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Humana, Inc. (NYSE:HUM)

Q4 2008 Earnings Call

February 2, 2009 9:00 am ET

Executives

Regina Nethery – Vice President, Investor Relations

Mike McCallister – President and Chief Executive Officer

Jim Bloem – Senior Vice President and Chief Financial Officer

Jim Murray – Chief Operating Officer

Chris Todoroff – Senior Vice President and General Counsel

Analysts

Joshua Raskin - Barclays Capital

Gregory Nersessian - Credit Suisse

Charles Boorady - Citigroup

Justin Lake - UBS

Scott Fidel - Deutsche Bank

Carl McDonald - Oppenheimer

John Rex - J.P. Morgan

Ana Gupte - Sanford C. Bernstein

Matthew Perry - Wachovia Capital Markets

Matthew Borsch - Goldman Sachs

Operator

At this time I would like to welcome everyone to the Q4 2008 earnings release conference. (Operator Instructions). Ms. Regina Nethery, Vice President of Investor Relations, you may begin your conference.

Regina Nethery

Good morning and thank you for joining us. In a moment, Mike McCallister, Humana’s President and Chief Executive Officer and Jim Bloem, Senior Vice President and Chief Financial Officer, will briefly discuss highlights from our fourth quarter 2008 results as well as comment on our earnings outlook. Following these prepared remarks, we will open up the lines for a question and answer session with industry analysts. Joining Mike and Jim for the Q&A session will be Jim Murray our Chief Operating Officer, and Chris Todoroff, Senior Vice President and General Counsel.

We encourage the investing public and media to listen in to both management’s prepared remarks and the related Q&A with analysts. This call is being recorded for replay purposes, that replay will be available on Humana’s website www.humana.com later today. This call is also being simulcast via the internet along with a virtual slide presentation. For those of you who have company firewall issues and cannot access the live presentation, an Adobe version of the slide has been posted to the Investor Relations section of Humana’s website.

Before we begin our discussion, I need to cover a few other items. First, our cautionary statement. Certain matters discussed in this conference call are forward looking and involve a number of risks and uncertainties. Actual results could differ materially. Investors are advised to read the detailed risk factors discussed in our most recent filings with the Securities and Exchange Commission. All of our SEC filings are available via the Investor Relations page of Humana’s website as well as on the SEC website.

Additionally, investors are advised to read Humana’s fourth quarter 2008 earnings press release issued this morning, February 2, 2009. This press release and other historical financial news releases are also available on our website.

Second, this morning’s call and slide presentation include references to non-GAAP financial measures. The company believes these non-GAAP measures when presented in conjunction with comparable GAAP measures are useful to both management and its investors in analysing the company’s ongoing business and operating performance since the non-GAAP adjustments relate to items that were primarily not related to the underwriting or servicing of our products. Internally, management uses this non-GAAP information as indicative of business performance as well as for operational planning and decision making purposes. Non-GAAP financial measures are to be considered in addition to but not as a substitute for or superior to financial measures prepared in accordance with GAAP. This slide shows the reconciliation of GAAP to non-GAAP financial measures used in conjunction with this presentation.

Finally, any references to earning per share or EPS made in this morning’s call refer to diluted earnings per common share. With that I’ll turn the call over to Mike McCallister.

Mike McCallister

This morning, we reported earnings per share for the fourth quarter of $1.03 and $3.83 for the year. These results are in line with the quarterly guidance we issued in October of $1 to $1.10 per share and our guidance of $3.80 to $3.90 for the full year that we also issued at that time. While 2008 certainly had its challenges, we fully believe those issues are behind us. Though the economic environment continues to be volatile, we feel confident that our businesses are well positioned to succeed.

Looking to 2009, we are once again reaffirming our EPS guidance of $5.90 to $6.10 for the full year, which we shared with you in our third quarter 2008 earnings release. This EPS guidance returns Humana to the trajectory of earnings growth we had been experiencing prior to 2008. With 2008 now behind us, we are even more keenly focused on our prospects for 2009 and the future. We continue to view 2009 positively with opportunities across each of our businesses not only to grow but to continue implementing strategic consumer-oriented solutions that proactively address many of the healthcare issues our country is facing.

Let me begin with our Medicare business. Looking first at our stand-alone PDP offerings, as expected, we lost a significant number of these members on January 1st. The magnitude of the member loss was greater than we previously had anticipated, but we are confident that our premium and product designs for each of our standalone PDP offerings will return these products to profitability in 2009. As you can see from this chart, the PDP membership attrition was primarily driven by our product design and prices against the benchmark, with over 40% of the decline a result of losing many low-income seniors, some of whom were reassigned to plans to below the benchmark while some others opted not to pay the incremental premium to stay in our plan.

Turning now to Medicare Advantage, we are pleased with the results we are seeing thus far with two months left in the enrolment season. In spite of a very competitive environment with many of our competitors offering zero premium private fee-for-service products, we were able to sell 112,000 network-based products to new members and 172,000 new members in total. We were able to transition 65,000 private fee-for-service members to network-based products. We changed the industry paradigm by introducing member premiums, something we believe is an essential element to the future operating model. Approximately 60% of our Medicare Advantage membership is already using our network-based products.

Our 2009 premiums and benefit design for all products are representative of our estimate of likely medical costs, and finally because of all the above as well as our focus on medical care management opportunities, we believe we are uniquely positioned to thrive in future enrolment periods. As we’ve said in the past, we believe seniors understand value very well, and our achieving 60% of our Medicare Advantage membership using network-based products again reinforces that point.

Seniors are very comfortable with PPOs and HMOs, products they’ve come to know in their workplaces. The 65,000 Humana private fee for service members who chose to move to one of our network plans on January 1st are indicative of the satisfaction of our membership and is particularly meaningful given the change we introduced by implementing member premiums.

