Humana Inc. Q1 2010 Earnings Call Transcript

Apr.26.10 | About: Humana Inc. (HUM)

Humana Inc. (NYSE:HUM)

Q1 2010 Earnings Call

April 26, 2010 9:00 am ET

Executives

Regina Nethery – Vice President of Investor Relations

Michael B. McCallister – President and Chief Executive Officer

James H. Bloem – Senior Vice President and Chief Financial Officer

James E. Murray – Chief Operating Officer

Analysts

Matthew Borsch – Goldman Sachs

Josh Raskin – Barclays Capital

Christine Arnold – Cowen and Company

Scott Fidel – Deutsche Bank

Kevin Fischbeck – BofA Merrill Lynch

John Rex – JP Morgan

Ana Gupte – Sanford Bernstein

Justin Lake – UBS

Doug Simpson – Morgan Stanley

Operator

Good morning. My name is Andrea, and I will be your conference operator today. At this time, I would like to welcome everyone to the Humana first quarter 2010 earnings release conference call. (Operator Instructions) I would now like to turn the call over to our host, Ms. Regina Nethery, Vice President of Investor Relations. Please go ahead.

Regina Nethery

Good morning. Thank you for joining us. In a moment, Mike McCallister, Humana's President and Chief Executive Officer, and Jim Bloem, Senior Vice President and Chief Financial Officer, will briefly discuss highlights from our first quarter 2010 results as well as comment on our earnings outlook.

Following these prepared remarks, we will open up the lines for a question-and-answer session with industry analysts. Joining Mike and Jim for the Q and A session will be Jim Murray, our Chief Operating Officer, and Chris Todoroff, Senior Vice President and General Counsel.

We encourage the investing public and media to listen in to both management's prepared remarks and the related Q and A with analysts. This call is being recorded for replay purposes. That replay will be available on the investor relations page of Humana's website, humana.com, later today. This call is also being simulcast via the Internet along with a virtual slide presentation. For those of you who have company firewall issues and cannot access the live presentation, an adobe version of the slides has been posted to the investor relations section of Humana's website.

Before we begin our discussion, I need to cover a few other items. First, our cautionary statement. Certain of the matters discussed in this conference call are forward looking and involve a number of risks and uncertainties. Actual results could differ materially. Investors are advised to read the detailed risk factors discussed in this morning's press release as well as in our most recent filings with the Securities and Exchange Commission.

Today's press release and other historical financial news releases are available on our investor relations website. All of our SEC filings are also available via the investor relations page of Humana's website as well as on the SEC's website. Finally, any references made to earnings per share, or EPS, in this morning's call refer to diluted earnings per common share. With that, I will turn the call over to Mike McCallister.

Michael McCallister

Good morning, everyone, and thank you for joining us. Today I will comment briefly on our first quarter results and then speak to why we believe that change brings opportunity – in our case an opportunity to grow, not only in existing areas like Medicare Advantage, despite the challenges of the new reform law, but also in new products and services around our strategy of helping all consumers achieve lifelong well being.

We have long operated in a challenging environment and believe our focus on the consumer has been the driver of our success in Medicare Advantage. Going forward, this same focus exemplified in our perfect service initiative, our member guidance and our wellness programs will remain in Medicare Advantage and will be increasingly evident in our commercial products.

Well being includes our health insurance business, but also embraces emerging opportunities in consumer rewards, financial protection products, aging in place for seniors, and other areas you will hear more about throughout the year.

Let me begin by offering a summary of the first quarter's results and operational highlights from our Commercial and Government Segments. Today Humana reported earnings per share of $1.52 for the first quarter, an increase of $0.30 over the prior year's first quarter results of $1.22 per share.

This quarter's results are significantly higher than our previous forecast of $1.10 to $1.20, reflecting both a higher-than-anticipated favorable prior period reserve development and a higher effective tax rate. Were it not for these items, our results would have been near the top end of our previous guidance. Jim will elaborate more on the quarter in a few moments as part of his comments.

Moving now to our business operations, let's start with our Commercial Segment. First, we've raised our 2010 commercial pretext guidance to $150 million to $175 million, primarily the result of favorable prior period development of $14 million. Additionally, we saw favorable progress on three important fronts: A leaner administrative cost structure, accelerated growth in our ancillary and specialty businesses, and the beneficial effects of taking premium actions in 2009.

At March 31, 2010, our specialty membership stood at 7.2 million compared to 6.5 million special members at March 31, 2009, an increase of 11% year-over-year. Overall commercial medical membership at the end of the quarter was 3.3 million compared to 3.5 million a year ago, reflecting the general economy.

Turning now to our Government Segment, I will start with our TRICARE business. Our Humana military associates continue to deliver exceptional service to our TRICARE beneficiaries. Relative to our contract, there's been no further word from the Department of Defense since the end of December. It was then that the DOD notified us it would be taking action in response to our protest being upheld by the Government Accountability Office, though we still don't know the type of action to be taken. Until we hear otherwise, we continue to anticipate that this contract will end on March 31, 2011.

Moving to our Medicare business, we experienced a successful open enrollment period for Medicare Advantage and followed that up with the execution of an alliance with Cigna this month, which we believe provides meaningful opportunity for expanding our group Medicare presence going forward.

Progress around our 15% Solution helped drive the higher-than-anticipated favorable prior period development we recognized in earnings this quarter. As we have said in the past, we believe our 15% Solution allows the economic value we deliver to seniors to remain strong during periods of reduced government funding. We believe members continue to choose our plans due to the better value proposition they provide compared to their alternatives.

Further, our network plans, which have the most compelling value proposition, continue to gain in popularity with approximately 72% of our April 2010 fully insured membership in network-based products. This speaks to the work our network and product development teams have done over the past several years to insure our members have an offering that includes an ample and effective provider network.

