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Executives

Mark Bertolini - President and Head of Business Operations

Kim Keck - Vice President of Investor Relations

Ronald Williams - Chairman, Chief Executive Officer, Chairman of Executive Committee and Member of Investment & Finance Committee

Joseph Zubretsky - Chief Financial Officer and Executive Vice President

Analysts

Matthew Borsch - Goldman Sachs

Ana Gupte - Bernstein Research

Joshua Raskin - Barclays Capital

Justin Lake - UBS Investment Bank

Peter Costa - FTN Midwest Securities

Scott Fidel - Deutsche Bank AG

John Rex - JP Morgan Chase & Co

Kevin Fischbeck - BofA Merrill Lynch

Doug Simpson - Morgan Stanley

Christine Arnold - Cowen and Company, LLC

Aetna (AET) Q2 2010 Earnings Call July 28, 2010 8:30 AM ET

Operator

Good morning. My name is Beth, and I will be your conference operator today. At this time, I would like to welcome everyone to the Aetna Second Quarter 2010 Conference Call. [Operator Instructions] We will begin by turning the call over to Ms. Kim Keck, Vice President of Investor Relations and Treasures. Ms. Keck, please go ahead.

Kim Keck

Good morning, and thank you for joining Aetna's Second Quarter 2010 Earnings Call and Webcast. This is Kim Keck, Head of Investor Relations and Treasures for Aetna. Today, we have two main objectives: To discuss the second quarter results and our recently announced strategic agreement with CVS Caremark. With me this morning are Aetna's Chairman and CEO, Ron Williams; Mark Bertolini, President; and Joe Zubretsky, Executive Vice President and Chief Financial Officer. Following their prepared remarks, we will respond to your questions.

During this call, we will make forward-looking statements. Risk factors that may impact those statements and could cause actual future results to differ materially from currently projected results are described in Aetna’s 2009 Form 10-K or first quarter 2010 Form 10-Q and our second quarter 2010 Form 10-Q, when filed with the SEC. Pursuant to SEC Regulation G, we have provided reconciliations of metrics related to the company’s performance that are non-GAAP measures in our second quarter 2010 earnings press release, financial supplement and our 2010 guidance summary. These reconciliations are available on the Investor Information portion of aetna.com.

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

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

Ronald Williams

Good morning. Thank you, Kim, and thank you all for joining us today. Last night, we announced our second quarter earnings, which reflect strong underlying operating results, positioning us for an improved outlook for the remainder of 2010. We also announced a long-term pharmacy benefit management strategic agreement with CVS Caremark, which will result in enhanced value for our customers, members and shareholders. I will discuss the strategic aspects of our agreement with CVS Caremark in a moment. But first, I will begin with our second quarter operating results.

For the second quarter, we reported operating earnings per share of $1.05. These results include favorable prior-period reserved development of $0.30 per share, primarily from first quarter incurred Health Care costs. Excluding this favorable development, second quarter operating earnings per share were $0.75, higher than the consensus estimate of $0.74. These results are a continuation of the strong fundamental performance we experienced in the first quarter, bringing our year-to-date operating earnings to $2.03 per share.

Our second quarter Commercial medical benefit ratio was 80.1%, or 83.2% excluding favorable prior-period development. Our performance this quarter, as it did last quarter, reflects the benefits of our enhanced management processes to improve the underwriting margin profile of our business. We were successful this quarter in all three dimensions of our strategy, which are: First, obtaining deep insight into the evolving needs of our customers to identify areas for future profitable growth; second, providing information and decision support to help our customers make better informed health decisions; and third, aspiring to achieve operational excellence in everything we do.

The most notable accomplishment, which addresses all three dimensions of our strategy, is our innovative agreement with CVS Caremark. This arrangement creates differentiation in the marketplace by deploying the collective strength of Aetna and CVS Caremark to create value for Aetna's customers and shareholders. This opportunity provides significant benefits to our customers by preserving and enhancing our integrated value proposition, an important aspect of our long-term strategy; integrating medical care with clinical and pharmacy programs and data to improve quality while lowering costs; and enhancing the affordability of our Health products through improved retail, mail-order drug and specialty pricing at a time when Health Care costs are a key concern for our customers and members. This agreement will also improve our financial and operating profile by creating a lower cost structure to drive future earnings growth and increasing our retention of pharmacy membership and penetration of our medical membership base. We chose CVS Caremark because we both share a common vision for the future of Health Care. In addition, this agreement creates immediate tangible value for our customers. The arrangement provides a future opportunity to build on each other's key strategic assets such as Aetna's active Health Care engine and CVS Caremark's medical franchise. Joel will provide further details on the financial aspects of this agreement, and Mark will speak to the customer and operational details.

As we look to the remainder of this year, our strong second quarter performance provides us with increased confidence and an updated 2010 full year outlook. We now project a Commercial medical benefit ratio of 82.5%, plus or minus 50 basis points, and operating earnings per share of $3.05 to $3.15.

