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Executives

Thomas F. Cowhey - Vice President of Investor Relations

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

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

Analysts

Joshua R. Raskin - Barclays Capital, Research Division

Justin Lake - JP Morgan Chase & Co, Research Division

Ralph Giacobbe - Crédit Suisse AG, Research Division

Christian Rigg - Susquehanna Financial Group, LLLP, Research Division

Albert J. Rice - UBS Investment Bank, Research Division

Andrew Schenker - Morgan Stanley, Research Division

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Christine Arnold - Cowen and Company, LLC, Research Division

Ana Gupte - Leerink Swann LLC, Research Division

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Carl R. McDonald - Citigroup Inc, Research Division

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

Sarah James - Wedbush Securities Inc., Research Division

Scott J. Fidel - Deutsche Bank AG, Research Division

Thomas A. Carroll - Stifel, Nicolaus & Co., Inc., Research Division

David H. Windley - Jefferies LLC, Research Division

Aetna (AET) Q4 2013 Earnings Call February 6, 2014 8:30 AM ET

Operator

Good morning. My name is Lynette, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Aetna Fourth Quarter and Full Year 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to Tom Cowhey, Vice President of Investor Relations. Mr. Cowhey, please go ahead.

Thomas F. Cowhey

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

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

We have provided reconciliations of metrics related to the company's performance that are non-GAAP measures in our fourth quarter 2013 financial supplement and our 2014 guidance summary. These reconciliations are available on the investor information section of aetna.com.

Please note that the inclusion of Coventry's business in 2013 results impacts the quarter-over-quarter and year-over-year comparisons. Additionally, for the purpose of today's discussion, unless otherwise noted, all references to 2013 operating earnings and operating EPS include amortization expense related to acquired intangible assets. All references to 2014 operating earnings and operating EPS reflect Aetna's revised definitions, which exclude amortization expense related to acquired intangible assets.

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

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

Mark T. Bertolini

Good morning. Thank you, Tom, and thank you, all, for joining us today. This morning, we reported operating earnings per share of $1.34, a 43% increase over 2012. This fourth quarter result brings full year 2013 operating EPS to $5.85, representing a record result for the company and 14% growth over 2012, a 3-year operating EPS CAGR of 17%, well in excess of our managed care peers and another year where we exceeded our low double-digit operating EPS growth objective.

Looking back on 2013, Aetna executed well across most of our businesses; pricing with discipline and generating 120 basis points of improvement in our operating expense ratio; closed the acquisition of Coventry healthcare, the largest acquisition in Aetna's history; continued to advance our efforts to shift the network model toward patient-centric population health management; and developed a strong strategy and foundation to participate on exchanges.

Aetna's 2013 financial results are a testament to the strength of our diversified portfolio and its ability to deliver sustainable results. Underlying these full year results, we ended the year with nearly 22.2 million medical members, representing our seventh sequential quarter of medical membership growth. We reported record annual operating revenues of over $47 billion, driven by the Coventry acquisition and solid underlying growth.

Our full year 2013 Commercial medical benefit ratio was 80.1% at the low end of our projected range. Aetna's operating expense ratio improved again to 17.7% as we grew operating revenue and continued to focus on synergy realization while investing for the future.

Finally, 2013 was another strong year of cash generation, helping us to fund the Coventry acquisition, increase our shareholder dividend and still repurchase $1.4 billion of our shares.

Aetna's solid finish to 2013 gives us good momentum as we drive towards our 2014 operating earnings projection of at least $6.25 per share.

In a moment, Shawn will discuss our 2013 results and 2014 guidance in greater detail, but first, I would like to discuss Aetna's growth strategy and how we are executing on that strategy.

At our investor conference in December, we highlighted the following elements of our growth model built on the strength of our diversified portfolio of businesses. Specifically, we project that Aetna's Large Group Commercial business can grow profitably, Aetna's Government franchise can be a growth engine, Small Group and Individual represent an opportunity for future growth, next-generation networks enhance the core business and Coventry enhances top line growth and strengthens our capital position. I will now provide a brief update on how we are executing against some of these growth levers.

Starting with our government business. We just completed a highly-successful Medicare annual open enrollment period where growth exceeded our initial expectations. We believe this strong performance speaks to the value we provide to our customers. We now expect to add at least 110,000 Medicare Advantage members in the first quarter of 2014 representing an excess of 11% sequential growth. This projected result comes primarily from strong sales in the Coventry Individual Medicare Advantage book and another year of growth in Aetna's Group Medicare Advantage business. Both of these businesses performed well in 2013 and are projected to be solid performers in 2014 as well.

Aetna is pleased to be a key participant in this important and growing program. While we remain concerned about further cuts to the Medicare Advantage program in 2015 and the potential for member disruption, we continue to believe that the Medicare business can be a valuable part of our earnings profile over the long term.

Moving on to exchanges. At our annual investor conference in December, we laid out our vision of the shift toward a retail marketplace. The driving force behind this shift is plan sponsor interest in defined contribution models for employee health benefits. We believe the most efficient way for plan sponsors to achieve their goal would be through private exchanges. Most private exchanges today are consultant or broker-sponsored multi-carrier exchanges that we view as a first step in the evolution of the private exchange marketplace. As we discussed previously, Aetna is participating in a number of private exchanges in 2014, and we believe we are winning our fair share in this emerging retail marketplace.

Based on available data in the first quarter of 2014, we project that 90,000 existing Aetna ASC members will convert to a private exchange model. More than offsetting these first quarter losses, we project that 130,000 new private exchange members will select an Aetna product, with over 2/3 of those members enrolling in fully-insured products. Our early results have been encouraging and speak to the opportunity private exchanges offer Aetna.