Before addressing our growth prospects in Medicare Advantage this year, let me put to rest a concern that some of you’ve expressed about the possible risk profile of our membership given nearly all of our 2009 include a member premium. As you know, as you know our payments from CMS are adjusted for the risk score of individual members, but what you may not realize is how precisely the CMS risk-adjusted revenue has historically matched the overall risk profile of our Medicare Advantage membership. As we’re said in the past, there is only minor variation in the benefit ratio of our Medicare Advantage products. So again, with payments adjusted for risk, as long as the combination of premium and benefit design adequately reflects expected cost, our offerings will produce the results we anticipated when our filed our bids CMS.

We’ve spoken about the long-term Medicare opportunities, so let’s spend a few moments looking beyond 2009. With rates for 2010 due out April 6th, we are already looking to next year as well as 2011. In meetings with investors, there seems to be a general consensus of questions around, one, will seniors go back to original Medicare when private fee for service goes away; and two, if Medicare Advantage payments are adjusted downward, will we be offer enough benefits to make the products attractive to seniors; and three, will our network offerings be expansive enough to attract seniors accustomed to private fee for service. I’ll respond to the first two questions together as they’re related.

CMS data shows that less than 1% of the seniors that leave our Medicare Advantage offerings return to original Medicare, with or without a Medigap policy. Simply the Medicare Advantage value proposition is too good. Our products stack up very well against original Medicare, even when it’s combined with a Medigap policy, and with continued progress in our medical care management model, we fully expect the value we can deliver to seniors could be compelling in 2011 and beyond, since medical spending efficiency provides room for better benefit coverage, lower premiums, or importantly an ability to adjust to changing government payment rates.

As for our network offerings, the work of our provider contracting team is already showing return in terms of the growth in our network based plan membership as referenced earlier, clearly demonstrating seniors’ willingness to move into network offerings. The combination of the medical care management model, the administrative productivity, and strong networks help us ensure we have a viable Medicare Advantage offering for many years to come.

Why are we confident about the continued viability of our Medicare Advantage products? Again, through disciplined execution around provider network contracting and our medical care management model, we can mitigate medical cost trends, allowing plenty of headroom for incremental benefits for seniors. This coupled with ensuring that seniors have good coverage and are provided guidance around their choices and are financially in a position to make sound choices can represent a real solution to the Medicare crisis that confronts us as taxpayers.

At our investor day in November, we shared with you some detail regarding the ways in which we expect to achieve an initial cost mitigation bill of 15% over original Medicare. Today, I’d like to highlight a few elements of our medical care management model. These are illustrative of how we engage seniors to try and get ahead of episodic events and work to evaluate seniors help holistically.

We are making significant headway in engaging seniors before an episodic event with over 60% of our new Medicare Advantage members completing a health risk assessment. As a result of having prepared this assessment, 18% were identified as candidates for our integrated medical and behavioral health program and 8% were referred to our medical case management program.

I have spoken frequently about the power of integration. So, let’s spend a moment talking about our integrated medical and behavioral program. With a cost of less than $1 per member per month bridge participants, this program has generated savings of approximately $1.15 to $2 per member per month. More importantly, most of members are experiencing for the first time how much better their health and wellness can be in an organized system.

This program along with the multitude of others reinforces our confidence that we achieve or targeted savings and outcomes versus original Medicare. Achieving these savings is a win-win solution. The members win in terms of the value and care they receive and the government wins because over time it offers a solution to the Medicare financial crisis we’d all face.

In terms of the network activity I mentioned earlier, this charge shows that approximately 80% of our private fee for service members live where a Humana PPO product is available today. That number holds true even with our membership attrition in private fee for service for 2009.

With the continuing expansion of our net worth, we anticipate that 94% of our current private fee for service members would have a PPO available to them by 2011. But of course, a potential member has a final key question before joining a Medicare Advantage PPO, is my doctor in the network? Importantly, approximately 75% of the claims we pay for our private fee for service members are paid to doctors that are already part of our PPO network.

Our network build-out work has remained robust in the past year and will continue as we close in on 2011. Thus, as our networks expand so will the percentage of claims that we pay to network doctors for private fee for service members making it easy for the member to join to stay with Humana. Again, there were 60% of our members that had already chosen our network products.

As I mentioned before, we’re working to drive efficiency in both medical and administrative spending. Our approach has been to reinvest these savings to further build-out our capabilities. As a result, our medical care model gets increasingly better and more broadly applied to our business every year. These improved processes in turn lead to enhanced value for our seniors as we simultaneously mitigate medical cost trend and produce better health outcomes.

This slide shows some of the administrative process improvements to which I’m referring. These examples are but a few of the many administrative cost opportunities that collectively can make a real difference in lower cost. Process improvements start by having associates who are engaged in their day-to-day activities, and as we say here, bring their “A” game to work. Associates who enjoy what they’re doing translates to customer, in this case, senior customers who understand the value of our products and services. Engaged associates also facilitate the operational improvements shown on this slide, which as I said earlier, produce savings that we’re able to invest in more value offerings for the customers we serve.

The work we’re doing is critical to our company and our stake holders. It benefits our members, young and old. It benefits employers, it benefits the government, they need our help. We see the challenges of our healthcare system as opportunities. It’s clear government’s role in healthcare will growth while at the same time the healthcare market will growth at a multiple of the overall economy.

Obviously, this is a defining time for our company in our industry. The expressed willingness of the new administration to adopt sweeping change, it’s eagerness to take on fundamental problems not just in healthcare but across the board, and today’s fiscal pressures mean that this may be our best chance to achieve meaningful improvement in healthcare for the United States. As the administration works toward healthcare reform, Humana is prepared to play major positive role bringing to bare the elements outlined on the slide.

I spent a lot of time on our Medicare operations this morning, but let me also provide brief updates on our military services and commercial businesses.

As previously disclosed, we submitted a bid on the south region for the next round of TRICARE contracts. While we have no definitive date for the related award announcement, we anticipate that a decision is likely some time before June of this year when the transition period for the new contract is set to begin. However, a specific date is not set and the Department of Defense may decide to take a while before reaching a determination.

In the interim, we have signed agreements with the Department of Defense for additional auction periods with the first extending through March 2010 and two more 6-month period extensions to follow, all to be exercised at the discretion of the Department of Defense.