Joe and Mark will provide additional details on our performance this quarter and our 2010 outlook in a moment. But first, a few comments on Health Care perform. There is still much to be determined regarding how Health Care reform will be implemented. We remain committed to addressing affordability and quality through policy changes and market innovation, as these issues remain challenges for our nation as a whole and for Health Care consumers.

As we implement the newly enacted legislation, the more comprehensive benefits required will result in higher costs for American consumers. We are actively involved in the regulation development phase of reform and working collaboratively with the parties responsible for developing the regulations to provide our thought leadership and expertise. Once the regulations have been finalized and there is more clarity with regard to implementation details, particularly those dealing with minimum medical benefit ratios, we will provide more specific guidance on our post-reform outlook.

In closing, I have a great deal of confidence in Aetna and our long-term future. Our operating performance continues to improve, as we maintain our focus on responsible pricing and effective medical quality and cost management. We are successfully executing our customer-focused strategy to build a better, more information-driven Health Care marketplace. We have a seasoned leadership team, and our financial strength and flexibility provide a strong foundation for future success. I would like to thank our employees for their dedication in meeting the needs of our customers. We are confident that through their efforts, we will be successful in 2010 and beyond.

I will now turn the call over to Joe Zubretsky. Joe?

Joseph Zubretsky

Thanks, Ron, and good morning, everyone. Last night, we reported second quarter operating earnings per share of $1.05, an increase of 54% compared to the prior year quarter. Excluding prior-period reserve development, operating earnings per share was $0.75. Our year-to-date operating earnings per share is $2.03, including $0.22 of favorable development from 2009 incurred Health Care costs.

Second quarter operating earnings of $450 million were 46% higher than the prior year quarter due primarily to a higher Commercial underwriting margin from favorable prior-period development and improved underlying performance in the quarter, partially offset by lower Commercial Insured volume. I will now discuss the drivers of our second quarter financial performance, starting first with operating margin and its key components.

Second quarter before-tax operating margin was 9.2% or 6.9% excluding prior-period development, which is 4.4% on an after-tax basis. Second quarter revenue of $8.5 billion reflects a 2% year-over-year decrease in Health Care revenue, primarily from a 2% decrease in premiums. Second quarter fees and other revenue also declined 2% due to lower fee yields, reflecting a competitive pricing environment. The 2% decrease in Health Care premium reflects a net decrease in Commercial premium of approximately 4%, resulting from a volume decline of 9.5%, an overall rate increase of 10.5% and a 5% decline from mix of business. Health Care premium also reflects a 6% increase in Medicare premium and a 7% increase in Medicaid premium, related primarily to membership gains.

Our second quarter total medical benefit ratio was 81.8%, which includes $199 million before tax of favorable prior-period reserve development across all products, $160 million in Commercial, $34 million in Medicare and $5 million in Medicaid.

Our second quarter Commercial medical benefit ratio was 80.1%, or 83.2% excluding prior-period development. This result is 80 basis points better than the low end of our previous guidance range of 84% to 85%. This favorable variance to guidance is due primarily to lower-than-projected utilization.

The Commercial favorable prior-period development of $160 million is primarily related to first quarter incurred Health Care costs. Relative to our first quarter reserve estimates, we experienced lower flu cost and utilization. This lower utilization included the impact of severe weather on the East Coast. Year-to-date, our Commercial medical benefit ratio is 80.6%, or 81.5% excluding favorable reserve development from 2009 incurred Health Care costs.

Our second quarter Medicare medical benefit ratio was 86.4%, an improvement from the prior year due primarily to the favorable prior-period reserve development in the current quarter. We continue to reflect appropriate assumptions regarding medical cost trend, operating metrics and payout patterns in setting reserves for estimated Health Care costs.

Days claims payable were 43.2 days as of June 30, a decrease of 3.7 days during the quarter. This change was due primarily to the payment of previously reported pending claims that were higher than normal at the end of the first quarter and the impact of our second quarter of favorable prior-period development. We project days claims payable to be in the low 40s for the remainder of the year.

Group Insurance operating earnings were $44 million during the quarter, in line with our expectations and the prior-year quarter.

Our business segment operating expense ratio of 18.1% was in line with our projections. We ended the quarter with 18.6 million medical members; a sequential decrease of 86,000 comprising a decrease of 156,000 Commercial members, partially offset by growth in Medicaid of 70,000 members. The Commercial decrease consisted of 65,000 insured members and 91,000 ASC members. Included in the Commercial decrease is economic-related attrition of approximately 80,000 members.

The final area of financial performance I will comment on is our investment performance and management of capital. Second quarter net investment income on our continuing business portfolio was $175 million, a 2% increase over the prior year, as growth in invested assets more than offset lower yields. Our financial position, capital structure and liquidity all continued to be very strong. As of June 30, we had a debt-to-total capitalization ratio of 28.3%, in line with our expectations.

Our liquidity remains strong as well. We began and ended the quarter with holding company liquidity of approximately $100 million. Second quarter dividends to the parent were approximately $350 million, which we deployed to fund $229 million of share repurchases, cover fixed charges of $93 million and reduce our outstanding Commercial paper by $30 million. Our outstanding Commercial paper at June 30 was $450 million.

