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Aetna (NYSE:AET)

Q1 2013 Earnings Call

April 30, 2013 8:30 am ET

Executives

Thomas F. Cowhey - Vice President of Investor Relations

Mark T. Bertolini - Chairman, Chief Executive Officer, President, Chairman of Executive Committee and Member of Investment & Finance Committee

Shawn M. Guertin - Chief Financial Officer, Chief Enterprise Risk Officer and Senior Vice President

Analysts

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Joshua R. Raskin - Barclays Capital, Research Division

Carl R. McDonald - Citigroup Inc, Research Division

Justin Lake - JP Morgan Chase & Co, Research Division

Peter Heinz Costa - Wells Fargo Securities, LLC, Research Division

Ana Gupte - Dowling & Partners Securities, LLC

Christine Arnold - Cowen and Company, LLC, Research Division

Scott J. Fidel - Deutsche Bank AG, Research Division

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Ralph Giacobbe - Crédit Suisse AG, Research Division

David H. Windley - Jefferies & Company, Inc., Research Division

Albert J. Rice - UBS Investment Bank, Research Division

Sarah James - Wedbush Securities Inc., Research Division

Operator

Good morning. My name is Celia, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Aetna First Quarter 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to turn the conference over to Tom Cowhey, Vice President of Investor Relations. Mr. Cowhey, please go ahead.

Thomas F. Cowhey

Good morning, and thank you for joining Aetna's First Quarter 2013 Earnings Call and Webcast. This is Tom Cowhey, Vice President of Investor Relations for Aetna. And with me this morning are Aetna's Chairman, Chief Executive Officer and President, Mark Bertolini; and Chief Financial Officer, Shawn Guertin. Following the prepared portion of the remarks, we will respond to your questions.

During this call, we will make forward-looking statements. Risk factors that may impact those statements and could cause actual future results to differ materially from currently-projected results are described in this morning's press release and the reports we file with the SEC, including our 2012 Form 10-K and our first quarter 2013 Form 10-Q, when filed.

We have provided reconciliations of metrics related to the company's performance that are non-GAAP measures in our first quarter 2013 financial supplement and our 2013 guidance summary. These reconciliations are available on the Investor Information section of aetna.com.

In addition, please note that Aetna will now be guiding to our operating expense ratio rather than our previous guidance on the business segment operating expense ratio. This change reflects the decline in variability of pension obligation expense following our pension plan changes in 2010.

Also note that Aetna has begun providing adjusted operating EPS in our financial supplement. Consistent with our presentation of this metric at our Investor Conference in December, this metric starts with operating EPS and adds back the intangible amortization associated with our acquisitions. We believe this is a useful way to look at the strength of the cash generated by the business, particularly after the Coventry acquisition, as it helps demonstrate our financial capacity to invest in the business, make acquisitions and return cash to shareholders.

Unless specifically otherwise noted, all of Aetna's projections discussed today include the impact of the sale of our Missouri Care business but exclude the impact of the proposed Coventry acquisition.

Finally, as you know, our ability to respond to certain inquiries from investors and analysts in nonpublic forums is limited. So we invite you to ask all questions of a material nature on this call.

With that, I will turn the call over to Mark Bertolini. Mark?

Mark T. Bertolini

Good morning. Thank you, Tom, and thank you all for joining us today. This morning, we reported first quarter operating earnings per share of $1.50, representing a 12% increase over the first quarter of 2012. Aetna's first quarter result is a testament to the strength of our diversified business model and represents solid performance across multiple business lines.

Underlying our first quarter result, Aetna grew underlying medical membership by a net of approximately 50,000 members, representing organic growth of almost 160,000 members, offset by the divestiture of 106,000 Medicaid members in the Missouri Care transaction. We grew health care premiums by 8% over the prior year quarter, with growth across multiple lines of business, particularly Medicare. We reported a pretax operating margin of 9%, at the high end of our long-term targets. And finally, we continue to generate substantial free cash flow and aggressively deploy excess capital. In short, I am very pleased with our first quarter results.

Looking ahead to the remainder of 2013, we continue to expect strong top line growth and solid operating performance. Based on our first quarter results, today we are raising our full year 2013 operating EPS guidance to a range of $5.50 to $5.60 per share from our previous projection of at least $5.40 per share.

Following the closing of the Coventry transaction, our combined projection for 2013 will be higher than the standalone projection, consistent with our previous disclosures and reflecting projected Coventry results and synergies.

Before I turn the call over to Shawn to discuss our results and guidance in greater detail, I would like to discuss the execution of Aetna's growth strategy. At our Investor Conference in December, we outlined 6 critical tenets that support the overall Aetna growth story: Aetna's diversified portfolio of businesses can grow predictably; our large group commercial business can grow profitably; Aetna's government franchise is a growth engine; Small Group and Individual are modest contributors to our consolidated earnings and represent an opportunity for future growth; Accountable Care Solutions is gaining traction and enhancing our core business; and Coventry is a strategically and financially attractive acquisition, which can accelerate growth across multiple lines of business.

I will now highlight some of our recent successes that demonstrate the execution of our growth story. We exhibited strong membership growth in the quarter and have now grown medical membership in each of the last 4 consecutive quarters, a validation of the strength of our diversified book of business. We are maintaining our year-end medical membership guidance of 18.4 million, in spite of the divestiture of 106,000 members associated with our Missouri Care business. This represents underlying organic growth of 100,000 members for the remainder of the year and 250,000 members for all of 2013.