We also continue to work to develop our own proprietary exchange called the Aetna marketplace, integrating the best that our brand has to offer. We believe that the Aetna marketplace will offer stable and affordably-priced products that plan sponsors require to make defined contribution models successful and empower consumers to take greater control of their health benefits decisions. This marketplace is available today for Small Group members and we will be expanding our capabilities in this area throughout 2014.

Shifting to the public exchanges. First, a reminder that individual health insurance was a small portion of Aetna's business in 2013, representing 3% of our membership and operating revenues, and less than 1% of EBITDA. Despite the well-publicized challenges during the initial exchange rollout, enrollment has increased in recent weeks. Through the end of January, Aetna's exchange enrollment totals approximately 135,000 paid members and should continue to grow over the remainder of the open enrollment period. We continue to believe our overall exposure to the individual insured business will not materially increase in 2014 and the financial risks to Aetna are manageable.

Let me now spend a few minutes discussing our provider transformation efforts. In 2013, we continued to advance our efforts to shift the provider business model from a fee-for-service model toward patient-centric population health management. Across the spectrum of value-based networks, we now have over 340 agreements encompassing over 1.5 million medical members, including 32 signed ACO collaborations covering over 550,000 members, 112 patient-centered medical homes covering 740,000 members, 112 Medicare collaborations covering 115,000 Medicare members and 88 high-performance networks acquired in the Coventry transaction covering 105,000 Commercial and Medicare members. Looking forward, we project that 20% to 25% of our medical costs will run through some form of value-based network contract in 2014 and are committed to increasing that participation percentage to 45% by 2017.

Moving on to the Coventry integration process. For 2013, we achieved the high end of our targets for both synergies and accretion, and for 2014, we currently project $200 million in synergies and $0.50 per share of operating EPS accretion. We are pleased with the execution of our integration plans and the excellent work that has been done by our integration teams. Our results to date speak to the financial and strategic attractiveness of the Coventry acquisition, and we continue to work diligently to mitigate potential integration and migration risks and deliver additional value for our customers and shareholders.

Finally, before I turn the call over to Shawn, I would like to take a few minutes to discuss our multi-year outlook. As I have said before, in 2014, we faced many unique challenges, including pricing or solving for the ACA fees and taxes and offsetting the rate pressures in the Medicare Advantage program. It will require a strong execution to overcome these meaningful headwinds, but we remain committed to growing operating earnings and operating EPS this year.

In 2015, ACA fees and taxes will be largely incorporated into our baseline rates and premiums. However, further ACA-mandated cuts to Medicare Advantage and the prospects for additional Medicare rate pressures could make 2015 another challenging year for this important business. Despite this challenge, 2015 could be a year of improved core business fundamentals, which should further benefit from capital actions and incremental accretion from Coventry. By 2016, we expect ACA-related pressures will largely abate and longer-term revenue growth opportunities will begin to mature. As we stand here today, we view 2016 as a year when we can return to our long-term growth dynamics.

As we think about longer-term prospects, one of the keys to Aetna's growth story is the power of our diversified portfolio. Historically, we have talked about our diversified portfolio in terms of mitigating risk. We also believe it provides us with multiple opportunities to capture future growth and achieve our goal of doubling operating revenue by the end of the decade. These opportunities include: private exchanges, the potential movement of commercial membership from self-insured to fully insured products; Medicare Advantage growth, as 11,000 baby boomers age into the Medicare program on a daily basis; dual eligibles growth, as up to $300 billion in annual spend migrates to managed care; public exchange growth, which could grow to 25 million members by 2020; and Medicaid expansion, as 15 million additional people become eligible for the program under the ACA.

The revenue growth opportunities in front of us may be unprecedented in the history of managed care and we believe our diversified portfolio positions us to capture our fair share and grow operating revenues at double-digit rates.

In summary, as we begin 2014, I am confident in our strategic direction and our ability to execute, our ability to achieve Coventry synergies and our accretion goals, the power of our diversified portfolio to drive growth and our 2014 operating EPS guidance of at least $6.25 per share.

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

I will now turn the call over to Shawn, who will provide additional insight into our results and our 2014 outlook. Shawn?

Shawn M. Guertin

Thank you, Mark, and good morning, everyone. Earlier today, we reported full year 2013 operating earnings of $2.1 billion and operating earnings per share of $5.85, consistent with our most recent projections and well in excess of our initial guidance for 2013. Aetna's operating results continue to be supported by solid revenue growth and operating margins. I'll begin with some comments on overall performance for the year.

We grew operating revenue by 33% to a record level of over $47 billion driven by the Coventry acquisition and underlying growth of nearly 7%. Our full year Commercial medical benefit ratio was 80.1%, an excellent result reflecting our disciplined pricing posture and historically low and stable medical cost trends. We improved our full year operating expense ratio by 120 basis points to 17.7%, driven by higher operating revenues and continued disciplined in controlling costs. We closed the Coventry acquisition earlier than expected and began the integration process and delivered on our synergy and accretion targets. Finally, we generated approximately $2.7 billion in dividends from subsidiaries and returned nearly $1.7 billion to shareholders.

Looking more specifically at the quarterly results, during the fourth quarter, operating revenue increased by 47% from the fourth quarter of 2012, primarily from the addition of Coventry. We grew underlying operating revenue by over 7%, driven by Medicare membership increases and commercial insured premium yield growth. Medical membership increased by 38,000 in the quarter, driven by Commercial Insured and Medicare Supplement, partially offset by a modest decline in Medicaid membership.

From an operating margin perspective, our businesses are performing quite well. Our fourth quarter total medical benefit ratio was 83.9%, a 20-basis point improvement compared to the prior year quarter, driven by strong performance in our Commercial business and improved performance in our Medicaid business, mostly offset by the previously disclosed pressures in our Medicare business. As a result of our operating revenue growth, realization of synergies from the Coventry acquisition and our disciplined focus on costs, we drove 170 basis points of improvement in our operating expense ratio versus the prior year quarter, and our pretax operating margin was 6.7% for the quarter and 7.9% for the year, consistent with our high single-digit target.