Turning to our commercial business, the good news there is that the operating results for each of our medical lines of business are on track. We continue to anticipate membership being relatively flat this year with gains in strategic areas such as small group and individual and losses in large group and mid-market accounts netting out by year end.

Pricing continues to be generally rational with some pockets of outlier activity and we don’t see anything that would case a major shift in medical cost trends.

We’re also excited about the opportunity to see some of our newly acquired supplemental and voluntary product lines growth. With the exception of the impact upon the segment’s net investment income, our commercial business thus far has seen only minimal disruption with respect to the country’s economic turmoil.

In summary, with 2008 now behind us, we are confident in our prospects for 2009. Our Medicare Advantage business is on target with a substantial number of members choosing PPOs well ahead of 2011. Our segment-specific focus in the commercial business continues to drive improving earnings and our belief that aligning with the interest of consumers provides the best opportunities for our business has never been stronger.

With that, I’ll turn the call over to Jim Bloem.

James H. Bloem

Good morning everyone. Let’s start with our fourth quarter results. As Mike mentioned, we’re pleased to report that the operating performance of each of our business segments was in line with our prior expectations. We did incur approximately $10 million or $0.04 per share of other than temporary impairments in our investment portfolio. This was a factor in our reported earnings per share being slightly below the midpoint of our previous guidance of $1 to $1.10 per share.

Moving on to 2009, I will focus my remarks on the following 6 items. First, three fairly minor changes in our 2009 earnings per share guidance points which have occurred since November. Taken together, they don’t affect our previously announced 2009 EPS guidance range of $5.90 to $6.10; second, the anticipated quarterly progression of our expected 2009 overall Medicare benefit ratio; third, the outlook for our commercial segment operations; fourth, our expectations for 2009 quarterly earnings seasonality; fifth, our investment portfolio and the income; and finally, our capital liquidity as we begin 2009.

Turning first to 2009 earnings per share, we’re pleased to reiterate our previous guidance of $5.90 to $6.10. While the fundamental operating performance of our business segments has not changed, we have had three noteworthy changes in our guidance components since November. In total, these 3 items essentially net each other out.

First, we reduced our forecast for investment income by approximately $45 million versus our last forecast. I will elaborate on this change of approximately $0.17 per share in a few minutes. Second, we expect a favorable resolution of a contingent tax matter in the first quarter of 2009. This will result in an effective tax rate of 28% to 30% for the first quarter which in turn lowers our anticipated full year tax rate by approximately 100 basis points or $0.10 per share versus the prior forecast. And finally, we now anticipate the recognition of approximately $15 million in revenue associated with a 3-year CMS demonstration project called Green Ribbon Health.

Green Ribbon Health studied the impact of disease management programs on a defined human population. The nature of our arrangement with CMS required Humana to expense costs as incurred while deferring any potential revenue. The exact amount of any revenue to be recognized was contingent on the specific outcomes obtained. Based on the final outcome data, we expect to recognize approximately $15 million or $0.06 earnings per share of previously deferred revenue during the third quarter.

Now, I will comment on our expectations for 2009 operating results for our two business segments.

Turning first to Medicare, we expect improvement in our pre-tax operating margin as a result of our correction of the stand-alone PDP error that impacted our earnings throughout 2008 as is shown on this slide.

As we’ve discussed many times, the declining float of the overall Medicare benefit ratio as the calendar year progresses generally is driven by planned designs associated with Medicare Part D benefits.

We’ve analyzed our 2008 claims experience for the approximately 924,000 members that left our PDP plans in January, and we’re comfortable that we do not incur any overall materially adverse selection. Additionally, to confirm this observation, we’ve examined prescription drug claims incurred in the first 26 days of January and are comfortable that the run rates that are being incurred this year are in line with our forecasting models.

On the Medicare Advantage side, we expect to achieve our target margins since we’re very comfortable with our pricing discipline and benefit designs around these combined medical and drug plans. Additionally, as we continue to realize improvements around our medical care management model as illustrated by some of the initiatives that Mike just described, we continue to regain further assurance that we can deliver our pre-tax operating margin target as well as competitively position ourselves favorably for future years.

Turning next to the commercial segment, we anticipate 2009 pre-tax earnings in the range of $270 million to $290 million. This is an approximately $30 million lower than our previous guidance due to the reduction in expected investment income not into the operating performance of the commercial segment.

Otherwise, our commercial segment lines of business continue to perform well. The performance continues to be driven by the following 5 factors: First, our consumer focus strategy; second, our sustained pricing and underwriting discipline; third, our continuous benefit expense trend analysis and forecasting; fourth, our integrated guidance solution and our medical care management model; and finally, we have a well-balanced membership portfolio.

Year 2008 marked another year of delivering benefit expense ratios in line with pricing expectations. We continue to experience stable cost trends in the 6% to 7% range on a same-store basis with net trends in the 3% or 4% range. As we’ve discussed before, these lower net cost trends, reflect the effects of changes in business mix including increasing membership in our lower cost networks and our relative business mix between fully insured group sizes.

With respect to secular cost trend components, that is the annualized trend before benefit buy-downs, there were no surprises during 2008. We saw inpatient utilization trends come in a bit favorable versus our expectations for 2008 and we expect a relatively flat trend in 2009. For both inpatient and outpatient hospital rates, we experienced the trend in the mid to upper single digits for 2008 and expect roughly the same for this year. Physician cost trends averaged in the mid single digits in line with our forecast. And finally, as expected, prescription drug trends were in the mid to high single digits.

Based on our ongoing deep dive analysis of benefit-expense trend factors, we don’t foresee any significant changes to the components of our cost trends as we move into 2009. We continually assess cost trends in order to ensure that we keep our pricing where it needs to be.

Now, let’s pull together each of the items that I just covered and combine them with some of our other regularly discussed seasonality factors such as the timing of the Medicare selling season and the ongoing growth of commercial membership in high deductible health plans. The result of this synthesis which is summarized on the slide is an implied 2009 quarterly earnings pattern that is back half weighted just as has it been the case since the initial Medicare Part D roll-out in 2006. However, for 2009, the pattern is not as heavily back weighted as in the past due to the just described expected first quarter tax rate benefit combined with the continuing growth in high deductible health plans in our commercial plans.

