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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

Scott Fidel - Deutsche Bank

Charles Boorady - Citi

Christine Arnold - Cowen.

John Rex – JP Morgan

Ana Gupte - Sanford C. Bernstein & Company

Doug Simpson - Morgan Stanley

Matthew Borsch - Goldman Sachs

Josh Raskin - Barclays Capital

Kevin Fischbeck - Bank of America

Michael Baker – Raymond James

Aetna Inc. (AET) Q4 2009 Earnings Call February 5, 2010 8:30 AM ET

Operator

Welcome to the Aetna fourth quarter 2009 earnings call. (Operator Instructions) We will begin by turn the call over to Ms. Kim Keck, Vice President of Investor Relations and Treasurers. Ms. Keck, please go ahead.

Kim Keck

Good morning and thank you for joining Aetna's fourth quarter 2009 earnings call and webcast. This is Kim Keck, Head of Investor Relations and Treasurers for Aetna. 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 will 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 our 2008 10-K, our third quarter 2009 10-Q, as well as our 2009 10-K when filed with the SEC. Pursuant to SEC Regulation G, we have provided reconciliations of metrics related to the company's performance that are non-GAAP measures in our fourth quarter 2009 earnings press release and financial supplement and our 2010 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.

As a reminder we are holding our 2010 Investor Conference at the Plaza Hotel in New York on March 19th at which time we will provide you with additional insight into our strategy and outlook. 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 today. This morning we reported fourth quarter operating earnings per share of $0.40 and full-year 2009 operating earnings per share of $2.75 in line with our previous full-year guidance.

The fourth quarter performance reflects a commercial medical benefit ratio of 85%, favorable to our previous guidance up approximately 86.5%. This positive variance to our guidance includes a 20 basis point improvement from lower than projected H1N1 flu costs with the remainder due to improved premium yields and lower medical costs.

Fourth quarter performance also reflects lower than projected group insurance operating earnings due to an increase in reserves in our long-term disability business and excellent investment returns and cash flow from operations.

The underwriting margin improvement plans we put in place during 2009 are beginning to show positive results. We considered the long-term aspect of customer relationships in our plans to improve our operating margin by pricing each customer or group of customers to an appropriate margin. To date we have repriced a significant portion of our commercial insured business and are creating momentum toward the improvement of our long-term operating margin profile.

We continue to focus on strategically positioning the company for future success along with four dimensions of our strategy; segmentation, integration, consumerism and operational excellence. As examples, we commercialized and new serve more than 700,000 members on our leading edge Aetna One integrated platform. As a testament to the success of this new innovative model Aetna was recently awarded the JD Power and Associates certification for providing an outstanding customer service experience through our Aetna One Concierge Customer Service Center.

In addition we acquired Horizon Behavioral Services to further strengthen Aetna’s behavioral health business and enhance our portfolio of integrated product offerings, making Aetna the second largest player in the domestic employee assistance program marketplace. Also, to sustain leadership in segmenting the market and focusing on creating value for our customers we increased net medical membership by more than 1.2 million members during the year including almost [500,000] members in our newer segments.

Looking ahead to 2010 we expect to face continued environmental challenges during 2010 and have factored them into our outlook. These challenges include continued macroeconomic pressures impacting employment growth and medical costs, pressure on premium and fee yields as plan sponsors deal with budgetary concerns, lower Medicare reimbursement rates which again do not keep pace with medical cost trends and heightened activity in the regulatory and public policy environment.

Given all of this we project a decline in first quarter medical membership of approximately 350,000, favorable to our original outlook of a decline of 600,000 to 650,000 members, a full-year 2010 commercial medical benefit ratio that improves from the 84.5% we reported in 2009 by up to 50 basis points, a 2010 total company before-tax operating margin that is lower than 2009 and full-year operating earnings per share of $2.55 to $2.65. We continue to view 2010 as a repositioning year, a year that will not fully reflect the earnings potential of our business but positions us well for the future.

Joe will provide additional details on our 2010 in a moment. Mark will then provide insight into the key operational drivers of our expected 2010 performance.

First though I would like to briefly comment on healthcare reform. Recent developments have created some uncertainty regarding specific next steps. However, the fundamental trends and underlying issues driving the need for underlying healthcare reform continue and it is our hope that we return to a bipartisan approach to address the accessibility and affordability of healthcare in America. I have a great deal of confidence in Aetna and our long-term future. We are intensely focused on the operational performance of our businesses and are confident that actions we have taken will yield positive results.

