Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Aetna (NYSE:AET)

Q2 2013 Earnings Call

July 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

Justin Lake - JP Morgan Chase & Co, Research Division

Scott J. Fidel - Deutsche Bank AG, Research Division

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Christine Arnold - Cowen and Company, LLC, Research Division

Carl R. McDonald - Citigroup Inc, Research Division

Ana Gupte - Dowling & Partners Securities, LLC

Stephen Baxter - BofA Merrill Lynch, Research Division

Sarah James - Wedbush Securities Inc., Research Division

David H. Windley - Jefferies LLC, Research Division

Operator

Good morning. My name is Wynette, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Aetna Second 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 Mr. Tom Cowhey, Vice President of Investor Relations. Mr. Cowhey, please go ahead.

Thomas F. Cowhey

Good morning, and thank you for joining Aetna's Second 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 answer 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, our first quarter 2013 Form 10-Q and our second 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 second quarter 2013 financial supplement and our 2013 guidance summary. These reconciliations are available on the Investor Information section of aetna.com.

Please note that the inclusion of Coventry's business in 2013 results impacts the quarter-over-quarter and year-to-date comparisons. 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, Aetna reported second quarter results that included approximately 2 months of performance from the Coventry acquisition. Bolstered by the acquisition and strong underlying performance in our Commercial business, Aetna achieved medical membership of 22 million, quarterly operating revenue of $11.6 billion and quarterly adjusted operating earnings of $583 million. Each of these metrics represent historic highs for our organization and a strong foundation to continue to expand our franchise to best meet the needs of both our customers and our shareholders.

Our diversified business model produced another solid quarter. Operating earnings per share of $1.52, a 16% increase over the second quarter of 2012. Pretax operating margins were 8.4%, consistent with our long-term targets. And we continued to generate substantial parent cash flow that we deployed to complete the Coventry acquisition, pay our shareholder dividend and repurchase 7.2 million shares in the quarter.

Our first half results give us increased confidence in our full year performance. And this morning, we raised our 2013 operating earnings guidance to $5.80 to $5.90 per share. At its midpoint, our revised 2013 guidance would represent 14% operating EPS growth in 2013 and 17% compound annual growth from 2010 through 2013, a 3-year growth rate that is well in excess of our diversified managed care peers.

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 discuss some of the successes we had during the quarter that demonstrate the execution of our growth strategy. Aetna's second quarter again exemplifies the strength of a diversified portfolio of businesses. Strong performance in our Commercial Insured and Medicaid businesses allow us to absorb the impacts of sequestration, as well as some isolated pressure in our Medicare business, and still raise our operating EPS guidance range for the third time this year. As I mentioned, the second quarter benefited from strong performance in our Commercial Insured business with strong premium growth and medical cost trends that continued to develop favorably. While structural changes in the health system may be playing a modest role in the low-cost trend we are experiencing, we continue to believe that this low utilization is largely driven by the weak economy. This view is validated by a recent Kaiser Family Foundation study, which concluded that over 75% of the decline in recent health spending trends can be attributed to broader changes in the economy. We continue to price our products with a bias toward margins over membership and with a view that utilization will begin to rebound from the current low levels.

During the quarter, we also completed the largest transaction in the company's history with the acquisition of Coventry Health Care. The Coventry acquisition builds upon Aetna's existing capabilities, expanding our local presence and shifting our mix of business toward higher-growth government programs. The combination positions Aetna to generate over $50 billion in operating revenue and $4.4 billion in EBITDA annually while providing services to an estimated 44 million people in nearly every country around the world. While we are still in the very early days of integration, we are pleased with our progress. Our integration teams are engaged and hard at work. Many of Coventry's employees have taken on key leadership roles in the combined organization.

Coventry's performance and our synergy realization are on track. And we now project that Coventry's contribution to 2013 operating EPS will be towards the high end of our $0.20 to $0.25 guidance range. While it is too early to give projections and guidance on 2014 performance and as we examine the specific challenges and opportunities we expect to see next year, in particular, our progress with the Coventry integration, we are increasingly confident that we will grow both operating earnings and operating EPS in 2014. Many uncertainties remain, but we believe we have the right strategic positioning to generate a positive result.

Moving on to our Government businesses. In Medicare, Aetna now serves over 3 million Medicare members as the third-largest national Medicare Advantage provider and the fifth-largest PDP provider. As we look to continue to profitably grow our Medicare Advantage membership, we are preparing to operate at parity with fee-for-service while maintaining our targeted returns on capital. As you know, Medicare Advantage rate pressures in 2014 will represent a meaningful challenge for the program.

