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Executives

James Bloem - Chief Financial Officer, Senior Vice President and Treasurer

Michael McCallister - Chief Executive Officer, President, Director and Member of Executive Committee

James Murray - Chief Operating Officer

Regina Nethery - Vice President Investor Relations

Analysts

Ana Gupte - Bernstein Research

Daryn Miller - Goldman Sachs Group Inc.

Joshua Raskin - Barclays Capital

Justin Lake - UBS Investment Bank

Sarah James - Wedbush Securities Inc.

Peter Costa - FTN Midwest Securities

Carl McDonald - Citigroup Inc

John Rex - JP Morgan Chase & Co

Doug Simpson - Morgan Stanley

Kevin Fischbeck - BofA Merrill Lynch

Humana (HUM) Q2 2010 Earnings Call August 2, 2010 9:00 AM ET

Operator

Good morning. My name is Maria, and I will be your conference operator today. At this time, I would like to welcome everyone to the Q2 2010 Earnings Conference Call. [Operator Instructions] Ms. Regina Nethery, Vice President of Investor Relations, you may now go ahead.

Regina Nethery

Good morning, and 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 second 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&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&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 available on the investor relations page of Humana's website, as well as on the SEC's website.

Humana's results for the second quarter and year-to-date in this presentation include financial measures that are not in accordance with generally accepted accounting principles. Management's explanation for the use of these non-GAAP measures is included in both today's press release and the slide presentation. This slide shows the reconciliations of GAAP to non-GAAP financial measures being used today. Finally, any references to earnings per share or EPS made during this morning's call refer to diluted earnings per common share.

With that, I'll turn the call over to Mike McCallister.

Michael McCallister

Thank you, and good morning, everyone. In my remarks this morning, I'll speak not only to Humana's operational progress, which was the primary driver of our favorable second quarter results but also to how Humana continues to invest in innovative delivery and care management support systems to help our members in the post health insurance reform environment.

I'll begin with our financial results for the quarter. For the second quarter, Humana earned $2.11 per share on a non-GAAP basis, $0.44 above the midpoint of our guidance. This compares to the $1.67 per share we reported in last year's second quarter. We are very pleased that our underlying operating earnings and cash flows demonstrates solid operational progress in both our business segments for the first half of this year.

As we look ahead to the remainder of 2010, we now expect full year earnings per share in the range of $5.65 to $5.75, reflecting our improving operating results, higher-than-expected favorable prior-period claims development and the write down of deferred acquisition cost, as well as some offsetting newly anticipated expense items for the back half of 2010, all of which Jim will discuss more fully in his remarks.

We continue to experience strong operating performance in both our business segments and believe we are positioned to ensure that momentum carries on in the long term. To that end, continuing to gain traction with our Medicare Advantage 15 percent Solution becomes all the more critical, and as we shared with you in the past, there are four primary elements to the 15 percent Solution. One is the early identification of members most in need of integrated care; two, ensuring that our members benefit from the integration of clinician-based support; pharmacy solutions; physician guidance and wellness and productivity initiatives that all comprise our clinical guidance model; and three, managing claims costs through diligent timely reviews of provider coding and admission status, as well industry-leading fraud detection and lastly analysis for physician outcomes versus utilization to ensure we develop an efficient and effective network for our members.

I'll spend the bulk of my remarks this morning discussing how our progress on the 15 percent Solution increasingly creates a value proposition that we believe will continue to be appealing to seniors for many years to come. I'll also highlight Humana Cares, one of the many 15 percent Solution clinical programs that provide a great return on investment for both our senior members and Humana.

Let's start with our provider network development activities. Approximately four years ago, we began to expand our Medicare network to ensure long-term access for our senior members. We have long believed that Medicare Advantage payment rates would eventually be at parity with original Medicare and recognized the importance of network solutions in helping to address medical costs. This map demonstrates the results of that work to date. It clearly shows the broad extent of our networks, the factoring ensuring our Medicare members have the access to doctors and hospitals they need and want, while at the same time providing a more cost-effective alternative, thus enhancing our value proposition. Our networking initiatives are also expected to result in a smooth transition for our Private-Fee-for-Service members in 2011. We have filed for network plans around much of the nation and anticipate approximately 95% of our current PFFS members will have the option of either remaining in their current plans or transitioning to a network plan next year.

Now let's look at how our clinical guidance positively affects health outcomes. I'd like to briefly describe Humana Cares, a good example on how we put the 15 percent Solution into action. Humana Cares is a new holistic approach to consumer engagement whereby a multi-disciplinary team coordinates a Medicare Advantage members care in close cooperation with the member, the member's doctors, pharmacy, family and community-based resources. This complex chronic care management program focuses on the member and his or her experience, not just the case or the disease. The program employs predictive models to identify individuals before critical events occur. A primary nurse is assigned to the member and becomes that individual's personal contact and advocate across the healthcare system. This primary nurse works with the team, including physicians, who continue to own the treatment plant, family, community-based support and behavioral and social service experts. The member also becomes an active participant by developing individualized self-care goals, which support behavior change through proven psychological techniques, while maintaining the critical support system I just mentioned.

