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Executives

Kim Keck - Head of IR and Treasurers

Ron Williams - Chairman and CEO

Joe Zubretsky - EVP and CFO

Mark Bertolini - President

Analysts

Josh Raskin - Barclays Capital

Matthew Borsch - Goldman Sachs

Scott Fidel - Deutsche Bank

Charles Boorady - Citi

Ana Gupte - Sanford C. Bernstein & Company

Greg Nersessian - Credit Suisse

Carl McDonald - Oppenheimer

Justin Lake - UBS

Kevin Fischbeck - Bank of America

Doug Simpson - Morgan Stanley

Christine Arnold - Cowen.

Peter Costa - FTN Equity Capital Markets

Presentation

Aetna Inc. (AET) Q3 2009 Earnings Call October 29, 2009 8:30 AM ET

Operator

Good day and welcome to Aetna's third quarter 2009 earnings call. Today's conference is being recorded. At this time I’d like to turn the conference over to Kim Keck. Please go ahead, ma'am.

Kim Keck

Good morning. And thank you for joining Aetna's third quarter 2009 earnings call and webcast. This is Kim Keck, Head of Investor Relations and Treasurers for Aetna. And with me this morning are Aetna's Chairman and CEO, Ron Williams, Mark Bertolini, President; and Joe Zubretsky, Executive Vice President and Chief Financial Officer.

Following their prepared remarks, we will respond to your questions. During this call, we’ll make forward-looking statements. Risk factors that may impact those statements and could cause actual future results to differ materially from currently expected results are described in Aetna's 2008 10-K, our second quarter 2000 10-Q, and our third quarter 2009 10-Q to be filed with the SEC later today.

Pursuant to SEC Regulation G, we have provided reconciliations of metrics related to the company's performance that are non-GAAP measures in our third quarter 2009 earnings press release, second quarter 2009 and third quarter 2009 financial supplements and 2009 guidance summary.

These reconciliations are available on the investor information portion of the aetna.com website. Also, as you know Regulation FD limits Aetna's ability to respond to certain inquiries from investors and analysts and non-public forums. So we invite you to ask all questions of a material nature on this call.

With that, I will turn the call over to Ron Williams. Ron.

Ron Williams

Good morning. Thank you, Kim. And thank you all, for joining us this morning. This morning, we reported third quarter operating earnings per share of $0.69, $0.03 above the consensus estimate.

Our 2009 full-year outlook now includes, operating earnings per share of $2.75, at the low end of our previous guidance range. A total medical benefit ratio of approximately 85.5%, and year-end medical membership of approximately 18.8 million members. This full-year outlook reflects a third quarter total medical benefit ratio that was inline with expectations. And a third quarter commercial medical benefit ratio that was higher than projected, due primarily to higher than projected costs associated with the H1N1 flu, increased COBRA participation rates. And a provision established for certain provider medical costs related to prior years.

Our current period results do not reflect the impact of the decisive actions we are taking to improve our commercial medical benefit ratio in the future, including pricing, underwriting and total quality and cost initiatives.

Specifically, these initiatives include, applying rigorous discipline in our underwriting processes, designed to achieve our targeted underwriting margins. And focusing on the frequency and intensity of medical cost management processes, while ensuring that members receive high quality cost effective care, in accordance with evidence based clinical protocols.

We are not providing the 2010 expected impact of these actions at this early stage, but we are confident that they will improve our commercial medical benefit ratio. Mark will provide additional perspective regarding the implementation of our action plans, later in the call.

Additionally, we are evaluating our operating cost structure to ensure that it remains appropriately aligned with the size, profile and needs of our customers. As we work through our 2010 planning cycle, we can see the unprecedented nature of the current business environment. There is a great deal of uncertainty regarding the US economy with respect to employment and growth. Financial pressure on providers, members and plan sponsors affecting their behaviors, medical costs, and customer preferences. And heightened activity, in the regulatory and public policy environment.

We are working diligently to be well positioned in this new environment. We view 2010 as a repositioning year, a year that does not fully reflect the earnings potential of our business. Our pricing actions should have a noticeable effect beginning in the first quarter of 2010, with additional financial impact realized during the remaining three quarters of the year.

Joe will elaborate on 2010 challenges and opportunities in a moment. Given the importance we place on providing you with clear and specific guidance, we will share our 2010 outlook on our fourth quarter earnings call on February 5, 2010, when we have better visibility into the impact of our pricing on achieved premium yields, the retention of our members, and the impact of the economy on our business.

Accordingly, the company's investor conference will be rescheduled from December 15, 2009, to the first quarter 2010. We continue to strategically position our company for opportunities that may emerge in-light of health care reform. As you know, Aetna has been a leader in health care reform, advocating for an individual coverage requirement, beginning more than four years ago.

We seek a workable solution to health care reform that gets and keeps everyone covered. Builds on the strengths of today's employer based system that covers more than 175 million Americans. Improves the quality of health care services, and bends the cost curve of health care spending in America. And improves the affordability of health care.

We have worked very closely with the administration, lawmakers, their staffs and others in the policy arena in Washington, to put forth constructive, fact based solutions to address these issues. We recognize that many of the current reform proposals would improve access to health care.

However, we also believe current reform proposals do not sufficiently address the underlying cost and affordability of health care. In fact, we believe that several items currently being considered increase taxes, narrow our rating bands and guaranteed issue without a strongly enforced individual coverage requirement would have the unintended consequence of making health care coverage less affordable for Americans.