In advance of submitting our 2014 Medicare Advantage bids in early June, we worked diligently to adjust our cost structures, processes and products by: reviewing our contractual arrangements with providers; evaluating the impact of enhanced care management and medical management, including our ACO initiatives and provider collaborations; examining our administrative costs; and where necessary, making changes to benefit plan design and premiums. Guided by our bias to protect margin over membership, we factored in our most recent views of our 2013 experience, our projected cost structure improvements and our targeted positioning into the 2014 Medicare bids we submitted in early June. On the whole, we believe that our 2014 bids, including those of Coventry, strike an appropriate balance in support of our members, the Medicare Advantage program and our shareholders.

I would also like to spend a few minutes discussing our strategy for exchanges, which we think about across 3 dimensions: first, public exchanges; second, multiparty private exchanges; and third, proprietary private exchanges. Let me begin with the public exchanges. We continue to take a cautious approach to our participation in the public exchanges as we evaluate the longer-term viability of these marketplaces. We hope to gain sufficient exposure through our early exchange experience to position ourselves to capture profitable membership in the initial years of the program. We have taken a prudent risk-based approach to both our overall exposure and exposure within a given marketplace. As we have stated previously, our strategy is to participate on the public exchanges on a limited basis. We are continuing to evaluate where Aetna and Coventry have submitted bids and are in the process of rationalizing our combined exchange participation. We continue to believe that public exchanges can represent a longer-term upside opportunity.

Aetna is also moving forward with participation in many of the multiparty private exchanges that are emerging today. While many existing private exchanges are self-funded, we believe over time these exchanges will provide a vehicle for employers to provide a defined contribution health benefit through a fully insured product. Aetna expects to participate in approximately 15 private exchanges in 2014.

In addition to participating in multiparty private exchanges, we are also developing our own proprietary exchange. Aetna's proprietary private exchange model will go beyond simple aggregation and focus on true population management. These tailored private exchanges can offer unique network configurations and medical management, which will make them particularly attractive to industry verticals. With Aetna proprietary exchanges, we will also be able to offer a rich, guided selling experience, where consumers will be able to select products and services that offer the highest value based on their individual needs. We believe it is these Aetna proprietary exchange models which may offer both consumers and employers the most value over the years to come.

Aetna continues to believe that provider collaboration is the vehicle for transformative change in the health care marketplace. We continue to view this value-based contracting across a spectrum, ranging from simple provider collaborations that include embedded case managers and some elements of pay-for-performance, to more advanced forms of collaboration that include integrated technology and case management, aligned incentives and true risk sharing. At our investor conference in December, we simplified these broad-based efforts into 3 categories and have continued to make progress across each of these dimensions. Our basic Medicare provider collaborations have grown by over 15% year-to-date and we now have 75 of these relationships nationally. Combined with our single-payer and multipayer Patient-Centered Medical Homes have grown by over 50%. And in the past quarter alone, Aetna signed 7 new accountable care agreements, bringing our total signed collaborations to 27. With 35 letters of intent and over 200 additional opportunities in the pipeline, we are now on track to exceed our goal of 30 ACO arrangements by year-end 2013.

It is important to remember that Aetna's Accountable Care Solutions, powered by Healthagen technologies, represent an advanced form of provider collaboration and risk sharing. As evidenced on our advanced capabilities, early this month, KLAS, an independent research of technology and solutions in the health care provider market, said that Aetna is having the most transformational accountable care relationships as compared to other payers. Additionally, one of our marquee Accountable Care Solution partners, Banner Health, just announced the results of their first year participating in the Medicare Pioneer ACO program. Through coordinated care with providers, advanced population health technology and supportive case management, the Banner Health Network achieved over $13 million of savings, which made them a top performer when compared to other pioneer organizations nationally.

Approximately 15% of an Aetna's standalone medical spend is paid through some form of value-based contract. And our goal is to more than triple that percentage by the end of 2017. We are proud of our efforts and achievements to date and remain convinced that we have the winning platforms and technology to transform the network model and bend the cost curve.

In summary, we are pleased with our progress and execution. Our Commercial Insured business is performing well, benefiting from lower-than-projected medical cost trends. Coventry is performing at the high end of our projections, giving us increased confidence in our 2013 and 2014 performance. Our initiatives to transform the network model are on track to exceed our projections for 2013. Our capital generation is strong, enhancing our flexibility to execute upon our strategic vision and return cash to shareholders. And we are able to raise our operating EPS guidance again today to range of $5.80 to $5.90 per share, projected results that would drive our 3-year compound annual growth rate well in excess of our long-term guidance.

