

Okay. So, if we assume that it will be 100% that might be 200, $250 million. What is the cost to run the business as far as kind of the if you think about for instance interest payments, you’re going to make next year. Just trying to figure out the flexibility that you have there?

Joe Capezza

We could get back to you on that. But right now we expect absolutely no problems with regards to cash flow in the amount that we need to run the business.

Justin Lake

Okay. And then, just a couple of quick numbers questions, I think investors at this point might be looking at -- we’re looking at Healthcare companies like typical insurers and looking at book value and tangible book value. I looked at your third quarter report and I kind of calc out your tangible book value at a little over $8. So, is it correct for me to kind of think about this as a liquidation value? If you literally shut down the business tomorrow, you would have $8 of share in cash? Just let it run out?

Joe Capezza

I couldn’t tell you because we haven’t contemplated shutting down the business. We haven’t done that calculation.

Justin Lake

I realize that, I’m just looking at the current equity values are embedding some significant risk. And I’m just trying to think about worst case scenario here. Just theoretically is that correct?

Joe Capezza

I have to look and get numbers.

Justin Lake

Okay, and then just last question. Has the company I know you didn’t want to talk specifically on the M&A side, but can you tell us if you have hired an investment banker to work with Jay as he goes through the strategic review of assets?

Jay Gellert

Well, we’re going to just go forward and look at those without commenting specifically on that process.

Justin Lake

Okay, thank you very much.

Operator

And next is John Rex with JP Morgan.

John Rex

Thanks. I just want to be clear on a couple of things here. So, you’re saying your current view assumes the trends stay at the levels, so, is that correct? Are you saying you assume your ‘09 guidance is contemplated on 11% cost trend? Is that correct?

Joe Capezza

No, we’re assuming that the current level of PMPM expenses are the baseline they that we’re setting our trends on. And then, there was a separate trend evaluation performed by state, by legal entity to determine what is going on with cost -- what is going on with utilization, and what is going on with medical management. So, we’re using the higher trends to establish the base and then having that as our jump off point.

John Rex

So, what does your ‘09 contemplate in terms of cost trend then?

Joe Capezza

Right now I think we should save that for Investor Day.

John Rex

So, just give me directionally does it contemplate lower than 11% or higher than 11% from the baseline you are giving us for ‘08?

Joe Capezza

Well, it’s going to be -- it will be lower than 11% because you have to remember our current trends that we’re using right now include the effect of guardian in there.

John Rex

So, what would it look like -- what would be 11% look like ex-guardian then?

Joe Capezza

It’s lower.

John Rex

200 basis points?

Joe Capezza

Yes, it’s around that.

John Rex

Okay. So, and then what does this contemplate in terms of pricing for ‘09, in terms of the outlook that you’re providing? In line with that trend level that we’re not quite sure what it is yet sounds like, but in line with that trend level you’re expecting or above it?

Joe Capezza

Again, we’ll have to give you more information on Investor Day. Our expectations, our hopes are that we’ll be able to price to at least our cost trend. However, as you know a significant part of our book of business has been priced at the large accounts in January renewals. So, we’re in the process of evaluating where those stand in relation to what the final trends are.

John Rex

And it maybe helpful to on that piece, could you tell me what are your affective yields now on the January renewals that have occurred?

Joe Capezza

I don’t have that with me I will have to get back to you on that.

John Rex

Okay. Can you tell me what is going on your bed day per thousand members trends?

Joe Capezza

The bed day trends have gone up; I don’t have the exact number of days.

John Rex

Can you give me order of magnitude in terms of percentage change?

Joe Capezza

At this point, I would probably be just giving you a bad guess. So, we should get back to you on that as well.

John Rex

Okay. What has changed in benefit design or networks that would have driven the sudden higher utilization of outer network care that you’re referring to as being one of the core components? It seems very out of step. So, something must have changed on your end that would drive that. Can you give us some of things; you thought us, I’m quite sure don’t have the precise answer at this point but some things that may have driven the higher utilization of network providers?