From a balance sheet perspective, we remain confident in the adequacy of our reserves. Our reserve growth kept pace with our premium growth and our days claims payable were 45 days at the end of the quarter, stable both sequentially and on a year-over-year basis. In addition, we experienced favorable prior period reserve development in the quarter across all of our core products, primarily attributable to our 2013 performance.

Turning to cash flow and capital. Operating cash flows in the fourth quarter were strong at nearly 1.5x operating earnings and full year 2013 operating cash flows were equally strong at approximately 1.3x operating earnings. We also continue to aggressively deploy capital to create shareholder value, repurchasing over 6.8 million shares in the quarter for $450 million and distributing another $74 million through our quarterly shareholder dividend. In 2013, Aetna returned nearly $1.7 billion of capital to our shareholders through these 2 programs, including approximately $1.4 billion deployed towards share repurchases.

In short, we are pleased with our fourth quarter results, which we believe demonstrate the successful execution of Aetna's growth strategy and the value of a diversified portfolio. I will now discuss the key drivers of the fourth quarter performance in greater detail.

Consistent with our performance throughout 2013, the main driver of our strong operating performance this quarter is our Commercial insured business. This business, which represents over 50% of our 2013 operating revenue, continued to pose year-over-year revenue growth despite continued underlying membership pressures. As before, and especially as we look forward to 2014, we remain committed to fair and financially responsible pricing where we favor margin over membership and price to projected underlying medical cost trends.

Our Commercial medical benefit ratio was 81.7% for the quarter, an excellent seasonal result and a decrease of 170 basis points from the same period last year. Drivers of this improvement included favorable prior period development and the favorable effect of early collection of ACA fees and taxes. Medical cost trends developed consistent with our previous projections, and based on our year-to-date experience, we continue to project that Aetna's stand-alone 2013 Commercial medical cost trends will be in the range of 5.5% to 6%.

Another important growth lever is our Government franchise. Our Medicare book of business continued to demonstrate growth in the fourth quarter, growing by 30,000 members. In total, our Medicare revenue more than doubled over the fourth quarter of 2012, a result of the Coventry acquisition as well as strong underlying membership growth. Our Medicare medical benefit ratio was 87.9% in the quarter, stable sequentially.

In our Medicaid business, medical membership declined by 49,000 in the quarter. These were primarily ASC members related to county losses in the previously-announced Arizona reprocurement. Despite the sequential decline in membership, premiums more than doubled on a year-over-year basis, reflecting the inclusion of Coventry. The performance of the business was very good in the quarter as our Medicaid medical benefit ratio was 84.7%, a 260-basis point improvement from last year's fourth quarter. Our total Government medical benefit ratio for the quarter was 87%.

Moving on to the balance sheet, our financial position, capital structure and liquidity all continue to be very strong. At December 31, we had a debt to total capitalization ratio of 37%. Looking at cash and investments at the parent, we started the quarter with $200 million. Net subsidiary dividends to the parent were $523 million. We repurchased over 6.8 million shares for $450 million and paid a shareholder dividend of $74 million. After other uses, we ended the quarter with $200 million of cash at the parent representing our core liquidity. Our basic share count was 362.2 million at December 31.

I would now like to spend a few moments discussing our 2014 outlook. Our solid finish to 2013 and our encouraging early membership results for 2014 give us good momentum as we drive towards our 2014 operating earnings projection of at least $6.25 per share. Note that this projection reflects our new convention of excluding the amortization of acquired intangible assets from operating earnings and operating EPS.

Our 2014 guidance is influenced d by the following drivers. We project that our first quarter medical membership will be approximately 22.2 million members, an increase from year-end 2013 of approximately 50,000 members. There are numerous moving pieces inside this aggregate forecast. Commercial ASC membership is projected to increase by 120,000 to 160,000 members due to new business wins, primarily in our public and labor business. Commercial Insured membership is projected to decline by 120,000 to 160,000 members, influenced by declines in our individual insured business and the transition from limited benefit products, partially offset by private exchange membership gains. Medicare is projected to grow by at least 135,000 members, comprised of at least 110,000 Medicare Advantage members and 25,000 Medicare Supplement members. Finally, Medicaid membership is projected to decline by 80,000 to 100,000 members, primarily related to our exit from a low-revenue ASC contract in California accounting for 125,000 members.

Consistent with our operating revenue update in January, we continue to project full year operating revenue to be at least $54 billion. We project our full year Commercial medical benefit ratio to be 79% to 80%. As a reminder, the impact of including ACA fees and taxes in pricing is expected to reduce this ratio by approximately 250 basis points. Absent the adjustment to premium for fees and taxes, our full year Commercial medical benefit ratio is projected to be 81.5% to 82.5%. The year-over-year increase in this adjusted figure is primarily driven by the exclusion of prior year development in our 2014 guidance and the crediting of favorable 2013 experience back to customers through the renewal process.

Aetna's 2014 Commercial medical cost trend is projected to be in the range of a 6% to 7%, reflecting a projected increase in utilization of 75 to 100 basis points. We project our Government medical benefit ratio to be 85% to 87%, which, at the midpoint, represents an improvement of 150 basis points, driven primarily by actions designed to solve for or recover the impact of the health insurer fee. We project our operating expense ratio will be in the range of 18.5% to 19%. This figure is impacted by the expense related to the ACA fees and taxes, which runs through the SG&A line, increasing the reported SG&A ratio for 2014 by approximately 140 basis points. Our underlying operating expense ratio, excluding these fees and taxes, is projected to be in the range of 17.1% to 17.6%, an improvement over 2013. We project pretax operating margin to be at least 7.5%, consistent with our high single-digit target.