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 second quarter results and our updated 2013 outlook. Shawn?

Shawn M. Guertin

Thank you, Mark, and good morning, everyone. Earlier today, we reported second quarter 2013 operating earnings of $549 million and operating earnings per share of $1.52, a 16% increase over the second quarter of 2012. These strong operating results continue to be supported by solid revenue growth and operating margins. I'll begin with some comments on overall performance.

From a top line perspective, we are growing. During the second quarter, operating revenue increased by nearly 31% from the second quarter of 2012, primarily from the addition of Coventry. Organically, we grew operating revenue by over 7%, driven by Medicare membership increases and premium yield growth. We also grew medical membership by 3.7 million members with the acquisition of Coventry. Organically, membership was down slightly as Medicare membership growth was more than offset by the loss of one large ASC account and continued Commercial Insured membership losses.

From an operating margin perspective, our businesses are performing quite well. Our second quarter total medical benefit ratio was 82.5%, stable when compared to the prior year quarter, driven by strong performance in our Commercial business and improved performance in our Medicaid business. Our operating revenue growth, disciplined focus on costs and the initial realization of Coventry synergies have driven 100 basis points of year-over-year improvement in our operating expense ratio. And our pretax operating margin was 8.4% for the quarter, consistent with our target operating margin range.

From a balance sheet perspective, we remain confident in the adequacy of our reserves. After adjusting for the timing of the Coventry acquisition, our days claims payable were 45 days at the end of the quarter, stable sequentially and up nearly 1 day from the second quarter of 2012. In addition, we experienced favorable prior-period reserved development in the quarter across all of our core products, primarily attributable to 2013 performance. Our year-to-date favorable prior year's development is now $370 million. This figure includes not only the prior year's development on the Aetna book but also the prior year's development experienced on the Coventry book since the acquisition.

Turning to cash flow and capital. Operating cash flows in the second quarter were pressured by 2 tax payments, as well as items related to the Coventry acquisition, including: transaction and integration costs; the timing of certain Medicaid premium payments, which were subsequently received in early July; and some additional timing issues as a result of the mid-quarter close. Year-to-date on an adjusted basis, Health Care and Group Insurance operating cash flow were almost 1x operating earnings. We continue to project that full year 2013 operating cash flows will be in excess of operating earnings. We also continue to aggressively deploy capital to create shareholder value, repurchasing approximately 7.2 million shares in the quarter for $440 million and dispersing another $65 million through our quarterly shareholder dividend. Year-to-date, Aetna has returned over $750 million of capital to our shareholders through these 2 programs. In short, we are pleased with our second quarter results, which we believe demonstrate the successful execution of Aetna's growth story and the value of a diversified portfolio.

I will now discuss the key drivers of second quarter performance in greater detail. The main driver of our strong operating performance this quarter and year-to-date is our Commercial Insured business. This is evident in both the Aetna and Coventry blocks of business. Our combined Commercial Insured business, which represents over 50% of our projected 2013 operating revenue, continue to post year-over-year revenue and underwriting margin growth despite continued underlying membership pressures. As before and especially as we look forward to the changes in 2014, we remain committed 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 79.1% for the quarter, an excellent result as medical trends continue to develop lower than our previous projections. Based on our updated experience, we now project that Aetna's standalone Commercial medical cost trends will be 6%, plus or minus 50 basis points, in 2013. Further, Coventry's Commercial medical cost trends are also developing favorably. As a result, we now project that our combined full year 2013 Commercial medical benefit ratio will be between 80% and 81%. Another important growth lever is our Government franchise. Both the Aetna and Coventry Medicare books of business continued to demonstrate growth in the second quarter. In total, our Medicare revenue increased 79% over the second quarter of 2012, a result of the Coventry acquisition as well as strong membership growth in Aetna's underlying Medicare business.

Our Medicare medical benefit ratio was 89.1% in the quarter, an increase of 130 basis points sequentially. This result reflects pressure from sequestration, as well as from 2 specific product offerings, largely driven by new member claim experience. The substantial majority of our Medicare business is performing quite well and consistent with our projections and we continue to project full year Medicare MBRs well within our guidance range but more towards the middle to upper end of our previously projected range. Importantly, the pressure in these 2 product offerings was known as we evaluated our 2014 Medicare bids.