Since high deductible health plans tend to have a benefit ratio that behaves inversely to the PDP driven overall Medicare benefit ratio pattern, the relative waiting of the first and second half of this year’s earnings are closer this year. So accordingly, our first quarter earnings per share guidance of the $1.10 to $1.20 represents approximately 20% of our expected full year’s earnings which is a bit higher than what we’ve seen in the last few years.

Turning next to our investments, our $7.2 billion portfolio continues to benefit from broad diversification, appropriate duration, and a high credit quality. With $10 million or $0.04 per share of additional impairments recorded in the fourth quarter, our total investment write-downs for 2008 were $119.5 million or 1.7% of the average portfolio balance for the year. The $10 million of fourth quarter impairment consisted of 12 securities from 11 issuers.

Just as in the third quarter, you can get further detail on our portfolio composition from our recently added statistical page as 13 of this morning’s press release.

At December 31, 2008, we had approximately $232 million of total net unrealized investment losses. That was 9.4% lower than the $254 million we had at September 30th. As of January 28, 2009, our total net unrealized losses were approximately $202 million.

Based on continuing dislocations in the credit markets both in the fourth quarter and through January, we’ve lowered our expected 2009 investment income from a range of $370 to $385 million to a range of $325 to $345 million. This is approximately $45 million decrease in investment income represents roughly 55 basis points on an approximate $8 billion of 2009 average invested balance.

The 55 basis points decline in expected investment yield results from the following: First, the effect of the federal reserves establishment and continuation of a 0 to 25 basis point targeted federal funds rates since mid December. The new target represents a 75 to 100 basis points decline from its October 29th announced target. Second, continued weakness in the economy which is reflected by a widely held consensus of the economists is now expected to last throughout 2009 rather than just in the first half. Now the second factor is also reflected in fewer new debt issuances which meet our investment guidelines for short duration, adequate liquidity, and high credit quality. These factors require us to maintain higher cash and cash equivalent balances than we originally anticipated, all at historically low yields which again by a widely held consensus are not expected to change materially for the year.

Turning last to capital and liquidity, as demonstrated by the following 4 points, we continue to both have and conserve ample capital and liquidity in these uncertain times. First, cash flow from operations was $1 billion in 2008, and we’re reaffirming our 2009 guidance of $1.2 billion to $1.4 billion. The primary driver of the year-over-year increase is the expected increase in net income this year.

Second, we have $750 million in remaining availability under our $1 billion revolving credit agreement after having completed the cash acquisition of Cariten Health Care for $253 million in the fourth quarter. Our bank facility remains effective until July 2011.

Third, our debt to total capital ratio at December 31st was 30.3%, at the top end of our 25% to 30% target range. As previously disclosed, we expect to repay the Cariten acquisition driver in the first half of 2009, which together with the anticipated net income will both restore the revolver to its full availability and return the debt to total capital ratio within our targeted range.

Finally, we continue to carry significant levels of aggregate statutory surplus in capital than our state regulated operating subsidiaries. While the exact amounts will not be available until the second quarter after the individual state reports are filed and discussed with the respective departments of insurance in the credit rating agencies, we maintain our expectation that we should be able to dividend $500 million from the subsidiaries to the parent versus $296 million in 2008. In addition, we expect capital contributions to the operating subsidiaries to be less than $243 million in 2008.

As usual, we will update these amounts in our second quarter 2009 earnings conference call in early August after the process is complete.

So, in conclusion, we’re pleased with how 2008 played out although it certainly did not meet our expectations of a year ago. The continued lessons learned and processes developed both in 2008 and in prior years give us confidence in the reiterated earnings guidance we are giving today. As we enter 2009, the operating discipline and financial strength of Humana have never been greater.

With that, we’ll open the phone lines for questions. We request that each caller ask only two questions in fairness to those still waiting in the queue.

Question-and-Answer Session

Operator

(Operator Instructions) The first question is from Joshua Raskin from Barclays Capital.

Joshua Raskin - Barclays Capital

My question relates to the migration of the private fee for service license to the PPO and some of them to the HMO networking; maybe Mike if you could help us understand the difference in cost structures in terms of your visibly run medical and admin costs, where did they line up or Humana currently versus the traditional fee for service sort of benchmarks?

James E. Murray

The way that I would think about it is that for the private fee for service, the cost structure is probably 5% to 10% below the regional PPO and the local PPO is probably another 5% or so percent different from that. The way I try to think about it is that the premiums on the regional PPOs will likely one day be about $100 to $150, the local PPO will be $50 to $100, and the HMO will be somewhere around 0 to $50 some time in the future. That kind of gives you a sense for the different values that can be achieved. So, if I were a senior and I was looking at some of the different offerings of private fee for service, I’m probably saving $20 to $30 per member per month by moving from a private fee for service into a regional or local plan.

Joshua Raskin - Barclays Capital

So then it sounds like when you said eventually the local PPOs will still be something in the ball-park of $50 pmpm were expensive than the HMO, is that a fair way to look at it?

James E. Murray

Yes.

Joshua Raskin - Barclays Capital

Okay, that’s helpful.

Michael B. McCallister

Josh, there’s another thing I think we should think about; now is the time to really move people into PPOs because the payments rates are such that it gives us more flexibility in terms of product offerings and the level of benefits and all other things. The issues over time relative to that to get people to switch, one is the benefit, one is the premium, all that stuff is in place; I think it’s smart to go now and really emphasize the PPOs, and that’s what we’ve done. We’ve taken advantage of where we are from a payment perspective to begin that process now as opposed to waiting for 2011. I said many times in 2011 people will sit down and make a value judgment about what they want to have and I’m pretty comfortable they’re going to make the right call and the rest of them, however, many are still left will probably move to a PPO, we expect them to, or an HMO, but I think the timing is now to be moving to PPO and that’s what we’ve tried to do here.