Many of those on this call have asked about our risk of transitioning our 480,000 private fee for service members throughout the U.S. as we look to 2011. We believe the same network provider development team has done a great job of positioning us well by developing the provider networks required to protect our private fee for service plans in nearly all of the country.

By the start of 2011, we expect to offer network-based products to approximately 90% of our current private fee for service membership. Approximately half of the remaining 10% reside in counties unaffected in 2011, while the remaining 5%, or 22,000 members, will be at risk. These members will return to traditional Medicare, but will need a medi-gap and Part D plan, both available from Humana. We anticipate keeping many of these members in other lines of business.

Our positioning for 2011 is a testament to our ability to strategically plan for changes and then execute on the course of action necessary to succeed in spite of volatile environment. You have heard me say on previous calls that we have been preparing for health reform over several years. Now let me go into detail on how we prepared in one of the most important parts of our business, Medicare Advantage.

Over time, we anticipate Humana will be on a short list of national footprint participants in Medicare Advantage that have the requisite size and scale to adjust to a changed payment environment. Beyond our size, our breadth and depth of operational experience has been a key element to our many year of Medicare success, most of which were marked by payment volatility.

Our team is highly experienced from the middle management to senior executive level. It is this longevity and effectiveness that has shown its mettle in successfully overcoming a variety of challenges while more than tripling the size of the company through largely organic growth over the last ten years.

Our 15% Solution, which represents our commitment to provide coverage and services to our Medicare Advantage members at a cost 15% less than what it costs traditional Medicare with better quality, is the best way to illustrate our preparation. The significant element of our 15% Solution is our ability to engage the member.

As this slide shows, we are able to achieve significant results by focusing our engagement programs most heavily on the 5% of our membership responsible for 40% of our costs. This is why working closely with a small number of members produces disproportionately positive results.

For example, Humana Cares is our complex care management program which combines home visits, telephonic support, and, importantly, community resources for our most vulnerable Medicare members. It significantly reduces costly hospital admissions and other cost and quality benefits. The program is expected to double its enrollment and cover nearly 50,000 members by year's end.

Historically, Humana Cares has produced savings of $4 for every $1 invested in infrastructure. When you consider that the costliest 50,000 Medicare Advantage members account for over $3.5 billion in annual medical costs, it's clear why we're confident in the 15% Solution. Similarly, other programs like integrated medical and behavioral health, medication therapy management, and disease-specific programs are also expected to experience significant enrollment gains this year.

By year's end, we project approximately 200,000 of our Medicare members, or between 10% and 11%, will be enrolled in care management programs that have historically produced returns from $2 to $8 for every $1 invested.

Most importantly, our clinical care infrastructure development continues as planned, helping to drive us closer to seamless integration of clinical and administrative services for our members. We use data analytics to target the members most in need of the programs like those I just described.

These analytics then combine with [CIRA], our clinical integration guidance system, utilization management processes, and support and care programs which include important integration with community resources, resulting in improved health metrics which in turn lower utilization benefiting both the member and the company.

Now let me show you how all this comes together. Many of the analysts on this call have asked how our membership breaks down in terms of the Medicare fee for service cost quartiles spelled out in the new health insurance law. As you will see from this slide, we expect to receive payment rates between 95% and 100% of traditional fee for service rates or approximately 64% of our current membership under the new payment structure.

Notably, as the pie charts on slide 9 show, over 70% of our members are already at least 10% below traditional Medicare costs. Given this good progress, we believe the takeaway is that we are very well positioned to have our costs at least 15% below the traditional Medicare programs cost by 2014.

A broader perspective in a backward glance also yield the observation that Humana has successfully mastered several other periods of Medicare payment restraints, most notably by making strategic market-by-market decisions in the wake of the Balanced Budget Act of 1997. We balanced annual reductions in our Medicare benefit ratio with a sustained value proposition, thus leaving us poised to take maximum advantage of the Medicare modernization act when it passed in 2003.

In summary, we have successfully anticipated the new Medicare Advantage payment environment and ways to focus on Medicare beneficiaries by adding and expanding provider networks, increased product offerings, and developing member-focused coordinated care services that distinguish Medicare Advantage from traditional Medicare.

With our singular focus on delivering to seniors we serve with a value above the traditional Medicare program and with the coming age wave of baby boomers turning 65, we believe our Medicare business will not only remain solid but will continue to grow. Together with stabilization in our commercial operations and growth in ancillary and specialty products, and a strong balance sheet, we anticipate continued success in 2011 and beyond.

As our results this quarter and our guidance for the remainder of 2010 indicate, we are ready for the post reform world, a world where we believe (1) margins will be under pressure in light of the medical expense ratio requirements; (2) only major competitors will have the long-term scale and strength to thrive in an atmosphere of margin compression; (3) our enhanced well being strategy will open doors to new markets and revenue sources as well as adjacent business opportunities, producing a larger company, less reliant on underwriting profits; (4) a relentless focus on cost savings on both the medical and the administrative side will keep us more than competitive; and (5) significant opportunities do remain.

Change brings both challenges and opportunities. The challenges of the new insurance market reforms are substantial; but we feel we've demonstrated our ability to overcome substantial challenges before, and we are confident we will be able to do it again. With that, I will turn the call over to Jim Bloem.

James Bloem

Thanks, Mike, and good morning everyone. Today we reported $1.52 in earnings per share for the first quarter and raised our full year earnings per share guidance to a range of $5.55 to $5.65. Let's start by reviewing the three primary drivers of today's changes in earnings per share, both for the quarter and for the full year.

First and foremost, we experienced higher-than-anticipated favorable claims development from prior year's estimates. As we have discussed in the past, our reserving practice is to consistently recognize the best point estimate within a level of confidence required by actuarial standards. When we recognize a release of claim reserves that's not in the ordinary course of business, we disclose the amount.