Joe Capezza

It was mostly not prior authorized hospital utilization out of network. So, by prior utilization, by not authorized we are talking about emergency room visits, here in California there has been a trend of hospital groups to cancel contracts, and accept admits on an emergency basis, once they are in, it’s difficult to move. They’re billing us at 100% of charges because there are no contracts. So, that’s phenomena that we are struggling with right now here in California.

John Rex

But you are telling me that bed days per thousand members is higher. Is that correct? This is not just about unit cost, this is utilization issue also?

Joe Capezza

Yes, it’s up somewhat as well. So, we are looking at utilization as well as costs.

John Rex

Okay. When you kind just, sit back and think about this, and so you do look out of step with the industry right now with the trends are seeing broadly from the vendor community. Have you thought about how much of this, you think is a result of maybe kind of the franchise deterioration is what I’m referring. How much is due to suboptimal market positions in scale? Do you think is now kinds of accelerated to where it is more biased to that side, that’s why you’re showing as some another outlier in the industry?

Jay Gellert

John, this is Jay. I think that that the vulnerability that we see is in some of the slice business where we definitely have instances where employers are biasing themselves from areas business. And, in addition that we’re seeing some risk as with the economy as some younger people seem to leave accounts and so we have in group deterioration along those lines.

I think one of the key points, we’re making today is that, it’s not only an execution/management issue but there are some structural issues that you’ve raised. And, that’s what we are going to be reviewing. I think that we see the other kind of regional player that comment, we have some of the same trends, we saw some other same things in their announcement.

So, I think there is reason to consider this in some of the structural issues you raised and that we’ve been directed to really look at, as well as moving the operational responsibility and that I’ve already discussed.

John Rex

Okay. Thank you.

Operator

And our next question comes Scott Fidel with Deutsche Bank.

Scott Fidel

Thank you. Our first question, just on the Medicaid enrollment guidance, it looks like you’re guiding for 4% this year. Are you adding a contract or something in the fourth quarter there? I didn’t calculate in the third quarter being up much?

Joe Capezza

Well, calculate it being up excluding Connecticut which we dropped.

Scott Fidel

Okay. that’s ex-Connecticut up 4%.

Joe Capezza

Right. And, we’re still need business.

Scott Fidel

Okay. And then, just relative to the commercial Medicare MLRs. Can you just give us some contexts around, how those are tracking in the northeast business as compared to California, the West Coast business in terms of, are they relatively similar, is one showing a significant variation from the other. And, then, is the North East business was profitable in the third quarter?

Joe Capezza

Let me pull that data out, Scott. Scott, have too many pieces of paper that I have to pull up on that.

Scott Fidel

What about just to the more simple question of what does is the northeast business was profitable in the third quarter?

Joe Capezza

Yes, it was profitable.

Scott Fidel

Okay. And then just relative to part D, first your expectations for how many duals you expect to lose in 2009? And then, I know your prior guidance was that of a 1% margin in PDP this year. Sounds like you’re backing away from that. What’s your updated view around PDP margins for 2008 baseline?

Joe Capezza

Well, as far as ‘09 membership losses on PDP, we’re expecting a significant decline. And we’ll get specific with you at Investor Day in two weeks. And then, with regards to the PDP side, we’re expecting PMPM margins to be somewhere around 8.5 to $9.

Scott Fidel

Okay. And then, with the duals for ‘09, I think or did you say maybe down a 100,000 on the duals?

Joe Capezza

I haven’t said anything. But since almost 8% of our business is from dual eligibles, that’s probably about right.

Scott Fidel

Okay. And then, just one last question just on Medicare advantage just within the network based products. Can you update us on what you’re SNP, your SNP membership is within that and what you’re plans are for SNP in ‘09? And how much cost pressure you’ve seen in that book this year?

Joe Capezza

Yeah, I don’t have that level of detail in front of me. We’ll have to follow-up with you on that one Scott.

Scott Fidel

Okay, thanks a lot.

Operator

And next we have Brian Wright with Banc of America.

Brian Wright

Thanks, good morning. Could you tell us of the litigation settlement that you took at the end of last year, how much you’ve actually paid out on that?