We have a customer focused strategy and a seasoned leadership team. We have a robust product suite 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. We are confident that through their efforts we will reposition Aetna for success in 2010 and beyond.

I will now turn the call over to Joe Zubretsky to provide insight into our fourth quarter and full-year financial performance and our outlook for 2010. Joe?

Joe Zubretsky

Thank you Ron. Good morning. Earlier today we reported fourth quarter operating earnings per share of $0.40 and full-year operating earnings per share of $2.75, in line with our most recent full-year guidance.

Fourth quarter highlights include a reported commercial benefit ratio of 85%, 150 basis points better than our previous projection of approximately 86.5%, lower than projected group insurance earnings as we increased reserves in our disability business, favorable prior period reserve development in all medical product lines and excellent investment returns and operating cash flows.

I will now discuss the drivers of our 2009 financial performance starting with operating margin and its key components; revenue, medical costs and operating expenses. Full-year 2009 pre-tax operating margin was 6.4%, a 390 basis point decrease compared to 2008 due primarily to lower commercial risk underwriting margin and higher pension expense. Full-year 2009 healthcare revenue grew 10.2% driven by a 10.7% increase in healthcare premiums and an approximate 6% increase in healthcare fees and other revenue.

Healthcare premium growth reflects an increase in commercial premium of approximately 7.5% resulting from 4% volume growth and a rate increase of 5% partially offset by a 1.5% decline from product mix. Premium growth also reflects strong performance in our Medicare and Medicaid businesses with year-over-year increases of 19% and 56% respectively. This growth was the result of attracting new customers through strong value propositions in those markets.

The approximate 6% year-over-year increase in healthcare fees and other revenue was due to a 9% increase in volume resulting from strong membership growth in our commercial ASC business partially offset by a 3% decline from the impact of lower fee yields and product and service mix. The second key component of operating margin results is medical costs. Fourth quarter and full-year 2009 total medical benefit ratios were 85.4% and 85.2% respectively, favorable to our previous guidance.

Our reported commercial medical benefit ratio was 85% for the fourth quarter, 150 basis points better than our previous guidance and 84.5% for the full-year. This positive variance to our guidance includes 20 basis points from lower than projected H1N1 flu costs with the remainder due to improved premium yields and lower medical costs. Costs related to Cobra were generally in line with previous projections.

We reported favorable prior period reserve development of $103 million before tax during the quarter. This development includes favorable commercial reserve development of $59 million that was essentially offset by the reestablishment of the reserve strengthening we previously reported and continue to hold on our December 31st balance sheet. Fourth quarter favorable prior period reserve development also included $28 million and $16 million in Medicare and Medicaid respectively.

After giving effect to the prior period development we had off of December 31, 2008 reserves, total 2009 year-end health reserves increased approximately 15% year-over-year relative to the annual increase in full-year total health premium of approximately 11%.

2009 medical cost trend was approximately 9%, in line with our previous guidance. Trends within major healthcare cost categories were in line with the projections we have shared with you previously. Day’s claims payable remained at 43.8 days as of December 31st, in line with the September 30 level. Our projected day’s claims payable remains in the low 40’s reflecting the effectiveness and efficiency of our claim operations.

Group insurance total operating earnings were $103.8 million, a 24% decline from 2008. This includes a fourth quarter operating loss of $14.1 million as solid group life results were more than offset by a reserve increase of approximately $50 million before tax in our long-term disability business. This reserve increase reflects longer disability claim durations due in part to the soft economy and a lower reserve discount rate reflecting our new outlook for yields in the investment portfolio that supports this business.

Our disability underwriting practices remain sound as new claim incidence rates are in line with expectations and our current pricing reflects updated investment yield and claim duration assumptions.

The third key component of operating margin results is operating expense management. We continue to invest in our future to capitalize on marketplace opportunities for future profitable growth while also improving productivity and ensuring we appropriately serve the needs of our customers. For the year we achieved a business segment operating expense ratio of 17.6% in line with our previous guidance. This 70 basis point year-over-year improvement was the result of revenue growth and positive fixed cost leverage as well as a decrease in our performance based variable compensation pool.

Turning now to membership we ended 2009 with 18.9 million medical members, a sequential decline of 113,000 members. This was approximately 100,000 members better than our previous outlook due primarily to better than projected customer retention and lower than projected economic related membership attrition.

The final area of financial performance I will comment on is our investment performance and management of capital. Investment performance closed the year on a very positive note. Fourth quarter net investment income on our continuing business portfolio, primarily healthcare and group insurance, was $176 million, an increase over the prior-year quarter by $46 million. This increase was due primarily to higher average asset levels and improved returns on alternative investments, partially offset by lower average yields.