This program is especially effective with our most fragile members, many with multiple chronic conditions and restrictions on activities of daily living. More than 75,000 Humana members are projected to participate in the Humana Cares program this year. For those who have been in the program at least a year, clinical outcomes include reductions in hospitalizations, which are down 36%; emergency room visits, down 22%; outpatient procedures, down 14%; and physician visits, down 23%.

The improvements in quality of life are equally impressive. As detailed on the chart, Humana Cares members reports life-enhancing progress across a number of factors, including health status, pain levels, sleep disruption and depression. Further, an independent survey revealed that 77% of Humana Cares participants are more confident and comfortable proactively addressing their medical conditions.

Humana Cares is only one component of our broad-based 15 percent Solution. Let's step back and take a look at how the four major elements: early identification, clinical integration and guidance, claims cost management and provider contracting come together in an integrated fashion to provide comprehensive results. The comparison of Humana's utilization to traditional Medicare provides an overall snapshot of the effectiveness of the 15 percent Solution. Inpatient acute admissions were more than 7% less for Humana's Medicare Advantage members compared to traditional Medicare, while the hospital readmission rate within 30 days of a discharge was approximately 9% less. As expected, outpatient surgery visits were 30% higher. Emergency room visits declined nearly 16% with only a nominal change in physician office visits.

I often speak about productivity gains in Medicare spending. Increasing outpatient surgery volume traded against lower inpatient utilization is a good example to why such productivity gains are good for the patient and for Humana. While these utilization reductions are impressive, weekly value quality improvements in the lives of our members and strive for progress across numerous measures. Comparisons to original Medicare measures have been historically difficult due to a lack of data transparency, but our industry is now beginning to gain access to more expansive data from CMS.

We consider data like that shown on the right side of this slide as further evidence of the value our coordinated clinical efforts add to the good work of physicians around the country. This work represents a growing body of evidence that healthcare for seniors can be organized and improved and that our government needs the good work of companies like Humana to help with the solvency of the Medicare program over the long term.

Ultimately, the 15 percent Solution must help position Humana for long-term success in an environment where payment rates are changing. As you can see from this slide, our efforts, though not complete, continue to bear fruit. This chart shows our current medical cost positioning versus the adjusted Medicare payment rates we ultimately expect to receive as the new Medicare payment quartiles are phased in over the next several years. We are very pleased with the good work the leaders and associates across the company have done and continue to do here.

Were it not for our 15 percent Solution work, our Medicare Advantage members would likely have seen substantial benefit reductions in 2011. This graph shows the medical cost trend used by CMS in determining Medicare payment rates each year, broken down between the current year forecast and the catch-up adjustment as prior-year actual experience becomes known. Clearly, there is a disconnect that we believe will get better over time as original Medicare claims history from the most recent payment years completes. The funding formula must by law reflect actual costs in out years as data matures, so that the payment rates more accurately reflect long-term cost trends in the Medicare program.

In the interim, we've invested the payments we received, which were above original Medicare, in recent years quite wisely. Using these dollars to not only improve coverage for seniors across the nation but also to: one, build expanded provider network systems, some of which have tested and proven innovative payment models; and two, to build technology support in the care management systems that drive innovative delivery system models. This investment has positioned us to reduce the unfavorable impact on our senior members of the temporary imbalance of 2010 and '11 between Medicare payment rates and what actually is happening the with medical costs.

Turning briefly to health insurance reform, although it might appear that major aspects of the new laws won't take affect for several years, a number of them are already in place. As you can imagine, insuring that all elements of health insurance reform are incorporated into our businesses seamlessly is no small task. We have well over a 100 leaders across the organization actively involved in health insurance reform project teams on a daily basis. These leaders represent all lines of business in functional areas. The lead more than 10 strategic teams and more than 30 tactical project teams. Product filings and rate filings are at or on their way to state DOIs in approximately 40 states. About 20 Humana leaders from a number of functional areas are actively involved in regulatory committees at the NAIC, AHIP and the American Academy of Actuaries. A number of external experts linked to reform are also providing us additional perspective. By quickly establishing appropriate processes, we are moving down the path to ensure what we believe will be a smooth and effective ongoing transition for our members over the next few years.

With initial commercial business implementation deadlines of September 23 of this year, we believe we are well positioned. In fact, within a month of the bill's passage, we've demonstrated our commitment to rapid progress by becoming one of the first companies in our sector to offer coverage for dependent children up to age 26.