Having said that, we continue to believe the right reforms can still yield positive market-based change. And that we are well positioned for a post health care reform environment. Although next year will be challenging, I continue to have a great deal of confidence in our long-term future.

We have strategically positioned our diverse portfolio of businesses to capitalize on marketplace opportunities, including health care reform. We have a customer focused strategy and a seasoned leadership team. We have a robust product fleet that includes benefit designs, product features and price points that continue to meet the needs of our customers. And our financial strength, capital structure and cash-flow generation continue to be excellent.

I would like to thank our employees for their unwavering dedication in meeting the needs of our customers, especially given the current political environment. Their continued focus on putting the customer at the center of everything we do will help us return to the level of execution we and you have come to expect from Aetna.

I am confident, that by working together, we will improve our performance and create shareholder value.

I will now turn the call over to Joe Zubretsky to provide insight into our third quarter financial performance and our outlook for 2009. Joe?

Joe Zubretsky

Thank you Ron, and good morning. Earlier today, we reported third quarter operating earnings per share of $0.69, $0.03 above the consensus estimate and a decrease of 38% from the prior year quarter, resulting primarily from a decline in commercial underwriting margin.

I will discuss the drivers of our third quarter financial performance, starting with operating margin and its key components. Revenue, medical costs and operating expense management. Third quarter business segment operating margin, was 6.9% before tax, a year-over-year decrease of 400 basis points, due primarily to a higher year-over-year commercial medical benefit ratio.

Third quarter health care revenue grew 9.4%, driven by a 10% increase in health care premium, and a 5% increase in health care fees and other income. Health care premium growth reflects an increase in commercial premium of 6.5%, resulting from 3.5% volume growth, and a rate increase of 4%, partially offset by a 1% decline from the effective product mix. It also reflects 19% Medicare premium growth and 58% growth in Medicaid. The 5% year-over-year increase in health care fees and other income was the result of higher volume, partially offset by the impact of lower fee yields.

The second key component of operating margin results is medical cost. Our third quarter reported total medical benefit ratio, improved sequentially by 120 basis points to 85.6%, due primarily to improvements in our Medicare and Medicaid medical benefit ratios. Our commercial medical benefit ratio was 85.6% in the third quarter, a sequential decrease of 30 basis points on a reported basis. After adjusting for the prior period development, we reported in the second quarter, however, our commercial medical benefit ratio increased sequentially by 100 basis points.

Approximately, half of this increase was due to a specific provision established for certain provider medical costs related to prior years. And the remainder was due primarily to higher than projected H1N1 flu and COBRA costs.

Our third quarter Medicare medical benefit ratio was 85.4%, improving 400 basis points sequentially on a reported basis, due primarily to favorable results in our group private fee-for-service business, the normal quarterly pattern associated with Medicare Part D, and the negative impact in the second quarter of our previously revised risk adjusted revenue estimate.

Our Medicaid medical benefit ratio, improved sequentially by 560 basis points during the quarter, to 86.6%, due in part to the positive impact of mid-year premium renewals, and modest favorable prior period development. We continue to reflect recent medical cost trend, operating metrics and payout patterns in setting reserves for estimated health care costs.

As of September 30, the health care reserves we established at June 30 have proven to be more than adequate. In fact, we had approximately $30 million of favorable prior period development, including modest favorable development in each of our commercial, Medicare and Medicaid businesses. This favorable development is net of the provision for certain prior year provider medical costs we established during the third quarter.

In addition, we believe our September reserves reflect conservative assumptions, comparable to those used at June 30. We have maintained the approximately $60 million of reserve strengthening established at June 30 in our September 30 balance sheet. The strength of our reserves is demonstrated by third quarter sequential commercial reserve growth of 5%, relative to commercial premium growth of 0.9%.

Days claims payable increased 2.6 days during the quarter, from 41.2 days at June 30 to 43.8 days at September 30. Reflecting variations in time to receipt, and the timing of pharmacy payments.

Our projected days claims payable, continues to be in the low 40s, reflecting the effectiveness and efficiency of our claim operations.

Group Insurance third quarter operating earnings declined 28% on a year-over-year basis to $33 million. This change reflects normal life insurance underwriting performance during the quarter relative to unusually favorable life underwriting performance during the prior year quarter.

The third key component of operating margin results is operating expense management. We achieved a third quarter business segment operating expense ratio of 17.4%, representing a 50 basis point improvement over the prior year quarter.

We regularly review our cost structure and are committed to taking actions to ensure that it remains appropriately aligned with the size profile and needs of our customer base, particularly as we look toward 2010.

Turning now to membership, third quarter medical membership declined by 25,000 members during the quarter. Commercial membership decreased 70,000 members, partially offset by gains in Medicare and Medicaid of 5,000 and 40,000 members, respectively.

The commercial membership decline of 70,000 members included a decrease of 16,000 insured members and a decline of 54,000 ASC members. This change in commercial membership, reflected economy related in-group attrition of approximately 135,000 members during the quarter, for a total of slightly more than 500,000 members year-to-date.

For the quarter, the commercial ASC decline was driven primarily by in-group attrition in larger accounts. The decrease in insured commercial membership, reflects declines in core commercial membership, partially offset by gains in newer segments, such as individual and Aetna Global Benefits.

Medicaid membership grew 40,000 members during the quarter, primarily in our ASC business as a continued increase in unemployment resulted in higher participation in this important segment.

The final area of financial performance I will comment on, is our investment performance and management of capital. Third quarter net investment income on our continuing business portfolio, primarily health care and Group Insurance was $173 million, a $3 million sequential improvement and $15 million higher than the prior year quarter.