In our large group Commercial business, despite a challenging economy and labor market, underlying commercial ASC membership grew by nearly 100,000 members, offset by the conversion of TRS members to our Medicare Advantage product. After 2 consecutive years of membership losses in our Commercial ASC business, we are pleased with this result.

In our Government businesses, we had a very strong quarter of membership growth, driven by Medicare. Medicare Advantage membership grew by 180,000 members, well ahead of our initial guidance from December. This growth is a testament to the strength of our Medicare Advantage products, relationships and distribution and speaks to the value we offer our senior customers. Also with the addition of approximately 150,000 members in group products in the first quarter, Aetna is now the leading national group Medicare Advantage player by membership.

Our Medicare Supplement business also continues to perform well. During the quarter, we added 75,000 members, a sequential quarterly increase of over 30%. Since we acquired our Medicare Supplement platform from Genworth in October of 2011, membership has nearly doubled, another example of Aetna's focus on deploying capital effectively to grow the business and generate shareholder value.

Let me take a moment to comment on the final 2014 Medicare Advantage rates. Medicare Advantage is a highly successful program that serves 14 million Americans or almost 30% of the Medicare population. The program has demonstrated excellent growth over the last few years, as eligibles have come to appreciate the exceptional quality and value that Medicare Advantage plans can offer. As our membership has grown, we have been strategically positioning our business to be able to provide attractive products at parity with fee-for-service Medicare rates. The changes in the recent 2014 rate notice suggest we will get to parity faster than we had previously expected.

Following the 45-day notice, Aetna engaged with leadership in Congress and the administration, including HHS and CMS, to seek solutions that would address the near-term challenges facing this highly successful program. On April 1, when the final 2014 Medicare Advantage rates were released, we were encouraged by the commitment that CMS demonstrated to the program, addressing many of our concerns. However, Medicare Advantage will still be facing significant challenges in 2014 that will be difficult to solve through efficiencies alone.

Tactically, we continue to undertake a combination of initiatives to address this funding gap, including: reviewing our contractual arrangements with providers; evaluating the impact of enhanced care management and medical management, including pursuing or accelerating ACO initiatives and provider collaborations; examining our administrative costs; and changing benefit plan design and premiums.

As we re-examine the challenge in front of us, the acceleration of these changes versus our previous expectations may force us to impact beneficiaries more than we would like in 2014. Aetna remains committed to the Medicare Advantage program, and we will continue to work to improve the health of our members, preserve member benefits while lowering costs and earn an attractive return for our shareholders.

As I just mentioned, Aetna's accountable care and provider collaboration efforts will be a critical part of our strategy to bridge the gap in Medicare Advantage. Aetna's collaborative efforts can have a meaningful impact on quality and cost.

Our 750-member NovaHealth pilot, featured in the journal Health Affairs last fall, speaks directly to the success our collaborations have had for Medicare Advantage populations. As a result of implementing many of our accountable care and provider collaboration strategies, NovaHealth's total PMPM costs for its Aetna Medicare Advantage members were 16.5% to 33% lower across all medical cost categories than for other comparable Aetna Medicare Advantage members not cared for by NovaHealth. Aetna currently has over 73 Medicare collaborations across the country, and one of our goals is to serve approximately half of our individual Medicare Advantage members through an ACO or provider collaboration by the end of 2013.

Our ACS capabilities and partnerships will also enhance the growth of our core Commercial business. These capabilities were instrumental in a recent contract win, where we were selected by the Commonwealth of Virginia to offer a self-funded health benefits option to over 200,000 eligible employees, retirees and family members effective on July 1. In Virginia, we are working to build another statewide ACO network similar to what we have built in Maine, and this win demonstrates the power that the network of ACS relationships can provide.

To date, Aetna has signed 20 Accountable Care collaboration agreements with leading health systems, with an additional 36 letters of intent in place and a pipeline of over 200 opportunities. We remain confident in our ability to grow to 30 ACS partnerships in 2013, encompassing approximately 375,000 members and $1.5 billion in revenues.

More broadly, we continue to make progress as we execute upon our strategy to transform the network model. During the first quarter, we introduced Healthagen, a new business brand for our provider collaboration and consumer empowerment strategy, including our Medicity, ActiveHealth and iTriage businesses. Under the Healthagen banner, we will continue to be an innovator in health care technology solutions designed to improve care quality, control health care costs and increase access. By engaging consumers with new convenient tools and mobile technologies to manage their health, we can keep people healthy and improve outcomes.

These advanced technologies and solutions will help to drive our core domestic businesses and also enhance our international growth opportunities. For example, in China, we have signed a joint venture to bid on a project to set up the health information technology infrastructure for an area-wide health system in Tianjin. Also, in the Middle East, we are piloting new population health management models for potential use on a national scale. Both of these pilots rely upon the core intellectual property of Aetna, in combination with some of Healthagen's leading population health management tools and technologies.

Moving on to our Small Group and Individual businesses. We have started to file rates for exchanges and plan to participate in Individual exchanges in approximately 14 states, as well as in the SHOP exchanges in a small handful of states. While we may continue to offer products in certain geographies off-exchange, our strategy continues to be defined by a measured approach as we evaluate these new and changing marketplaces. We continue to believe that if exchanges are successful and we can reasonably earn our cost of capital, they will represent an upside opportunity for Aetna.