Joshua Raskin - Barclays Capital

That makes sense. And then a followup on that, the 65,000 switch that you guys transitioned out of your old private fee for service into network based products, one, can I assume those were all into PPOs, and then two, how did that 65,000 come in versus your expectation?

James E. Murray

Generally, almost all of those moved into PPOs, some did go to HMOs, and that was significantly above our expectations. In total, we sold 258,000 gross members and included in that were 86,000 plan to plan changes as we call it member selecting are different options and the strong majority of those were into network based plan. So, we’re really excited about that because it was a really good movement towards the next couple of years, moving almost all of our private fee for service members into network based options. So, we feel like we got an incredible start on that process.

Joshua Raskin - Barclays Capital

Just so I understand this, the 65 was well above your expectations?

James E. Murray

Yes.

Operator

The next question is from Gregory Nersessian from Credit Suisse.

Gregory Nersessian - Credit Suisse

My first question again on the private fee for services, just wondering from a competitive standpoint, are you seeing any new competitors entering in any of your private fee for service markets with network based options that you hadn’t seen before, and then also, how has the provider contracting behavior been relative to your expectations from competitors, are they contracting rationally or do you see some aggressiveness on that?

James E. Murray

I’m assuming you’re referring to Medicare contracting, so I’ll answer your first question. One of the phenomenon that we had this January as we’ve said in the past is that some of our competition has significantly expanded their 0 premium private fee for service offerings in many of those markets that we operate in and that has significantly impacted our growth for January of this year. In terms of whether we see those competitors creating new network based options, we’re not seeing significant growth from our competitors in network based options, we are seeing one or two of our competitors growing private fee for service but we’re not seeing significant growth in PPOs or HMOs from the competition.

Michael B. McCallister

I’ll take the contracting piece, Greg, I don’t anticipate at the end of the day when it comes to contracting for Medicare business that any of the payers are going to be treated materially different. We’ve decided from the very beginning that we were going to have to make this work, paying providers at least what the government was paying; you weren’t going to be able to make this work unless you could find spending efficiency somewhere else than the actual clinical care. My experience so far with the hospitals is they are very willing to do business with us at the level the government pays them, but to do better than that is unlikely. So, I think it’s about speed in execution in relationships when it comes to the actual hospital contracting and whether they trust you to be a good partner in terms of being at least as good as the government or better in terms of payment, speed, and accuracy, and that sort of things. We’ve had good experience these, so that’s why the networks have built-up as effectively as they have.

Gregory Nersessian - Credit Suisse

Okay, great, and then if I could just ask a quick followup for Jim. Given the drop in the PDP enrollment, how do you think that might impact the DCP and then also the seasonality of the cash flow next year, should we expect an uptake in the DCP next year?

James H. Bloem

No, I think basically what we’ve said before the big thing in the cash flow as we said is really the income. It’s still very early to look at every thing and there would be no change that we could perceive based on the days in claims payable.

Gregory Nersessian - Credit Suisse

Okay, it’s the same range?

Regina Nethery

Just to clarify, the days in claims payable calculation that we disclosed does not include stand-along PDP.

James H. Bloem

Just to clarify, the profitability of the PDP is going to improve over last year, so I would anticipate that that will improve our cash flows…

Michael B. McCallister

I think it’s reflected in income, that range is still based on the change in income.

Operator

The next question is from Charles Boorady from Citigroup.

Charles Boorady - Citigroup

Approximately what percent of the roughly 180,000 have a drug users that you pointed to ’08 as causing the shortfall in your Part D profitability are still enrolled in one of your plans this years?

Michael B. McCallister

We don’t have the exact percentage, Charles, but we did lose some number of those members. We had anticipated keeping some of them, and as we look at the PDP result in the main, because we shrunk more than we thought we were going to shrink, obviously our underwriting results because of the less revenue have decreased, but some of the conservatives in that we built into some of our assumptions around the risk mix of business that we were going to keep seem to be playing out better than we anticipated. So, in the main, our underwriting results overall for the PDP look to be pretty solid, and as Jim said in his remarks, we’ve looked at the claim payments in the month January and we feel very good about how those are coming in relative to our projections and our ultimate view for 2009’s profitability on the PDP.

Charles Boorady – Citigroup

What are some specific things that you’re doing or looking at this year that you did not do last year to try to identify any potential shortfall so that we get a earlier read than we did in ’08 on the risk of your book?

Michael B. McCallister

Every day I look at the claim payments relative to the PDP membership, we’re looking at the risk mix of the PDP membership; we’re looking at the utilization of our RightSource facility, that’s our mail-order facility; we’re looking at our generic dispensing rate on the MA side; we’re looking at daily receipt information; we’re looking at utilization information; we’re studying the tapes that we get in from CMS to the risk mix of the business that we sold and lost, and so we’re doing quite a bit to get ourselves comfortable with the guidance that we’ve put out there today.

Charles Boorady - Citigroup

Can you clear; these are things that you’re doing this year that you were not doing last year, Jim?

James H. Bloem

We’re doing them much more vigorously and identifying new opportunities to evaluate data that makes us feel much more comfortable than we did at this point last year.

Charles Boorady - Citigroup

Last year, it was early March, but what point this year do you think you’ll get to the same degree of confidence in your guidance for this year?

Michael B. McCallister

As respect to the PDP and the MA, it’s today.

Operator

The next question is from Justin Lake from UBS.

Justin Lake - UBS

Just a couple of questions on the commercial side; one, the MLR in the quarter was a little bit higher, and I know you pointed to the greater seasonality from selling high deductible plans; given we didn’t see that last year in the numbers, can you give us some color around how much more high deductible numbers should we have this year than last year, as a percentage?

Michael B. McCallister

The percentage is about 55% higher, and we did have some last year if you look at how last year went through the year, we did allude to it being a factor, but then it was 11% of the total fully insured book, it’s like I said it’s sub 65%, it’s around 225,000.