During the quarter, we repurchased 7.8 million shares. Our basic share count was 417.4 million at June 30. For the second quarter, Health Care and Group Insurance operating cash flow was negative $11 million. This result reflects previously reported timing differences, including the seasonal pattern of our income tax payments and the payment of higher-than-normal pended claims at the end of the first quarter of approximately $120 million. Year-to-date, Health Care and Group Insurance operating cash flow represented 97% of operating earnings, excluding pension expense. I will now discuss our updated 2010 guidance.

We now project full year 2010 operating earnings per share of $3.05 to $3.15, a $0.30 increase from our previous guidance. This increase from the midpoint of our previous guidance range reflects $0.30 of favorable reserve development reported in the second quarter, $0.06 of higher Commercial underwriting margin due to the favorable underlying results we reported in the second quarter, offset by $0.06 of integration costs for our agreement with CVS Caremark that we will incur in preparation for transitioning our customers to this new arrangement. I will provide additional financial details of the CVS Caremark agreement in a moment.

Our projection reflects operating earnings per share to be lower in the second half of the year compared to the first half of the year. This decrease is due primarily to two factors: The favorable prior-period reserve development from 2009 in our first-half results, and the seasonal pattern of higher medical costs and SG&A spending in the second half of the year. We project earnings per share in the third quarter to be higher than the fourth quarter.

Medical membership is projected to decrease by 220,000 members during the remainder of the year. This decrease includes 280,000 Commercial members, primarily due to projected economic to attrition, partially offset by growth of 60,000 members in Medicaid.

We have maintained our outlook for total company revenue to decrease by approximately 3% from 2009. With respect to medical benefit ratios, we project a full year Commercial premium yield that exceeds medical cost trend, which we now project to be 8% plus or minus 50 basis points, a 2010 Commercial medical benefit ratio of 82.5%, plus or minus 50 basis points, and a 2010 Medicare medical benefit ratio that is in the high 80s.

In projecting our full year 2010 Commercial medical benefit ratio, we believe the second quarter result of 83.2%, which excludes favorable development, is an appropriate representation of the underwriting margin profile of the business. We are placing less reliance on our first quarter result, as it included the impacts of lower flu costs and utilization, which we do not expect to recur. Our projection also reflects the higher Commercial medical benefit ratio we expect in the second half of the year, due primarily to the seasonal pattern of our business.

Turning now to our agreement with CVS Caremark. This agreement is the capstone of a comprehensive strategic review of our pharmacy operations, in which we scanned the entire PBM marketplace and thoroughly evaluated all strategic options. Our objective was to maximize long-term value for both our customers and our shareholders. We are confident that this strategic agreement with CVS Caremark will strengthen our long-term competitive position in the marketplace and realize significant drug cost savings for our customers and Aetna, as well as produce operational efficiencies through economies of scale.

We expect to begin transitioning to CVS Caremark's platforms and pharmacy networks on January 1, 2011, following all required approvals. Our customers will begin to benefit immediately, but any earnings impact to Aetna in 2011 is likely to be offset by the cost of integrating CVS Caremark’s pharmacy systems into our infrastructure.

In 2012, Aetna and our customers will each see significant financial benefits of this long-term agreement. While we have not yet provided long-term earnings per share guidance beyond 2010, we estimate that this agreement will create earnings per share accretion of approximately $0.30 per share when the agreement is near-fully implemented in 2012. The significant benefit that will be delivered to our customers has been contemplated in this projection.

As we consider the impact of this agreement on our future financial profile, the synergies would be realized across multiple aspects of our Pharmacy business, including enhanced fee revenue, lower SG&A expenses and lower medical costs. With respect to 2010, we expect to incur one-time transaction costs in the second half of the year that are not included in our operating earnings per share guidance due to their one-time nature.

In summary, we are pleased with our second quarter performance and are confident in our outlook for 2010. We are also excited about the opportunities and value that our agreement with CVS Caremark creates for our customers, members and shareholders.

With that, I will turn the call over to Mark for commentary on our operations. Mark?

Mark Bertolini

Thank you, Joe, and good morning. I would like to start with an update on our second quarter strategic accomplishments and operating performance. I will then provide further details on the operating aspects and customer benefits of our strategic agreement with CVS Caremark.

We had a number of accomplishments this quarter which aligned to the three dimensions of our strategy to provide value to our customers and shape more effective Health Care systems. I would note this quarter, we expanded our payment estimator tool to our entire customer base. This industry-first capability provides members with personalized estimates for expenses based on their specific plan of benefits before services are rendered. We also launched our virtual online assistant to provide members with 24-hour support to answer their questions about their health benefits as they navigate our Web site. And our focus on operational excellence led to a continued improvement in key metrics.

Turning to our operating performance, I will first discuss pricing and underwriting. We have continued to maintain discipline in these areas, with the objective that our pricing decisions reflect our projected medical costs. During the quarter, we produced a positive spread between our premium yield and medical cost trend of 150 basis points, excluding the impact of favorable reserve development. This achievement demonstrates that the management processes we put in place to price appropriately are working. We project a positive yield trend spread for the remainder of the year, with the second half of the year higher than the 150 basis points we reported in the second quarter.