Before I conclude, I would like to provide a quick update on the proposed Coventry transaction. As we are now within our projected mid-2013 closing timeframe, we thought it would be instructive to update you on our progress towards closing.

We have all of the state regulatory approvals needed for the transaction. Therefore, the closing is now contingent upon final approval from the Department of Justice, where we continue to cooperate with the DOJ; our discussions are focused on a limited set of issues; we believe that the impact of the resolution of these issues has been contemplated in our original financial projections; and negotiations are day-to-day, and we hope to come to a resolution soon.

We continue to project that the transaction will be modestly accretive to 2013 operating earnings per share, with $0.45 of accretion in 2014 and $0.90 of accretion in 2015. Our integration planning teams have been extremely diligent. And shortly following the closing, we will be prepared to discuss combined guidance for 2013.

In summary, I am confident in our strategic direction and our ability to execute; our ability to manage through the legislative and regulatory changes associated with health care reform; our ability to close and successfully integrate the proposed Coventry acquisition; our ability to maintain our pricing discipline and grow membership over the course of 2013; and our 2013 operating EPS guidance range of $5.50 to $5.60.

I would like to thank all of our employees for their dedication in meeting the needs of our customers. By focusing on sound fundamentals, creating new approaches to satisfying customers and generating and deploying capital responsibly, we believe that we can continue to create value for our customers and our shareholders.

I will now turn the call over to Shawn, who will provide insight into our first quarter results and our 2013 outlook. Shawn?

Shawn M. Guertin

Thank you, Mark, and good morning, everyone. Earlier today, Aetna reported first quarter 2013 operating earnings of $495 million and operating earnings per share of $1.50, a 12% increase over the first quarter of 2012. These strong operating results are supported by solid revenue growth, sound operating fundamentals and high quality of earnings metrics. I'll begin with some comments on overall performance.

From a top line perspective, we are growing. During the first quarter, we grew underlying membership by 159,000 members prior to the sale of our Missouri Medicaid business. On a year-over-year basis, we have grown by 486,000 members, again, before the Missouri Medicaid sale. This sustained membership growth has led to an acceleration in our operating revenue growth, which is increasing by over 7% from the first quarter of 2012.

From an operating margin perspective, our businesses are performing quite well. Our first quarter total medical benefit ratio was 81.9%. Our operating revenue growth and disciplined focus on costs have driven an 80-basis-point year-over-year improvement in our operating expense ratio. And our pretax operating margin was 9% for the quarter, at the high end of our target operating margin range.

From a balance sheet perspective, we remain confident in the adequacy of our reserves. After adjusting for the Missouri Care divestiture, reserve growth kept pace with premium growth, and our days claims payable were 45 days at the end of the quarter, stable sequentially but up over a full day from the prior year quarter. Additionally, we experienced favorable prior year's reserve development of $325 million in the first quarter of 2013 as compared to $169 million in the first quarter of 2012. This strong favorable development was experience across all of our core business lines and is primarily related to fourth quarter 2012 dates of service. The basis for the favorable development figures I just mentioned is consistent with the roll-forward included in our SEC reporting. Prior year's development is the basis upon which we intend to quantify reserve development going forward. We believe this treatment provides improved consistency and comparability with our larger peers and is better aligned with our practice of providing annual guidance. To this end, Aetna now will regularly produce an updated roll-forward of prior year health care cost payable for investors each quarter, the first of which is included in this quarter's financial supplement.

Turning to cash flow and capital. Our operating cash flow generation in the first quarter was excellent, as Health Care and Group Insurance operating cash flow was approximately 1.3x operating earnings. And we continue to aggressively deploy capital to create shareholder value, repurchasing approximately 4 million shares in the quarter. In short, we are pleased with our first quarter results, which we believe are a testimony to the successful execution of Aetna's growth story.

I will now discuss the key drivers of our first quarter performance in greater detail. Our efforts to improve the positioning of our Commercial ASC business are beginning to show results. We grew membership by nearly 100,000 members in the quarter before adjusting for the TRS Medicare Advantage conversion. Underlying growth was driven by our network access products and continued improvement in our National Accounts business. While overall net growth was modest, we are pleased with the direction of these results after experiencing significant membership losses in the first quarter of each of the last 2 years.

One of Aetna's important growth levers is our ability to grow our Commercial Insured business. In the first quarter, we were able to increase our Commercial Insured revenue and underwriting margin despite a decrease of 93,000 members. Our previous guidance assumed a 50,000-member decrease. Majority of the membership losses above our guidance come from our Small Group and Individual businesses and speaks to our commitment to fair and financially responsible pricing, where we favor margin over membership and price to underlying medical cost trends.

Our commercial medical benefit ratio was 78.9% for the quarter, a very good result and a 100-basis-point improvement over the first quarter of 2012, including the impact of favorable reserve development. As a result of this favorable development, our 2012 commercial medical cost trend estimate improved by approximately 50 basis points and now stands at approximately 6%.