Finally, in our Medicaid business, medical membership increased by 900,000 members in the quarter and premiums more than doubled on a year-over-year basis, reflecting the inclusion of Coventry. The underlying performance of the business was very good in the second quarter. Our Medicaid medical benefit ratio was 85.9%, an improvement from last year's second quarter. We also saw continued improvements in Kentucky this quarter. Our first half results put us on track to achieve the low end of our high 80s Medicaid MBR guidance range for the full year.

In regard to Kentucky Medicaid, in early July, Centene exited the program and their remaining membership was split between Aetna and one other participant in that program. Aetna was auto-assigned approximately 65,000 members from this transition. We currently project, based on Aetna's Kentucky Medicaid rate structure, that this new membership will be approximately breakeven in 2013. Financial position, capital structure and liquidity all continue to be very strong. At June 30, we had a debt to total capitalization ratio of just under 40%. With the Coventry acquisition now closed, our risk-based capital ratio is approximately 285% of company action level in our regulated subsidiaries.

Looking at cash and investments at the parent. We started the quarter with $2.6 billion. Net subsidiary dividends to the parent were $875 million. Net of incremental paydown, we issued $450 million of commercial paper. Using proceeds from our debt offerings and cash on hand, including approximately $900 million from Coventry, we spent approximately $4 billion to purchase Coventry's equity and pay transaction-related expenses. We repurchased 7.2 million shares for $440 million and paid a shareholder dividend of $65 million. After other uses, we ended the quarter with $200 million of cash at the parent representing our core liquidity. Our basic share count was 372.1 million at June 30.

Based on our year-to-date performance, this morning we raised our guidance range and we now project 2013 operating earnings of $5.80 to $5.90 per share. This increased guidance, which would represent growth of 14% over 2012 at the midpoint, reflects continued strong performance in our Commercial Insured business and improved performance in our Medicaid business, partially offset by the performance in our Medicare business. Aetna's adjusted operating EPS guidance range has also been updated to approximately $6.20 to $6.30 per share.

Additional elements of our 2013 guidance include the following. We are now projecting full year medical membership of over 22.1 million members. This projection represents growth of more than 150,000 members over the remainder of the year, driven primarily by Commercial ASC, Kentucky Medicaid and Medicare Supplement. We continue to project full year operating revenue to be approximately $47 billion. We now project that our full year Commercial medical benefit ratio will be between 80% and 81%, continuing to reflect both our pricing discipline and a favorable medical cost trend environment.

We continue to project our Medicare medical benefit ratio to be in the mid- to high 80s, consistent with our previous guidance range but with projected performance towards the mid- to upper end of that range. We continue to project that our 2013 operating expense ratio will be approximately 18%, representing nearly 100 basis points of improvement from 2012. This year-over-year improvement is the result of higher revenues and changes in business mix, as well as anticipated cost synergies. Aetna's pretax operating margin projection remains at 8%, plus or minus 25 basis points. We would note that as we examine our quarterly forecast for the remainder of the year and as we consider the timing of recovery of health insurance fees and taxes, which will ramp over the course of the year, we expect operating earnings per share to be more evenly distributed between the third and fourth quarters of 2013 than in prior years.

Finally, we continue to project operating earnings in 2013 will be approximately $2.1 billion. We currently project net dividends from subsidiaries of approximately $1.9 billion. After debt paydown, shareholder dividends and other uses, this is projected to result in approximately $1.1 billion of excess parent cash in 2013 available for share repurchases or other corporate uses. Approximately $625 million of this excess parent cash has already been deployed towards share repurchase in the first half of 2013. Based on our year-to-date repurchases and projected repurchase activity over the remainder of the year, we now project our full year weighted average diluted share count will be between 360 million and 361 million shares.

We believe that these results demonstrate our ability to execute on the growth strategy we shared with you in December. Our Commercial Insured business is delivering strong performance. The substantial majority of our Medicare business, including our leading Group Medicare Advantage franchise is performing consistent with our projections. Medicaid is performing better than our projections. Coventry is on track to deliver the high end of our projected operating EPS accretion and our capital generation continues to be robust as we deploy capital to generate value for our shareholders.

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

That will come from Justin Lake with JPMorgan.

Justin Lake - JP Morgan Chase & Co, Research Division

My questions are on Medicare Advantage. First, can you give us more color or specifics on the products that drove the issues in Medicare Advantage this quarter and what you did with 2014 bids to remediate?