Next, with respect to medical quality and cost management, the actions we took last year to improve the management of our medical costs are working as planned. We continue to work with our customers and the medical community to improve the quality and value of our services for an improved experience for our members within the Health Care system. By offering the right benefit designs, effective provider networks, health and wellness programs and information tools, our members can make informed decisions about their Health Care.

The results of these actions, as well as the low utilization that we experienced in the first half of 2010, contributed to our new projected annual 2010 medical cost trend of 8%, plus or minus 50 basis points. This projection also includes an increase due to mandated benefits as required by Health Care reform and reflects inpatient cost trending at high single digits, outpatient cost trending at high single-to-low double digits, physician costs at mid-to-high single digits and pharmacy costs at high single digits. Our 2011 medical cost trend will include the full year impact of mandated benefits. These projected costs are reflected in our 2011 pricing. I will now discuss our arrangement with CVS Caremark.

Our Pharmacy business has been and continues to be a key component of our integrated value proposition. However, as we conducted our strategic review of this important asset, it became clear to us that by working with a larger, independent pharmacy benefit manager, we could create additional value for our customers and shareholders. By entering into a 12-year strategic agreement with CVS Caremark, we believe we have created a doable [ph] competitive advantage in the marketplace.

From an operational perspective, Aetna will maintain its control of the clinical integration of pharmacy and medical benefits. We will also retain most of the customer-facing functions of our Mail Order and Specialty Pharmacy businesses and continue to control medical and pharmacy policy, formula and contracting and other core functions. CVS Caremark will provide the administration of selected functions for Aetna's claim processing, customer service and retail pharmacy network contracting. They will also be responsible for the purchasing and fulfillment functions of our Mail Order and Specialty Pharmacy businesses.

CVS Caremark shares our objective of providing quality outcomes and lowering Health Care costs for our members. In fact, customer benefits of our agreement include improved drug pricing, as CVS Caremark serves a greater volume of customers and is able to offer a more competitive cost structure; enhanced clinical capabilities through best-in-class integrated clinical programs focused on medication adherence for our members that foster better health outcomes and reduce overall medical costs; improved customer service and member experience as we migrate to CVS Caremark's platform. The agreement will enable Aetna's members and customers to take advantage of CVS Caremark's innovative technology and significant retail presence.

Additionally, this agreement provides the flexibility to collaborate on future pharmacy offerings to generate profitable growth. Overall, we believe that this agreement will improve our competitive position as a premier provider of pharmacy benefit management services.

Turning to Health Care reform. We continue to be an active participant in the development of Health Care reform regulations, both at the national and state levels. We are providing our expertise on all of the regulations, including minimum benefit ratio requirements, grandfathering, rate review guidelines and the impact from mandated benefits. Additionally, we are working very closely with state insurance departments on our ongoing rate filings. We continue to responsibly price our products in alignment with underlying medical costs. In working with all parties involved in developing the regulations, we remain committed, as we have been in the past, to be part of the solution. Our Health Care reform implementation team remains focused on the immediate impacts to our business and our customers. Importantly, Ron, Joe and I are very engaged in this implementation to ensure that we are compliant with the intent of the law and identify the strategic business opportunities that may emerge as the result of reform. We are confident that Aetna's well-positioned to be successful in the post-reform environment.

With that, I will turn the call back over to Kim. Kim?

Kim Keck

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

Question-and-Answer Session

Operator

Joshua Raskin with Barclays Capital.

Joshua Raskin - Barclays Capital

Question on the CVS relationship. I guess sort of two parts. One, could you sort of help us understand the, I guess, lack of financial impact on 2011 in light of sort of the big jump for '12? And maybe tie in what are expected drug savings over the long term? And then maybe you could juxtapose the timing with your comments around reform and how we’re probably only a couple of weeks away from an MLR [medical loss ratio] definition and sort of why now?

Ronald Williams

I would start out by saying that as we look at the transition process, one of the things that we have done is structure the arrangement in such a way that our customers will begin to get the value of the pricing power that our new strategic agreement will provide. In terms of the impact on our shareholders and our EPS, there’s a transition process we will go through. As you know, a big portion of our business renews January 1. That would be January 1, 2012, principally for those clients with that renewal date. So I think you can think of the lack of impact as the normal process of transitioning a large client base into this new type of arrangement.

Joshua Raskin - Barclays Capital

I'm not sure I understand why the renewal cycle would be so important. I assume your drug contracting rates are going to change January 1 when the relationship starts beginning. And then just as a reminder, just a question around how this impacts your thoughts around the minimum MLRs.

Joseph Zubretsky

Josh, this is Joe. It's actually a complex migration. And during 2011, think of it as a transition year. We need to disintegrate our pharmacy benefit management systems and processes and integrate CVS Caremark's. That process is a comprehensive and complex process. It will take the full year. And we will be migrating our customers onto the more attractive pricing and CVS Caremark’s networks over time as the year progresses. So the benefit will ramp for both our customers and for Aetna, but for Aetna, our earnings impact in 2011 will likely be offset by the cost to integrate those systems.

Operator

And John Rex with JP Morgan.