For the full-year continuing business net investment income increased by $75 million and $689 million before-tax. The investment portfolio also had a very strong year from a valuation perspective. The tightening of credit spreads resulted in a net pre-tax unrealized gain position for our continuing business portfolio of $517 million as of December 31st, a mark to market improvement of $870 million during the year.

Now with respect 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 December 31st we had a debt to total capitalization ratio of approximately 30%, $6.8 billion of total adjusted capital, more than $5.7 billion in excess of our regulatory requirements and a risk based capital ratio of approximately 600% of the authorized control level.

We generated significant excess capital during 2009. We began 2009 with holding company liquidity of approximately $100 million. Full-year dividends to our parent company totaled approximately $640 million and net commercial paper issuance was $265 million. This cash flow generation enabled us to cover fixed charges, fund the Horizon acquisition and repurchase approximately $775 million of shares. We ended the year with approximately $100 million of holding company liquidity and approximately $480 million of commercial paper.

During the year we repurchased 28.9 million shares. Our basic share count was 430.8 million at December 31, down from 456.3 million at the beginning of 2009. We produced excellent operating cash flows during the fourth quarter with healthcare and group insurance GAAP operating cash flow representing approximately 320% of operating earnings excluding pension expense. Drivers of this performance were the timing of Medicare cash receipts, increased group insurance reserves, higher commercial premium collections and lower income tax payments. Our full-year cash flow ratio was approximately 200%, exceeding our previous guidance.

I will now provide some additional insight into our outlook for 2010. Overall we project 2010 operating earnings per share of $2.55 to $2.65. This year-over-year operating earnings per share decline using the $2.60 midpoint of our operating earnings per share guidance range is due to several factors including; a year-over-year increase in commercial insured underwriting margin of approximately $0.08 per share as operating margin expansion is partially offset by a decline in volume; a decline in Medicare underwriting margin of approximately $0.08 per share and a decline in ASC fees of approximately $0.05 per share, partially offset by an improvement in group insurance underwriting results of approximately $0.05 per share; a decrease of approximately $0.35 per share due to higher business segment SG&A expenses and improvement from capital actions and lower pension financing costs of approximately $0.20 per share.

Our 2010 projections include a total net medical membership decline of approximately 350,000 members during the first quarter, an improvement from our previous outlook due to a more successful open enrollment season in national accounts and growth in newer segments. The first quarter change in total medical membership includes a decrease of approximately 450,000 commercial insured members, an increase of approximately 75,000 commercial ASC members and a combined increase of approximately 25,000 members in Medicare and Medicaid.

Total net medical membership is projected to remain generally flat for the remaining three quarters of the year leading to a projected 1-2% decline in full-year total company revenue. With respect to medical benefit ratios we project a full-year commercial premium yield that exceeds medical cost trend of 9% plus or minus 50 basis points leading to a full-year commercial medical benefit ratio that improved from the 84.5% we reported in 2009 by up to 50 basis points.

For our Medicare business we project a higher year-over-year medical benefit ratio although still in the high 80’s. While we expect to largely offset the impact by lower reimbursement rates our experience rated large group Medicare business is projected to have higher medical benefit ratios in 2010 compared to the favorable experience we had during 2009.

2010 business segment SG&A expenses are projected to increase year-over-year. The majority of this increase is due to variable compensation pool restoration of approximately $100 million, funding of new initiatives such as ICD10 conversion costs the TriCare platform should we prevail on the protest and retain the contract, and the full-year impact of our Horizon acquisition.

The impact of these items and some negative leverage associated with our membership and revenue outlook is projected to result in a 2010 business segment operating expense ratio of approximately 18.6%. Our projections exclude any impact of healthcare reform such as taxes imposed upon us or costs we would incur to operationalize market or other reforms should legislation be enacted this year. These projections also assume a weighted average share count of approximately 430 million shares.

We have been appropriately conservative in the assumptions supporting our outlook and as such we do not project operating margin expansion in 2010. We have repriced a significant portion of our commercial insured business and are creating momentum toward the improvement of our long-term operating margin profile. We will provide you with an update to our outlook for 2010 and beyond at our investor conference on March 19th.

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

Mark Bertolini

Thank you Joe. I will now provide some additional insight into the performance of our commercial insured, commercial ASC and Medicare business.