Shawn M. Guertin

Sure, Justin. Before I delve into the specifics, I want to make sure that we keep 3 things here in context. Overall, obviously, as you heard, our diversified portfolio of businesses are doing quite well, including Coventry. The majority of our Medicare business, say, 80% or so, is performing quite well and consistent with our previous expectations. And as you mentioned and alluded to, we had full awareness of what I'm going to talk about as we evaluated our bids for 2014. So more specifically, the pressure that I referenced was observed in 2 really unrelated pockets of our business. One was some of our Aetna Individual Medicare Advantage offerings and the other was a single Coventry PDP plan offering. Both of these pockets of business experienced strong membership growth in 2013, particularly the PDP offering that I mentioned, which grew 40% or so. In a nutshell, the experience on the new members in these products was higher than we had previously projected. As you know, experiencing higher costs on first year members, especially in MA, isn't atypical as we generally have to ramp up medical management, revenue enhancement, and things like that can take time. But having said that, they were still higher than we had previously projected. So in terms of -- as I mentioned, in terms of the bids, obviously, we recognize that. And in particular for these products, we took very tangible and measurable action around premium levels, benefit plan design, formulary changes and things of that sort to sort of address the issues. The one point I would make as well here is when you think about the statement that we just made that we now expect Coventry to end up at the higher end of our accretion range, that is inclusive of this issue on the PDP that I mentioned and I think it's a testament actually to how well that business is performing overall.

Justin Lake - JP Morgan Chase & Co, Research Division

And can you give us an idea of the size of these offerings in terms of how many Medicare Advantage members are affected, as well as Coventry PDP members?

Shawn M. Guertin

Well, again these 2 issues, as I mentioned, represent in total 20% at the most of our Medicare revenue. As I mentioned, the Individual MA that I mentioned is really isolated in Aetna's book. That book in total was only about 160,000 members.

Justin Lake - JP Morgan Chase & Co, Research Division

Got it. And then if I could just ask a follow-up on Medicare Advantage, any early thoughts on '14 membership growth? And as you look at your employer group business, can you tell us whether these employers are expected to still have enough value to want to stay with the program, given the next 2 years of reimbursement pressure? And that's it for me.

Mark T. Bertolini

Sure, Justin. As we look at 2014 Medicare and 2015, quite frankly, they're going to be a couple of tough years relative to how rates are going to move, how the Stars Program is going to be implemented. But that's against the backdrop where we have 100,000 people retiring on a daily basis and more and more people coming into the program. So we see it happening -- I'm sorry, on a weekly basis. We see it happening that there will be overall growth in the marketplace and we think we can continue to grow Medicare. Not as quickly as we have in the past would be the major headline there. On the employer side, we see more interest in Medicare exchanges. We see them continue to be interested. And I actually think there's more momentum for them to move their employees to a Medicare Advantage program, so we think that bodes well for our group business.

Operator

Up next is Scott Fidel from Deutsche Bank.

Scott J. Fidel - Deutsche Bank AG, Research Division

Wondering if you could just give us an early look at how the membership trends appear to be shaping up for you in the national accounts market and Commercial ASO. And then just on -- if you can talk a bit about whether you're seeing any changes in the competitive environment in the ASO business, particularly as it relates to the Blues just given that one of the large Blue competitors did guide to add significant membership in ASO in 2014.

Mark T. Bertolini

Yes. I think, first of all, Scott, that guide also included a very large data count of over 600,000 lives. So I don't know that it was all national accounts membership. I think they were talking about ASC membership. As we look at the ASC market, we think it's too early to tell in large part because of private exchanges becoming much more part of the conversation. So we think there are going to be delays in making decisions this year. However, we think that private exchanges, particularly those that move self-funded clients to fully insured, bodes well for us given that 4 to 5x the revenue of margin on a dollar basis is associated with each of those accounts. So too early to tell. We think that we are in the mix where we want to be. We believe we will hold our own, come 2014. But we see revenue shift occurring as more large employers consider private exchanges as a model.

Scott J. Fidel - Deutsche Bank AG, Research Division

So Mark, overall, for -- when thinking about the Blues, is it fair to say that you're not really seeing a notable change in their competitive appetite on fees for 2014?

Mark T. Bertolini

We don't see anything notable or anything irrational. Of course, there's always pockets of irrationality. But I'm not sure if that's our view or a competitor's distinct advantage in a given market. So right now, we view the market as remaining very rational, everybody's getting their fees, pricing to expectations in the exchanges. And we believe that this is still a rational market.