John Rex - JP Morgan Chase & Co

Just to continue on the CVS transaction. So I just want to make sure I understood the transaction costs. So I think you sized $0.06 impact in 2010, but then you’ve also noted that there are transaction costs not included in your guidance for 2010, and you're talking some in 2011 also. So can you give kind of a rough order sizing of magnitude for those two elements; the 2010 [indiscernible] guidance and then what you’re thinking about for 2011?

Joseph Zubretsky

Sure, John. The transition cost, the integration cost, will be expensed in our operating earnings and that is the $0.06 that we conveyed in our earnings per share outlook for the year. With respect to transaction cost, cost to execute the transaction, we will be recording that as a one-time charge either in the third, fourth or both quarters later in the year. And that could be up to between $50 million and $60 million on a pretax basis.

John Rex - JP Morgan Chase & Co

So what is that for?

Joseph Zubretsky

This was a very comprehensive and elaborate exercise with lots of financial advisors, consultants and legal advisers, and that was the cost to get the transaction executed.

John Rex - JP Morgan Chase & Co

For '11, what are you thinking about in terms of additional transition costs that you would bear also?

Joseph Zubretsky

Since we haven't given specific 2011 guidance, we haven't sized that yet. But we do know enough about it that any of the earnings per share accretion due to the more attractive drug pricing will be offset by the cost to integrate. We'll size that for you at a later date.

John Rex - JP Morgan Chase & Co

Rough thematically here, in the quarters we’ve seen lower utilization. Can you just give some sense and what you're seeing in your books also? Are you seeing it across segments; that is, Commercial, Medicare and Medicaid? And is it relatively consistent within those books? And what we’re just trying to tease out here, is it the economy or is it something else that’s having this impact?

Mark Bertolini

We believe it's going across the full book of business and we're seeing it everywhere in every segment of the business at this time. So we believe there is some economy impact, also some wear-off of the COBRA and the change in the flu and the severe weather that we had in the first quarter. So there are a number of impacts, but the economy does definitely have an impact here.

John Rex - JP Morgan Chase & Co

But consistent Medicare government books also with Commercial? Where I think there’d be less economic sensitivity in the government books. Is that…

Mark Bertolini

It is less in the government books than it is in the Commercial.

Operator

And Justin Lake with UBS.

Justin Lake - UBS Investment Bank

Ron, you mentioned the impact on trend from reform-mandated benefits. I was hoping you might be able to give us some color there as to what you see the impact on trend, starting in the fourth quarter and into 2011? And any specifics around the benefits by benefit?

Ronald Williams

Well, I think when you think about the 2010 impact, as you know, a very small percentage of our business renews in that period. So we would say it was de minimis in terms of the Health Care Reform Bill. I think the biggest area that we saw in 2010 is really the minimal health parity, which we sized at about 50 basis points for 2010. As we go into 2011, we certainly have our estimates of the impact of what we expect to see there, which will be rolled in as cases are renewing. In the broader context, there's an awful lot of unanswered questions that are still being talked about and debated, which we are very actively involved in. And we're watching those very carefully.

Justin Lake - UBS Investment Bank

Why do your peers put it in low-single digits? Is that a number that you would think would be reasonable as well?

Ronald Williams

I would say that it’s variable by book of business. It’s variable by where the benefit plan designs start out. And so I think their number would be a reflection of their book of business and their judgment about that. Plus, I would just say stay tuned. When we have what we think is a good estimate of it, we will share that with you and provide you the context.

Justin Lake - UBS Investment Bank

Just a last question around the fact – you’ve talked about targeting Commercial margin improvement over a multi-year period. Obviously you’re off to a very good start there. Given the pressure on cost and rates from Health Care reform that you just discussed, I was curious as to whether this might impact the trajectory there of that margin improvement into next year in regards to potentially delaying repricing actions, or make you rethink that over a longer period of time. Is there any impact from that cost trend impact that could cause you to change your thought process there on repricing for '11?

Ronald Williams

All the guidance we've given on margin improvement in the past has been very clearly outlined as pre-reform impacts. We don't know the reform impacts. Certainly rate reviews are going to be a more onerous process, minimum MLR guidelines et cetera. So we're still confident that we have SG&A leverage, fixed cost leverage, yet to gain, that our MLR and the discipline of having pricing yields stay paced with medical cost trend is working. And that when reform impacts are better known and regulations are out, they will give you a revised outlook for our margins. Clearly more to deal with for maintaining the margin profile, but we have not yet given post-reform margin guidance.

Operator

And Christine Arnold with Cowen and Company.

Christine Arnold - Cowen and Company, LLC

If my math is right, you’ve got an SG&A load by business segment, as you report, of 18.1% year-to-date. You've increased your guidance from 18.9% to 19%, and yet you’ve lost TRICARE, so you’re not going to have that second half of your spending. How much of this is due to Caremark's expense implementation spending and how much is other stuff? And can you give us sense of the opportunity in 2011, recognizing that you can't comment on the MLRs because you don't have the regulations yet? But SG&A help would be helpful.