The lack of deductibility of the health insurer fee is projected to increase our reported tax rate by approximately 600 basis points. We project operating earnings to be over $2.2 billion. And finally, based on our previously disclosed increase in operating revenue guidance, we now project net dividends from subsidiaries to be in the range of $1.7 billion to $1.9 billion as additional capital to support this growth is held at the subsidiaries. Despite this change, we continue to project excess cash flow to the parent of approximately $1.2 billion.

In summary, we are pleased with our fourth quarter and full year 2013 results and believe that these results demonstrate our ability to execute on the growth strategy we shared with you in December. I want to reiterate that we are committed to growing operating earnings and operating EPS in 2014, and consistent with that objective, we are focused on: Collecting or solving for the ACA-mandated fees and taxes; integrating Coventry and accelerating, or possibly exceeding, our synergy targets; delivering on our plans to offset the Medicare Advantage rate pressures; and executing on our exchange strategies.

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

Thomas F. Cowhey

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

Question-and-Answer Session

Operator

[Operator Instructions] The first question will come from Josh Raskin from Barclays.

Joshua R. Raskin - Barclays Capital, Research Division

I just want to follow up on Mark's comments around private exchanges and some of the moving parts that you guys were talking about, and I think I got some of the numbers that you were saying in terms of the movement there that some of your ASO, I think it was about 90,000 lives into exchanges, but then it sounded like you got 130,000 out, of which 2/3 are risk. So obviously, that's net-net, I would think, a positive for revenues and earnings. So I just want to make sure I got those numbers right. And then two, can you talk a little bit about how you're measuring share and success as you think about accounts that are converting in, accounts that were previously Aetna and those that were previously at competitors, how are you sort of assessing your level of success? What sort of market share numbers you're seeing, any sort of selection issues and things like that?

Mark T. Bertolini

Good. Thanks, Josh. Your numbers are right. So 90,000 ASC members went into the private exchange model. We got 130,000 new private exchange members, of which 2/3 were risk, representing approximately $450 million of revenue increase on the net change, which has 4x to 5x -- the greater Commercial insured contribution has 4x, 5x greater contribution than ASC on a dollar basis. So we felt good about that. We continue to see our share as a net gain so far. But as the environment changes and more private exchanges evolve, including our own proprietary exchanges, which we now have in the marketplace, we'll see how those share dynamics change.

Joshua R. Raskin - Barclays Capital, Research Division

So Mark, are you at the point where you would recommend, say, some of your customers, even if you've got 100% share of an ASO account, for example, that they would convert into one of that consultant-based exchanges because you're getting more than your fair share of the enrollment and the contribution margin's 4x to 5x. Are you at that point?

Mark T. Bertolini

We are talking to our large ASC clients about moving into private exchanges. The first conversation is about our own.

Operator

We'll go next to Justin Lake from JPMorgan.

Justin Lake - JP Morgan Chase & Co, Research Division

My question's on the public exchange side. First, can you tell us what the early indicators look like on the risk profile, the membership you're getting here and what margins are embedded in guidance for this business for 2014? And then Mark, you've been fairly vocal on the issues facing exchanges post the rollout. I was hoping you could give us some color on what needs to happen between now and May for the company to be comfortable with the business going into 2015 bidding.

Mark T. Bertolini

Thanks, Justin. We have, right now, 135,000 paid members that's growing every day because open enrollment's still open until March 31. We have, from an interest standpoint, just under 200,000 lives enrolled. And I would be cautious. So we have maintained that ratio of somewhere around 70% paid to enroll, although I will say that the folks who've enrolled before January were at about a little over 80% on paid versus enrolled, I think almost 90% now. So that's rolling up quickly. So my view is, is that I think people are enrolling in multiple places. They're shopping. And what happens is that they never really sort of get back on healthcare.gov to disenroll from plans they prior enrolled in. The only reason that we know they didn't enroll is when we don't pay their premium. And that's pretty typical of the individual marketplace, which leads to probably the next set of things that we need to see happen in the public exchanges. The back-end operational accounting for the public exchanges is still not up and running. We are doing that largely manually. Now with Aetna, because we've been an alpha tester, we've been exchanging information back and forth and have figured out how to get as clear a set of data from healthcare.gov that we can to manage this, but the whole add, change, delete functionality still needs to be built on the back-end, and I think that's our next biggest concern as we move forward on managing the enrollment in the exchanges -- in the public exchanges. As it relates to our May renewal increase, we have a team already on it. I am, and Shawn, is personally involved in understanding. We know -- understanding what to do next. We know the information and the questions we need to answer before we can be comfortable with the rates that we will submit. We are quickly gathering that information, and quite frankly, it's way too early to tell because we have very little information. As it relates to the risk in the pool, the demographics are about where we thought they would be, a little skewed to higher cost individuals. We are using our underwriting databases that we use when we underwrite groups to access as much information about these individuals as we can. Some of these individuals are former Aetna individual market members moving into the public exchanges. Others, we can find information about through national databases. And so far nothing alarming. But I'd like to remind everybody, 3% of our revenue, less than 1% of our profit out of this business. We expect this book of business to actually have a negative impact on our earnings, and that's built into our guidance for 2014.

Justin Lake - JP Morgan Chase & Co, Research Division

So you have negative margins built in, Mark?

Mark T. Bertolini

We expect the business to lose money in the first year.

Operator

Moving next to Ralph Giacobbe from Credit Suisse.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Just wondering, anything to call out on the commercial cost trend in the fourth quarter? I think at least one of your peers discussed higher utilization given disruption and cancellation notices that went out. Did that impact you at all or anything else sort of along those lines to call out, first? And then you noted that the early collection of the industry tax helped in 4Q. I was just hoping that you can help quantify the benefit of that.