With respect to our TRICARE business, the Department of Defense has issued several RFP amendments since our last earnings call, each superseding the previous one. However, just this past week, we submitted our final proposal revision to the TRICARE Management Activity. Our team has shown its mettle in dealing with the many starts and stops that are inherent in this process. Given this uncertainty, our projections continue to assume the contract will transition to another carrier after the first quarter of 2011 that we continue to be hopeful that we will retain the contract.

Turning now to our Commercial segment. Our underlying operating results have improved substantially versus the prior year. Non-GAAP second quarter pre-tax earnings for this segment were $115 million compared to the $35 million we reported for Commercial segment pre-tax earnings in the second quarter of 2009. This improvement reflects a combination of pricing discipline, lower levels of healthcare services utilization and our focus on lowering administrative costs. With respect to membership, we continue to adjust our commercial footprint to focus on those geographies where we can compete and win. We are also working to increase the value of each commercial member through cross-buying opportunities for our specialty, financial protection, behavioral health and mail-order pharmacy products.

Nationwide, reform is likely to increase the individual market over the long term by between 23 million and 40 million new eligibles according to a recent McKinsey study. While it is clear the individual market represents a significant growth opportunity, we will need to learn more about the regulatory implications of state's approaches to product offerings and exchanges to fully assess this opportunity. What we do expect is that the knowledge we have accumulated through our more than 25 year focus on the retail senior population will serve us well in this market, which clearly is going to evolve towards a more individual consumer focus.

In summary, some have expressed concern over future growth opportunities in Medicare Advantage. In fact, the Congressional Budget Office has projected significant disenrollment across the sector as payment rates move towards original Medicare. Against this backdrop, we believe the higher quality and lower cost embedded in our 15 percent Solution will enable us to continue to grow. This is particularly good news, not only for seniors enrolled in Humana's Medicare Advantage plans, but also for the millions of baby boomers nationwide who will age into the Medicare program in coming years.

With the continued success of our consumer-oriented approach to health benefits and now to lifelong well being, Humana faces the post-reform future with confidence. Our aggressive approach to preparing for and implementing reform is already paying off. Our traditional strength in Medicare Advantage and in the one-to-one approach is directly line with two post-reform mega trends: the coming vast expansion of the individual market and the age wave of baby boomers moving into Medicare.

Through it all, we continue our relentless and successful focus on four operating principles that have served us well, and we expect will continue to do so for years to come: consumer-focus products, industry-leading cost, robust actionable data and constant innovation to help our members improve their health and well being. We look forward to expanding upon these concepts with you at our Investor Day on November 18 here in Louisville. Regina can provide details regarding that event offline. We are pleased with this quarter's operational progress and believe our forecast for the full year 2010 demonstrates the success our associates and leaders can achieve despite the numerous changes faced by our sector today.

With that, I'll turn the call over to Jim Bloem.

James Bloem

Thanks, Mike, and good morning, everyone. I'd like to begin by detailing the changes in our earnings per share since we reported the first quarter results on April 26. As Mike alluded to in his remarks and as indicated on the slide, there were several significant items that affected our earnings per share for both the second quarter and our full year 2010 outlook.

First, during the second quarter we recorded $148 million or $0.55 per share of expense to recognize the substantial impairment of deferred acquisition costs or DAC associated with our individual medical product line. These costs, which include first-year broker commissions, as well as underwriting and other policy issuance costs, had been capitalized and then amortized over the life of our individual medical policies. We account for this line of business as a long-duration insurance product due to the guaranteed renewability provisions of the various contracts, plus, our fundamental approach to underwriting these plans. This results in pricing this book of business with a policy lifetime target medical expense ratio. From an accounting perspective, the amount of DAC on the balance sheet is continually compared to the ongoing actuarial assessment of the financial performance of these policies in order to determine whether the DAC asset is recoverable or impaired. In the second quarter, our assessment of the impact of health insurance reform, including among other things, the 80% minimum medical expense ratio, resulted in the DAC impairment charge.

Additionally, in order to meet our new lifetime policy target medical expense ratio, we expect to record an additional $38 million or $0.14 per share of individual medical policy reserves in the second half of 2010. Thus as the slide shows, a total of $186 million or $0.69 a share of expenses will be recorded this year to conform our existing individual book of business to the mandates of the new health insurance reform legislation. Neither the DAC impairment charge nor the additional policy reserves affects 2010 operating cash flows.

Second, we experienced an additional $38 million or $0.14 per share of higher-than-expected favorable medical claims development from prior years during the second quarter. As you may recall, we experienced $100 million of greater-than-anticipated favorable development during the first quarter. So with the additional $0.14 per share we experienced during the second quarter, we now have included $138 million of benefit from favorable development in our year-to-date earnings. The additional $38 million of prior period development recorded during the quarter consisted of $25 million associated with the Government segment, with the remaining $13 million being derived from our Commercial segment.