Starting first with the commercial insured update. We have been prudent and disciplined in our pricing strategies. Based upon our experience to date we project achieved yields on our first quarter 2010 renewals to be in line with our expectations due to our approach for examining experience by product, geography and segment for each renewal cohort, our strong distribution partner relationships and our widely recognized reputation for service excellence in the marketplace.

As a result of our pricing actions we plan to achieve a positive spread between premium yield and medical cost trend during 2010. As 80% of our 2010 member months have now been priced we are confident that our pricing strategy is striking the appropriate balance between improving our commercial medical benefit ratio and the retention of profitable, commercial insured membership.

Turning to medical costs, the quality and cost management actions we initiated last year are proceeding as anticipated and producing tangible benefits. These actions include contractual changes with providers to address the types of risks and behavioral shifts we experienced during 2009, restructuring of contracts for laboratory and other ancillary services to achieve more favorable terms, implementation of fee schedule changes where appropriate and increased utilization management at certain targeted facilities.

We have also developed detailed plans to achieve additional reductions while ensuring quality in a variety of medical cost areas. I am confident in the robust management and measurement processes we have in place to ensure we deliver quality and total cost outcomes for our customers.

With respect to commercial ASC, Aetna is a widely recognized leader in the national accounts customer market segment serving 71 companies in the Fortune 100 and 56% of Fortune 500 companies. Our leading edge Aetna One integrated platform now serves more than 700,000 members as of January 1. We have a broad portfolio of products and services to meet the needs of our commercial ASC customers.

As we have shared with you previously, the challenging economic climate is prompting some customers in this segment to reduce short-term costs. This is putting pressure on our national accounts commercial ASC fee yields. We are also experiencing a modest decline in product penetration and buy-up programs purchased by our customers. We continue to find ways to provide additional value in the marketplace. We also regularly look for opportunities to offset the impact of inflation in our cost structure with business process improvements, productivity and fixed cost leverage. In addition over the last 90 days we have right sized our business to offset the impact of inflation.

Some comments now regarding Medicare. Our Medicare strategy remains sound with a well balanced portfolio of individual Medicare Managed, group private fee for service and Medicare Part D business. Our performance in the individual Medicare marketplace continues to be strong. We exited several private fee for service markets where we could not develop appropriate networks for our customers. This was offset by strong sales in individual network based products which continue to perform well.

Our group private fee for service business which had very favorable results in 2009 leverages our institutional sales and network management capabilities. As this market is largely experience rated these 2009 favorable results have been shared with our customers in 2010 negotiated prices. This pricing is projected to result in 2010 group private fee for service operating margins that are not as high as in 2009 but still meet our expectations.

Our January Part D results also illustrate the effectiveness of our Medicare strategy. We just concluded our Part D sales season, our most successful season to date, due to the competitiveness of our offerings, enhanced direct to consumer marketing efforts and the strength of our pharmacy management capabilities. We look forward to continued strong financial performance in this business during 2010.

Through well designed benefit plans, effective medical management, disciplined pricing and prudent provider contracting we have been able to mitigate the majority of the impact of lower 2010 Medicare reimbursement rates while still maintaining a very strong value proposition in the marketplace. As such, we project first quarter Medicare membership of approximately 450,000 members and first quarter Part D membership of approximately 550,000 members.

In summary, the operational enhancements we put in place during 2009 are gaining traction. Our key areas of focus remain; accurately forecasting and managing medical quality and costs, pricing our business to an appropriate margin based on this forecast of level of medical costs and providing service excellence to our customers in the most efficient way possible. In fact, our continued focus on service excellence contributed to a net increase in medical membership of approximately 150,000 during open enrollment. We remain intensely focused on improving performance in each of these areas across all of our businesses during 2010 and we continue to have a great deal of confidence in our long-term future.

With that I will turn the call back over to Kim Keck. 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 as many individuals as possible have an opportunity to ask their questions. Operator, the first question please.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Scott Fidel - Deutsche Bank.

Scott Fidel - Deutsche Bank

If you could give an update on TriCare and then also how much expense if any you booked in the fourth quarter for the implementation and what your guidance assumes for 2010 on the SG&A side in case you do end up winning the contract?

Ron Williams

I think in terms of the TriCare contract it is going through an appeal process. We therefore don’t really comment on it specifically. We continue to be optimistic about our prospects and I think we are in a period where the TriCare management authority is conducting the appeal process according to their guidelines.

Joe Zubretsky

With respect to our fourth quarter and 2010 because there is a pending process we have been counseled not to discuss specific financial aspects of the contract but we did guide you in the fourth quarter we would spend some money on TriCare and we did. We felt compelled to at least include the cost to build the platform in our 2010 plan although that spending is not yet committed. We will wait to see the outcome of the contract before we commit to that spending.