Shawn M. Guertin

Ralph, I would say that while we seasonally saw higher costs in the fourth quarter, which, as you know, we typically do, that was not anywhere markedly different than our expectations. So I would have to say that we did not observe that phenomena as the quarter played out largely consistent with our expectations. The health insurer fee, I believe, year-over-year, is in the neighborhood of 50 basis points, I think, plus or minus.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Just I'm staying on the cost trend, we've obviously seen several years of lower cost trend. I guess, when we think about next year, how concerned are you on the uptick in underlying trend? Anything over the first month so far that you've seen that would suggest any type of pickup?

Mark T. Bertolini

Obviously, too early to tell. We're -- we just got a few weeks’ worth of reliable claims in the first 6 weeks, and so I would be reluctant. I mean, we run our reserves everyday, and I'd be reluctant to give any color other than to say that we believe that trend is stable. We expect utilization to increase by 75 to 100 basis points, which is a big difference between last year and this year. We expect that to happen in the outpatient area going from mid to high-single digits to high-single digits, otherwise physician, hospital and others are at mid to high-single digits like they were last year. So it's really being driven by utilization is our expectation, and we price to that. 90% of our business, when you include Medicare and Commercial together is priced for 2014 and those are our expectations going into the year.

Operator

We'll go next to Chris Rigg from Susquehanna Financial Group.

Christian Rigg - Susquehanna Financial Group, LLLP, Research Division

Just wanted to come back to the Medicare Advantage membership growth. I guess, is there any incremental detail you can provide as to whether the growth of above and beyond what you were looking for in December is coming from a relatively small group of markets, or whether those individuals were previously enrolled with a competitor plan? Any color on the membership would be great.

Shawn M. Guertin

Chris, the increases are quite broad-based geographically. What I would start with is most of this growth is actually happening in the individual MA business that was on the Coventry platform, as well as the Group Medicare Advantage business. And as you know, both of those businesses performed quite well this year. About 1/4 of our growth is a result of expansion counties, and I would also point out that the significant majority of our member growth has occurred in our 4-star or better plans. In terms of members from prior plans we're about 65% of the new members appear to have come from other plans, that's up a little bit from last year where that number was 57%.

Operator

A.J. Rice from UBS.

Albert J. Rice - UBS Investment Bank, Research Division

Maybe I'll ask you about the Medicaid plans and the ability to get the tax fully incorporated there. I know you guys have been somewhat cautious on that. Is there an update on what you're seeing on the states? And how have you factored in the guidance your thinking on that?

Shawn M. Guertin

I would say that, A.J., that we have done, actually -- that's continued to progress in a positive way. As of today, we actually have signed contracts on about 3/4 of our exposure to the health insurer fee, and even within the other 25%, we have various written documentation and rate memos on some of them that would indicate that we're going to be reimbursed. So this one has definitely trended favorably. I would also say, not in general, but almost entirely, we are getting a tax gross-up as well in that reimbursement. So this one has continued to go in a positive direction.

Albert J. Rice - UBS Investment Bank, Research Division

Okay. And is that all factored into your guidance at this point, that you're going to get to gross up on the tax as well?

Shawn M. Guertin

I think, largely, that's true with where we are right now in the year.

Operator

We'll go next to Andrew Schenker from Morgan Stanley.

Andrew Schenker - Morgan Stanley, Research Division

I was just wondering if you could guys give any updates on how your early renewal strategy played out for you on the end of December there, and how -- any impact that may have had on your enrollment trends or thoughts for next year.

Mark T. Bertolini

I think our renewal process, early renewal process worked really well; the result of what was happening with the public exchanges and the government's extension. I think what we don't know yet, and we're still watching settle out and we'll probably know in the next few weeks, is what membership left us. And we usually, again, in the individual market, nobody ever calls us to say, "Jeez, I've left your plan. Thanks for all you've done for me." They just don't pay their bill and then we disenroll them. And so we're waiting for all of that to settle through. So the net-net of all of it, we're not quite sure. Out early enrollment worked the way we thought it was going to work. It was helped by the public exchanges. I think in the end analysis, the level of disenrollment is still to be determined.

Andrew Schenker - Morgan Stanley, Research Division

Okay, was there any indication on your exchange enrollment, numbers of people who were previously Aetna members?

Mark T. Bertolini

We do have some of that, and we are sorting through that. And as a matter of fact, we are reaching out to new enrollees, getting them engaged in any transition of care, which helps us move them into case management and disease management, where we find the opportunity. And so we're actively reaching out to each of these new members and, obviously, keeping the folks that were in our former Aetna IDL [ph] product very engaged in their current programs.

Operator

Matthew Borsch from Goldman Sachs.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Yes, just a question on the fourth quarter. Was the operating cost level higher than you anticipated? It may have been that we modeled lower operating expense. I'm just curious how that came in relative to your budget.

Shawn M. Guertin

Just to be clear, Matt, are you asking about SG&A?

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Yes, I am.

Shawn M. Guertin

No, the SG&A came out very consistent with our expectations. Actually, probably net-net on a ratio basis, we actually did better than we thought for the quarter.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Okay. And also in the fourth quarter, I think you said 50 basis points benefit from proactive pricing of the health insurer fee. Is that, to calculate, that's maybe worth $0.05 to $0.06 to fourth quarter EPS. Is that in the ballpark?

Shawn M. Guertin

Yes. Let me just be clear on my answer. The 50 is probably closer to the full year effect. The quarterly effect, specifically, is up probably more up like 75 to 80 basis points.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Okay. And just last question on the 2014 outlook. Can you -- you gave us a number, and I think it's 243. It may be slightly different in your footnotes to your disclosures on how much amortization expense would have previously been booked for '14, and is going to be excluded. How much amortization -- unless I'm misunderstanding. Is there some amortization expense that you're going to report on cash EPS for '14? And can you give us what that number is?