Third, and turning now to our 2010 operating performance, we also experienced approximately $79 million or $0.30 per share of greater-than-anticipated favorable development from the first quarter's medical expense estimates. This amount was recorded during the second quarter. Approximately $52 million of this $79 million related to the Government segment, with the remaining $27 million coming from the Commercial segment. Much of this favorable development was due to a lower level of healthcare services utilization, which has continued through the second quarter. Accordingly, first half year-to-date effected these lower medical cost trends, drove the majority of our over performance in the second quarter. I will elaborate on these trend improvements by business segments in just a minute, but as the slide shows, we've been cautious about re-projecting these lower utilization levels in our outlook for the second half of the year.

Continuing with operations, the second quarter also benefited from favorable performance in most of our Ancillary and Specialty lines of business, as well as better than expected selling, general and administrative cost reductions. In the first half of 2010, we have made significant progress in realigning our cost structure and organizational competencies for the future. Finally, and still with respect to 2010 operations, as we move into the second half of the year, we now anticipate investing $75 million or $0.28 a share on two things: first, certain targeted growth initiatives for our Senior Products business; and second, enhanced infrastructure.

For our Senior business growth initiatives, we've identified specific opportunities that we believe will enhance our ability to continue to grow membership in 2011. We look forward to sharing more of the details around these efforts in our third quarter earnings call, when we anticipate giving initial 2011 earnings guidance. That call is scheduled for November 1.

With respect to the enhanced infrastructure costs, we foresee investment spending on such items as increasing our capabilities with respect to the CMS five-star quality rating system, as well as continuing to build out our data capture and recording capabilities as required by the new health insurance reform law. To conclude this section, there were several significant items moving in opposite directions with respect to our second quarter results and our increased 2010 earnings guidance. Also, it's important to note that while we hope to retain the contract, our earnings guidance continues to include $50 million to $75 million or $0.19 to $0.28 per share of TRICARE charges associated with the loss of the South Region contract.

Turning next to the Government segment, As I previously mentioned, our second quarter results included $77 million of greater than anticipated favorable development, $52 million of which was derived from the first quarter and the remaining $25 million coming from prior years. Looking at our strong overall Government segment first half results, we experienced better than expected performance, primarily in our networked Medicare Advantage offerings, especially in our PPO plans. As we have discussed before, we've added approximately 190,000 Group Medicare members to our regional PPO plans in January. We've been pleased with the performance of these new groups, which experienced lower first quarter medical cost trends than previously estimated. We invested significant time and upfront effort when we enrolled these members in order to ensure that they were quickly integrated into our care coordination processes and clinical outreach programs. Accordingly, we have experienced lower than expected utilization of outpatient and physician services, as well as a higher generic substitution rate for these members.

As I mentioned in my opening remarks regarding our full-year earnings outlook, we have been cautious in projecting medical cost in the second half of the year. We have not assumed that the first half utilization improvement will continue at its current level through the second half of this year. In addition, since we experienced a significant increase in new Group Medicare members on January 1, we also remain cautious due to the possibility of a durational effect. The durational effect results in lower than normal claims cost during the initial month of membership, with claims reaching normal levels after the transition period is complete.

Moving on now to the Commercial segment. The second quarter results included a charge of $148 million for writing down our DAC asset, as I previously described. Additionally, we experienced $40 million of greater than anticipated favorable claims development, $27 million of which was derived from the first quarter, with the remaining $13 million coming from prior years.

On an operating basis, we're also pleased with the improvement in both our retail and group offerings. You will recall that last year we began experiencing higher than anticipated trends during the second quarter as a result of the number of issues, but primarily the deteriorating economy and the job markets. Thus comparing our year-to-date this year to year-to-date last year, we have experienced lower than anticipated medical cost trends and in particular, we've seen nearly flat overall physician costs, combined with negative inpatient admission trends and only a modest uptick in our outpatient utilization in the first half of the year. These trends also have been widely reported in the media.

Once again, however, we remain cautious about re-forecasting these trend improvements through the full year. I would also note that we will have some newly mandated benefits from health insurance reform beginning in the fourth quarter. In summary, we're pleased with the turnaround in overall improvement in our Commercial business this year, especially after a very challenging 2009.

Turning last to operating cash flows and capital deployment, we also are pleased to note solid progress on both these items. First, with respect to operating cash flows, we continue to generate strong second quarter operating cash flows of $325 million versus $162 million in the second quarter of 2009. This brings our total 2010 first half to $1,080,000,000 versus $207 million in the same period a year ago. As we detailed in our first quarter earnings conference call, this year's first half cash flows from operations benefited both from the nearly 190,000 increase in Medicare Advantage members since year end versus the first six months of last year, as well as the accompanying normal initial claims payment lag. And conversely, in 2009, the first half was unfavorably impacted by significantly greater PDP membership losses and corresponding claims runoff when compared to the first half of this year. Consistent with our improved but yet cautious earnings guidance for this year, we've raised our 2010 operating cash flows guidance range to $1.3 billion to $1.5 billion.