Scott Fidel - Deutsche Bank

On SG&A more generally obviously 18.6% is above where you can probably deliver longer term. I am interested if you could talk about the longer term SG&A potential you see in terms of where you can get that ratio down and if you have any annualized savings targets that you are looking for over the next couple of years based on your restructuring actions?

Ron Williams

I think the thing we would expect long-term is as we go through the reduction and begin to normalize in terms of some of our growth we would get back to some level of efficiency. As you know historically we have been able to improve our SG&A in the 50 basis point range net of the investments we have made in growing our business. This year the SG&A is up a bit because we are continuing to make important investments we think are essential to create value for our shareholders over the long-term. I would say in terms of future guidance we would give that as we get closer into other periods and have a better sense as we complete 2010.

Operator

The next question comes from the line of Charles Boorady – Citi.

Charles Boorady - Citi

On the prior period reserve developments can you tell us what it was for 2009 versus previous years for commercial Medicare and Medicaid?

Joe Zubretsky

Most of the fourth quarter development was related to 2009.

Charles Boorady - Citi

Any way to get more specific in terms of the time period?

Joe Zubretsky

The most recent quarters.

Charles Boorady - Citi

On ICD10 as you prudently accounted for in your guidance the G&A expense related to implementation. Can you sort of size that up for us? Also can you characterize for us how you would expect the patterns of claims and coding to evolve once ICD 10 is actually implemented? Is there a risk of kind of up-coding that we have seen with previous coding design changes?

Ron Williams

I think we believe we are starting early, mindful of the potential implications of the change in coding. I will ask Joe and Mark to give you some perspective both on how we are thinking about it from a contracting and business point of view as well as the expense.

Joe Zubretsky

We are still formulating our long-term budget for this project over a multi-year period but we are committing to spend $30 million of cash expenditures in 2010 on ICD10.

Mark Bertolini

I would add just a couple of points. There are two things to consider in the implementation from a business perspective. Indeed the mapping from the current codes to the new codes and what we have done is we have done some of our own homework on that. We are going from, for example, 7,000 CPT to 43,000 under ICD10 and so we are working on that internally but we have also begun to form an industry coalition beyond just the insurance industry but into the healthcare delivery system to try and get everybody on the same page about how we are going to work that transition.

The second part that is probably just as important is that as we get near the implementation date there is always during these kinds of government program implementations a need to work in a dual environment for some time as not everybody is going to be ready by the implementation date so we are preparing for that as well.

Charles Boorady - Citi

Did that include protection from the risk of any up-coding or coding creep as a result of the switch over?

Mark Bertolini

I think the protection is going to be largely based on the coalition we are going to try and pull together to get everybody on the same page. We will be looking at what potential there are for abuse or mistakes in the coding as we go forward.

Operator

The next question comes from the line of Christine Arnold - Cowen.

Christine Arnold - Cowen

Your guidance on ASC and Medicare is comforting but I kind of need help into the commercial MLR. Just about prior period negative development seems to me your MLR should improve 50 basis points, then you strengthened reserves, you have less H1N1 it seems to me your MLR before pricing should improve on commercial at least 100 basis points. Can you give us some sense what I am missing there and give us a sense for how this might start the year versus end the year in terms of the commercial MLR?

Joe Zubretsky

Yes you are right we did have prior period development in 2009 with reserve strengthening. At this time we are willing to commit to up to 50 basis points improvement in that ratio. A significant portion of the booked business has been repriced. The risk membership will be down 8% in the first quarter. Until we see the premium yields we have very good systems that track prices we put in the market in the underwriting but until we see the yields come in January and February we are just going to be cautiously optimistic.

With respect to trend the same thing applies. Mark talked about all of the management actions we have in place and we are confident that we will see the improvement come through but until we see it we think this is the appropriate guidance.

Christine Arnold - Cowen

So what am I missing in it should improve 100 basis points before pricing? Are you expecting the pricing not to cover the trend? Are you seeing a different mix of business than you expected? Did you lose lower MLR and keep higher MLR? Can you just give us some metrics that help us see what you are seeing?

Joe Zubretsky

We believe that the accounts we have lost had slightly higher MLRs than the accounts we retained. We also are committing to pricing in the aggregate above trend. Yield will be above trend to the year and as the older, less robust member months roll off throughout 2010 that spread should get more positive as the year unfolds.