For the first quarter, we estimate that amount to be $100 million or $0.37 a share. The reserve table on page S11 of this morning's press release shows approximately $308 million of favorable development since December 31, 2009. This is a greater amount than we had expected. Again, about $100 million of this amount is not expected to recur in future periods; and, accordingly, it benefited the first quarter by $0.37 a share.

There were several factors that resulted in the better-than-anticipated reserve development. The primary factor was claims processing improvements, particularly in Medicare private fee for service, where we continually are focused on eliminating waste and provider overbillings. Additionally, but to a lesser extent, fourth quarter 2009 utilization played out slightly better than originally estimated for both our Medicare and commercial businesses.

Looking back at 2009, after giving effect to the claims runout, we see both Medicare and commercial medical costs trends being about 20 basis points better than previously estimated – not a huge change, but moving in the right direction. Accordingly, we haven't projected forward much of these minor cost trends improvements since it's still early in the year.

After favorable claims development, the second item impacting our 2010 first quarter earnings per share, both in the quarter and for the full year, was the increase in our effective income tax rate. The increase primarily is caused by the nondeductibility of certain items as a result of the new tax reform law.

We now expect an effective income tax rate of between 37% and 37.5% for the full year, an increase of about 125 basis points at the midpoint from our previous estimate. This increase unfavorably impacted the quarter by about $0.04 per share and the full year forecast by about $0.10 a share.

Third and lastly, we had a few other items that improved incrementally, driving a $0.04 per share of higher-than-expected earnings in the first quarter and $0.08 per share for the full year. No single item was all that significant, but to that I will mention the increase in Medicare Advantage membership, which is tracking slightly ahead of plan, and increased investment income where we modestly increased the related forecast.

Turning now to selling, general, and administrative expenses, we continue to realign both our cost structure and organizational competencies for the future. In February, we announced 2,500 position eliminations by the end of this year with a net workforce reduction of 1,400 positions after giving effect to another 1,100 positions we are adding to support growth areas of the company.

The position eliminations are occurring primarily through attrition, process efficiencies, and outsourcing. As you can see from the slide, our full-time equivalent positions, or FTEs, have been tracking down for over a year. While difficult for our associates, we continue to simultaneously create employment opportunities to help us prepare for the future.

Moving to the first milestone on a continuing journey to achieve a leaner administrative cost structure, we remain comfortable with both the $100 million of savings we reflected in our 2010 earnings per share guidance and the at least $200 million of run rate savings to be achieved by the beginning of 2011.

Turning next to operating cash flows, we enjoyed strong first quarter operating cash flows of $755 million which differed from the relatively weak cash flows we experienced in the first quarter of each of the last two years. As the slide indicates, there are four factors associated with this year's $709 million of improved first quarter cash flows.

The largest contributor to the stronger operating cash flows was the addition of over 200,000 more Medicare Advantage members since the end of the year than in the first quarter of 2009. For this increase in Medicare Advantage membership, we received the full quarter's premium revenues; but due to initial claims payment lag that normally occurs from the date services are rendered to when the resultant claims are paid, we did not pay a full quarter's level of medical claims.

Additionally, 2009's first quarter was unfavorably impacted by significantly greater PDP membership losses and the corresponding claims runoff. The total of these two items was $338 million of the $709 million difference.

Another item favorably impacting our cash flows was the temporary increase in claims inventories of approximately $160 million. This increase also primarily resulted from the growth in Medicare Advantage membership and the accompanying provider learning curve which occurs when a member switches from traditional Medicare to Medicare Advantage.

Lastly, the remainder of the increase in year-over-year cash flows improvement resulted from a combination of an increase in net income, income tax differences, and normal working capital fluctuations.

Looking out to the full year now, we have increased our cash flows from operations guidance range to $1.2 billion to $1.4 billion due to the increased visibility into the remainder of the year and our increased full year earnings guidance.

Finally, with respect to capital deployment and liquidity, we continue to both have and conserve ample liquidity and capital. This enhances our ability to continue to compete effectively in the environment that we are now approaching. We also carry significant levels of aggregate excess statutory capital in surplus in our state regulated operating subsidiaries. Cash and investments held at the parent were approximately $730 million at March 31, 2010.

As in prior years, dividends from the subsidiaries to the parent are expected to be declared and paid after the individual state reports are filed and discussed with the various departments of insurance and credit rating agencies. Those discussions are going well and are anticipated to be completed by June 30. We expect to discuss the results in our second quarter earnings conference call in early August.

To conclude, we are pleased with both our overall and operating results for the first quarter of 2010. We are confident that our updated 2010 guidance range of $5.55 to $5.65 in earnings per share reflects our organizational experience as well as our continued disciplined and intentional approach to the current and coming operating environment.

As we move into the middle of 2010, we believe that we are both able to help our members face the uncertainty that comes with the coming changes in our health care system as well as financially strong and liquid. Accordingly, we are well positioned for continued success in providing both strong satisfaction to our members and solid operating results to our owners.

With that, we will open the phone lines for questions. We request that each caller ask only two questions in fairness for those still waiting in the queue. Operator, will you please introduce the first caller?

Question-and-Answer Session

Operator

Your first question comes from Matthew Borsch – Goldman Sachs.

Matthew Borsch – Goldman Sachs

Thank you. I was wondering if you could just remind us what the tax rate, higher tax rate issue relates to? I know you said health reform, and maybe I missed it, but what component specifically is that driven by?

James Bloem

Matthew, the principal reason is the fact that executive compensation under the new law is limited to $500,000 per year for years beginning January 1, 2013. However, it's on all amounts that are earned after 12/31/2009. Accordingly, in this quarter we had to do a catch-up and for this year we will then be going forward on the equity grants that are outstanding and that are expected to be exercised during 2013 and beyond.