Second, with respect to capital deployment, we completed our annual discussions with the various state Departments of Insurance and the credit agencies during the second quarter. These discussions included reviews of our current statutory and surplus levels, our 2009 performance and our 2010 projections for each of the major operating subsidiaries. Based on these discussions, we remitted $747 million of dividends from the various operating units to the parent company this year. These dividends were the principle factors in the increase in our parent cash and investments to just over $1 billion at June 30, 2010.

We continue to both have and conserve ample liquidity and capital, which in turn continues to provide us with the financial flexibility needed to compete effectively in the new environment as it is unfolding. We were pleased to repurchase $50 million worth of our shares late in the quarter, following the conclusion of our discussions with the states and the rating agencies. Our capital deployment efforts remain focused on effectiveness building capital expenditures, potential acquisitions and strategic investments, as well as additional share repurchases.

To conclude, we are pleased with both our overall and operating results for the second quarter. We're confident that our updated 2010 earnings guidance range of $5.65 to $5.75 per share reflects the organizational experience and confidence that we have, as well as our continued discipline and intentional approach to the current and coming operating environment. As we move into the second half of 2010, we believe that we are both able to help our members face the uncertainty of the coming health insurance reform changes, as well as to remain financially strong and flexible as a company. Accordingly, we believe we're well positioned for continued success in providing high satisfaction to our members and solid operating results to our owners.

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

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Joshua Raskin from Barclays Capital.

Joshua Raskin - Barclays Capital

First question relates to Government segment and maybe more specifically your Medicare margins running a little bit above your 5% target. So curious just in terms of the timing of the recognition of that positive trend and maybe juxtapose that with your June bidding, and how we should think about margins for 2011 to give sort of know about all the good news? Or do you think some of this trends into next year?

Michael McCallister

Josh, I'll start by again setting the context. I mean we've always said we're targeting a 5% overall, and we did that again in the bid process. And the only question is, is where were we in terms of these trends. And there's no question that costs are soft enough this year, but we don't make any long-term assumptions off of relatively short-term data. So I think we did what we normally do, we bid based on what we knew at the time and put a 5% target for our overall business in place.

Joshua Raskin - Barclays Capital

I guess my thought is sort of understanding every year you target that 5%, but if you see favorable trends running post the submission of your bids, is it fair to assume that, that continues because your bids were just too conservative now with more hindsight?

Michael McCallister

The only way that can work, but even the 5%, as you know, we always continue to work on that. I mean, I target my bids at 5%. I always want to run better if I can because it means I'm further getting further down the path of solving my 15% problem. So again, the 5% is a target, we bid it that way, we try always to improve it, we reset it and what you're describing, which is happening to some extent here, we get a little bit better news. It's something we can't do much about it, the bids are already in.

Joshua Raskin - Barclays Capital

And then just sort of related to that, could you talk a little bit about the change in benefit design for 2011 maybe versus some of the changes that you made in 2010? Would you say it's not as dramatic, more dramatic? How did you guys think about from a bidding perspective?

James Murray

This is Jim Murray. Mike went into a lot of detail around the 15 percent Solution, and also talked a little bit about the trend environment that we were beginning to see as we did our bids. And so I would suggest that next year's not only benefit designed but also the premiums will be very positively received by the senior members that we currently have or that we hope to acquire next year. I think that one of the things that we had is a going in desire was to reduce member angst or disruption, and we feel very, very pleased with the way we were able to accomplish that in the bid process.

Michael McCallister

I'm actually anxious to see where the rest of the industry comes out on this because I know in Washington there's a fair amount of fear that premiums are going to shoot up or benefits are going to go down or some combination of both as a result of no premium increase, given what we noted the trend to be. So it will be interesting to see what happens for the industry word. I think we're in a little different spot because we've been working at this a little bit longer and we're starting to see some good traction around some of our medical management work.

Joshua Raskin - Barclays Capital

Then last part of that, what date do you send your letters out to your current members on the new benefit?

Michael McCallister

I believe it's sometime in early October, late September.

Operator

[Operator Instructions] Your next question comes from the line of Justin Lake from UBS Investment Bank.

Justin Lake - UBS Investment Bank

First, just given the introduction of new government-mandated benefits via reform, I was hoping you could talk about what you think the impact of these benefits will be to a cost trend and pricing starting in the fourth quarter and into 2011?

James Murray

This is Jim Murray. On the commercial block, we've looked at the benefit changes that were mandated, and for our small group and large group, we don't think it will have a significant impact. The line of business that it does impact primarily is our Individual or HumanaOne block of business. I've heard or read about ranges that have been thrown out there of 2% to 4%, and I would suggest that the impact that we're seeing would be on the higher end of those ranges that I've read about. But we feel very comfortable with our ability to absorb that cost increase, given where we're running on a MER basis and the 80% target that's in place for 2011.