Christine Arnold - Cowen

Can you give us a sense for how many that will be first quarter?

Joe Zubretsky

We are not giving guidance on that specifically.

Operator

The next question comes from the line of John Rex – JP Morgan.

John Rex – JP Morgan

You have spoken to the pressure on the ASC fees. I was wondering if you could quantify that for us in terms of what that means effectively in terms of realized [PNPM] in 2010. What your expectations are versus 2009. If you can provide anything specifically in terms of the type of specialty products that aren’t being taken up as regularly.

Ron Williams

Let me first start out by framing a bit about where we are perhaps relative to others. We have been historically we think very successful in selling a lot of the value added products and services. So as the marketplace is changing in the context of employers becoming more budget conscious we are seeing more employers beginning to examine those additional add-ons they historically have purchased. So I think our relative success in this context has really placed us in a place where we are seeing a bit more pressure than perhaps others. I will ask Mark to add a few comments.

Mark Bertolini

The national account ASC market on the base fee has been competitive for a number of years. I would say at least the last four. All of us have been competing in that space. That is the number everybody can measure one company against the other. In these additional add-ons and buy-up premium products we have been offering over the years we have largely been able to offset or grow our fee yield as a result. Employers are doing exactly the same thing we are doing as a company which is looking at our line items, understanding what we can afford right now and they are taking action on some of those. So we are seeing less of an attitude toward buying buy-ups while the base fees are still very competitive and continue to be a competitive marketplace.

However, we are seeing some employers buy. As we noted earlier in our Aetna One platform people are buying. We have now 700,000 members in that product. We expect as the economy turns around that pricing market will become much more rational.

John Rex – JP Morgan

What is your estimate of what kind of impact we will see in the realized 2010 ASC yields? How negative would that be? Are we talking $1? Can you size that?

Joe Zubretsky

In earnings per share terms we quantify the compression in ASC fees to be $0.05 earnings per share year-over-year.

John Rex – JP Morgan

Can we just take that right back to assuming, I assume there is different profitability levels on these things. I was just kind of trying to understand what you are seeing in the actual [PNPM] yield if you have a sense of that.

Joe Zubretsky

We obviously have a sense but we are not guide to that specifically. You know what the yields are in this business and I think you can do a pro forma on that.

John Rex – JP Morgan

Yesterday Cigna was able to size what they have at risk in their guarantees and performance guarantees in 2010. Can you size that for us on your fee book also?

Joe Zubretsky

We continue to say that 25% of our total consolidated fees and other revenue are at risk for some form of guarantee and that approximately 55% are at risk for service level guarantees. We have not given specific guidance on the remaining 45% and how that is parsed. We could entertain that at some point in the future but that is the guidance for now.

Operator

The next question comes from the line of Ana Gupte - Sanford C. Bernstein & Company.

Ana Gupte - Sanford C. Bernstein & Company

Can you give me some more color on what exactly happened on your group business? It sounds like from your competitors that the number of claims don’t appear to have gone up in the recession. Is it around the duration of claims and how is that going to change how you employ some return to work type initiatives and pricing any new business?

Ron Williams

Let me first start out by stressing how important we think the disability product is to our integrated value proposition. As you recall we have talked about significant growth in our Aetna One products and what we do see is when we have the integrated health and disability we see 15% fewer inpatient admissions. We see 33% fewer hospital inpatient days and 6% shorter short-term disability durations. So we think that the integrated product is extremely important and working relatively well. I will ask Joe to talk about the environmental issues we are seeing that we think are impacting the reserve.

Joe Zubretsky

I think you hit it straight on. We have seen in the fourth quarter some extending claim durations meaning our claim resolution rates are down. We decided to change the assumption in our reserve balance to reflect a new expectation going forward. As you suggested we are seeing very good incidence rate, meaning the number of claims per thousand on the book of business have met our expectations. We think this is due to the soft economy. We think it might abate in the future but we decided to take a reserve action to get ahead of what we think could be an emerging trend.

Ana Gupte - Sanford C. Bernstein & Company

Going forward on the outlook will that impact your dividend of cash from the subs to the parent? Do you see any downside risk there?

Ron Williams

No, this will not have any impact on our dividend or cash flow.

Operator

The next question comes from the line of Doug Simpson - Morgan Stanley.

Doug Simpson - Morgan Stanley

To step back a bit, 2009 turned out to be a pretty choppy year and the outlook for 2010 the initial outlook is on the order of $1.00 lower than where the company was a year ago. Obviously this has been a year of unusual economic times but how much confidence do you have in your outlook? As you think about forecasting for this year versus last year what are the major swing factors in your mind?