Another important growth lever is our government franchise. As Mark highlighted in his remarks, we had strong membership growth in our Medicare businesses in the first quarter. Total membership grew 255,000 members sequentially, comprised of 180,000 Medicare Advantage members and 75,000 Medicare Supplement members, leading to a 28% increase in Medicare premiums. Our Medicare medical benefit ratio was 87.8% in the quarter, which is an increase of 340 basis points year-over-year and consistent with our full year guidance. As first outlined at our Investor Conference in December, a 300- to 400-basis-point year-over-year increase in the Medicare MBR was projected, driven primarily by Aetna's Group Medicare Advantage business, where we have credited favorable 2012 experience back to customers through the renewal rating process.

Finally, in our Medicaid business, membership declined by 112,000 members in the quarter, reflecting the sale of 106,000 Missouri Care members on March 31. Premiums increased by approximately 30% on a year-over-year basis, due primarily to our in-state expansions and growth in serving high-acuity populations. Our Medicaid medical benefit ratio was 89.3% in the quarter, in line with our full year guidance of high-80s and an improvement from last year's first quarter.

Our financial position, capital structure and liquidity all continue to be very strong. At March 31, we had a debt-to-total capitalization ratio of approximately 38%, consistent with our guidance. Prior to the closing of the Coventry acquisition, we continue to target a risk-based capital ratio of approximately 300% of company action level in our regulated subsidiaries.

Looking at cash and investments at the parent, we started the quarter with $2.4 billion. Of this amount, $100 million represents core liquidity, but the remainder held to fund the Coventry acquisition. Net subsidiary dividends to the parent were $230 million. We issued $100 million of commercial paper, and we repurchased 4 million shares for $184 million and paid a shareholder dividend of $66 million. We ended the quarter with $2.6 billion in cash and investments at the parent. Of this amount, $100 million represents core liquidity, with the remainder held to fund the Coventry acquisition. Our basic share count was 325.9 million at March 31.

As a result of our first quarter performance, we are increasing our 2013 operating earnings guidance to a range of $5.50 to $5.60 per share. At the midpoint, this $0.15 increase from our previous guidance of at least $5.40 per share is driven by a $0.25 increase to our previous outlook due to favorable operating performance in the first quarter of 2013, including the effect of the favorable prior year's reserve development. This increase is partially offset by the projected impact of sequestration on our Medicare business for the rest of 2013, which was not reflected in our previous guidance.

Additional elements of our updated 2013 guidance include the following. We are projecting full year medical membership of 18.4 million members, an increase of 100,000 members over the remainder of the year, led by growth in our Commercial ASC and Medicare Supplement businesses. After adjusting for the sale of our Missouri Medicaid business, this would represent organic growth of over 250,000 members during 2013.

We now project that our operating revenue will grow by 8% to 9% in 2013, reflecting the impact of our first quarter membership results, the completed Missouri Care divestiture and sequestration.

Including the impact of favorable prior year's development, we now project our commercial medical benefit ratio will come in at the low end of our previous guidance range of 81.5%, plus or minus 50 basis points. At this early date, we remain comfortable with our full year 2013 commercial medical cost trend guidance of 6.5%, plus or minus 50 basis points.

Our Medicare medical benefit ratio is projected to increase from the mid-80s in 2012 to the mid- to high-80s in 2013, consistent with previous guidance. Reductions to Medicare premiums related to sequestration will create upward pressure on this measure within our guidance range.

For 2013, our operating expense ratio projection remains consistent with previous guidance at 18% to 18.5%, an improvement over the 18.9% reported in 2012.

We now project operating earnings in 2013 of approximately $1.8 billion and a pretax operating margin of 8% to 8.5%. Based on these earnings, we now project net dividends from subsidiaries of approximately $1.3 billion, an increase of $200 million from prior guidance, resulting in deployable capital of approximately $700 million. Aetna's share count projections for 2013 remain unchanged at this time, as incremental repurchase dollars are offset by a higher assumed share repurchase price.

We believe that these results demonstrate our ability to execute on the growth strategy we shared with you in December. Our core business is growing, it's executing well, and we are well-positioned for the Coventry integration. Our emerging businesses continue to work to transform the health care delivery model, improve our cost structure and drive additional membership growth. Our capital generation remains strong, and we expect it to only be stronger going forward once we close the Coventry acquisition. Finally, we remain confident in our ability to generate low double-digit operating earnings per share growth on average over time.

I will now turn the call back over to Tom. Tom?

Thomas F. Cowhey

Thank you, Shawn. The Aetna management team is now ready for your questions. [Operator Instructions] Operator, the first question please.

Question-and-Answer Session

Operator

We'll go first to Matt Borsch with Goldman Sachs.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

My first question just on the pricing environment and how your account base is reacting to the surcharges that you're starting to put through for health reform on the insured side that, that would include the industry fee. Is that starting to become a meaningful component as you head into July 1 renewals?

Mark T. Bertolini

Matt, this is Mark. I think we are early in the cycle of putting these fees and insurance premium charges into our rates. So we only have a couple of months worth of 2014 into the rates now. So it's fairly low noise, but I think the market is waking up to all the taxes associated with the Affordable Care Act, and we're getting a lot of questions. And that leads to the strategy as we think about how we renew people into 2014 and do we give them more time to adjust into the marketplace relative to impacts like benefit plan changes that they'll be required to make, impacts like guaranteed issue and the tighter rating requirements. So the market is waking up. People are asking a lot of questions. Too early to see the ultimate reaction, given that we only have a couple of months priced in.

Operator

We'll go next to Josh Raskin with Barclays.