Shawn M. Guertin

Certainly. There will be no amortization of acquired intangible assets in 2014. All of the other depreciating items will continue to sort of run through operating earnings.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

So what does that look like then? I guess, is what I'm trying to get at.

Shawn M. Guertin

What the other depreciation is?

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Yes. What you're projecting for '14.

Shawn M. Guertin

We can pull that. I'll get you -- we can get you the specific number, no matter what the depreciation element is.

Operator

Christine Arnold from Cowen.

Christine Arnold - Cowen and Company, LLC, Research Division

Back to Medicare Advantage. At your investor day, you said you expect MA flat pretax margins off of kind of a depressed '13. Couple of questions here. Was the headwind this year that you kind of overcame with pricing and bidding for 2014, was that still in the 200-basis point range or does that move at all?

Shawn M. Guertin

Christie, sorry, you're breaking up a little bit, so can you repeat the specific question there at the end?

Christine Arnold - Cowen and Company, LLC, Research Division

Sure.

[Technical Difficulty]

Operator

And we'll move to the next question. It will come from Ana Gupte from the Leerink Partners.

Ana Gupte - Leerink Swann LLC, Research Division

The question is about some of the recent changes that are being proposed on narrow networks. I think there's a few of them. 2015, HHS has asked for an increase in the central providers running 20% to 30%. There's a lot of buzz around this. Any willing provider legislation by the states and one of your competitors saw pressure of -- or backlash, if you will, for making some providers exit their networks. So just wanted to get a sense for, is this just because the pendulum has swung too far and the regulators are trying to get it in the middle? Or do you see that impacting your ability to generate a positive contribution from exchanges in '15 and then withstand the additional pressure on Medicare in 2015 on margins?

Mark T. Bertolini

Yes. I think, Ana, what you're hearing now, seeing now, is largely political posturing around the Affordable Care Act and all of its various pieces. And so I think that is going to be, and I think we talked about it as the next big thing, will be the dock shock as people realize the kind of networks that are in place and the impact that making the more affordable product in the marketplace available would require different kind of network models, is now coming to fruition as people actually access the system. So I think we're going to hear a lot about this over the next 6 months. I think it's going to be part of the dialogue as we move forward in ways to improve the Affordable Care Act. I can tell you that we do pay a lot of attention to it because it does impact pricing, but our pricing that we will submit for May relative to the public exchanges, and in June, for Medicare, will be very specific about the networks that we will include in that pricing.

Ana Gupte - Leerink Swann LLC, Research Division

So just to close that out then, in 2015, would you say that you would change your negative assumption on margins for exchanges? And for Medicare, given your baseline was impacted by some very specific items in '13, in '15, do you have a better likelihood of keeping your margins flat over the whole year for Medicare?

Mark T. Bertolini

So let me take public exchanges first. There are a lot of moving parts in public exchanges. We don't know the risk pool we have today. We don't know keep -- what will happen with keep what you have. I mean, there's some talk out there to have keep what you have continue for 3 more years. So all of this has to come into play and get settled down before May 15. It's part of the data and the answers we need to have in order to feel confident in participating in public exchanges in 2015. So all of that's on the table and we're working through that. So I can't say with any confidence where margins for the public exchanges will be next year given all the moving parts and, particularly, since we don't know what we have for 2014 yet. As it relates to Medicare, we always view a cascading set of opportunities in addressing the funding gap on Medicare. First, it's what can we do to the provider network, and we haven't had any pushback in them in the changes we've made for 2014. Second, what do we do about care management and disease management and getting people better cared for inside the system and followed up when they're not in the hospital any longer? Third is what do we do about our own SG&A? How do we make our system more efficient, and we make strides there every year. And then fourth, what do we do to impact benefits and/or premiums? The last is pulling out of markets, which we view as an option that's not very palatable, but is always on the table and will particularly be on the table in 2015. So given the funding cuts we saw in '14, for '14 we are expecting somewhere less than 600 basis points to solve for in 2015. We hope it's a lot less than that's because depending on how large that cut is, we'll pull all of those levers trying to solve the funding gap, and to the degree we are not successful in 2014, that will only put more pressure on those levers in 2015. So more to come on that. We're working very collaboratively with the administration, with CMS on the rate letter coming out in February -- February 20, 21. And we expect to be very involved and have been very involved in making sure that nothing bad happens to the beneficiaries of Medicare, but more importantly to the importance of the program as it moves forward.

Shawn M. Guertin

Ana, the one thing that I would add, too, just more logistically. I mean, literally, since the notice came out on '14, we have had a work plan that encompassed both '14 and '15 and we have been at that, as you would expect. So we are managing the business and looking at all the levers that Mark described, assuming that the 600 basis point plus or minus cut is coming.

Operator

At this time, we'll go back to Christine Arnold from Cowen.

Christine Arnold - Cowen and Company, LLC, Research Division

Sorry. If I try and pick up the phone -- I'm in a hotel, it just dies. Medicare Advantage, you had about 200 basis points of headwind in '14 that you -- or '13 that you thought you've bid and corrected for in '14. Is that still about 200 basis points? Or did that move in terms of the headwind in '13 that goes away with the bidding?

Shawn M. Guertin

Certainly, the 200 plus or minus is the correct amount for the pressures. Again, whether that goes away, I think, is frankly wrapped up in the bigger question that we have about solving for the overall funding gap. Certainly, we feel like we put the changes through those products to get at that, but again, there's a lot of bigger swing items going on. The one thing I would say as it pertains to PDP is when you -- when we look at our membership, it's likely that, that membership will be down 500,000 to 600,000 members, and so clearly, we have had an impact based on the changes that we put into the problematic PDP products in terms of the membership.