Joe Zubretsky

I think as we said many times during 2009 it was an unusual environment. We saw behavioral economics at work in terms of some unusual healthcare trends emerging. We got behind the reserves and we nipped the trend and so we can’t help but just be more conservative in this environment. We definitely have a more conservative bias in our reserving and in our forecasting particularly with respect to medical cost trends.

Doug Simpson - Morgan Stanley

Talking about the repricing initiative, it sounds like membership is shaping up a little bit better than expected even as you are trying to reprice. Can you touch on that a little more specifically? Also you said the MLR for the enrollment loss I think were higher than the ones you retained. Can you talk about that in the context of adverse selection from repricing across the book? How does that develop?

Mark Bertolini

We have 80% of the business priced for 2010 already. We took a very specific pricing model aimed at the loss ratio cohorts across the book of business particularly in small group and [inaudible] market. So those books of business were based on where they were on their MLR and where they were on their target profit margin. By specifically pricing each of those we were able to have a very targeted approach across all of our markets. I can say with great confidence based on my weekly review of the pricing that we met our pricing objectives for 2010.

Now what we have to watch for and what we are looking for is what is the retro lapse potential particularly in small group where half the cases lapse after the effective date and then select the lower end of small group market that [event] a number of accounts could lapse after the effective date and what effect that has on premium yield as well as the final buy downs which we are seeing probably 100 basis points higher across the whole book of business over last year.

So once those premium yields come in we will have a better perspective on the final action on our pricing. All-in we have seen the cases leave that we expected to leave. In the risk business we saw the lapse rate we expected to see and we believe we have held our discipline in the market relative to pricing.

Operator

The next question comes from the line of Matthew Borsch - Goldman Sachs.

Matthew Borsch - Goldman Sachs

On the disability business are the claims where you are assuming a longer duration or you are seeing a longer duration are those tending to be in some of the newer contracts that you entered into that the large or packaged medical disability contracts from a couple of years ago?

Ron Williams

No. There is no particular correlation between the newness of the case. It just has to do with the general nature of the economy. We think in some instances companies may not be ready to take people back given their current issue and aren’t maybe working as hard to help end the duration and to the extent that the worker is concerned about going back and being reduced they may be motivated to stay a little longer. I think what we are trying to do is be certain those people who are appropriately disabled are getting access to the benefits they are entitled to but those who are ready to return do return but there is this environmental pressure and it is not synchronized to the newness of the case or the integrate value proposition.

Matthew Borsch - Goldman Sachs

On a different topic, your last contracting initiative is that something new that you have got something that is done or you are planning to get done for this year? If you could elaborate a bit on that.

Mark Bertolini

We have about 14.4% of our facility contract dollars open for 2010 so we have most of our contracting completed. We looked at all ancillary contracts and looked at opportunities to improve both our partnership with those contracts in those facilities as well as understanding with the change in the economic environment and behavior we were seeing in medical use last year how we can better impact that. We came up with and completed contracts across that spectrum that are fair to our partners as well as it won’t have an impact on medical costs in 2010.

Matthew Borsch - Goldman Sachs

On your client account management we have heard you are doing a consolidation or you have done the consolidation of regions from eight to four. Is that correct and where are you in that process?

Mark Bertolini

We are constantly evaluating our operating model and make changes from time to time in each of our segments. Nothing extraordinarily unusual at this point in time. We are moving in a number of places where we have had trouble in certain markets we are making changes in those markets and where we have new customer segments we are focusing on operating models that better meet those segments.

Operator

The next question comes from the line of Josh Raskin - Barclays Capital.

Josh Raskin - Barclays Capital

Thinking about 2009 obviously it was a difficult year and 2010 not seeing any earnings improvement because it looks like most of that SG&A pressure from future initiatives. So you are running an operating margin next year somewhere in the ballpark of 5%. You have been as high as 10% historically. How do we think about what the current book of business looks like long-term and do we start to see a movement back towards that long-term goal in 2011 in a more serious way?

Ron Williams

I think what we are describing is that 2010 is a year of repositioning for the business. While we are not giving specific margin guidance in the future our expectation is that the margin would go up. We will be talking in March at the investor conference about our perspective regarding the future.

Josh Raskin - Barclays Capital

More specifically is that 10% not a reasonable goal based on your current set of assets anymore or is that something you have historically achieved and don’t think there is a reason why your organization right now couldn’t get back to that level?