You remember that the compensation of $500,000 also includes the proceeds of such exercises or the vesting of such grants. Basically, the health insurance industry is going to be taxed much like those companies who receive TARP funds.

Matthew Borsch – Goldman Sachs

I got it. Thank you. Also on the topic of health reform but on a different angle, as we try to look ahead to the yet-to-be-published regulations on minimum medical cost ratios, is it fair to break down your commercial risk membership as approximately 1 million members in the small group under 100 and individual category and the remainder being what would be defined as large group?

Any thoughts you can offer in terms of your current ratio, sort of 80 to 81 for this year and the same last year, how that might break out at all between the group sizes or how you expect to tackle this regulation which admittedly we don't exactly how it's going to apply?

James Murray

This is Jim Murray. The numbers that you referenced are pretty close, about 370,000 individual members and around 625 to 650 small group [to do] 100 case sizes. The MERs that we experienced for those different lines of business, as you might expect, vary. When we look at the small group medical expense ratio being 80% in the regulations, we feel pretty comfortable that will be fairly insignificant in terms of exposure for us. We are running fairly close to that number now.

The large group issue is one that we feel very comfortable with. The area that we're going to have some issue with with the 80% is on our individual business. That runs below that. Right now, obviously, the guidance that we're getting in terms of how the MERs are going to be calculated has yet to be determined. We don't know whether it's going to be based upon states or legal subsidiaries or consolidated, and we don't know how expenses and revenues are going to be included in that.

So there's lots of stuff that has to come out over the next several weeks and months, but we're doing lots of things to prepare ourselves for that and trying come up with tactics to operate in that kind of an environment.

Michael McCallister

Let me follow that up. Might as well preempt a couple of questions I am sure we're going to get. We have not changed any business practices yet relative to the individual business because of that MLR requirement. We are in the process of assessing exactly what that's going to look like. We have a fair amount of flexibility.

I can tell you directionally it's going to require getting your admin expenses very, very low. So that brings up all sorts of questions around scale and distribution models and all those sorts of things which are still under review. We have not changed anything relative to that marketplace yet.

Matthew Borsch – Goldman Sachs

One last follow up, when you say you think you are probably okay on the small group and large group, am I correct that assumes of course that or am I correct that assumes that the regulation will be defined as a consolidated entity? Wouldn't it be more complicated if it's defined at the state or insurance subsidiary level?

James Murray

When I referenced that for small group and large group, I was actually thinking it would be defined at a much more granular level. There are obviously some states where we have some issues, but we don't think that the impact is significant for the smaller and large group business.

Michael McCallister

You are right. The smaller the unit, the more variability there's going to be in all this.

Operator

(Operator Instructions) Your next question comes from Josh Raskin – Barclays Capital.

Josh Raskin – Barclays Capital

Good morning. Very helpful, I think, the breakout that you guys gave around the cost relative to the fee for service for your book of business. I guess is there a way to look at that by product as opposed to by county? Your HMOs versus your PPOs, where would you determine your cost structure versus traditional fee for service program?

Michael McCallister

I will start, and Jim will probably jump in here. At the end of the day, directionally, the HMO is always the most cost effective model. It happens to be that as you look at some of those pie charts, the HMO overlay with the lower paid locations is pretty good. It doesn't line up too poorly relative to how we're paid versus the type of products we have.

I think the opportunity and the challenge longer term, this is where we're going to try to outperform everyone else in this business, is to bring as much of that really disciplined, integrated medical management into the other product lines over time that we have in the HMOs.

The second piece of that is to continue to expand HMO capabilities, so we have lot of new locations and states and counties going forward where we're going to be really pushing the idea of HMO management. In some way, this is a little bit back to the future relative to Medicare managed care. I think we're going to see more HMO, but I think there's still an opportunity to provide a great deal of clinical management and productivity in those other product lines.

Josh Raskin – Barclays Capital

Thank you. I guess I was looking at your 15% Solution. Just with the understanding that you guys are moving towards that benchmark, you showed a slide that said 744,000 lives were already sort of attaining that solution 15% or better relative to fee for service, another 500,000 were somewhere between 10% and 15% below fee for service. Then there's sort of 479,000 that have progress to go that are less than 10%.

Is it simply, okay, 480,000, that's kind of the private fee for service, that's where you got a lot of room to go? Then sort of the break up between the HMOs and the PPOs is where I am curious relative to that necessity to get down to that 15% Solution.

James Murray

As you might expect, and just to reiterate exactly what Mike said, we obviously do much better with the HMO model. I will reiterate what he said about that would likely be the model of the future in terms of the low-cost structure.

You can rest assured that on a regular basis we study not only county but also how we're doing in each of the three product lines. Private fee for service is doing the least in terms of solution towards the 15% Solution; but as we sit here today, we're extremely positive about what we've been able to accomplish, not only in the HMO, but also in the PPO because, as we've told you in the past, our long-stated goal is to migrate all of our private fee for service members into the network-based options which include PPO and HMO.

We feel very, very good about where we stand relative to our PPO progress towards the 15% Solution. We think that, over time, as we get closer to some of the changes that are going to take place in 2014 with the minimum MERs and our 15% Solution, we feel very good about how we're positioned with both our PPO and our HMO offerings.

Michael McCallister

Strategically, I would go to even a different place. You can make a case for Humana, maybe not for the industry, that the requirement for networks is a positive because it does two things. It nudges the customers towards a network product, which over time will be more cost effective; and it nudges some of our competition to the side. I think the fact that we have spent several years getting ready for the network requirement is going to turn out to be a really good thing.

Josh Raskin – Barclays Capital

Just one quick follow-up on the inventory. What's causing the increase in the inventories to sort of levels we haven't seen before? And any comment on customer service metrics that you have seen while this has occurred?