This resulted primarily from higher asset levels and improved performance on alternative investments, although short term yields continue to provide pressure. The investment portfolio had a very strong quarter from a valuation perspective, due to the continued improvement in the credit markets. Specifically, the tightening of credit spreads and decrease in treasury yields, resulted in a net pretax unrealized gain position, for our continuing business portfolio of $629 million as of September 30, an increase of $618 million during the third quarter.

Since January 1, the continuing business portfolio on realized gain has been $982 million on a pretax basis.

Turning now to liquidity and capital management. Our financial position, capital structure and liquidity all continue to be strong. Our balance sheet metrics are excellent. As of September 30, we had a debt-to-total capitalization ratio of approximately 28%; $6.3 billion of statutory surplus, more than $5.2 billion in excess of our regulatory requirements. And, we also continue to have a target risk based capital ratio of approximately 600% of the authorized control level.

During the quarter, we repurchased 3.9 million shares. Our basic share count was $433.5 million at September 30, down from $436.5 million as of June 30. We also continue to have very strong operating cash flow. Health care and Group Insurance GAAP operating cash flow for the quarter was approximately 300% of operating earnings excluding pension expense.

This was the result of the timing of Medicare cash receipts, increased health care reserves, and higher commercial premium collections. We therefore now project this full-year 2009 operating cash flow ratio to be approximately 150%.

I will now provide additional comments on our 2009 guidance and some preliminary thoughts regarding 2010. Starting first, with 2009, we project year-end medical membership of approximately 18.8 million members, reflecting total economy related in-group attrition of approximately 625,000 to 650,000 members.

We also project double digit Health Care revenue growth. With respect to medical benefit ratios, for the full year, we project a total medical benefit ratio of approximately 85.5%, consistent with the high-end of our prior guidance range. A commercial medical benefit ratio, of approximately 85%; and a fourth quarter commercial medical benefit ratio of approximately 86.5%.

We also project a full-year Medicare medical benefit ratio in the high 80%'s. This full year outlook includes, approximately $95 million of lower underwriting margin due to higher than normal COBRA costs. And approximately $95 million of medical costs for the H1N1 flu, in excess of traditional flu costs.

Our 2009 medical cost trend projection remains at 9%, plus or minus 50 basis points, with trends by cost category being consistent with our previous outlook. Our 2009 outlook also includes continued expense management discipline, leading to a projected business segment operating expense ratio of approximately 17.6%. This represents a 70 basis point improvement over the prior year. This reflects fourth quarter investments relating to the creation and expansion of new programs such as our Aetna One integrated platform, the investments necessary to prepare for TRICARE, and normal seasonal costs for information technology spending in open enrollment.

Our guidance also includes a full-year 2009 weighted average share count of approximately 450 million shares. Taking, all of this into account, we project 2009 operating earnings per share of $2.75 which includes $0.41 per share for the fourth quarter. This fourth quarter per share estimate includes certain costs, which are higher than a normal quarter, approximately $0.10 from SG&A, $0.08 from the H1N1 flu and $0.04 from COBRA.

Turning now to 2010, we are in the midst of developing our 2010 operating plan, and are factoring the potential impact of the macroeconomic, regulatory and public policy environment into our analysis. There is a great deal of uncertainty at this time, with respect to these key factors for next year.

Given the importance we place on giving clear and specific guidance, we will provide you with our 2010 outlook on our fourth quarter earnings call. At that time, we believe we will have better visibility into the impact of our pricing on achieved premium yields, the retention of our members and the impact of the economy on our business. We would note that there are several challenges to confront and opportunities to garner with respect to 2010.

Challenges with respect to economic factors and employment levels include, continued in-group attrition and high COBRA participation rates, continued pressure on medical costs, associated with changing provider and consumer behavior. Pricing pressure as customers deal with a difficult economy, and uncertain levels of risk membership.

Challenges with respect to the regulatory environment include pressure on revenue associated with lower Medicare reimbursement levels, and increased G&A costs, including potential investments to prepare for health care reform. There are also opportunities in 2010. These include the impact of pricing actions and medical quality and cost initiatives, our continued focus on actions to right size our cost structure in accordance with changes in membership and higher excess capital generation and deployment.

In summary, 2010 will be a repositioning year. A year that does not fully reflect the earnings potential of our business. Our pricing actions should have a noticeable effect beginning in the first quarter of 2010, with additional financial impact realized during the remaining three quarters of the year.

I will now turn the call over to Mark Bertolini for an update on the actions we are taking to improve our operational performance. Mark.

Mark Bertolini

Thank you, Joe. In light of the rising medical costs we have experienced during the last two quarters, we are taking specific actions to improve our operational execution. These actions fall into three main categories: pricing and underwriting, medical quality and cost management, and ensuring that our cost structure remains appropriately aligned with our customer base, while continuing to provide our customers with industry leading service.

This morning, I will provide an update on these actions and discuss our expectations regarding first quarter 2010 membership. Starting first with pricing and underwriting actions, we analyze our business by customer segment, geography, product and plan design. We evaluate experience within and across each of these views and have implemented a combination of underwriting enhancements, pricing actions and plan design changes intended to ensure that each customer is priced to an appropriate margin.

We have also conducted a thorough review of our products and plan designs, revised our product offerings in several markets and have successfully collaborated with many customers to revise plan designs and benefit features to be more commensurate with the profile of their employee independent populations.

As approximately 50% of our insured member months renew during the first quarter, our pricing action should have a noticeable effect beginning in the first quarter of 2010, with additional financial impact realized during the remaining three quarters of the year.