Ron Williams

I would say that we really aren’t going to comment today specifically on what we believe the long-term aspiration and target should be. I would ask you to view that we would say directionally up, which is I think consistent with what we have been saying. Exactly what the terminal point is I would say stay tuned.

Josh Raskin - Barclays Capital

On the pension expense I am assuming the change in discount rate has offset some of the funding status of the pension for next year. What is the expectation embedded in your 2010 guidance in terms of change in pension expense?

Joe Zubretsky

The financing component of pension expense will be down by $60 million pre-tax which is $0.09 equivalent earnings per share. You are absolutely right, asset growth was offset by a lower discount rate and the discounted value of the liabilities.

Josh Raskin - Barclays Capital

Total change in the actual expenses.

Joe Zubretsky

$60 million reduction year-over-year in the financing component of pension expense.

Operator

The next question comes from the line of Kevin Fischbeck - Bank of America.

Kevin Fischbeck - Bank of America

I wanted to get a little bit more sense of what you thought about the outlook for repricing. It sounds like you believe that 2010 repricing is on schedule but I guess I want to get a little more clarity about how long of a repricing cycle do you think you are in? Is this 2 year pricing? 3 year? Any color there?

Mark Bertolini

We have said in the past that we believe our repricing will be at least 2 years, maybe 3. 2-3 years is what we said.

Kevin Fischbeck - Bank of America

Is it appropriate to think from [our perspective] you are looking at 50 basis points this year? Is that the kind of incremental improvement we should be looking for going forward? Is there any reason to think the repricing is more front end loaded or back end loaded?

Joe Zubretsky

As you look at the way member months flow there should be a slope to it because if you just roll off the older, underpriced member months there will be some pull through towards the end of 2010 and at this point we are not giving any outlook for 2011.

Kevin Fischbeck - Bank of America

Separately, you talked about the cash flow being strong due to some things like the timing of payments, lower tax rate, is any of that reversed in 2010? Is there a reason to think that some of what helped 2009 cash flow might be a headwind just from an accounting perspective?

Joe Zubretsky

I wouldn’t call it a headwind but the timing of Medicare receipts does reverse and long-term we guide to cash flows over net income of at least 100%, maybe up to 125% of net income.

Kevin Fischbeck - Bank of America

Do you have an order magnitude on the [MA]?

Joe Zubretsky

No we haven’t given any specific guidance on what that is worth in the ratio.

Operator

The next question comes from the line of Michael Baker – Raymond James.

Michael Baker – Raymond James

I was wondering as you look out five years and look at your business mix within the health segment, if you could provide us some updated thoughts on your exposure to the government pieces of Medicare and Medicaid, given what we have seen so far in health reform and the dynamics of the various constituencies along those lines.

Ron Williams

Five years is a long time obviously but what I would say is grounded really in our fundamental strategy which is as you recall when we entered the Medicare segment with expansion plans or renewed our commitment to it with expansion plans we took a long-term view and we focused on those markets we felt we could build good solid networks in. Other companies had different strategies. They were kind of trying to be everywhere. What you have seen for us is a continuing focus on building what we think are networks that give us a good value proposition and hopefully a longer runway.

I think in terms of Medicaid it is a market we continue to grow in and we have added new contracts. The platform we acquired a number of years ago continues to expand in combination with the Aetna brand and relationships and as long as these are good businesses that give us a good return on our capital they are businesses we will continue to invest in. It is hard to know exactly how they will unfold with all the turmoil we are seeing in Washington but we think the combination of our commercial business, our Medicare, our Medicaid and also our segments that focus on government as employer give us a good level of diversification.

Michael Baker – Raymond James

Would it be unreasonable to expect you to do acquisitions that would enhance in those areas?

Ron Williams

I think what we have said is our M&A strategy remains consistent. We don’t obviously comment on particular targets. I think what we have said is we believe the ability to increase local market share in geographies in particular segments is in fact something that is in scope. We have said that acquisitions that help us manage medical costs and quality are in scope and acquisitions that give us new skills and capabilities to penetrate our customer base are in scope. Horizon Behavioral Services would be a good example we just completed. It was we think a good scale, gave us some important new software capability and with the addition of the federal mental health parity it will enhance our ability to serve the mental and behavioral health needs of our clients.

Kim Keck

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

Operator

Ladies and gentlemen this does conclude this morning’s conference call. A recording of the call will be available for two weeks by dialing 888-203-1112 or 719-457-0820. The pass code is 5132468. Thank you for participating. You may now disconnect.

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Source: Aetna Inc. Q4 2009 Earnings Call Transcript
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