James Bloem

No. Customer service is fine and the inventories are temporarily increased due to the fact that there was a provider lag basically with new group members who came from other places into our place, into Humana. Those claims didn't really come in until the end of March. Therefore, the inventories increased by 160 or to 5.6 days versus 4.2 days. That's all temporary and it's reversing itself.

James Murray

To your question on customer service, a lot of our claims that come in go first pass 80% to 90%. Although we got the claims in in the latter part of March, we were able to move a lot of them out. At the end of the quarter, we found ourselves with a temporary increase which resolved itself in the month of April.

Operator

Your next question comes from Christine Arnold – Cowen and Company.

Christine Arnold – Cowen and Company

Good morning. Thanks for all the detail and also for breaking out the prior period development. It's real helpful. As we look at Medicare, you grew about 200,000 Medicare Advantage members. Can you give us a sense for how many members are new when we account for the churn?

Then you mentioned that you have got this inventory. You probably worked through a lot of it. Can you just give us a sense or your line of sight on where those trends are coming in for those new members in light of whatever churn you might have seen?

James Murray

For the first quarter, excluding plan-to-plan to changes, individual sales were around 240,000 new members exclusive of the group, which was 190. Terminations were around 200,000. All of those numbers are very close to where we were last year at this time. As we look forward, we feel pretty good about what we see in terms of the rest of the year, we refer to that as the ROY, and our ability to add some nice membership over the remainder of the year.

One of the things that we constantly do here is study claim payments and claim inventories and utilization and claim receipts information. As you might expect, we have studied the heck out of all of that information to get ourselves comfortable that the members that we receive this year don't look any different than our existing base of membership.

We feel very good about the risk profile of the membership that we receive. That includes the new groups that we put on the books. We have done lots of analysis and studied utilization trends and scrips per thousand and days per thousand and feel very good about what we're seeing develop in the first quarter.

Christine Arnold – Cowen and Company

Last quarter you mentioned that you thought the commercial business was looking kind of commodity-like. I kind of sensed you were thinking about changing your commercial strategy. You said you were going to be examining different geographies and products. Could you just elaborate on what you meant?

Michael McCallister

There's a few things we can look at from the reform bill that, I think, give us some look into the future to the extent these exchanges get up and running and become a viable market place. I think the individual business is going to get larger. I think there will be employers dropping coverage and sending people to the exchanges of all sizes. I think it's important for us to get focused on how do we participate in that market when it really becomes effective? And now it's several years away.

But I think the individual market is something that is going to be very interesting going forward. Despite whatever short-term challenges may come from MLR requirements, I think it's a place to be long-term. I think we're positioned well to deal with all that. I have said it forever. I like retail direct to consumer businesses. That's why I like Medicare. That's why I like some of the specialty products, voluntary products, individual health insurance.

Humana has been sort of moving in that direction for a while. I don't see anything in the reform bill that would do anything but say we need to get bigger and better and more aggressive about it. I think the large group fully insured business is always a challenge.

Now, it's possible that the individual health insurance products could become commoditized even more than they are already. It's possible. That's why it's important that we have a broader relationship with the individual. We use the term share of wallet a lot around here these days. We're going to get good at making sure we execute on that idea. Having as many customers as possible in a direct relationship is key, and finding ways to have a much broader relationship with them is the second big component. That's the way we think about it.

Operator

Your next question comes from Scott Fidel – Deutsche Bank.

Scott Fidel – Deutsche Bank

Good morning. First question just looks like the CMS office of the actuary put out a new estimate on health reform just recently and projected that MA enrollment could decline by around 50% due to the reform law. Definitely interested in your thoughts just on the long-term projections around MA enrollment and how you're thinking about how the market adjusts relative to that forecast from the CMS actuary.

Michael McCallister

Two things. Most of those projections rarely ever become accurate when we look back at the results. Everybody has their work to do. I would say that I doubt, and I am pretty confident, there hasn't been a lot of consideration given to the kind of work we just described this morning around getting productivity and better cost effectiveness out of all this, which could materially change the long-term nature of the membership numbers here.

As an individual company, I don't get very excited about those sort of projections because I think there's going to be significant differences in performance inside of the industry among participants. Clearly, I think the business will get pressured by the law. We have said all along we expect consolidation and a lot of smaller players to disappear. We watched it happen during the BBA in the 90s. When times get difficult, people depart. I expect that to happen again.

I have no way of really knowing the accuracy of membership projections at that level over that period of time. I doubt they've taken into account the kind of productivity and the good work that's going to be done to make this a very healthy long-term program.

Scott Fidel – Deutsche Bank

Just had a follow-up question maybe for Jim just on the balance sheet and as a review the health reform law. Just any other changes or adjustments that you think you might need to make because of reform? And one thing I was just thinking about is any type of changes to valuations of goodwill? Just as you review the impact of certain markets because of health reform.

James Bloem

Not at this time. We believe there's still a lot of detail as Mike and Jim mentioned to come out of the health reform law. We will be looking at those as they come out. We test the balance sheet each quarter to look at intangibles, look at goodwill and things like that. Right now, we feel that, aside from the TRICARE goodwill, which we mentioned the last three quarters, we're in good shape. Again, as things become available and more knowledge becomes applicable, then we will continue to look at our carrying values in light of that knowledge.

Operator

Your next question comes from Kevin Fischbeck – BofA Merrill Lynch.

Kevin Fischbeck – BofA Merrill Lynch

Thank you. Those charts in the slide deck were very helpful about the 15% Solution and also the breakout of where your rates are going to be. I guess what I'd like to see is maybe a combination or overlay of those two slides.

If you're 5% below fee for service in a place where you are going to be getting 95% of fee for service, that's different than 5% below fee for service where you are going to be getting 115% of fee for service rates. Is there any color there? I assume that the numbers kind of match up pretty well that you're farthest below fee for service and [inaudible] below. Any color there about how those two charts might overlap?