In addition, the two higher medical benefit ratio blocks-of-business we referred to on our second quarter earnings call, have been retained at pricing that is aligned with our target operating margins. The majority of the higher than expected increase in third quarter medical costs are not expected to be recurring. And, therefore, have not impacted our view of 2010 pricing.

We remain confident in achieving the appropriate premium yield, relative to medical costs. That said, we do not expect to achieve the full realization of appropriate margin in one pricing cycle across our entire book-of-business.

Turning now to medical quality and cost management, we have taken specific and measurable actions in many areas to enhance medical quality and cost management. These areas include, adjusting our provider contracts to address recent and expected medical cost trends, strengthening laboratory management initiatives, continuing to refine claim reimbursement policies consistent with evidence based clinical protocols. And increasing utilization management at certain targeted facilities.

In addition, approximately 25% of our projected 2010 facility costs are still open to negotiation and will be contracted in response to the experience we have seen through the third quarter of 2009. We expect these initiatives to have a positive impact on 2010 medical costs.

Finally, I will conclude with an update of our expectations for first quarter, 2010 membership. First, with respect to national accounts, a key component of our strategy is sub segmentation. This strategy enables us to provide targeted solutions that meet the unique needs of our customers. Our quality and total cost strategy continues to resonate in the market marketplace and the national accounts customer market segment continues to see the value of this strategy. In the current economic environment, there is also an emerging sub segment within the National Accounts market that is now placing increased emphasis on near term cost savings.

This buying preference is putting pressure on our National Accounts membership outlook, resulting in a projected net decrease in total National Account membership of approximately 300,000 to 350,000 members during the first quarter of 2010.

We continue to invest in capabilities that provide flexibility to meet the changing needs of all of our customer segments, including those focused on near term cost savings. The expansion of our Aetna One Integrated platform is proceeding as planned with more than 700,000 members to be serviced on this leading-edge concierge service model as of January 1.

This includes existing Aetna One business, new customers and the conversion of several existing ASC customers onto our new Aetna One platform. While we have some visibility into projected national account membership levels, the plan sponsored decision making process occurs later in the small group and middle market customer segments.

Our visibility into first quarter membership in segments such as these is limited by the extended decision time frames, associated with the pricing actions we are taking. We currently project a net first quarter membership decline in these customer market segments of approximately 300,000 members, particularly in risk businesses. In the midst of this challenging economy, we are taking appropriate actions to evolve our business model for future success. We have a diverse portfolio businesses that can withstand the challenges we may face, and we continue to have a great deal of confidence in our long-term future.

With that, I will now turn the call over to Kim for the Q&A portion of the call. Kim?

Kim Keck

Thank you, Mark. The Aetna management team is now ready for your questions. We ask that you limit yourself to one question and one follow-up, so that as many individuals as possible have an opportunity to ask their questions. Operator, the first question, please.

Question-and-Answer Session

Operator

That will come from Josh Raskin from Barclays Capital.

Josh Raskin - Barclays Capital

A question around, you guys used the term repositioning year for 2010, and I guess I'm trying to sort of [juxtapose] that what exactly happened in 2009. And, obviously, the first half was good, and then the second half obviously was a lot worse than expected so, on a sort of overall basis, would you expect 2010 to be more reflective of your earnings power than 2009? Or was 2009 slightly higher because you had sort of a benefit of what you saw in the first half of the year?

Ron Williams

The way I would think about it is that we felt that 2009 overall started off very solid, and then as we all know, we experienced the effects of the economy. And as we described in prior calls, as we looked back in 2009, we saw changes in both provider behavior that we experienced, as well as consumers making increased use of certain services, such as preventive services. As a result, that's caused us to, excuse me, I said 2009, I meant 2008.

What that has meant in the context of 2009 is that the pricing that we put in place for 2009 turned out to not really be what we needed to achieve the results and margins that we had historically been delivering. As we go forward, and look at 2010, we believe that what we will be doing is capturing in the 75% of the membership that had not been priced at the point that we had clarity, the level of price increases that will begin to get our margins where they need to be. The process that we’ll go through means that we’ll have some impact on the first quarter and moving through the rest of the year, so that by the time we get to the end of the year, the impact of our actions will be more mature.

Josh Raskin - Barclays Capital

Okay. So just so I understand, those pricing actions will result in what I think Mark said, was 600,000 to 650,000 of net membership decreases excluding Medicare, Medicaid, etcetera but you are expecting a significant improvement in pricing beginning in 2010. To me that sounds like a better year than 2009.

Joe Zubretsky

Yes, Josh, the way I would, this is Joe. The way I would characterize it is as Ron said, we experienced a slight negative spread between trend and yield in the earlier part of the year. And due to the inflection point in medical costs, that negative spread grew in the latter half of the year. Our pricing actions are expected to reverse that so that we are achieving a positive spread between trend and yield for next year, which should improve the commercial medical benefit ratio with the obvious impacts being heavier in the latter part of the year, than in the early part of the year.

Josh Raskin - Barclays Capital

Maybe I can ask it more directly. Does that mean earnings next year is expected to be higher or lower than '09?

Joe Zubretsky

We are not giving any earnings guidance at this point, Josh, but we clearly believe the medical benefit ratio, commercial medical benefit ratio will improve. And we’ll have a better managed spread between our achieved yields and our experienced trends.

Josh Raskin - Barclays Capital

Okay; that's great. Thank you.

Operator

Our next question will come from Matthew Borsch from Goldman Sachs.