Operator

Matthew Borsch from Goldman Sachs.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Yes. I just wanted to ask a question on the Medicaid business and as it relates to seeking to recoup the industry fee on that side of your business and what sort of discussions you have and if you have an updated outlook on that front.

Mark T. Bertolini

Well, I think financial solvency is the notion we hold on to. And I'll call it a notion when we sit down with the states to discuss rates. We think this is probably the hardest sector to get a return on the full fee from the states because as you may guess, it's all fungible in the rate because it's an insured rate. So far so good for us. We don't see any unreasonable pressure, the conversations are tough. But as we have renewed some accounts, we feel that we are being treated fairly in that process. But again, we would note Medicaid as probably being the most difficult sector at the state level to get a return of the health insurance fee.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

And so with -- if I'm correct, so some of your accounts are incorporating the fee into your rate renewals for 2014. Did I understand you correctly?

Mark T. Bertolini

They are, but again it's all fungible. So all the factors that go into that pricing are for a matter of negotiation. So are we getting -- if we were just to take last year's factors and put them forward and put the fee on top of it, are we getting all of that? I would say that based on where utilization is, there are a whole bunch of different trends moving inside of rates. And so we expect that we're getting treated fairly in the process as we negotiate rates of the states.

Operator

Moving on to Christine Arnold from Cowen.

Christine Arnold - Cowen and Company, LLC, Research Division

A couple of follow-ups. On the Medicare Advantage, can you size this issue? Because it seems like if we've resolved this in the bids, it could be a tailwind for next year. And then Texas TRS and other Medicare Advantage group accounts, are any of these kind of not up for renewal? In which case, how are you going to recoup what looks like a pretty tough Medicare payment outlook relative to kind of what you expected when you signed up these accounts?

Mark T. Bertolini

Well, let me answer the group, and I'll have Shawn give further commentary on the sizing and whether or not it's a tailwind. I would say, overall, Christine, that the group market remains robust and we are in active conversations. Private exchanges in the Medicare Advantage market place will be new. So there is one already, Extend Health, but there will be newer ones coming forward. We will participate in that and we feel good about where the group market is. We actually think there's more momentum in the group market to move into Medicare Advantage than there ever has been before. Let me have Shawn respond to your second-part question.

Shawn M. Guertin

Yes. So Christine, I would say in terms of the impact that these are having, in the quarter, if you rolled it forward from first quarter to second quarter, there's probably 100 to 150 basis points of pressure from these 2 products sort of in that roll-forward.

Christine Arnold - Cowen and Company, LLC, Research Division

Okay. So 100 to 150 basis points, first half of the year. And then Texas TRS and any others that may not be up for renewal in '14, can you recoup the tough Medicare Advantage group -- Medicare Advantage payment outlook in renegotiating and opening those up? Or is that a risk factor for '14?

Shawn M. Guertin

We certainly have other avenues on these accounts, especially newer accounts like the one you mentioned, because the second year and later is when we see a lot of the medical management things really begin to kick in, as well as a lot of the revenue enhancement work that you can do once you have the customer onboard. Again, the majority of our business we have open for sort of a normal renewal cycle, and this is front and center in those discussions.

Operator

Carl McDonald from Citi.

Carl R. McDonald - Citigroup Inc, Research Division

On the private exchanges, a couple of your competitors, like Health Net and WellPoint, have basically positioned them as no-risk propositions in '14. Essentially, that the downside is that there really isn't any downside. If you guys believe that to be true, I would expect you'd be in a lot more individual exchanges than you're going to be in next year. So I'd just be interested in your perspective on what you see as the risks of wider-scale participation in '14.

Mark T. Bertolini

Well, I think there's 2 questions in there, Carl. I think on the private exchange marketplace, we will probably participate in as many, if not more, private exchanges than we will on public exchanges, in large part because we can define in a number of ways the way we participate, including those exchanges that we build for our own clients through industry verticals. So we see that as a newer opportunity than the public exchange marketplace. And we think the Affordable Care Act has driven much more receptivity in the industry and across competitors, which actually fought these efforts back in 2009 and earlier as association health plans. But now I think we've gotten over that hurdle and now see the value of these in the marketplace. In the public exchanges, we continue to evaluate where Coventry came from and where we came from. And our strategy on assessing the public exchanges, I would tell you we remain very cautious, if not more cautious, given the readiness of exchanges and the current conversations we have going on around rates in the public exchanges and do not view them as a large opportunity in 2014. We view them as appropriate to be cautious. And with the exception of a very few number of states, we view our ability to participate in 2015 and 2016 as wide open, should these public exchanges take off.