Michael McCallister

I doubt that we're ever going to get very granular with that kind of information because I think it's too useful to our competition. I know why you would ask it, because we look at the same exact thing. That is the ultimate question for us.

These broad based numbers are interesting, but you have to get down to the unit level and the county level and this sort of thing to really know where we are. All I can tell you is we do that. This is what we do. This is how we lay out products and prices and approaches and tactics. I am not going to get too granular with it. What you are asking for is the way we think about it and the way we do it.

Kevin Fischbeck – BofA Merrill Lynch

Then I guess if you could maybe talk a little bit about the agreement with Cigna. Generally just talk about kind of why you entered into it, what you're getting out of it, then maybe how we should think about when we might expect to see some membership benefit from that agreement?

Michael McCallister

There are several big things that have been occurring. We talked in the past about the fact that there was a big opportunity in the employer space, but that it appeared that the employers were going to sit on the sidelines until they had clarity around the future of Medicare Advantage so they didn't have to go through more than one disruption with their people. I think that's behind us because we have the bill. We know what we have now. We can assess our ability to meet their needs. That's one piece.

The second piece is that Humana, as you all know, is not a major player in what I would call the large, large company space. Currently our partner, obviously our partner is. This was kind of a nice opportunity where two things came together. The timing around clarity is there, plus we get to marry up two companies that do not really compete in this space head on to the benefit of both of us.

I think we now have an entree that's better than it otherwise would have been into that large space, and I think the large companies are now ready to take a serious look at their opportunity here. That's both from, I've been spending some time with some of these people. They have been hesitant to jump in until they knew what the future looked like. We now know that.

Kevin Fischbeck – BofA Merrill Lynch

So when should we think about this potentially starting to impact? 2011 event?

Michael McCallister

There's likely to be some then. It's a little too early to know. We have only been looking at this for a month, or at least the impact of the bill. Big companies are always hard to predict because they tend to be real inertia bound and slow to move. They've been like that on everything forever. It's a little hard to say. I would be shocked if we don't see some movement in 2011 from getting a lot of doors opened up.

Kevin Fischbeck – BofA Merrill Lynch

Just one quick clarification. The guidance for the PDP membership down 220 from the prior year. I assume that's off of the 12/31 number?

Michael McCallister

Yes. It is.

Kevin Fischbeck – BofA Merrill Lynch

So that's another 200,000 from where we are now?

James Bloem

We're down 10.8 right now. The difference really is, a large part of the difference is a plan that we have taken over from assistance that CMS asked us to do. Those members kind of go in and out. There's about 130,000 of those, and they're expected to leave later in the year.

Kevin Fischbeck – BofA Merrill Lynch

So then you're looking for a kind of core number, another 70,000 or so?

James Bloem

[inaudible]

Operator

Your next question comes from John Rex – JP Morgan.

John Rex – JP Morgan

Thanks. Just first on the Medicare Advantage PMPM. Looked like those were up year-over-year in the queue. I assume a lot of that was member metrics. Can you break out for us what kind of was the all in impact if you look at same member, same store basis on what premiums would have done, thinking about the rate reduction that occurred for 2010?

James Bloem

It is up, John, as you point out, maybe $11 or $12 PMPM, but some of that has to do, the mix is a big part of it because we got a lot of group members as Jim mentioned. Group members have a little bit higher PMPM. I think that's part of the reason. When you look at the mix, I'm not sure exactly how you would come back to the same store. I would say the 5% rate reduction that we have has a much bigger impact if you would exclude what I mentioned about the group rates.

James Murray

The 5% reduction obviously would have a big impact on the same store membership. There might be some offset from risk revenue that we received, but it wouldn't be all that significant. I would suggest that same store, the overall revenue is likely down unless there was some geographic growth, which I don't recall offhand.

James Bloem

There was one other thing. There was obviously higher member premium this year, too.

John Rex – JP Morgan

That was what I was thinking about. How much offset on the member premium, when you kind of look at that same member metric, you're 5% was effectively what? And then the point you raised, I was just trying to also see if there was a unusually high risk adjustor impact also that we had in the quarter.

James Murray

Generally speaking, I think we believe that our average premium went from about $40 PMPM to $50. That's usually worth about 1 percentage point, $10 PMPM. That would have offset a portion of the 5%. I don't recall offhand what the MRA improvement would have been, but I would have thought it would be probably similar to that $10 PMPM that we cut from the member premium. So still a reduction on same store basis.

John Rex – JP Morgan

Then I guess when you were talking about the lower med costs and the later quarters in '09 developing better. I think as you prioritized it, you put the kind of claims processing improvement first as driving the better result. I guess just understanding a bit better there, are you saying that you're just catching more inappropriate coding? In the past this wasn't getting caught and now you have kind of changed the processes so you're catching it? I just want to understand that a little better.

James Bloem

There are a couple things like that. One is the DRG coding validation. That was a part of it. We also made some system improvements that made recoveries easier. We also took a look at things like overnight admissions or admissions or observation and checking how they were billed. Were they billed as inpatient or more appropriately as outpatient? Those were the types of things. You're right. That's the biggest share. I mentioned, and as you mentioned, the 2009 trends did favorably stay as well. But not nearly as much.

James Murray

As Jim went through a lot of those, we characterize those in all of the releases as claims payment improvement practices. Frankly, what we think of on a day-to-day basis is that's a part of our 15% Solution. We are operationalizing that in all the markets that we do business.

John Rex – JP Morgan

When I think about that, if there was kind of some significant improvements there, was that going back? Was the benefit you derived in the 1Q this year then going back throughout all of '09 as you challenged prior assumptions there or was that still kind of typically like very much weighted to just the last quarter or so in '09?

James Bloem

It was more weighted toward the back half of the year, but it did go back. It did go back through the entire year.