Justin Lake - UBS Investment Bank

And then just a follow up on the Medicare Advantage side. The table that you put in the slide deck here that looks at your cost versus Fee-for-Service is interesting. I'm just curious, can you give us some color there given clearly you've done a great job in the HMO and that has proven to be sustainable. Can you talk a little bit about the Private Fee-for-Service book and the PPO book look versus Fee-for-Service costs and how you're able to take costs out there?

Michael McCallister

Justin, we've been talking about this for a long time, we've been working at it for a long time. I mentioned in my comments that we have been receiving obviously payments above old Medicare. We've done two things with those: we improved the benefits for the seniors just on pure a benefit design perspective; but we've also been investing in taking what we can of what we know about managing and organizing and coordinating healthcare and trying to take it to those looser models, which are the PPOs and the Private Fee-for-Service. So we've been expanding that across the country, we've been growing those capabilities, we've been adding people, technology and platforms and everything we can do to take best-known methods over to those more loosely operated plans, and we're seeing some decent traction. That is why we have some work to do over the next few years there. We have some work to do to get those type of plans as productive as we can possibly get them in terms of medical spend, and that's where the focus is. So are we optimistic that we can take good management across all these products? Yes. The most effective organizational structure is a well-run HMO. That's a fact, but HMOs are not attractive to everyone. They're new ideas as you take them through much of the Midwest and parts of the Western part of the U.S. So we have to take a product that people are interested in, in the short term as they get comfortable with being in the private sector. And so I would characterize the whole thing as it's going well. We have a lot of upside still. It's one of the reasons we have a fair amount of confidence over ultimately meeting the targets that are necessary for Medicare Advantage as a long-term big footprint.

Justin Lake - UBS Investment Bank

Is there a number you can put on even the PPO side? Is it 2%, 5%, 10% that you've taken out?

James Murray

The chart that was included in Mike's slide deck included obviously the HMO, the PPO and the Private Fee-for-Service, and I would suggest that the PPO is performing better than the Private Fee-for-Service and not as well as the HMO. But we're well on our way towards the 15 percent Solution in all of the lines of business, and as you know, the Private Fee-for-Service ultimately goes away and becomes a network-based plan over the course of the next several years. But we're making very good progress on the not only regional but also local PPOs.

Michael McCallister

Justin, I would also remind you that if you look at the bill in terms of how the payments ultimately come down, there is a little bit of breathing room in some of these more rural areas because the rates don't drop as far, giving us a little more premium, we're going to have a little more time, to go into those areas where it is harder to introduce an HMO.

Operator

Your next question comes from the line of Kevin Fischbeck from Bank of America Merrill Lynch.

Kevin Fischbeck - BofA Merrill Lynch

You guys have talked about targeted cost saves on the G&A side of $100 million this year and $200 million over a little bit longer time period. And I want to get a sense of whether the cost saves that you're seeing here are an acceleration of that, or whether you feel better about maybe exceeding that cost save outlook.

James Murray

What we've done this morning is basically if you look in the comparison with the second quarter of last year, you can see that in absolute dollars spent, we only spent $10 million more in the quarter than we did last year. That's 1%, and we had a 9% increase in our revenues this time. So we're getting real operating leverage, and then what that translated into is if you look in the SG&A ratio guidance and you look at the things that we called out special, the spending and the other things, you'll see that we actually are taking that ratio down by 10 basis points for the year. So we think that we're ahead of schedule. If look at our employment levels, all the commitments we made at the beginning of the year are making very good progress on the $100 million we expect to save this year and the $200 million run rate.

Kevin Fischbeck - BofA Merrill Lynch

So those two numbers still stand, though?

James Murray

Yes.

Kevin Fischbeck - BofA Merrill Lynch

And I guess I appreciate maybe give me some more color on some of these initiatives on the Q3, but I guess wanted to get a little bit of a sense now for the extra spending on the Medicare initiatives. What drove the process now versus a quarter ago at the beginning of the year? And then is this something that should be an ongoing assumption above the baseline? Or is this something that is kind of, I don't know, onetime spend heading into a difficult rate cut year?

James Murray

This Jim Murray. As we looked around some of our competition and what might likely happen with some of the Private Fee-for-Service membership that they currently hold, we saw a tremendous opportunity to make our name more well known to those 500,000 to 600,000 Private Fee-for-Service members that with our competitors now. And there's other products that we would like to introduce this 2011 that we want to get some media recognition for that came together very nicely as we were doing our bid process, and so that's why we didn't talk about them he last time. So we're very, as Mike said earlier, very focused on growing our Medicare business, and we think that the spend that we're talking about here, some of which is probably ongoing and it has been for the last several years but because of some of the wonderful opportunity that we see out there for 2011, probably some of it is, as you described, onetime in nature.