Operator

We'll move on to Ana Gupte from Dowling & Partners.

Ana Gupte - Dowling & Partners Securities, LLC

So looking at through the other earnings reports that came out, WellPoint and Assurant are showing some pressure on their top line from individual and small group. And then Mercer -- separately, Mercer and Aon are talking about a very robust pipeline for private exchanges. And then lastly, the final trend on self-insured, there seems to be at least nobody is missing on that. And in many cases, it seems like there is a leading indicator of mix shift to self-insured. So as you're looking at the 85 million to 90 million self-insured lives, the 60 million plus fully insured lives, the all group insured and 10 million individual and you're thinking about 2014 and '15 given how big this is for your book of business, where do you see this shaking out in the next couple of years?

Mark T. Bertolini

Well, I think, Ana, that we see very little big shifts -- very little small shifts in 2014 going forward. We don't see a whole lot of change going on. We see a lot of experimentation. And we will be participating in that experimentation. We'll be participating in 15 private exchanges currently, maybe even more as we launch our own proprietary private exchanges. So we see a lot of experimentation and we see a lot of experimentation on the part of employers trying it. I think the real, ultimate expression of private exchanges will be the result of employers being able to move to true defined contribution. And in order to do that, the stability, the rate stability of that private exchange must be predictable over time, so those employers won't be coming back to that -- those employees won't be coming back to that employer and saying, "You didn't give me enough 2 years ago when you put me in a private exchange and you put me in defined contribution." So I think we'll see notional defined contribution, some shift to self-funding to fully insured. It will start slowly as experimentation in 2014. And whether or not these funds will be stable over time will define whether or not we see a wholesale shift. So I think it's very early to tell how we will look in 2015 or 2016.

Ana Gupte - Dowling & Partners Securities, LLC

And then on the Small Group with sort of with WellPoint and Assurant and the mandate being delayed, do you think at the very small end of the market you'll see more jumping? Because it appears we're beginning to see that already.

Mark T. Bertolini

Yes. I think the administration is already saying that they're going to see 7 million-ish in the individual exchange. And I think in 2014, particularly with the extension of renewing early small employers through November of 2014, you're not going to see a whole lot of change. We do see over time, though, that the Small Group market will shrink by as much as 5 million through the next couple of years, 2016 being the date, as employers make the evaluation of, "Should I put my employees in an exchange?" That exchange could be a private exchange. It may not necessarily be public exchange.

Operator

Moving to Kevin Fischbeck from Bank of America Merrill Lynch.

Stephen Baxter - BofA Merrill Lynch, Research Division

This is Steve Baxter on for Kevin. I was wondering if you could talk a little bit more about your exchange process. We saw in the news that Maryland is looking for some significant reductions. How similar is this or dissimilar to your normal rate renegotiation process? And also kind of how you're approaching states for both Coventry and Aetna bid?

Mark T. Bertolini

Well, Steve, we generally do not negotiate our rates with states in the paper. So I would argue that the current information that's in the public domain is in mid-process. We have not committed to the rates nor we will see ourselves committing to those rates anytime at this point. So there's a hearing to be held and we will have further conversations with the insurance commissioners as we move forward. Other states are in conversation as well, but they're not just in the public domain. And those are typical of our discussions with insurance commissioners as we submit rates with justification and the actuaries and the commissioners get involved in asking questions about credibility factors, trend factors, all the sorts of things that would drive our rating structure. So we're more than happy to have those conversations. We've been having them for years. We're used to them. And we believe that we'll come to the right place with rates in the markets where we believe we can be competitive. To the degree we can't, we will not participate. So that's our view.

Stephen Baxter - BofA Merrill Lynch, Research Division

That's helpful. But I guess, could you possibly -- I know Coventry is also bidding in Maryland and several of the other states you're looking at participating. So how are you looking at the states where both plans have bid?

Mark T. Bertolini

So for the last 2 months, we have been working with the Coventry team and understanding their approach, understanding their rates. And we continue to rationalize our participation and now our participations through Coventry market-by-market. And we have -- it's a market-specific event, continues to move forward. And those won't all settle out until we have to commit in September. But we're looking at them as a group of portfolio of opportunities across the individual market.

Operator

Sarah James from Wedbush.