Christine Arnold - Cowen and Company, LLC, Research Division

So as we think about kind of earnings year-over-year in your Medicare book, you have said that you expected kind of MA to have flat pretax margin but after-tax could be down. Now you've got more membership than you expected in MA, less in PDP, but PDP is lower PMPM. Is it possible to think to a profit target, kind of after-tax for the Medicare book, or is that too granular?

Shawn M. Guertin

I think it's too granular at this point. I think we need to have more insight sort of into the new membership, as well, again, as all of the fixes that we have tried to put in place to solve for the funding gap.

Christine Arnold - Cowen and Company, LLC, Research Division

So you're still targeting for an MA of flat pretax margin but down after-tax?

Shawn M. Guertin

Yes, that would still be our target.

Operator

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

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

I just wanted to ask about the cash flow to the parent. It sounds like the cash flow's down a little bit this year because of some of the revenue growth. But you specifically highlighted capital deployment as something in '15 that's going to help the growth improve off of what you're showing in 2014. Just wanted to see if there was a sense of what that kind of normalized cash flow to the parent might normally be. And if there was anything in particular around the commentary on 2015, whether it's just that your balance sheet and cash flow will be better and that's why you specifically highlighted that, or whether you feel like M&A is going to be a bigger theme in 2015? Any color there?

Shawn M. Guertin

Kevin, you're right. I mean, growth is one of the bigger drivers of sort of the cash flow to the parent, and the level of growth we see in 2015 will have an impact on what comes to the parent. I would point out, though, that even with the decreased subsidiary dividends, we are maintaining our existing guidance of $1.2 billion to the parent this year, and I think we would stand by our sort of run rate view that we can still do at least $1 billion going forward.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

And as far as that 2015 number, is that -- would you think that would be dramatically different than the 2014 number indiscernible] to think about it.

Shawn M. Guertin

Again, the $1 billion isn't necessarily a 2015 number specifically. It's what we think this business can produce sort of in the near-term. And again, without understanding the volume of the business that we project for 2015, I wouldn't want to speculate on a precise number there.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Okay. And then just as far as the capital deployment commentary for 2015 earnings growth, is that just kind of commentary saying you will probably buy back $1 billion of stock every year, or was there something more specific about using that capital for growth in M&A?

Shawn M. Guertin

No. I'll let Mark talk about the M&A one, but yes, they did. The $1 billion, I think that is exactly what we're saying that, that we will likely have $1 billion to repurchase shares in 2015.

Mark T. Bertolini

And the competing opportunity for that, Kevin, is that whether or not we will have other opportunities to invest in. So as we move through 2014 and we get through this, what I would characterize as a difficult year, and we execute against our plan, our expectation is, is that others may not execute as well and that we would be prepared to step into potential opportunities, consolidate in 2015. We have the balance sheet and we have the cash flow to be able to make that happen should the opportunity arise. Until early 2015, we're probably going to be largely defensive in our approach to M&A other than for what I would consider to be smaller technology kind of deals that will help us on -- in other areas of our business like ACOs or exchanges.

Operator

Will hear next from Carl McDonald with Citigroup.

Carl R. McDonald - Citigroup Inc, Research Division

On the Medicare loss ratio, with it being stable sequentially in the fourth quarter, did we not see the normal seasonal improvement in the PDP loss ratio? Or did the Medicare Advantage loss ratio deteriorate sequentially?

Shawn M. Guertin

No, Carl, you're exactly right. With the issues that we had on the specific PDP products this year, we did not see near the seasonal dip in the MBR that we've seen in prior years. And in fact, when you look at that PDP loss ratio where we had the problem, the aggregate loss ratio for that actually isn't all that different than the total loss ratio we booked from the quarter, so there really wasn't the effect this year of that getting pulled down.

Operator

Moving next to Peter Costa from Wells Fargo Securities.

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

I'm going to try one more time on the Medicare loss ratio here, guys. You have a guidance range of 200 basis points on your Medicare on your Government loss ratio for 2014, which a month ago we could understand that because you weren't sure about the premium tax, you weren't so sure about what was going to happen with your fixes to the 2 groups. We now know -- the underperforming groups that you had last year, we now know that you're getting most of the premium tax carried forward into the next year or paid by the states, we now know that the answer to 1 of those 2 groups, at least, was that those memberships -- that membership is gone. Can you describe why there's still a 200 basis point range in your guidance and what are the things driving that?

Mark T. Bertolini

The major thing driving it, Peter, is an 800 basis point issue of solving for funding gap for 2014, and we want to see evidence of it. We want to see the risk scores on the new membership we have, which we feel optimistic about now. And until we get all of that in the hopper, I think by the end of the first quarter, we'll have a much tighter range around that number, but we have to see some real movement and execution against our 800 basis point solve for the funding gap, of which some of the fixes you just mentioned go a ways toward helping us have that happen.

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

Can you describe how much of the Part D membership going away is going to help you next year?

Mark T. Bertolini

It helps us from the standpoint of the loss ratio we had on the PDP, but we also have a lot fewer members. So it's not a complete solve for what we saw a negative in 2013 coming through in 2014 because we have less membership there. Medicare Advantage, we're still settling out. But I think we'll have much more in the next 6 weeks to 8 weeks.

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

Okay. Then lastly, there's been some at the CMS and MedPAC about changing the way group MA bids work. You guys are really the biggest player in group MA. Can you talk about what those changes are in terms of using sort of an industry average bid and what your response has been? I know you've talked about using PPOs as opposed to HMO for the key criteria for group MA bids. But can you describe what that pressure is and whether you think that's going to happen in 2015 or not?