Matthew Borsch - Goldman Sachs

Yes. Good morning. Maybe I could just pick up where Josh left off there. So, without getting into the earnings guidance, I understand that you are not prepared to go into it at this point with a number of things in flux. But when you say improving the commercial MCR from what point are you referring to? In other words, is that relative to the full-year 2009 guidance or relative to the back half of the year? Can you comment on that at all?

Joe Zubretsky

At this time, Matt we are only saying that we can improve it on a full-year basis. How it rolls out by quarter, yet to be discussed. But clearly, as older member months that were priced with an older view of trend roll off and newer member months that are re-priced to our current view of trend roll-on, the latter half of the year should have a better impact than the first half of the year.

Matthew Borsch - Goldman Sachs

Okay. And sort of separate but related question, on the commercial medical cost trend view, given the pressure points and the higher guidance on MCR for the back part of the year, why is your view of trend unchanged? Is the pricing yield coming in at less than you expected? Or is there some other factor I should think about there?

Joe Zubretsky

The way I would characterize it, Matt, is that most of the pressure in the last half of the year was COBRA and flu related. And our trend for next year includes our view of COBRA and flu related costs for next year. But the underlying baseline trend pretty much is coming in as projected.

Matthew Borsch - Goldman Sachs

Okay. And if I could just sneak one more in, on Medicare Advantage, at this point do you anticipate that your margins and enrollment would be down for next year? Or how are you thinking about that?

Ron Williams

Well, Matt, as we said we are not giving the margin and earnings implications for 2010. In terms of the overall direction of the program, I would say that we continue to believe that it will be an attractive program long term. As we mentioned early on, strategically, we positioned our entry into this segment with a longer term view. We didn't go in as many places. We focused on those geographies where we felt we could build solid network relationships and have a longer runway. That said the reductions in Medicare Advantage are going to have reductions in benefits for beneficiaries. And those beneficiaries who have become accustomed to some of the lesser co-pays and lesser cost sharing that they have had and extra benefits will be impacted.

Matthew Borsch - Goldman Sachs

Okay. Thank you.

Operator

Our next question comes from Scott Fidel from Deutsche Bank.

Scott Fidel - Deutsche Bank

Thank you, good morning. First question, just interested if you can talk about how employers are responding so far to your corrective pricing actions, I guess relative to the prior turnaround back in the earlier part of the decade, have you seen sort of the similar reactions or any type of different response just given the different economies?

Mark Bertolini

Scott, this is Mark. A few different reactions than happened seven, eight years ago. I think the way we have approached this pricing cycle and the way we have analyzed the book of business, again by geography, by product, by plan design, by employer type, by segment, we are able to on a daily basis, track where our pricing is. And we are pricing different cohorts based on underlying experience in our target profit margins. So, taking this year's trend, which we believe is going to be relatively close to next year's trend, we have put that into our pricing. And where we have appropriate target margins, we are pricing to trend. Where we are behind on our target margins, we're pricing ahead of trend. As we go into the marketplace with that pricing, we are watching each case closely. We get weekly reports. And the results so far are tracking to our expectations.

Scott Fidel - Deutsche Bank

Okay. And then just had a follow-up question. Just on the provider claims intensity issue specifically and just on the up-coding trends, just interested if you look at the third quarter relative to the second quarter, are you seeing things getting worse, would you say there is pretty much the same, or have things gotten a little bit better?

Ron Williams

The answer is no change.

Scott Fidel - Deutsche Bank

Thank you.

Operator

We’ll take our next question from Charles Boorady from Citi.

Charles Boorady - Citi

Thanks good morning. First on the loss ratio, just to think kind of longer term beyond 2010 even, the 85% range is well above your historical levels. And if I look at a combined ratio, I see the same thing. You're talking about improvements for 2010. Are you signaling that we may be near a cyclical trough and entering a period of multi-year period of improvement? Or can you talk about how you target the loss ratio or the combined ratio long term, so we can sort of normalize margins from where they are this year?

Ron Williams

Well, Charles I think what we would say is that we continue to believe that we can have margins in the higher single digit category. I think I would hesitate to get out too far, given we have health reform and host of other issues that are going on. But, would simply say that obviously that's dependent on mix and a host of other issues. But, that's probably about as much as I could say that would be meaningful today.

Charles Boorady - Citi

Okay, thanks. And health reform. Speaking of that, I guess, that’s my last question just on the long term as well, Ron you talked about repositioning and 2010 being a year of repositioning. Can you elaborate a little bit on that? Should we think more acquisitions or more divestitures? You're thinking of expanding into non-medical products going back to Aetna's roots? And Medicaid expansion is something that was in all the bills. Is that something that you’d look to invest more heavily in?

Ron Williams

Well, I would say that we are focused, first and foremost on making certain that we have very strong execution on the plans that we have laid out. I think beyond that, we are looking at our customers and making certain, that we understand their evolving needs. I think our strategy remains very solid. We feel very comfortable with it, and we will continue to execute on that particular strategy.

Operator

Our new question will come from Ana Gupte from Sanford C. Bernstein & Company.

Ana Gupte - Sanford C. Bernstein & Company

Good morning. So are you talking about pricing at or above the solid estimation of your cost trend. And, I thought it was positive but you had PPRD coming net positive and you have some conservatism in your days claims payable. But how do we get comfortable that your trend estimation that you are saying will not increase for next year? Is something that will not over time, you didn't miss trend in some way because of process issues or IT systems or your actuarial stuff wasn't quite working the way it should have?