Operator

And your next question comes from the line of John Rex from JPMorgan.

John Rex - JP Morgan Chase & Co

Could you just compare or maybe actually contrast for us what you're seeing in terms of the lower utilization you're noting? When I say contrast, I mean within the government book as against the commercial book. Is it just trending directionally the same? Are you seeing anything unique in terms of the patterns of the lower utilization trends there?

James Murray

This Jim Murray again. We are seeing a slowdown in the utilization across all the books. However, I would suggest that where in last year we saw a pretty big acceleration in cost in our Commercial lines of business and not so much in the Medicare, the impact of the favorable is not as strong in the Medicare as it is in the commercial. This year it just seems like folks who are in the commercial environment, who get their coverage either by paying for it themselves or through their company, it appears like that utilization is more impactful this year than I would say that the Medicare business has been. We've tried to evaluate all of the things that might have caused that. I think Jim was very clear in all of the things that we've looked at. We looked at last year's economy versus what might be impacting things this year. Obviously, some of you have proposed that there is a high deductible health plan impact that's going on and there's probably some of that, the light flu season is contributing. And then naïvely we would like to take some credit for the good work that we do here, not only in the Medicare space, but also in the Commercial space in terms of our care coordination activities. So there's a lot of things that come together, we think, to create what we're seeing this year.

Michael McCallister

John, let me add to that. We've talked about it for years that Medicare is not real cyclical in nature. Occasionally you can get a flu season or something that'll change things a little bit, but generally it's relatively stable. If you look at the economics and the structure that sits with these folks that are in Medicare, that actually makes a lot of sense because they don't have the same economic impact from changes in the economy and this sort of thing. So if, again, it looks like that is holding to be true again. Medicare is a more stable business. It can be event driven as we saw last year, but when it comes down to cyclical in nature it doesn't seem to have much of it.

John Rex - JP Morgan Chase & Co

But while lower magnitude than the commercial book, I mean, would it be fair to say you're seeing a decline in utilization in all four of the major cost buckets in Medicare also, like you are on commercial?

James Murray

That would be a fair comment, yes.

John Rex - JP Morgan Chase & Co

And are you attributing that to the economy also when you think about, I know you talked about some of the Group business you picked up, but when you think about kind of your same-store membership, however you want to characterize it, are you attributing that to more the economic impact?

James Bloem

No, we're not. I mean, what we said this year was we've gotten new members, and those members we're looking at somewhat of a durational affect. But remember I said also, we spent a lot of time with our new members getting them enrolled, getting them introduced to our clinical integration, our outreach programs. We think on the Medicare side that's been very helpful.

John Rex - JP Morgan Chase & Co

And, John, I was thinking about kind of x those new members, that impact that you described in your comments, when you think about kind of your same store membership. When you look at that, is that just trending then the same as -- you haven't seen a change in utilization in those legacy books then?

James Bloem

Yes, not as much, and again, that sort of goes to Mike's comment that Medicare year in/year out sort of is much more constant.

John Rex - JP Morgan Chase & Co

And just the last thing. You made one interesting comment. You were seeing lower unit cost on the inpatient side also. Could you describe what you're seeing, what's driving that?

James Bloem

Lower utilization, not rates.

John Rex - JP Morgan Chase & Co

I saw in your prepared commentary also a comment that unit cost was also down in inpatient. Did I misinterpret that?

James Bloem

I believe so.

Operator

Your next question comes from the line of Carl McDonald from Citigroup.

Carl McDonald - Citigroup Inc

I was wondering how much you guys intend to rely on network Fee-for-Service plans next year? I guess maybe basically what I'm getting at is how much of your Private Fee-for-Service membership has a fairly seamless transition over to a new product versus how much of it will actually have to do dis-enroll and then re-enroll and say like a PPO?

Michael McCallister

As we talked I think last quarter, there's about 25,000 members that we are not going to be able to have a network-based solution for, and we're going to proactively go out to those folks and talk to them about our Medicare supplement products. But generally speaking, all the rest of our members have a network option that we can talk with them about be it a network Private Fee-for-Service or a local PPO, regional PPO. So we feel very good about our transitioning from the Private Fee-for-Service to the network options that has been a large part of our strategy for years and years and years.

Carl McDonald - Citigroup Inc

What I'm getting at is, maybe I'm misinterpreting this, but my understanding was if you're moving someone from a Fee-for-Service today to a network Fee-for-Service, it's a fairly easy transition. A senior doesn't have to do anything, they move over to the new product, whereas if you've got to move someone from Fee-for-Service to a PPO, there's actually some interaction that has to take place on the part of the senior.