Mark T. Bertolini

Well, our group MA payment versus fee-for-service is 103% versus the industry average of 109 so we think the impact is less for us. In addition, a large part of the population we have covered under group MA are unions and municipalities and governments, and so I think their involvement in having an appropriate program for their enrollees is going to help us maintain that program. But in the end analysis, we'll have to work with our clients to solve any gaps that arise as a result of this, but our difference is not as large as the industry's.

Operator

We'll hear next from Sarah James from Wedbush.

Sarah James - Wedbush Securities Inc., Research Division

Aetna's footprint is among the highest overlap with states, allowing the non-ACA-compliant plans to continue, so I was wondering if you could speak to whether or not the proposed updates to the 3Rs related to this are enough to offset and put you back on a similar playing field as when you first priced exchange products?

Shawn M. Guertin

Again, Sarah it's hard. Certainly, some of the positive changes will be positive contributors to that. But again, without knowing more about the risk profile and the experience of this initial set of membership, I wouldn't want to go as far as that we could get all the way back to any particular number. We just need to know more about this population. We certainly think the 3Rs are an intrinsic part of the long-term, frankly, viability of this program and we certainly know that the administration is there as well.

Mark T. Bertolini

And again, 3% of our revenues and less than 1% of our profit.

Sarah James - Wedbush Securities Inc., Research Division

Okay. And then I wanted to clarify an earlier comment. You mentioned an increase on outpatient to mid to high-single digits, to now, high-single digits. So is that an uptick driven by successfully managing people from using inpatient to outpatient? Or is that new demand coming into the system?

Shawn M. Guertin

That certainly is part of it. As you know, our assumption about the uptick is a bit of a preemptive one where we are not seeing that yet. So there certainly is an embedded assumption of increased utilization. But the ongoing shift from inpatient settings to outpatient settings is certainly a part of that overall trend.

Sarah James - Wedbush Securities Inc., Research Division

Is that the majority driver of that shift?

Shawn M. Guertin

I wouldn't say it's the majority.

Operator

Moving onto Scott Fidel from Deutsche Bank.

Scott J. Fidel - Deutsche Bank AG, Research Division

Just interested if you can update us on what percentage of your Small Group book is now on the ACA-compliant plans and how much of that you'll need to complete in 2015? And just on a separate topic, we'd just be interested if you can give us your thoughts on how maybe some of the extreme weather might be affecting utilization in the first quarter, particularly as we think about Aetna's pretty high exposure to the markets like the Northeast.

Shawn M. Guertin

Scott, I don't know the exact number. I would say those are phasing over. So given that Small Group, renewals are equally distributed generally throughout the year. I would certainly think it's the minority of our Small Group plans have converted at this particular stage. Again, it's too -- it's sort of tool real-time to make that call about this year. Clearly, in the past, when we've had various weather events that have impacted some of our markets, we have seen short-term favorability as a result of that event. But again, no real commentary at this stage on what we've seen early this year.

Operator

We'll will hear next from Tom Carroll from Stifel.

Thomas A. Carroll - Stifel, Nicolaus & Co., Inc., Research Division

So just to clarify a couple of things, Mark, on your private exchange commentary. The 90,000 ASC lives that shifted, they shifted away from Aetna or from an ASC arrangement to an Aetna private exchange?

Mark T. Bertolini

They shifted away from Aetna into the private exchange. Now we got some of those members back and 2/3 of them were -- on the whole population, 2/3 of the 130,000 we got back were insured.

Thomas A. Carroll - Stifel, Nicolaus & Co., Inc., Research Division

Okay, got it. Got that. And then Shawn, just would you mind repeating what you said about the Medicaid enrollment for 2014?

Shawn M. Guertin

I'm sorry, I'm not -- in enrollment, I don't recall making a comment about -- oh, are you talking about my prepared remarks?

Thomas A. Carroll - Stifel, Nicolaus & Co., Inc., Research Division

Yes.

Shawn M. Guertin

Okay, sorry.

Thomas A. Carroll - Stifel, Nicolaus & Co., Inc., Research Division

You referred to 125,000 ASC California customers. Was that related to Medicaid?

Shawn M. Guertin

Yes. So Medicaid membership will be down, and again, the biggest driving piece of that is the exit from a low-revenue ASC-type contract in California, which would account for 125,000 lives.

Operator

Your last question today will come from Dave Windley from Jefferies.

David H. Windley - Jefferies LLC, Research Division

Wanted to ask about your Small Group margin included in your 2014 guidance? As you pointed out several times on the call, the individual profitability had gotten quite small, I think in part because of some investment. I'm wondering if similar investment is being made in Small Group in advance of that exchange opportunity opening up in 2015. Just wanted to gauge how much Small Group is contributing in '14.

Shawn M. Guertin

As we've talked about, our Small Group business certainly isn't one that I would say has produced extraordinary levels of margin. It has generally been in sort of the low to mid-single digits in the past, and that's largely where we see it performing in 2014.

David H. Windley - Jefferies LLC, Research Division

Okay. And then, would your -- I guess, how does that compare to your ongoing expectation for margin from that book to that client segment?

Shawn M. Guertin

Again, I don't think it's all that different from margins that, ultimately, what we would see in this business.

David H. Windley - Jefferies LLC, Research Division

Okay. And then quick last question on, I believe from your investor day and guidance, some of the membership opportunities, perhaps, like in duals, that you have coming in over the course of '14 were not in guidance. Do I remember that correctly? And what are your views on timing and rates on duals?

Shawn M. Guertin

There was an element of the dual contracts in our guiding -- guidance. It was only a couple of hundred million plus or minus of revenue, but really, we didn't really assume any meaningful profit contribution from that business at all. There's been a couple of delays on the programs. But again, from a bottom-line impact, that won't have much impact on us in 2014 as we weren't banking on a lot from that business anyway, initially.

Thomas F. Cowhey

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

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