Joe Zubretsky

Sure, Ana. Well yes, you did sort of the lay out some metrics here that suggest that our reserve position is very strong. Cash flows are excellent. Days claims payable up and we are very comfortable that we maintained that $60 million of reserve strengthening we did at the end of the second quarter, on our third quarter balance sheet. I think the comfort we take in our forward-look on trend, and what we have priced into next year's accounts is all the behavioral change that we've been discussing, whether it's consumer driven or provider driven has created an up-tick in our medical cost. We have assumed that as the going forward baseline and a 9% trend off of that new baseline. So even if that behavior actually repeats itself, we have captured that in our medical cost outlook for 2010. And we feel a great deal of comfort around that.

Ana Gupte - Sanford C. Bernstein & Company

Okay, a follow-up to that. On that 9% with the hospital inpatient and outpatient how much of that is unit cost versus utilization related? And what are you doing on the contracting side? It seems like the ASO accounts are now looking at discounts as a key driver of competitive advantage. And from a local market density perspective, do you feel adequately advantaged to improve your discount position with facilities?

Mark Bertolini

Ana, Mark. A couple of points. We have about 25% of our 2010 contracts yet to finalize. But, a greater portion have been finalized with our understanding of current behavior incorporated into our contracting model. We have also done a number of other changes around claim payment policies, as I mentioned during my talking points that focus on the behavior that we are seeing in both the physician and the hospital community around the drivers of healthcare costs.

On the National Accounts for the self-funded side relative to discounts, we have a number of improvement markets we are targeting. However, we believe that we are strong in a number of markets and that not every client, we will be able to meet the needs of every client in the marketplace. And so we are focused on those areas where we can have an impact and a difference with our [little] discounts.

Ana Gupte - Sanford C. Bernstein & Company

Okay. Thanks.

Operator

Our next question will come from Greg Nersessian from Credit Suisse.

Greg Nersessian - Credit Suisse

Just wanted to follow up on that last question, I guess. When you are looking at this up-coding issue and sort of evaluating another quarter of analysis, are you finding that it's mostly a contracting issue, where you have to go back and reset the terms with maybe a little bit more specificity on, how these things need to be coded? Or you actually finding that there were some abusive instances that you can address either legally or through some kind of recovery effort?

Ron Williams

Yes, I think the answer is that there are some of every category. And I'll ask Mark in a minute to give you some specifics on some of the things that we are doing. But I think we have a very exhaustive review. And I think generally this is an organization that is highly engaged in observing these issues and making certain that we understand what's going on and that we have a series of actions that we believe can help us make improvements. I think for each area, there is a different category. And, Mark, maybe you can give some specifics on that.

Mark Bertolini

Sure. So, Greg, for the last couple of quarters, we have been doing a lot of audits where we believe there is the potential for some confusion around the way providers have billed us. We always assume positive intent going into these situations, and want to make sure that we understand how those bills are coming in. We respond in more than just a re-contracting issue. A number of these issues can be handled through claim payment policies. So, for example, where we are seeing multiple office visits billed at the same office visit, we are reducing the reimbursement for the second visit in that visit, by virtue of our claim payment policies versus having to re-contract.

Where we are seeing coding issues, we are putting audits in place and down coding where appropriate where we believe there are abuses or potential misunderstandings. And finally, there are some places where we do indeed, have to re-contract and those have a longer tail for getting benefits of those actions.

Ron Williams

And probably the final act would be that in some instances there are entities that would be no longer participating in our network.

Greg Nersessian - Credit Suisse

Okay, that's really helpful. And then my second question was just on the you provide the table with the pension expense impact this year. I was wondering, perhaps, if you could just give us a sense of maybe if the year ended today, what impact on 2010 pension expense would have?

Joe Zubretsky

Well, Greg, the pension evaluation, the deficit has actually expanded a bit. The assets have recovered. The stock market, as you know what it's done this year, so the assets have come back. But if you look at where credit spreads are the discount rate that one would have to use on the plan is nearly a 100 basis points lower than it was at the end of last year. So, the accounting deficit would actually expand a little bit. That being said, our GAAP accounting expense for next year, if valued at September 30, would be flat to slightly down over 2009.

Greg Nersessian - Credit Suisse

Okay. Thank you very much.

Operator

Our next question will come from Carl McDonald from Oppenheimer.

Carl McDonald - Oppenheimer

Thanks. In light of all the reform discussions on individual small group, it would be helpful if we had an understanding of how much of the business that book actually represents for you.

Mark Bertolini

Carl, Mark Bertolini. 2% of our book of business is individual and 6% is small group.

Carl McDonald - Oppenheimer

And that's of total enrollment?

Mark Bertolini

As of the total enrollment of the company, yes, as of 9/30.

Carl McDonald - Oppenheimer

Excellent. Great, thank you.

Operator

Our next question comes from Justin Lake from UBS.

Justin Lake - UBS

With your MOR guidance now for commercial going to 85%, I'm just curious and you mentioned that high single-digit margin target longer term. What's a reasonable SG&A number to kind of think about? We're just trying to figure out I mean where margins might be right now, kind of from a starting point to think about that potential for a recovery. Because, if I think about typical margins it might be around, SG&A might be around 12%, so would put you in kind of low-single digits. Is that the right way to think about it, or am I missing?

Joe Zubretsky

Justin, the way we think about it is it's really all about what happens to the top line. As we reposition our margin profile for next year, the top line is bound to be lower growth than it has been in the recent past. But I think we've demonstrated over the last three or four years as we've grown the top line very responsibly, the amount of fixed cost leverage is significant. We've reduced the SG&A ratio hundreds of basis points over the last five years. And so it really is all about once we get margins to where we need them, once we start growing the business again, we will continue to produce efficiencies and fixed cost leverage in the business.