Joe Capezza

Yes, we’ve paid out in excess of 200 million related to that settlement. We had to put in an escrow account.

Brian Wright

So, of the 201.5, there was medical cost, you paid that out?

Joe Capezza

What we paid out -- we paid out and put it into an escrow account to satisfy the claims. And the claims on the process of being accumulated and settled.

Brian Wright

So, when it goes into escrow, does that go into your operating cash flow?

Joe Capezza

Yes.

Brian Wright

Okay.

Joe Capezza

Cash flow reflects the monies that we put for that settlement escrow.

Brian Wright

Okay, thank you.

Operator

And our final question comes from Justin Lake, a follow-up with UBS.

Justin Lake

Thanks, for letting me in for a follow-up. Just wanted to kind of drill-down on the commercial MCR specifically. And you mentioned that it’s not a geographic question but I think you’ve talked about the sliced business here. So, I think it’ll be pretty simple to just look at you’re large group business versus you’re small which you’re kind of breakout from a membership standpoint. And if it is a sliced issue, we would think that the large group business would be seeing a much larger disproportional increase in MLR. Can you give us some color around that or specific numbers on how large group’s doing versus small group from an MLR standpoint?

Jay Gellert

Everyone is doing worst than expectations. The large group business traditionally has the significantly higher loss ratio than the small to mid marketplace. And we’re actually seeing a higher percentage increase with regards to absolute bids in the small group area than we are in the large.

Justin Lake

You’re seeing a larger increase in the small group area, okay. So, that would argue that the issue is in negative selection on the slide side. Is there anything else you can try to point something? Do you have a network larger on the smaller group side or?

Jay Gellert

Justin, one of these things is in California, a lot of the small group is even in slice because of Kaiser.

Justin Lake

Is that right? What’s the definition of slice or I’m sorry small group?

Jay Gellert

Small group is 50 employees and below. So, you have a lot of higher end of small group has some slice in it.

Justin Lake

Okay. So, maybe you could tell us how many of you’re members are actually are under a slice contract?

Jay Gellert

Nobody now I think. But, will get back to you.

Justin Lake

Okay. And then on the Medicare side? When we are seeing the large increases on the MLR, just kind of curious to given the fact that you have so many capitations in Medicare, you would think you would be insulated on a pretty large proportion of your Medicare population from variability in MLR? Am I not thinking about that right or are you seeing all of the variability on your noncapitated book?

Joe Capezza

The number of capitated hospitals we have in Medicare are very small in light of the total population.

Justin Lake

What about on the physician side, my understanding was you had a lot of IPAs that were taking full risk out there, or at least a significant amount of it?

Joe Capezza

That hasn’t been a problem.

Justin Lake

Okay. So, what proportion of your book is capitative?

Joe Capezza

So, physician side is about 80% capitated. And hospitals more along the lines of 20%.

Justin Lake

Okay you’re seeing all of the volatility outside of the physician side and the capitative hospital?

Joe Capezza

Pretty much.

Justin Lake

So, you would just argue that the volatility or the increase in MLR is even greater than what stated on a face of financial statement because the actual -- the denominator would be much smaller as part of providing the change of medical causes? If that will make sense.

Joe Capezza

Well, actually capitation gets included in the calculation of MLR. So, we don’t show MLR calculation exclusive of cap.

Justin Lake

Right, I guess that’s what I am trying to sum in. The MLR is several hundred basis points higher in Medicare and yet capitation hasn’t moved at all and would think that so far 600 without it, just magnitude as they’re going. I am wondering if there in anything you could point us to there?

Joe Capezza

We are kind of getting stuck in the weeds here, Justin. So, maybe we should take this one offline and walk through some numbers with you. So I can see what exactly you’re looking at.

Justin Lake

Okay, that’s helpful, thanks a lot.

Joe Capezza

Okay.

Angie McCabe

All right, thank you for joining us and we will see you at our Investor Day on November 18.

Operator

This does conclude today’s conference, thank you for attending and have a wonderful day.

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