Sarah James - Wedbush Securities Inc., Research Division

I was just trying to reconcile guidance. It seems like Commercial MLR is down 100 basis points at the midpoint. SG&A is down. Medicaid MLR is at the lower end of the prior range. Medicare MLR is at the high end of the prior range, but that's only really 1/4 of your revenue. So it just seems like with improvements on several material lines, the guidance EPS increase is modest. So just wondering if there's an offsetting cost increase that I'm missing or if we should think about current guidance as incrementally more conservative.

Shawn M. Guertin

No, Sarah. I think the point there might be the very first thing you mentioned, which is the Commercial MBR from guidance-to-guidance, that's probably more like 50 basis points better. The Medicaid MBR, probably of the same magnitude. When you put those 2 things together and you offset that by a bit higher outlook on our Medicare business, that nets back basically to our $0.075 midpoint increase in guidance. So I don't view it as overly conservative. In fact, that price kind of straight down the middle.

Sarah James - Wedbush Securities Inc., Research Division

Okay. And then how do you think about the relative attractiveness of Medicare Advantage when you deploy capital? Do you think that this is a segment that could be bigger in 2016 than it is today? So after you get through some of the lumpiness over the year or 2, is it...

Mark T. Bertolini

Yes, we think 2014 and 2015 will be difficult, but we think it's worth the investment. And that will give us ramp time to go after the issues that Shawn mentioned in his comments, looking at provider contracts, bolstering our Medicare case management and medical management programs, implementing ACOs, looking at our underlying cost structure and then ultimately, whatever's left impacting benefits and rates. And I think that is how we think about moving forward. We view leaving markets as the nuclear option, and we don't feel that, that's a sustainable proposition over time. So our view would be 2014 and 2015, very hard work. But we can see a line of sight, where in 2016, this is a good business and an important business for Aetna.

Sarah James - Wedbush Securities Inc., Research Division

And by good and important, is it possible that it's larger than it is today?

Mark T. Bertolini

We would expect to grow, yes.

Operator

Your last question in the queue today will come from Dave Windley from Jefferies.

David H. Windley - Jefferies LLC, Research Division

A couple. I was hoping that given your discussion and focus on ACOs, would you be able and willing to comment on, say, what proportion of your medical cost you expect to be running through these relationships, give us some sense of how much they would encompass?

Mark T. Bertolini

It's currently approximately 15%. We expect it to triple by 2017.

David H. Windley - Jefferies LLC, Research Division

Triple by 2017. Okay. And on exchanges, a lot of discussion around the exchanges. Our understanding from talking to some consultants is that some of these private exchanges can be set up for the customers in an ASO funding style. I'd be curious, Mark, if you could talk about maybe some of the triggers there. And if it is -- if they are set up as an ASO arrangement, would you be equally motivated to participate? Or is it really only if you switch over to full risk that those become attractive?

Mark T. Bertolini

No. I think, Dave, I think the preponderance of private exchanges in the beginning will be self-funded. And again, that's based around the employers wanting to understand how sustainable the cost structure of these exchanges will be over time. So what they will create is notional defined contribution. They will give their employees budgets up to which they can spend and after which, they spend out of their own pocket. But if they don't spend it all, it goes back into the employer's pocket through a self-funded vehicle. When they see some sustainability of affordability and cost structure over time, the employers will feel ready and able to move forward to true defined contribution, where they're actually giving the employees the money to spend and the employees are buying insured products on the exchange. So I think that's the shift that we will see over time. Some employers will move very quickly, particularly employers who move their employees just less than 30 hours into our bank kind of accounting around benefits. But I would see, in the beginning, largely notional defined contribution in a self-funded environment moving to full defined contribution and an insured environment over time. So we believe we need to participate in all of those and we need to follow this evolution through the industry.

David H. Windley - Jefferies LLC, Research Division

That's very helpful. And your thoughts on the evolution timeframe, is it 2 years, 3 years, 5 years?

Mark T. Bertolini

You pick your consultant, they'll give you a statistic. We think that private exchanges will eclipse public exchanges early on. And that depending on whether or not they're really affordable and sustainable, we could see a wholesale shift to private exchanges 2016 and thereafter. But again, it depends on whether or not there's an affordable proposition that allows employers to comfortably move the burden to their employees and that those employees won't be back knocking on the door, not only about wages but also the cost of their health benefits.

Thomas F. Cowhey

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 the 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.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Aetna Management Discusses Q2 2013 Results - Earnings Call Transcript
This Transcript
All Transcripts