Joshua R. Raskin - Barclays Capital, Research Division

Just on the Medicare side, I guess sort of a 2-parter. One, the TRS conversion, did that spur any additional interest? I'd be curious to see what your group pipeline looks like. And then assuming you guys -- it doesn't sound like you're going to close Coventry today, do you think you'll have enough time to work together before that first Monday of June to sort of work on a combined MA strategy in terms of bidding for 2014?

Mark T. Bertolini

Thanks, Josh. On the first point, the TRS conversion and the group pipeline is strong. And we -- it's way too early to tell, obviously, the results on TRS, although we watch it on a daily basis as the activity moves forward, but that is part of the impact on our MBR for the first quarter of 2013. As it relates to how we think about Medicare going forward, let me have Shawn talk a little bit about -- respond to the second part of your question.

Shawn M. Guertin

Yes. So Josh, I think the one thing I'd say at the outset is our proposed acquisition of Coventry never contemplated that we had to see those bids before they went in. As you know, they have a pretty profitable product line there themselves. Having said that, in the event that we do have the opportunity, sort of post-close, to get in there and see what the bids look like and influence them if need be, we will be ready to do that. And we have teams of people and a process all set up to do that if indeed we have that opportunity.

Mark T. Bertolini

And Josh, we did have a clean-room setup, where we've had analysis already done in a format that we can react too quickly, so those teams will be able to react to that information the day we close, if it happens before we have to submit the rates.

Operator

We'll go next to Carl McDonald with Citi.

Carl R. McDonald - Citigroup Inc, Research Division

To stick with Medicare, I'd just be interested in putting together your comments around the rate environment for '14, how you think that translates into membership next year, as well as the Medicare margin.

Mark T. Bertolini

I'll comment on the membership piece. I'll have Shawn comment on sort of the rate structure as we see it moving forward. For us, the first approach to impacting this coming pricing cycle is to, first, look at what we can do with provider contracting. We are getting more aggressive there; secondly, to look at what we can do at medical management and other programs to impact on the quality of care, like through our ACL models. And so the ACL is really an important part of our strategy, where we'll have half of our membership by the end of 2013 on the individual side into an ACO or collaboration model. The third part is to really streamline our administration, and we've been getting better and better at that. As we interface with an aging consumer that's more used to working with us over the Internet. And then finally, we have to indeed look at benefits and pricing, which will have some impact in 2014. Let me ask -- so from a growth perspective, everybody's impacted the same way, Carl, and so our approach would be is that we're in the same boat with our competitors. At least, we'll see people being sticky, given the quality of the products we offer, but it's too early to tell how the rest of the market shakes out, given that rates aren't in yet.

Shawn M. Guertin

Right. So Carl, I think -- as you know, I think others have commented on the rate impact being down, call it, 400 basis points. And that's pretty similar to, I think, what we would estimate it to be. And obviously, you're trying to bridge a gap of cost trend in the low single digits. So Mark mentioned all the levers that we would pull. And we would certainly want to pull all the cost structure levels first that we could to preserve the value in the product in the form of premium or benefits. The -- we are working through that now. I do not think a one-size-fits-all strategy is the right answer in every market. And that's really what we need to work through over the coming months. So that's how we're thinking about it. I would just say that if the notion, obviously, of this, as Mark mentioned, going to 100% fee-for-service environment, it certainly is a picture that we've had in our heads on how we have to operate in this product going forward. This might be a bit of an acceleration of it in terms of timing, but we are still sort of everyday thinking about making the product operate in that environment.

Operator

Our next question comes from Justin Lake, JPMorgan.

Justin Lake - JP Morgan Chase & Co, Research Division

So question on the commercial side. You mentioned you lost some Individual and Small Group business, that came in with the pricing. So can you talk about whether you're seeing aggressive pricing out there that's costing you Individual and Small Group membership? And then can you air on your latest thoughts on exchange participation, what you're thinking in terms of economics there for next year and what you're hearing from employers on dumping or conversions to ASO in 2014?

Shawn M. Guertin

Justin, I'll let Mark answer the exchange question. On the Individual and Small Group, it is not a function of irrational pricing in any way, shape or form. We've talked before about the importance of having solid operating margins going into 2014. And so we have continued to air on the side of caution in our pricing on that product. And as I mentioned, we'll favor sort of margin over membership on this.

Mark T. Bertolini

Yes, Justin, the market remains rational, from our perspective, with, again, the occasional pockets of behavior that may be based on cost structure or just on trying to seek some membership. As it relates to the exchanges, we have 14 -- approximately 14 Individual exchanges, a handful of SHOP exchanges across the country. We are entering these exchanges very carefully. We are about 2/3 of the way contracted for our exchanges. Those tend to be narrow networks that are generally 25% to 50% of the size of our base networks in those marketplaces. Currently, the rates we're getting for most of those networks is between Medicare and Commercial. And based on the narrower networks, the closer we get to Medicare. The rates will really be based on geography and probably, more importantly, will be based on how much we get the network contracted. So our approach in the initial pricing that we've submitted to the exchanges has been focused on where we have rates on a document inked. We'd include those into our cost structure, where we do not and we need to add providers for network sufficiency. We're pricing those at commercial pricing until we otherwise know that we have a better rate. And as you know, the negotiations will take place through the summer and into the fall. Obviously, at the end of all of this, we have an opportunity to pull out in September, and we continue to hold that as an option should the exchanges not develop favorably or they ask for unreasonable rates by the time we need to close on participation.