Ronald Williams

Yes. I think generally, I would start out by saying that we understand the importance of reducing our SG&A, being more efficient. And Christine, historically, if we look back, we were able to improve our SG&A about 50 basis points a year. I think that what we’ve always said is every year, we look at the investments we have to make in order to grow the business, and then in that context, we had historically been able to reduce by 50 basis points. As we go forward in 2011, we understand the need to bring our SG&A down. Joe’s going to give you the answer on the CVS and a sense of how we’re deploying some of the TRICARE dollars in terms of that. But I think the message I want to leave you with is that the increases that you're seeing now, we view as related to kind of one-time events in terms of the transition and some other things we have to do. But we are very, very, very focused on our SG&A, and you should expect to see improvements in the future.

Joseph Zubretsky

Yes, Christine, when we guided up to 18.9% the last time we reported, as you remember, we released the TRICARE spending because we lost the contact, but then we deployed it into reform-related activities, including ICD-10, which increased the ratio to 18.9%. The increase from 18.9% to 19% is primarily related to the integration cost of the CVS Caremark agreement which will commence in the third and fourth quarter.

Operator

And Peter Costa with Wells Fargo.

Peter Costa - FTN Midwest Securities

Getting back to the CVS contract, my question is, how do you know it's going to be a good contract for you, a good deal for you and your customers, 12 years from now? Is there some kind of a cost trend guarantee that goes along with this? And if there is not, can you describe how you're going to do pricing, given that you're negotiating the rebates, as I understand the contract, and CVS is doing the fulfillment?

Ronald Williams

Let me start out by saying that we looked at a full comprehensive range of all conceivable options in terms of what we should do from a strategic perspective. And I think we feel very good that the agreement we struck with CVS Caremark stood out as a superior opportunity for Aetna, for our customers and our shareholders. And we believe that it is going to improve our value proposition in the marketplace and provide substantial differentiation, given the pairings that you have seen among the leading players in different PBMs [pharmacy benefit managers]. So I would say, having looked at all of the alternatives, we’re convinced that this is going to create long-term value for our shareholders. And then I'll ask Joe to answer the rest of the question.

Joseph Zubretsky

Peter, yes, we have received pricing guarantees for the term of the contract. And we do have a preferred position in the pricing profile of CVS Caremark's book of business that we’re very comfortable with. And with respect to rebates, we have retained rebate contracting. We think our rebates are market-based. But it doesn't mean that in the future, we can't contemplate conveying that and transferring that to our partner as well. But for now, we decided to retain it. We think they’re at [ph] market level.

Doug Simpson - Morgan Stanley

So how much better-than--expected trend would you expect to have in terms of your cost trend on pharmaceuticals?

Joseph Zubretsky

We have not sized that and are not going to at this time. But the savings for our customers is meaningful. And obviously, the savings to our earnings per share line has been conveyed to you previously.

Ronald Williams

And I think the other point that's important to remember is that the reason we've chosen this particular model is that the greatest amount of leverage comes from integrating the pharmacy benefit with the medical benefit through clinical programs that use the pharmacy as a way to improve the quality of care and reduce the overall medical costs. And so we expect that we will get continued significant improvements in the implementation of programs in that area and an opportunity to further engage our members at the pharmacy, as well as by working at the MinuteClinic approach that CVS has.

Operator

And Ana Gupte with Sanford Bernstein.

Ana Gupte - Bernstein Research

Yes, a couple of follow-ups on the Caremark deal again. Is there any benefit from the steel [ph] on your CMS enrollment suspension with the June bids going in and open enrollment coming up quickly? And then the second part of the question was, is this just confined to Rx Home Delivery or to your Specialty Pharmacy as well, given that's a huge part of drug trend?

Ronald Williams

Yes. The answer is, it’s unrelated to the CMS issue in any way at this point. And it is mail order and it is fulfillment and support in the Specialty area, which is, as you know, a very rapidly growing area in terms of costs of medication.

Ana Gupte - Bernstein Research

On the pricing for next year, you talked about pricing in the mandated benefits. Can you give us an idea of how much of the member months for 2011 are already priced in?

Mark Bertolini

Yes, Ana. Only a small portion of 2011 pricing is already in the marketplace, and it’s related to the rollover of accounts that renewed during the year and roll into next year. So we believe we have the impact of mandated benefits into our 2011 pricing sufficiently to cover our costs.

Ana Gupte - Bernstein Research

On the limited benefits in student health, you probably got a waiver on limited benefits, and it looks like student health may also follow suit. Do you have a sense of what the timing would be on when you meet the mandated benefit requirements on those product lines as well?

Ronald Williams

Well, I think that in both of those areas, we have been in very good discussions around that. I think there's a real understanding of the impact of making a sudden and precipitous change that would disadvantage in the case of, for example, limited benefits, the 1.4 million people who have those benefits. I think there’s still things being finalized and I think we don't quite know what the slope would be in terms of accomplishing that. And I think much the same thing with the student. There is about 3 million students who are currently insured, and close to 5 million who could benefit from these programs. So I think as we've worked through this with HHS, they have an appreciation for what would happen if people could not keep the benefits they had and they didn't have access to what the world will look like in 2014. So I think they are really digesting that, and we're hopeful that we will get the kind of guidance that would be helpful.