James E. Murray

The way I look at the overall commercial result, I look to the full year’s medical expense ratio and it improved this year versus last, and the only thing that I look to is some of the discussion that we’ve had in prior quarters and in New York when we were there in terms of this year being a year where we’re focusing on improving our margins and delivering late increases that are designed to do that. So, I feel very good about how we’re starting 2009 in terms of our commercial opportunities.

Justin Lake - UBS

On the topline for the commercial business, it looks like you left the numbers relatively similar to your third quarter guidance, is that just buy-downs or is there anything else we’re seeing out there that that you think are conservative?

Michael B. McCallister

Actually, when we saw what the membership came in and the composition of that in terms of ASO and some of our smaller group and our individual, what we’re thinking for the year, we put all those together and that really explains the change in the amount.

Justin Lake - UBS

Is there anything you can talk to as far as the impact of the economy on your membership for next year?

James E. Murray

I have read some of our competitor’s investor call write-ups and I guess as I think about us we’re different in terms of our makeup, we don’t have as many national accounts as some of our competitors and I think a lot of the write-off news that we read about everyday is somewhat focused on the larger companies and to the extent that some of those larger companies are laying off folks, I think they’re going and starting their own businesses, and so, although it would be naïve of me to think that we’re not going to see some implications due to the economic crisis in our membership base, I don’t think we’re getting hit as significantly as some of the competition, particularly with some of the lines that we focus on, the individual where some folks are going to need some coverage, and so I would expect that we’ll see some pickup as a result of that in the small group business. Although, again, it would be naïve to think we’re going to go without any issues related to it. I think we’re a little bit differently constructed than some of the competition.

Michael B. McCallister

Justin, if you go back, we’ve been talking for a couple of years about the synergy between small group and individual, this is a place in this kind of economic period where that’s actually going to be quite important because there will be pressure on not only the big companies but everyone. Smaller employers have been dropping coverage for years and it could accelerate to some extent, but we haven’t seen any evidence of it yet, but it could happen, and the beauty of it is by having the individual business there and having enough maturity and experience with it to actually take advantage of picking up that business as things change, I think it’s going to turn out to be good for us, but we haven’t seen a lot of impact yet, as Jim said, it is inevitable that things will tighten up a little bit, but when you look at the implication of the growing uninsured and the unemployed and you spread it across the entire industry, the impact on a particular company, the going would have to get awfully bad before you would see, I would think, material impact on a single company.

Operator

The next question is from Scott Fidel from Deutsche Bank.

Scott Fidel - Deutsche Bank

First question; it looks like you boosted your other revenue guidance by around $30 million. Any particular factors you can cite around that?

Michael B. McCallister

As Jim mentioned, we’re continuing to focus on our RightSource, our mail order pharmacy, and I think generally more transactions, more emphasis for that for the commercial business is generally what made that change. We also had $15 million, as I mentioned, in Green Ribbon Health, I mentioned that in my remarks, that’s deferred revenue and that’s where it shows up when it’ll come in in the third quarter.

Scott Fidel - Deutsche Bank

Just a followup around cost trends; it looks like you tweaked down your inpatient utilization trend, you are just a smidge to flattish, but also increased at the same time your outpatient utilization also just slightly so; just wondering was there a mix shift that you’re seeing that’s driving just that that changes the margin or any other variables that you can describe?

James H. Bloem

The only thing that I would throw out is that we have some initiatives around utilization opportunities. We’ve hired some more nurses than we had in the past to focus on a new project, and we think that that’s beginning to pay some dividends, and there is some increase in outpatient utilization that is more difficult to get at, but in terms of the offset in the inpatient saving that we’re seeing significantly outweigh the outpatient increases that we’re seeing, so we like that.

Scott Fidel - Deutsche Bank

If I could just sneak one last quick one just on the CMS demo on the MHS payment in the third quarter, will that be nonrecurring payment in terms if you only expect that in the third quarter or other opportunities in 2010 to generate additional revenue CMS after that?

Michael B. McCallister

Not with that particular project. So, it’ll in the third of ’09 only.

James H. Bloem

That’s a true statement. The one thing that I would throw out is that because we had the opportunity to participate in that program we’ve internalized those resources and they’re a part of the initiatives that we talked about when we were in New York in terms of getting our medical spend 15% below Medicare. We’re very pleased with some of the progress that we’re making with that program. We now call that Humanicare which focuses on the top 22,000 folks that need complex care management, and so, our participation in that program will serve us well going forward. We’ve been participating in all these Medicare pilot projects over the last 10 years. We’ve learned a lot, some of them worked and some of them haven’t, this is one where we liked what we saw because it was a project targeted at the absolute sickest, most frail seniors in the population, and so as Jim says we like what we saw. The pilot is over, the project is over, but we’ve internalized the good learnings we had from that one. It is already part of our clinical model.

Operator

The next question is from Carl McDonald - Oppenheimer.

Carl McDonald - Oppenheimer

I wanted to spend a minute on the attrition in Medicare Advantage. You said previously that the private fee for service attrition was higher than you anticipated. Do you have any insight into the kind of membership you’re losing, is it mostly the zero dollar premium fee for service members that are going to similar plans of competitors?

James H. Bloem

Yes, but we looked at the loss inside state and where our value proposition is stacked up, and I can point to a number of states where our products last year were zero premium and we took the premium about anywhere from $18 to $48 per member per month, and the competition in those states is at a zero premium still and that’s where the lion’s share of our losses came from.

Carl McDonald - Oppenheimer

Alright. At this point, have you done any analysis in terms of looking at the 2008 profitability of the members you lost in January versus the profitability of the overall Medicare book?

James H. Bloem

Mike referenced in his remarks that we slice and dice our membership in terms of trying to figure out medical costs spent by the different categories, and generally speaking, when we look at the different categories because of the risk premium that CMS pays us, our membership is fairly evenly distributed. There are a couple of categories that we referred to as LIS and disabled where the medical expense ratio is higher, but still acceptable, and we’re pretty pleased with where we’re at today relative to our membership compliment this year compared with last year as respect to all that analysis that we’ve done.