Operator

We'll go next to Peter Costa with Wells Fargo Securities.

Peter Heinz Costa - Wells Fargo Securities, LLC, Research Division

You talked about part of your rising medical loss ratio for the Medicare product is due to increased sharing with the -- your Group customers. You guys have a slightly different Medicare product than others and that you have much more Group business. Can you talk about how the rates will affect you going forward with your sharing with Group customers?

Shawn M. Guertin

Yes, Peter. So obviously, the input to that renewal process on the rates is the same as we discussed for Individual. But unlike the Individual side, obviously, we have the ability to negotiate with the employer over both -- frankly, both benefit design and premium. So it's one more lever that we have in that business that maybe we don't have on the Individual side. Having said that, it's still in negotiation. Raising premiums on an employer plan is still an issue that you have to work through. But I think it does give us one more angle to try to bridge the gap on that particular business.

Operator

We'll go next to Ana Gupte with Dowling & Partners.

Ana Gupte - Dowling & Partners Securities, LLC

I wanted to get some color on the seasonal progression of the Commercial and the Medicare loss ratios and what the implications are for full year guidance for '13. Specifically, on Commercial, what is the underlying trend deal spread? You talked about the favorable development being a primarily contributor, but then you have lowered your cost trend guidance. Pricing should accelerate and seasonality, though is just a downside. So net-net, do you think there's upside to your 81.5%, the lower end revised guidance on Commercial?

Shawn M. Guertin

Let me try to cover all of that with an answer. Let me talk about our commercial business in particular in the first quarter. That business performed very well, as you saw by the MBR, and it was really very consistent with our internal expectations. Now I make that statement recognizing that we probably had $20 million to $25 million of flu expense pushing through there. So underlying that, the experience was a little bit better than we expected in the first quarter on the Commercial business. Given how early we are in the year and the fact that the quarter is still somewhat incomplete, I think it's premature to bank that for the rest of the year, but we did indeed see that in the first quarter. The one comment that I would make on just thinking about -- continuing to think about Commercial primarily, and sort of pattern of earnings is the question that was asked previously on the recovery of the ACA fees. As Mark mentioned, that's being phased in sort of in proportion to the number of months that a customer has in 2014. So the effect of that will build during this year. And in fact, about half of the effect of that is in the fourth quarter of this year. Other than that, I won't have any particular comments on the slope during the year on the Commercial business.

Ana Gupte - Dowling & Partners Securities, LLC

Sequestration and then the timing of the risk adjusters and any mix shift you've seen from -- to Group and HMO and so on? Is the mid- to high-80s still -- is that your full year guidance? Is there any upside to that as we progress through the year?

Shawn M. Guertin

It was hard to hear you, Ana. You were breaking up, but yes, mid- to high-80s...

Ana Gupte - Dowling & Partners Securities, LLC

Yes, is there any upside to your Medicare full year progression, if you will, from the timing of any risk adjusters, how you built in the impact of sequestration and then the mix shift that you're seeing to Group and on the retail side to HMO?

Shawn M. Guertin

No, I think our Medicare, we -- our Medicare business with sequestration out there, I think we've quantified that accurately. So I do still expect that we will be in the mid- to high-80s, but I wouldn't -- I certainly wouldn't say that there's a strong bias either way in that estimate. If anything, again, sequestration is pushing up in that range, not down.

Operator

We'll go next to Christine Arnold with Cowen.

Christine Arnold - Cowen and Company, LLC, Research Division

Mark, you mentioned that you're going to give accounts more time to adjust to the 2014 issues, guaranteed issue, rating bands [ph], all that kind of stuff in new benefits. Could you clarify what you meant on that? Was that kind of early renewals, and can you do with Individual and Small Group? And then how much do the ACA lower medical cost in Medicare Advantage?

Mark T. Bertolini

Okay. On the first one, I would say, Christine, that we expect that accounts will look at renewing early and into 2014, so they don't need to come up to full speed on that, although in Small Group, for all intents and purposes, they're in a bit of a community-rated environment, so there probably won't be a whole lot of impact there. But we are going to offer that opportunity as part of our renewal strategy with accounts. So that's how we think about that. Related to your second question, could you give me a little more color on that?

Christine Arnold - Cowen and Company, LLC, Research Division

With respect to Medicare Advantage, you said that you were -- a big part of this is moving folks into these Accountable Care organizations. How much is in now, so how much are we going to move between now and the end of 2013 into this arrangement? And how much does reduce to Medicare Advantage medical costs? I'm trying to bridge this portion [ph].

Shawn M. Guertin

Yes, it varies arrangement by arrangement. I think for '13, Christine, as we said, we intend to have about half of our Individual membership in arrangements like that. It's a meaningful impact within those arrangements, but it obviously varies arrangement by arrangement.

Christine Arnold - Cowen and Company, LLC, Research Division

Okay. Can you give us ballpark, 20%, 30%?

Shawn M. Guertin

I don't want to speculate. Again, it varies Individual, arrangement by arrangement.

Operator

We'll go next to Scott Fidel with Deutsche Bank.

Scott J. Fidel - Deutsche Bank AG, Research Division

Just interested if you can talk about what type of appetite level you're seeing from employers for self-funding in Commercial for 2014. There's been some market anecdotes recently that the interest may be accelerating due to the ACA premium taxes on fully insured business. So just interested in what you're hearing at this point.