Operator

And Kevin Fischbeck with Bank of America.

Kevin Fischbeck - BofA Merrill Lynch

I wanted to circle back to Caremark and the $0.30 accretion number you mentioned. You mentioned three items: SG&A, drug cost savings and enhanced fee revenue. I guess, it wasn't clear to me what you meant by “enhanced fee revenue.” And then how do you think about that $0.30 accretion in the face of minimum MLR? Should we be thinking about the drug savings as being a smaller part of that $0.30 or how do you think about that?

Ronald Williams

Well, we haven't parsed the $0.30 across synergies, but as you know, the way you earn your revenue and your earnings in the PBM business is quite complex across many aspects of the business. Certainly, a lot of this relates to our self-insured customers. So it will be in the SG&A and fee stream, and some of it relates to our risk book of business, which means that the benefit will be in medical cost and impact the MLR. So we haven't parsed that. We probably will in the future. But the benefits will be earned across all books of business and across all revenue streams in those books of business.

Kevin Fischbeck - BofA Merrill Lynch

Okay. I guess just the fee number in particular, are you assuming an increase in PBM business over time? Or is it things like rebates or other aspects of your contracts that will go up as a result of the better purchasing?

Ronald Williams

In our earnings outlook, we did not include any benefit from the growth in membership, but we certainly believe that the penetration of pharmacy in our ASC book of business and winning new customers with this new relationship is certainly upside to the case.

Kevin Fischbeck - BofA Merrill Lynch

Okay. If you could provide a little bit more color on some of the state issues. You mentioned before a little bit about it, but can you provide an update on what's going on in California? Timing there? And then any other states that you feel are particularly sensitive to the rate review risk? Maybe touch on Pennsylvania. I guess just talking about small-group investigation, what your exposure is there and how you're seeing that.

Mark Bertolini

Kevin, we are as to actively involved with every state insurance commissioner in understanding and dealing with our ongoing rate filings. In California, the rate filing issue was a technical issue with the filing. It did not impact the rate and we expect that once we get that technical issue resolved, which we expect to get that done soon, we will move forward with our rates in that marketplace. In other states, we have ongoing discussions with everyone about how we file our rates. The actuaries talk with the actuaries, and then we reach out where necessary to the insurance commissioners to have a conversation. And we believe that all of those conversations are going well.

Kevin Fischbeck - BofA Merrill Lynch

In Pennsylvania, I guess?

Mark Bertolini

Pennsylvania, moving ahead, going well.

Operator

And Scott Fidel with Deutsche Bank.

Scott Fidel - Deutsche Bank AG

Just interested in your thought in the future on how you think about allocating growth capital between the Health Care business and the non-Health Care businesses post-reform. And just interested if you would think about expanding the amount of capital that you invest on the non-Health businesses like Group Insurance, or do you see that mix remaining relatively similar to what we've seen in the recent past?

Ronald Williams

Scott, when you think about capital allocation, we are first and foremost committed to supporting the growth of our existing businesses. And when we think about other lines of business that are non- risk-based, we do have a strong interest in growing our Fee Income business. I would say we view the Group Insurance much more in the organic category as opposed to allocating significant amounts of capital for other reasons. We do believe that we have important capabilities that can help manage medical costs and quality in a variety of ways. And as we look at how the accountable care organizations will unfold, we’re looking at how some of our capabilities can in fact be used there. We’re looking at a whole next generation of products in the active Health Care suite. And so you should expect in the future to hear about other fee-based types of activity that we’re investing in.

Scott Fidel - Deutsche Bank AG

And I just had a follow-up on the MLR deliberations at NAIC [National Association of Insurance Commissioners]. And obviously they're not completed yet, but they’ve spent quite a bit of time over the last months on thinking about the International plans. And just based on what we've seen come out of NAIC so far, can you talk about what you think the impact from their proposal might be on the International business from a margin perspective and then from a distribution of those types of products perspective?

Ronald Williams

Well, I think they're still deep in their process of trying to reach some clarity on that. But I think it presents a very interesting challenge in the context of the competitive position of American companies. I think this is an example where our competitors, our global competitors, are companies like BUPA, actually, other companies that are actively involved in this space. And to the extent that we burden U.S. companies with requirements that our competitors don't have to meet, we basically would face the requirement of ceding those markets to others. So I think it's a very important issue that we're encouraging them to think beyond the impact just domestically, but how they’re really positioning what is one of the best capabilities I think the U.S. has, is really managing medical cost and quality and using health IT systems in ways that can enhance patient care.

Operator

And Matthew Borsch with Goldman Sachs.

Matthew Borsch - Goldman Sachs

Just curious if you can give us an early read on how you think the 2011 national account selling season is coming together for you. Generally, what type of movement? Do you think there's going to be less movement in 2011 as a result of still a lot of uncertainty around reform impact? And finally, if you could address how you think your employer clients are thinking about the grandfathering, and how much value they’re placing on that versus making changes to address cost trend?