John Rex – JP Morgan

Normally when I expect prior period development, say it's 80% coming from the 4Q or something like that. In this case, can you characterize for me how much of that was actually coming from the first half of '09 because of improvement in the claims processes?

James Bloem

I think it's best said the way you said it, that the farther back you go, the less impact it had. But it did go all the way back. Most of it, again, as I mentioned in my remarks, the fourth quarter was really what we looked at and had the biggest impact.

John Rex – JP Morgan

Is there still, as you look at it, how do we assess how much room is left on that also? How much one time and how much, I suppose you are going to say it's an ongoing process, we never stop. I am trying to figure out how we size it.

James Bloem

That's correct. You actually answered the question. It's an ongoing process we look at every quarter. There's a lot of integrity in the process. There's a lot of consistency in the process.

James Murray

The other factor that we have to consider when we're talking about this is the utilization that we anticipated that was going to take place in the fourth quarter that didn't come through. So what we thought about here is see how the rest of this year or the next couple of quarters of this year play out before we claim that it's a run rate improvement. Obviously we would report that as we play the rest of the year out.

John Rex – JP Morgan

Just the last thing, quick one, I apologize if I missed this. On the commercial member attrition, the change in outlook, what was driving that primarily?

James Bloem

We lost a large ASO account. We will lose it on July 1. About 130,000 members.

James Murray

Beside that, nothing else has changed with our commercial guidance.

Operator

Your next question comes from Ana Gupte – Sanford Bernstein.

Ana Gupte – Sanford Bernstein

Thanks. Good morning. The first question I had is on capital deployment towards share buybacks or M&A and how you are thinking about that. Particularly on the M&A side, do you see a focus on bringing your commercial business up to scale or will you just be the largest Medicare Advantage player and make your push towards that? And finally, any interest in getting into the Medicaid space in later reform?

Michael McCallister

I will start with the last, Medicaid. I stopped saying never to that about a year and a half ago. The challenges are still there. It's not at the top of my priorities. I realize that market is going to grow. Some people are getting excited about it.

As you watch state budgets and if you think about the implications of the money that came out of Washington to prop up that program this year and when that's going to end, I have to believe what I have said all along is still true, state budgets are challenged and they spend all their money on education and Medicaid. It's kind of hard to find a positive scenario there.

I am not all that excited about it still. I have said all along if we ever do it, it will be big because we're going to need a platform and infrastructure and people that really know that business. News at 11.

Relative to the company, I think the company has always been big in Medicare. As you all know, it's gotten very large in Medicare. I think we will always be quite large in Medicare. I think beyond that we are going to have to continue to assess the marketplace.

Right now, we have less of a focus on national accounts and large group coverage that we've had in the past. We're very focused on the smaller end of the market with particular interest in the individual market, as I said earlier. I think it's going to be important. I don't see a huge transformative commercial health insurance play in our future. You never can say never to that either. But that's not what I am thinking.

I am thinking ancillary product lines, voluntary products, finding a number of ways to get close to all these individual customers we have. Again, to have a broader share of wallet with these people. I think big Medicare and big other.

The other is what we're working on deciding exactly what that could be. That could involve some build-out of things. It could involve vertical integration of some of our spending in our Medicare business and others. It could involve acquiring companies that are just maybe not what you would normally expect. So a little bit of all of that.

Ana Gupte – Bernstein Research

On the small companies that may likely get shaken out, if you will, on the individual side and on Medicare Advantage. Is this expectation that you would actually engage in dollar transactions or would they just likely some of them just fold and the membership then accrues to players like yourself?

Michael McCallister

I think it will be both. There are some good, well-run small Medicare players around the country. I think if they're smart they'll find they need to find a new home for that business given what this thing looks like now. Others are weak, and I think we'll just take that business in the marketplace through just straight up competition with them. I expect both.

Ana Gupte – Bernstein Research

Finally on the selling season, which is compressed, you have this captive broker model. In the light of this compressed selling season, would you be able to leverage that sales force adequately in the MA space? Would you need to perhaps to cut it down some or do you have any plans to leverage it across these other broader individual efforts that you're going to, you know the [DTP] model?

James Murray

You hit it on the last one. We feel very bullish about the ability to have the market point agency sell many other products, all around what Mike talked about earlier with our focus on the individual. That's one of the reasons. Lower on the list, but certainly on the list in our desire to get into this space is to, because we feel like we've got a really good asset with our market point agency, having them sit across the table from folks who are not only over 65, but also under 65, and talk about all the products and services that we can bring to bear, is something we think the pretty, pretty impactful.

Although the 45 day period that's going to happen in 2011 is a little bit on the short side, we feel like we can move quickly to get folks focused on other lines of business. That's the silver lining in that change, frankly.

Ana Gupte – Bernstein Research

Just one last one and related to that, what percentage of the share of wallet do you think that would bring you? You talked about that being the big opportunity for you. Can you size that for us a little?

Michael McCallister

Not today. At this point I think we're still trying to figure out exactly how big that is. I don't mean to sound coy. The reason is you have to totally rethink the marketplace as soon as you look at the individual. Then you have to ask yourself how far from the core business are you willing to go? The further you go out, the bigger the opportunity is, at least in numbers, but the harder it is to execute on. There's always a balance between the two.

We see ourselves as a financial services company in health care, largely. You can start thinking about what boundaries that might produce if you have a relationship with an individual. We've seen some examples where we have already done some it. We have talked in the past about the development of our pharmacy capabilities. That's an expansion of our relationship with people that has gone quite well.

It's not just all new products and things like that. Some of it is just recapturing some of the economic power that exists from our base business and doing that. We bought up [Avery] health company. We started the pharmacy business. Those sort of things are there, too. That's something that's going to always with a work in progress because obviously at the end of the day we might like to make it as big as we can as long as we don't over-extend ourselves.

Operator

Your next question comes from Justin Lake – UBS.