So I think the answer is, based on the top line, there is more SG&A benefit that can be garnered over the foreseeable future.

Justin Lake - UBS

Okay. What is the starting point?

Joe Zubretsky

I'm sorry?

Justin Lake - UBS

I'm just trying to get an idea of the starting point.

Joe Zubretsky

The full year, we are projecting a 17.6% ratio for the current year. I think that's a good starting point. Now keep in mind, mix has a lot to do with that. So as you grow your national accounts business more slower or faster than your risk business, that will have an impact. But un-mix adjusted, the 17.6% number is a good starting point.

Justin Lake - UBS

Right. That's why I was asking about the commercial risk number specifically. That’s not if it was 17.6%, it would assume a negative underwriting margin, sure you don't have. Is there a better number to think about for commercial risk book?

Joe Zubretsky

No, we don't give SG&A ratios by our different business segments.

Justin Lake - UBS

Okay. And then I guess just a follow-up on Carl’s question. If we were to think about a ballpark number for commercial risk margin, would it be safe to say that the individual and small group business is running above the average margin? Or should we think about that as kind of in line with average margins?

Joe Zubretsky

The individual margins generally run above the commercial average.

Justin Lake - UBS

And what about the small group?

Joe Zubretsky

Small Group, slightly above the commercial average.

Justin Lake - UBS

Great. Thank you very much.

Operator

Our next question will come from Kevin Fischbeck from Bank of America.

Kevin Fischbeck - Bank of America

Okay, thank you. Good morning. I wanted to follow up on the comment that there was a provision for certain prior year provider of medical costs. What exactly was that related to? How much was that? And is there an ongoing impact from that?

Joe Zubretsky

Kevin, we routinely, bake into our run rate medical costs and our view of trends, we routinely have settlements and negotiations with providers related to prior year medical costs. It's part of the run rate of the business and part of our trend outlook. In this quarter, we had a particular situation that caused us to record a $25 million item or 50 basis points in the medical benefit ratio, related to prior year, so we figured we’d call it out for two reasons. One, it was a significant factor in the quarter's MBR. And second, it was very small amounts related to multiple prior years, so it really does not affect your view of the baseline medical costs. So, our view is we don't count it in our forward-looking run rate of the business. Although, these types of situations are a routine part of the business, that are in the normal run rate of medical costs.

Kevin Fischbeck - Bank of America

Okay. So in this quarter, it doesn't impact the fact that Q4 you're looking for a higher number again?

Joe Zubretsky

It would. If you look at our 85.6% for the quarter, without this item we would have achieved an 85.1% medical benefit ratio for the quarter. So as you do your quarter-over-quarter comparison, you should consider it.

Kevin Fischbeck - Bank of America

Okay. And then the fact that you're looking for a higher MLR Q4, does that change at all your view about the implication on the re-pricing of your business? I mean has this moved out your view about how long it will take? I guess earlier there's a multiple pricing cycle comment. Has this changed anything in your view?

Joe Zubretsky

Not really. And I'll tell you, just to make sure it's fully understood, what we have assumed in our fourth quarter medical benefit ratio. We've got 100 basis points of incremental impact over the third quarter of H1N1 and COBRA combined and 40 basis points of fourth quarter seasonality. So clearly, we look at the fourth quarter as being unusually high from that perspective.

Kevin Fischbeck - Bank of America

Okay. And one last question, if I can sneak it in. You mentioned earlier about taking kind of longer term view on Medicare Advantage. But I guess over the last couple of years, it looks like the majority of your enrollment growth has been the private fee-for-service growth. I wanted to get your thoughts about that business in 2011. Do you feel like you're going to have the networks in place to transfer that membership over there? Or should we be thinking about M&A enrollment declines in 2011 as that business goes away?

Mark Bertolini

Kevin, we continue to see a good deal of activity around Medicare private fee-for-service. One important note to remember, a number of these groups, a large number of these groups are groups that we had as Medicare Supplement groups, so we have clear understanding of their experience.

Secondly, we expanded our private fee-for-service program largely in-group, because it was in markets where we believe we had a strong network presence. And currently in the re-contracting for replacing private fee-for-service with PPO, we are about 90% of our network coverage necessary for our current membership and expecting new membership next year.

Kevin Fischbeck - Bank of America

Okay, great. Thanks.

Operator

Our next question comes from Doug Simpson, Morgan Stanley.

Doug Simpson - Morgan Stanley

Good morning everyone. I was wondering if you could put the current situation into context, maybe relative to what happened in '06 with Mid-Atlantic and pricing in Florida as well. Just there has been some comments about multiple pricing cycles needed to correct where you are. Obviously, you have H1N1 and COBRA to deal with and the economic situation is different. But are there any parallels to be drawn? And can you just give us a sense for the receptivity on that part of the clients to the actions you guys are taking?

Ron Williams

Yeah, I think the short answer is no, there really aren't a lot of parallels here. I think from a client point of view in terms of the pricing, what the clients look at really is the finished cost of the health product that we are selling. And so, as we go out with the premium increases, we also work with the customer in the context of helping them select product options that may lower the impact of the increase. But then also, at the end of the day, they look at what they can get from us. They look at the quality of the service, the features and benefits, the overall value add, the disease management, the capabilities. And then look at what else is available in the market and then make their decision accordingly.

Doug Simpson - Morgan Stanley

Okay. And then Joe, if I can just ask, I just wanted to clarify what you said about the pension funding. You said the deficit, the actual dollar value of the deficit would expand but the accounting impact on 2010 would be roughly similar to what we saw in '09. Is that accurate?