Operator

The next question is from John Rex from J.P. Morgan.

John Rex - J.P. Morgan

Just a question on MA and gross sales in that, just wanted to be clear, you said it was about 160,000 gross losses, is that correct, in total on the MA book? And then to compare the churn in the book, January ’09 over January ’09 in terms of magnitude, and then following in the risk profile, the average risk of a member leaving versus the average risk against your total book or the members that you’re picking up?

James H. Bloem

I’ll call out some numbers and hopefully it will hit all of our questions. We had what I referred to earlier as 258,000 gross sales. I say that because our market point representatives, our career agency for us, sat across the table with all of our existing members and talked about the different opportunities and value that existed in all of our products. So, they re-sold in our minds 250,000 gross new or sale. Included in that, and I am not trying to confuse you, were 86,000 what we call plan-to-plan changes, where generally a private fee for service member chose to go into a network based option which left us with net new sales of 172,000. So, members who were not part of our book before, the lion share or 65% of those were into network based options, we were really excited about that; most of the sale, 65% of them, chose network based plans, and then the terms that I think you referenced were around 162,000 after you take out the plan-to-plan changes. And again, to the risk score, we really frankly don’t care about what our risk score is because we get revenue from the government that adjusts for the changing risk scores, and so again, as I said earlier and Mike commented too in his remarks, the revenue that we get for each of our Medicare members is fairly adequate to cover the cost for that membership, and so the medical expense ratios for the various members that we get are generally in the same ballpark, and so, we’re not too concerned about what the risk scores are period to period. I talked a little bit about the membership that we refer to as LIS, low income subsidy, or disabled, where the medical expense ratios are slightly higher, but not significantly higher, but again, as we sit here today, we’re pleased with our mix risk, and we feel very good about the guidance that we just provided.

John Rex - J.P. Morgan

Is it fair to surmise then that the risk scores of the incoming members are on average higher than the risk scores of the members that you lost?

James H. Bloem

Generally in the same ballpark as they were in 2008.

John Rex - J.P. Morgan

I am not so sure, what does that mean? The risk scores of members that you lost were the same as the risk scores of members you gained, or they were higher or lower?

James H. Bloem

Our book of membership as we are here at January 31, 2009, end of the selling period, are just about the same as the risk scores for the membership that we had at the end of the year.

John Rex - J.P. Morgan

Okay, and no difference between the members that were lost, the 160,000 members that were lost, and the 170,000 members that were added, in terms of risk score?

James H. Bloem

No.

John Rex - J.P. Morgan

Okay. So, what we’re just trying to get at, there was no adverse selection, and again, I understand the risk…

James H. Bloem

That’s absolutely correct.

John Rex - J.P. Morgan

Okay. I thought so. I just wanted to clarify that. The Part D payments look like they’re up in the quarter. Were there some risk adjustor payments received, and if so, can you quantify how much?

James H. Bloem

I don’t have that information at my fingertips, but I think the answer is correct.

Michael B. McCallister

Yes, there were some, but again, looking at it in totality for the year, if I am not mistaken, everything is in line.

John Rex - J.P. Morgan

Okay. Any kind of gut sense on how much was received in the quarter on the Part D risk assessors?

Michael B. McCallister

Well, these are accruals and they’re not payments themselves. Yes, I think this reflects how the year turned out for the closing.

Operator

The next question is from Ana Gupte from Sanford C. Bernstein.

Ana Gupte - Sanford C. Bernstein

My question is about your network contracting rates; I think you mentioned that is in the mid to upper single digits and you’re seeing no chance from this year going into the next year whereas some of your competitors are talking about upward pressure on unit cost, severity spikes, and so on with the economy; so I was wondering if you are expecting to see any change or are seeing any changes, and if not, why not; and then the second part to that question is, you’ve mentioned hospital contracts being an ancillary contracting changes as one of the ways to bring your trend down; do you see that as a risk in anyway with what’s going on with hospitals and bad debt in the economy?

James H. Bloem

Let me start with the question. It’s important to look at these companies all differently when it comes to what’s happening with hospital negotiations and contracting because what happens is it’s often a function of where you’re starting from and where you are relative to others in the marketplace. If you follow what I’d been saying for about the last four or five years there is a movement among hospitals to get payers to a single rate or something as close to that as they can achieve because they have no rationale for differentiating among payers because all of these members are so big that the idea of moving business around has sort of fallen away. That’s a 100,000 foot view of the world. So, the implications are, if you have the lowest priced networks in the community against others that are paying those same providers more, you’re going to be under more pressure in price increases than they are. Now, it’s going to vary by market, by payer, by circumstance, situation; to try and compare exactly company to company is probably a little dangerous in this evolving environment.

Ana Gupte - Sanford C. Bernstein

One followup; on one of your slides you had privacy members at risk and networks owning the build-out in the north eastern California, is that moving more slowly than in the other areas where you’ve got all the blue and looks like you’re doing well on network build-out?

James H. Bloem

Those, Ana, are areas that we haven’t really emphasized the yellow on that sheet, basically where we’re at risk because there are multiple competitive offerings in those areas. If you look at where we’ve been concentrating on a program and concentrating all of our efforts over time, the states where that yellow appears are now strong states for us. The states where the grey appears is just the fact that there’s just a dearth of private fee for service or competitive offerings period. And again, what we’re very proud of is that if you look at the map, one is, how protected is the business we have today, which says the yellow PPO ready for 2011 and the network that will support it, the answer from that map is yes. Then the question is, given that map, is there a growth opportunities in Medicare after 2011 in the movement to full network product offerings, and if you look at the total, I don’t have that off the top of my head, but the total Medicare population in all those blue states that are highlighted, it’s quite large. So, we’re not focused on the other states is that frankly we don’t see that as a big opportunity for us. We may eventually find our way there, and in fact, we have got people there that are interested in us being there, but we’re dealing with this mid-term question of whether we can be ready for 2011; yes, and is there is growth after we do; yes, and we intend to be a fully national player in all those locations eventually, but it’s just not a high priority right now.