Justin Lake – UBS

Thanks. Good morning. Just a couple questions here. First, Mike, clearly there's a lot of focus on selling costs in the business right now given the introduction of MLR minimums. You mentioned the importance of getting your SG&A as low as possible. I was wondering if you could talk to where you see individual and small group commissions in the market at present and where they might go over time?

Michael McCallister

Well, I am going to be standing in front of a large group of agents here in a few weeks. It's going to be interesting what the questions look like there. Clearly there's going to be pressure on commissions. There's just no question about it. There's not room in the economic model for the commission system as we know it today to continue to exist.

We have flexibility in our contracts to change these when we need to or want to. The flexibility is there. We just have to figure out some sort of a transition from where we are to where we are going to end up. Then ultimately end up to these exchanges. We are still trying to assess exactly what that means to the agent community.

I will say to you what I say to them when they ask me the same question, and I get it from every one of them when I see them, what about our future? I said your future is about your own value proposition with your customers. They're sort of in the same situation. Most of them have multiple business relationships with these people, not just health care.

Where health care is going to fit in that, I do not know. Whether we can work with everybody we have historically, I don't know yet. My guess is there's going to be a lot of pressure in that space to get those commissions down. We will do what we need to do. I think we're going to end up working with agents on some level for a long time. I just don't think it's going to look like what it does today. It's going to be a key component of getting the SG&A down. Because in the individual market, it's a material piece.

Justin Lake – UBS

Absolutely. Makes sense. The last question is the reform legislation appears to allocate the potential bonus payments and rebates you're getting now depending on your plan quality scores. I wonder if you can talk about how this metric is calculated, because it's my impression that it's basically curved by CMS so that only a certain amount of plans can actually make it into the highest quartile, which might make that difficult to achieve no matter how much the emphasis the industry puts on improving it. I just wonder if that's correct and any color you can give me here would be helpful. Thanks.

James Murray

We're studying a lot of what's out there with respect to the quality and how it's going to be administered like the MER, lots of questions around that. There are 33 measures that we're going to be evaluated on. Of those 33, 20 are graded on a curve while 13 are on a straight average. What we need to get our arms around is how this is going to be operationalized. Is it going to be on a state basis again like we talked earlier? Is it going to be on a contract basis? Is it going to be in total?

We need to get a little more guidance on that, as you might expect, because we believe that quality bonuses will be an important part of the value proposition that we ultimately provide to the seniors that we serve. We're all over that. We're starting to get our arms around how to improve our scores and also to really create some opportunity from the quality bonuses that are spelled out.

Operator

Your last question comes from Doug Simpson – Morgan Stanley.

Doug Simpson – Morgan Stanley

A lot of my questions have been asked. Maybe just a bigger picture question. Just given some of the rhetoric around rate increases across the country and we've all seen the headlines over the last couple of weeks – what are your expectations or what should we be expecting to see from some of the less financially strong players in the market? Could we see withdrawals from some markets on the risk side over the next year or two?

And just given leverage in the business, it's hard to underwrite risk business if you're not earning a decent margin on that business. Sort of any sense of timing as to how that may play out or how you guys are thinking about that?

Michael McCallister

First of all, when you start by saying I don't think it matters whether you are a for-profit or a nonprofit entity, I think we all have operate under the assumption that there will be integrity in the regulatory process in evaluating the solvency of companies. Ironically, it's the obligation of the regulators to ensure solvency of firms like ours in all of these states. That's been their historical job.

I don't know much about the specifics of the circumstances we've seen in the media at this point. Without having the detail, I wouldn't have a real strong point of view about those individual situations.

I can say that over time, we assume that what is required to have strong solvent companies to provide insurance to people in these states will be done. The other part is it's always better to be big and strong and have the robust balance sheet behind you and all those sort of things. I would just say all of these are still challenges of all sorts and really put pressure on smaller players. It's not just small in terms of total. It could be a small player in a state. So is it possible some are going to have to fold up their tents and go? Absolutely.

I would hope that regulators and others that are trying to make political hay out of this would understand the implications from a competitive perspective of forcing people out of the marketplace. I don't think that's the intent. But it certainly could be the unintended consequences of the process falling apart.

Doug Simpson – Morgan Stanley

Just along those lines, obviously there was a lot of heated rhetoric over the last 12 months, but with the vote in and the bill having passed, do you have any sense, is there recognition that the plans are obviously very important to the success of expanding access for people which was a large part of this bill?

Do you sense that behind the scenes as the implementation moves forward there will be something of a coming together or understanding of that dynamic a little bit more than we've seen in the discussion over the last 12 months?

Michael McCallister

I can understand if you're reading the papers why you would think that wouldn't happen. I would say it's in everyone's best interest for this to work well, both from a national policy perspective and from the standpoint of those that are participating in the industry. I think we will do everything we can to successfully implement what the law of the land is. We don't know exactly what it is completely because a lot of this stuff is going to be done from a regulatory perspective.

Whatever it is, once the law is determined and the regulations are on the books, then we will work and I think the industry will work very hard to make sure they are fully implemented and we comply. I think over time some of the realities of the unintended consequences and the difficulty of this will become apparent both to those writing regulations and to those of us in the industry. I think at the end of the day we will hope that the process brings in a reasonable result.

Operator

This concludes the question-and-answer session of the call. Please continue with closing remarks.

Michael McCallister

Thanks again for joining us this morning. I want to thank all the Humana associates that are on the call for making this success possible. We now have health insurance market reform, at least the first stage of it, behind us and some clarity around what our jobs are.

We fully expect to execute on both the challenges and the opportunities that are embedded in all of that. We're coming off of a wonderful '09 and the beginning of a decent 2010 here. We are quite proud of it. We expect to meet the guidance we've given you this morning. Thanks for joining us. We will be chatting in the future.

Operator

This concludes today's conference call. You may now disconnect.

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