Joe Zubretsky

That is accurate. Yes.

Doug Simpson - Morgan Stanley

Okay. Any sense as to how much that has expanded?

Joe Zubretsky

It is between $900 million and $1 billion at this stage.

Doug Simpson - Morgan Stanley

Increase or total deficit?

Joe Zubretsky

The total deficit is between $900 million to $1 billion. And the last time we reported it was probably closer, it was between $600 million and $700 million.

Doug Simpson - Morgan Stanley

Okay. Thank you.

Operator

Our next question will comes Christine Arnold from Cowen.

Christine Arnold - Cowen.

I'm confused about your SG&A guidance. You talked about leverage, when you grow. But you are going to loose a large Medicare Advantage employer account, I think. You're going to be starting up TRICARE. And both risk and ASO commercial membership is going to decline. So is there an ability to ratchet down that SG&A, or should we expect that ratio to rise?

Ron Williams

Well, I would say, Christine, one, there are always accounts. Some come, some go. We always have lots of offsetting issues. In terms of the net impact, I think you should expect that as we give guidance we will give you a sense of what we expect to do. We are mindful of the impacts of both revenue growth and the negative leverage associated with not having that level of growth. We will look at our mix of products. We will look at the revenue we expect. And then we will work to make certain our SG&A is as competitive as we think it needs to be.

Christine Arnold - Cowen.

Okay. So that still leaves me kind of lost on that. Is it reasonable to think that the ratio would rise?

Joe Zubretsky

Christine, first of all, we're not giving any specific guidance on any metrics or ratios for 2010, as we reposition and see where the margins settle. What I was saying before was once we reestablish that baseline and continue to grow from there, un-mix adjusted, we should be able to enjoy the benefits of fixed cost leverage once again the same way we have in the past three to five years. But yes, you raised the issue of TRICARE. That's a great example. That is going to increase the ratio because it's an ASC account. So all these mix effects need to be taken into account when we're looking at those ratios.

Christine Arnold - Cowen.

Okay. And then on the commercial MLR, you said that you had $25 million that probably won't recur. How do we think about kind of intra-year development and any other things that impacted the commercial MLR this quarter that we should exclude? Is it just the $25 million, to kind of get an underlying run rate for the quarter, plus the H1N1 and Cobra estimates? Or is there other stuff that you consider?

Joe Zubretsky

No; it's approximately 100 basis points. 50 basis points was the provider-related issue and 50 basis points combined Cobra and H1N1.

Christine Arnold - Cowen.

Okay. And last question, you said that National Accounts really focused on near-term cost trends, and that's why your enrollment will be down. Can you clarify what you mean by that?

Mark Bertolini

Sure, Christine. In some sub-segments of National Accounts, we have seen the same pressures that we see as an employer in managing our costs manifest themselves in clients looking at scorable items that they can pull out of their expense structure in a given year. So we've seen a decrease in buy-ups, actually, some decreases intra-year in buy-ups that has had an impact on our revenue coming from ASC accounts. We believe that while the economy is difficult, a lot of employers will be taking this kind of view, including scoring hospital discounts as a potential savings. The result for us is, is that we are flexing the model. We are working with these clients. And while we believe our longer-term value proposition is appropriate, we are also offering product alternatives to these employers in the interim.

Christine Arnold - Cowen.

Great. Thank you.

Operator

We'll take our final question from Peter Costa - FTN Equity Capital Markets from FTN Equity Capital Markets.

Peter Costa - FTN Equity Capital Markets

Thanks for taking the question. You talked about the pricing pressure on the National Account business. How is that manifesting itself? Is that more guarantees being required? More or less stop-loss coverage? Can you kind of talk a little bit about how that pricing pressure is showing up and who is offering it that is causing your National Account business to decline?

Mark Bertolini

Sure, Peter. A couple of things. First, there's pressure on just administrative fees because again, those can be scored. So think of things that can be scored and logged into a current cost structure and P&L. Administrative fees, disease management fees, personal health record fees, fees like that that could be cut out and scored immediately as a savings in a given year for an employer to be able to put in their own bottom line. We have seen an increase in claim to trend guarantees.

We have been very strict on how we approach those and have pulled back from a number of accounts that have resulted in some losses in our book of business. Because we believe in this rising trend environment in this uncertain economy, some of the claim trend guarantees out there in place of hospital discounts are not appropriate for us to assume.

Peter Costa - FTN Equity Capital Markets

Okay. Is there somebody out there who has been more aggressive in offering some of those things than you guys have been?

Mark Bertolini

I would leave that up to them to decide.

Peter Costa - FTN Equity Capital Markets

Okay. And then you mentioned some of the accounts where you had offered it before, I believe, that you are no longer offering it. Is that correct? Or is that --?

Mark Bertolini

On the…?

Peter Costa - FTN Equity Capital Markets

Like an aggressive fee guarantee?

Mark Bertolini

We have lost some accounts over that discussion, yes.

Peter Costa - FTN Equity Capital Markets

Okay. Thank you.

Mark Bertolini

You're welcome.

Operator

That was our final question.

Kim Keck

A transcript of the prepared portion of this call will be posted shortly on the Investor Information section of the Aetna website at Aetna.com. If you have any questions about what management discussed this morning, please feel free to call me or one of my colleagues in the Investor Relations office. Thank you again for joining us this morning.

Operator

Thank you. That will now conclude today's conference. You may now disconnect.

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Source: Aetna Inc. Q3 2009 Earnings Conference Call
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