Mark T. Bertolini

I think there's a lot of interest as people try and figure out how to react to the Affordable Care Act, and more interest as you get closer to seeing the economic impacts of the Affordable Care Act, particularly in the taxes and fees. However, people can buy time, again, by renewing early and into 2014 for the full effects. And the 2.5% that they'd see on the premium tax can be adjusted in other ways going into 2014, which gives them more time to consider how to move forward. We're also seeing in the large employer segment a lot of interest in private changes, where we are now participating in 11. We will also be participating in the Aon Hewitt, the Mercer, the Xerox and the Towers private exchanges, which will actually take large employers from self-funded to fully insured. So we see more of that activity as well. So I think a lot to watch happen. I think 2014, from a standpoint of an event for employers, is going to be wait-and-see for the most part. In the Small Group market, we don't see a whole lot of traction in exchanges until we move into 2016, which, by then, we think there could be as many as 5 million lives that will leave the Small Group market through some sort of form of employers saying, "I'd rather work with exchanges." But that's going to depend on how well these things operate in the first couple of years, which we have yet to, obviously, experience.

Operator

We'll go next to Kevin Fischbeck with Bank of America Merrill Lynch.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

I just want to talk about some of the comments that you've made on the exchanges. I think you mentioned 14 states to participate in, and I think you had mentioned 15 states last quarter. So I just wanted to see what state that was that you decided not to participate in. And then just to kind of go into the commentary that you want to participate in more Individual exchanges than Small Group exchanges. How did -- that's a little bit counterintuitive to me just because Individual market is going to be changed so much by the changes that are happening in 2014, whereas the Small Group exchanges feel more like just one more distribution network for your Small Group exchange. Why are you being more cautious on the Small Group side than on the Individual side?

Mark T. Bertolini

We just think that we've got to see how these things operate. And we're not going to go in for land grab as we've heard some of our competitors have thought as an opportunity. I also believe that in the Individual market, that this is going to be a slow uptake. The process required to sign up to get the subsidies is going to take some time. And I think this is a 2-year ramp to get the individual exchanges up to a level where customers are going to feel appropriate signing up. And so our estimates of what we believe in enrollment are dropping for the first year, given the opportunity to enroll -- reenroll early, enroll into next year, and the fact that we don't have all the mechanics worked out about how these things enroll. And I think people are going to take a wait-and-see attitude. I think the people that will join will largely be low-income subsidy people, who have an opportunity to get health care at a very affordable rate that they otherwise would not have gotten. And I think that's where, actually, a lot of the marketing is going to be focused initially on this product. So our opinion is stand firm, participate where we know we have reasonable rules. We did say it was up to 15. We're now quantifying that to be 14 or approximately 14, but yet there is a lot of road to go yet before we get final rules on how these things are going to work.

Shawn M. Guertin

Yes, Kevin. And I would just add that, precisely for the reason you mentioned, that it's really not that different, is why we don't think there will be a lot of immediate uptake on the Small Group side.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Okay. So you don't see the Small Group as being a real opportunity, so there's no reason to go after it aggressively. But I guess it still doesn't -- it's still not clear to me why you're getting in -- I guess that you're saying the 14 markets that you're getting into are just kind of still in a measured small way, isn't that most of your kind of strong individual markets, 14?

Mark T. Bertolini

We're focused on those markets where we have strengthened networks and affordable price, sure. And so that's a lot where our membership exists today, so it's a good place to start and learn more. There's always an opportunity to participate in future markets. Also, remember on the Small Group market, a couple of things. First, because they're already pretty much community-rated in a lot of ways, with Group pooling and everything else and they're guaranteed issue, there isn't a whole lot of impact to rates unless an employer has a lot of low-income subsidy employees. And I think that's where we see that 5 million coming out of over the next couple of years. Also, the second point I would make is that private exchanges will emerge and are emerging that will provide very affordable alternatives to Small Group employers without having to go into the public exchanges.

Operator

We'll go next to Ralph Giacobbe with Crédit Suisse.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Just want to go back to the MA and your commentary on reviewing your contractual arrangements with providers. Just some more color there. Is that specific to MA rates? Maybe help us understand how you price that relative to kind of fee-for-service and/or is the point that you'll potentially squeeze on the Commercial side because of the MA pressure.

Mark T. Bertolini

Well, I can give you some color. Overall, we're just a little bit above Medicare rates when we look at our whole network, but we're under on the physician side, and we're over on the hospital side, particularly in outpatient. So that's where we view the opportunity, particularly as we start looking at exchanges and we start re-contracting these networks. It gives us an opportunity to open up those discussions with hospitals. Also, the ACOs that we're building give us fundamentally different rate structures than the current rate structures we have in Medicare and an opportunity to move people into those. So high on the hospital side, low on the physician side and average, just a little bit above, fairly above the Medicare average rate structure across markets. So we view the opportunity in pockets, by markets, focused on the hospital, particularly the outpatient side. And we're largely having those conversations around as we do other contract renewals and as we look at ACOs.

Operator

We'll go next to David Windley with Jefferies.

David H. Windley - Jefferies & Company, Inc., Research Division

I was going to change gears a little bit here. Just hoping for an update on your duals activity, I believe, in Illinois, and Ohio. Where do you stand on kind of getting visibility on rates and your thoughts on updates on timing? And then, finally, I think we saw that you -- that Aetna did not bid in the Florida Medicaid. And I was just curious if you had thoughts or reasons why you didn't go after the Florida Medicaid?