Mark Bertolini

On the national account selling season, we have actually seen a lot fewer RFPs out in the marketplace this year. A lot less activity. And we think that's related both to the economy and to Health Care reform. However, we are seeing some consolidation as employers try to simplify their offerings, and so we expect to see some of that activity. We do see it still as a very competitive market as employers look to reduce hard-cost savings, so there still will be some downward pressure on fees. So it's a tough selling season all-in. As it relates to how they're viewing grandfathering, I think as the regulations have come out, it's pretty difficult, if not impossible, for employers to maintain grandfathering in this environment. And so a lot of employers are viewing it is almost impossible to maintain grandfathering going forward.

Matthew Borsch - Goldman Sachs

That makes sense. And last question. Any early signs -- and I realize pricing for calendar year 2011 is in the very early -- but is there any signs that you see competitors pricing differently than had been the case as a result of lower in anticipation of the minimum MLR rules? If you can comment on that.

Mark Bertolini

Given that the regs aren’t out yet on minimum MLRs, I don't think anybody is taking any chances, particularly with mandated benefits coming in. So if anything, the market’s very rational at this point in time. There are always pockets of exceptions, but it's much the same as it's been for the last year.

Operator

And Carl McDonald.

Unidentified Analyst

I just wanted to see if you’d put together some comments on the second half outlook. So it looks like the earnings for the first half, excluding prior year, were $1.80. And you were looking for something like $1.05 to $1.10 in the second half. Even in we pull out the favorable development from the second quarter, it’d be sort of $1.50 to down to $1.05 to $1.10. So can we just walk through the pieces that drive that, including the integration costs and some of the normal seasonality and the reform factors?

Joseph Zubretsky

I’d focus you on the Commercial benefit ratio, because that's really where the story is. And if you look at that ratios we reported, 81.5% for the first half of the year. But keep in mind that was 83.2% in the second quarter, which is still a very good result, and 80 basis points lower than the bottom end of our previous projection. What we're saying is focus on that as a very good benchmark; a profile of the underwriting profile of the business. And if you look forward to the third and fourth quarter, and add normal seasonality, that should increase the ratio slightly in each of the third and fourth quarters, which brings you to the 82½%, plus or minus 50, for the year. So 83.2%; very good benchmark for the underwriting profile of the business. Continued positive spread between yield and trend in the second half, and that should produce the result that we've articulated.

Unidentified Analyst

On the pharmacy transaction, just trying to understand the EPS impact there a little bit more. So if you lower your unit cost because you get access to their better discounts, clearly you guys price to trend, so that would really flow through to the benefit of the customers as opposed to you. So do you keep some of that, or is it really the other factors that drive that sort of roughly $200 million in incremental earnings that you're looking for in 2011?

Joseph Zubretsky

There is no doubt that some of this benefit will inure to the benefit of the pricing of our fully insured risk business, and that is contemplated in the guidance that we gave you. And there is a lot of savings due to the SG&A efficiencies by CVS Caremark taking over many of the functionalities that we spoke to earlier. So I would say the answer to your question is yes. Some of the benefit will inure to the benefit of the pricing schedules for our full risk business.

Operator

And we'll take our last question from Doug Simpson with Morgan Stanley.

Doug Simpson - Morgan Stanley

Sorry if you gave this number earlier, but can you just size the dollar value of the expected incremental investments related to reform and maybe annualize that for us? Just trying to understand, how do we think about this, how much of it’s variable and dependent upon the size of the enrollment base, the number of states we’re in, and how much of it’s fixed?

Joseph Zubretsky

Doug, we have not sized or communicated our spending on reform except to say that in the last half of the year, the spending will be up. But as we move forward toward the end of the year and contemplate giving 2011 guidance, we'll size all the impacts of reform, both on the underwriting side and on the implementation side. So we haven’t done that yet, but stay tuned.

Doug Simpson - Morgan Stanley

And then maybe just if you could update us on your strategy regarding innovation unit cost. Just specifically, how are you approaching contracting with the hospitals to address that? Are you actively working to try to engage with them? Is this something that we should hear more about in 2011? And how do you see that playing out with unit price increases running where they are? How does that trend the next couple of years?

Ronald Williams

Well I think one of the things we’ve tried to do is to maintain the right tone and the right level of collaboration with the hospitals and physicians that we work with. I think we've been very clear that our customers expect us to manage unit cost and utilization while working to improve quality. I think it's clear that the economic challenges that the country has been through has created a new level of pressure and awareness of the need to do that, and I think some institutions have understood that message faster than others. And then I'll ask Mark to give you more detail.

Mark Bertolini

I think you can expect both us and our clients to be much more involved in hospital contracting going forward, particularly around rates. I would expect to see more noise in the marketplace as a result. However, as we have gone through these discussions and have had some already notable cases, we have come to a better result and have had greater strategic discussions around how we move forward more collaboratively in the new Health Care reform environment.

Operator

And I will now turn the call back to Kim Keck. Ms. Keck?

Kim Keck

A transcript of the prepared portion of this call will be posted shortly on the investor information section of aetna.com. 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 again for joining us this morning.

Operator

And that does conclude our conference for today. Thank you for your participation.

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