Operator

The next question is from Matt Perry from Wachovia Capital Markets.

Matthew Perry - Wachovia Capital Markets

I wanted to get into a little more detail on the members you were able to move from private fee for service to PPO. First, wasn’t quite sure if the number you cited, the 65,000, was simply from the open enrollment period or does that also include some switches in January; and then how do you think about the potential of switching more members in January, February, and March, or do you think it’s mostly just going to happen during open enrollment? You also said it was above your expectation, and I would like to know, what did you learn as your agents talked and sat down with these members; when they switched, why was it, and what have you learned that might even help you next year move more members over?

James E. Murray

The numbers that we’ve cited were through January 31st effective, and when we sat down with the folks and chatted with them what we learned was that the relationship that we’ve developed over the last number of years that they’ve been a member of ours had served us well in terms of their desire to work with us to try to find products that give them additional value. We feel very good about the fact that we had an over-the-kitchen-table conversation with these folks and 65,000 of the private fee for service members chose to go into some of our network based products which tells us that as we move through the remainder of our private fee for service members over the next several years, that a similar kind of event and result can happen which is something that we’ve said for a period of time that folks who are comfortable and familiar with PPOs and HMOs are very willing to go in that direction if value exists. The one thing that I would throw out that we’ve also learned is that the financial situation that we find ourselves in as a country somewhat impacted some of the activities that took place towards the end of the year, and in part, had something to do with some of the members choosing to go to some of our competitors’ plans because of the zero premium dynamic that existed, and that was unfortunate in terms of timing for us, but a lot of learnings that we’re going to apply and we feel good about what might happen in the OEP with similar kinds of result as we have these across-the-table conversations. So we feel very good about our first step toward moving folks into network based options, lots of learning and things that we’re going to do to try to continue that process over the next couple of years.

Matthew Perry - Wachovia Capital Markets

Just to squeeze one more in; do you think that over the long term, the PPO is a slightly higher margin or moderately higher margin product than the private fee for service has been?

James H. Bloem

As we’ve said time and time again, our target for these products is a 5% margin, and to the extent that they provide additional opportunities for us to enhance benefits or lower premiums, we’re going to take that and we’re going to keep reconciling to the 5% margin that we’ve spread out there. We think that’s the right answer, we think that gets more people in for the program, and we think that provides the solution that the government is looking for to this crisis that confronts us.

Operator

The final question is from Matthew Borsch from Goldman Sachs.

Matthew Borsch - Goldman Sachs

Just wondering if you could give us a little bit more information on the commercial enrollment outlook; specifically, I think you said that net for the year you expect total commercial enrollment to be flat, can you break out what you expect fee based versus fully insured, and if you have any view of where you think small group is going versus how much growth you expect in individuals?

James H. Bloem

One of the dynamics that we’re dealing with is that we lost an 80,000-member network-based ASO account in January, not much fee from a network rental arrangement, but it does count in our membership, and so that’s something that we’re overcoming for the remainder of the year. So we start January with a reduction. In terms of the different lines of businesses that we think about; individual, we think we’ll have a nice solid year, we see some pretty solid growth coming from our individual book of business; small group, we’ve delivered some rate increases that we think were called for, and in the environment that we were operating in over the last year or so, we think there was an opportunity to increase our premiums on the small group block, and so, we see that flattish for the year. Large group, which we define as 300 to 3000 is generally probably going to be flattish, and as I referenced earlier, our national accounts business starts the year in a little bit of a hole, obviously national accounts business renews in January, and so nothing much will happen for the remainder of the year there. So, that’s why we’ve guided to flattish. When you add all those pieces together, I think the individual, and maybe a little bit from the large group, will offset the losses that we’ve seen in national accounts and we’ll end the year flat, but as I said earlier, focusing on delivering some premium increases that are going to be targeted at increasing our margins.

Matthew Borsch - Goldman Sachs

It just seems a little bit difficult to reconcile that with what’s happening in the economic environment. I heard your remarks earlier. It’s just that I would think that those segments where you’re flat would have to reflect some market share gain, but I realize you’re talking about putting through some price increases that maybe, if I am reading on the margins, are perhaps above the market; so, can you just help me to understand that a little bit better?

James H. Bloem

I can just speak to what we’ve seen over the last several months, and as we’ve delivered on what I just described, and I’m talking about what we’ve historically seen for the last quarter in terms of gross activities and where that’s taking us for the remainder of the year to the extent that the economic situation begins to significantly impact the small group markets, then I would change what I’m saying right now, but based upon the last several months, we’ve seen some relatively solid individual growth, our small group membership has been flattish, large group is flat to slightly up, and the national accounts as I described in January we saw a loss of the one large account. So, when I look at what we’ve historically seen and what I’m hearing from the marketplace, I don’t anticipate any significant changes although to the extent that the economy and some of what’s going on there continues to hit some of the lines of businesses that I just referenced; there maybe some changes that we haven’t seen as yet.

Michael B. McCallister

In addition to that, we continue to focus on controlling your own trend and showing people how they can really mitigate these increases by their own behavior and by good guidance from us in our clinical programs and stuff. We think that that’s also a differentiator between us and the other people that I’m sure your question is alluding to.

Thank you for joining us this morning. I’d like to just reiterate that the fourth quarter of ’08 was a really good quarter for us. 2008 had its challenges, very narrowly focused really in the PDP space, which are behind us. 2009 is going to have us return to I think the best earnings growth rate in this industry. I think 2009 is also a very big year in terms of getting clarity around the long-term nature of the Medicare Advantage program as we play through the politics and the decisions that have to be made around how the private sector is going to play here in the Medicare space. I am very comfortable that at the end of the day we have a wonderful opportunity. The government does need us, many there do know that. Our consumer products continue to be attractive; it’s the best margin and the highest retention rates we have in our book, and we’re glad to see them continue to grow. And lastly, I want to thank all the Humana associates that are on the call for their great work that made this possible and made 2009 such a bright opportunity for us. Thank you very much.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Humana, Inc., Q4 2008 Earnings Call Transcript
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