Shawn M. Guertin

David, let me take on the duals. That has been pushed back in the year, and it is one of the reasons why we've talked about our revenue guidance going from approximately 9% to 8% to 9%. So that's generally pushed to the very end of the third quarter, the fourth quarter in those instances. So it's going to have a very minimal effect on 2013.

Mark T. Bertolini

And then on Florida Medicaid, we just believe that, that market was something that we could not adequately compete in nor can we get to a rate structure that will be satisfying for them, so we decided not to bid. And I think our record has been that we only bid where we believe we can have an impact on the marketplace and where we can win. And we didn't think we could win there.

Thomas F. Cowhey

David, it's Tom. One other thing that just is worth noting is that some people oftentimes don't see some of the work that we're doing because it's done with our ASC partners. And so we do have a partner in Florida. It's integral. And so we -- there is some expansion activity that has happened there under that banner. But under the Aetna or Aetna Whole Health banner, we have not just participate in that market.

Operator

We'll go next to A.J. Rice with UBS.

Albert J. Rice - UBS Investment Bank, Research Division

Two quick things. First of all, one more aspect to the exchanges. You mentioned that it will be your objective to get -- to be able to generate acceptable returns. I'm wondering, in a new product area like this on the exchanges, is that something you're trying to get to pretty much right out of the box? Or will you give yourself some time for that? Just a perspective along those lines. And my other question was regarding your reiteration of your overall cost trend at 6.5%, plus or minus 50 basis points. There's been a lot of commentary on the provider side about soft utilization. Could you comment within the buckets of that cost trend, whether you're seeing any variation relative to your expectation and maybe just comment on some of the components and what you're seeing there?

Shawn M. Guertin

Let me take the first one, A.J., on that, on the exchange strategy. Again, as we mentioned, we don't view this as a landgrab strategy. So I would certainly think that we would want to position our pricing in year 1 to earn a fair return on capital. That's not certainly any kind of excessive return. I think we've talked about this fundamentally being a low single-digit margin business for the long haul. But again, as Mark described, our approach is being measured and not doing it as a landgrab, I think we would look for a fair return on our initial pricing.

Mark T. Bertolini

And then as it relates to provider utilization, about 70% of our trend is related to unit pricing, and 30% is related to utilization. And so in our view, we believe it's prudent at this point in time to hold. We haven't seen any of the categories, inpatient, outpatient, physicians or pharmacy, move to our expectations. We did see some better performance in the first quarter, offset by the flu, which is hard to discriminate exactly which is which. And it is our best guess, at this time, given where the economy is headed and the potentials for behavior in the marketplace to change, that it's prudent for us to hold that trend at this point in time.

Operator

Our final question comes from Sarah James, Wedbush.

Sarah James - Wedbush Securities Inc., Research Division

I wanted to take a step back and ask for your big picture view on '14. Could it be a year of earnings growth on existing Aetna business, meaning x-Coventry? And then with respect to 2 major buckets, first, Commercial, you mentioned a slower exchange uptake but maybe some ASO to risk conversion on the private exchanges. So does that net out to a headwind or a tailwind on Commercial? And second bucket would be Medicare, if you could just size up the risk coding update, particularly given your exposure to collaborative care, given that's a model that some of your peers noted maybe more heavily impacted by these coding changes.

Mark T. Bertolini

Well, Sarah, generally, first, I will comment on the fact that we're not giving any guidance on 2014 earnings growth at this point in time other than to say that we see additional opportunity with the Coventry acquisition. So absent the Coventry acquisition, we are not in a position to give any kind of guidance for 2014 on earnings at this point in time. We would reiterate, though, with 2014, as part of our 5-year outlook, that we believe low double-digit earnings growth year-over-year, EPS growth year-over-year is our commitment to the Street. As it relates to some headwinds and tailwinds, maybe I can have Shawn comment on those.

Shawn M. Guertin

Yes, so I think as we sit here a quarter later, what I would say is we know more, but there's still an awful lot that we sort of need to see how it plays out. We've talked a lot about exchanges today. You talked about the Medicare bids. We're working through that now as we speak. And we also talked about the recovery at the ACA taxes and fees. We're early on in that process, where, really, we don't have a lot of data points yet in terms of recovering those from the Government business. So those are 3 big things we're looking at. I would say, again, though, that we do have a diversified portfolio of businesses. We're not overexposed to those areas that will feel the greatest impact from ACA. And that's true on an Aetna standalone basis, and that will be true even after we combine with Coventry. So I think we've talked a lot about the exchange strategy being sort of measured and looking to earn a fair return on capital. So this has more to do about looking at and getting some more information on these big data points. Probably the most immediate one is finishing our Medicare bids over the next 30 days or so.

Thomas F. Cowhey

Thank you, sir. A transcript of the prepared portion of this call will be posted shortly on the Investor Information section of aetna.com, where you can also find a copy of our updated guidance summary containing details of our guidance metrics, including those that were unchanged and not discussed on this call. If you have any questions about matters discussed this morning, please feel free to call me or one of my colleagues in the Investor Relations office. Thank you for joining us this morning.

Operator

And that concludes today's conference. We thank you for your participation.

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