James Murray

Of our 400 and I think 30,000 or so Private-Fee-for-Service members, we think that about, as I said earlier, 20,000 of those are not going to have a network-based option. I believe another 65,000 of those folks have a network solution, a local PPO that we will have to sell them into, and then the rest will have a network-based Private Fee-for-Service that the transition is very smooth.

Carl McDonald - Citigroup Inc

And then second, on the TRICARE, given that we have no final decision and the contract is supposed to transition eight months from now, is it possible that, that contract doesn't get extended maybe some period of time beyond the March 31?

Michael McCallister

They would have to change their historic pattern around transition periods because historically, they've dealt with a 10-month period. So obviously, we're already into that. So it's possible they can do it whatever they want relative to transitions, but if they stick to the past practices, they'll have to extend it.

Operator

The next question comes from the line of Ana Gupte.

Ana Gupte - Bernstein Research

My question is about your competitive advantage for Medicare Advantage and how sustainable that is. I think last week one of your commercially focused competitors made a comment that MA is a very attractive space. So would you be able to elaborate on to what extent from networks, product distribution, med management and the 15 percent Solution and servicing, it's very unique to the senior market versus you can leverage your spend in commercial health brackets?

Michael McCallister

Well, I read that comment. Actually, I've been surprised over the last 15 years, frankly, that we haven't had more people get serious about entering the Medicare market because, you've heard me, I talk about this 100x. It's a tremendous opportunity because of the incredible waste and abuse and nonsense that goes on in the Medicare program. The traditional Medicare program is a mess, and so it represents a huge opportunity to drive productivity, organization and all that, which makes the economics work, and that's been Humana's position for a long time. It stays that way. So do I expect others to try to get into this market and do well? Yes, of course and I think the answer's going to be is it possible? It's difficult to do. It's taken us a long time. We've been at it for 25 years to build out the level of understanding, data systems, infrastructure, the knowledge of the individual retail sale. I mean, all those things require some learnings, and you can't go buy them off the shelf anywhere in the marketplace. And so do I expect more competition? You bet, and are we concerned about it? Not really. I think we're going to enter a period over the next, short period, next two or three years, where we're going to have people leaving the market. And Jim talked about it earlier in, this next year around we're going to be dealing with hundreds of thousands of people that are in Private Fee-for-Service where we know that the companies are going to put them back in the marketplace, and so it's always a work in progress. There's always something happening. We've been successfully competing in this space against others for a very long time. So I don't know anything's going to change. I like us.

Ana Gupte - Bernstein Research

And near term when you look at the product bids, are you receiving any market intelligence as to what might be going on and who will be players that might exit and come in more strongly?

Michael McCallister

Well, we always have rumors that you probably have from the marketplace, and we try to keep our ear to the ground. But we won't know specifically what anybody's done until the cards are all turned over later in the year.

Ana Gupte - Bernstein Research

And then a related question, but not exactly on MA. Do you have any thoughts or commentary on this coding adjustment announcement that came out on the inpatient rates and what the implications are for Medicare Advantage and just broadly from a policy perspective of Medicare?

Michael McCallister

No, we don't.

Operator

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

Doug Simpson - Morgan Stanley

Could you just talk about your understanding of how reserve development related to 2010 will ultimately factor into 2011 rebates under the new rules? Just trying to understand the thought process around the specific $0.14 reserve boost in the second half of the year. And obviously we're waiting for clarity around how the MLRs are going to be calculated exactly, so just wondering sort of your level of confidence around that $0.14. And then, again, just how do you think PPD will be treated for periods prior to 1/1/11?

James Murray

This Jim Murray. As I understand it, the run out will be sufficiently long enough that as we've talked an incurred basis development of the MER and the rebate calculation. So there'll be a lot of time for those claims to ultimately resolve themselves and get paid. So I wouldn't anticipate that there'd be a problem with the implementation of this too early only to find out that prior-period development impacted it one way or another. So I think the way it's being structured will eliminate be the impact of that.

Doug Simpson - Morgan Stanley

But if did a look back, let's just say six months after the fact, so in June or July of 2012 they look back to 2011, certainly you'd have a read on how 2011 develops? But in the event that you had development in the early part of '11 related to the latter part of 2010 for periods thereafter it would be I think pretty clear, but just curious, do you think that they will include the latter part of 2010 in that development?

James Murray

I don't believe so as we're reading the regulations.

Doug Simpson - Morgan Stanley

So you don't think that late 2010 development would impact the rebate calc.

James Murray

Not as we're studying and trying to understand the mechanics.

Doug Simpson - Morgan Stanley

Is it your sense that is that something that's sort of still work in process or...

James Murray

I think the whole calculation methodology is still in process, but as to that specific element, I would be surprised to see that anything would get changed in that regard.

Doug Simpson - Morgan Stanley

And then just you guys came up with a $0.14 number. Should we think about that as being within a reasonable range of expectations depending on how the guidelines ultimately come out? Just kind of trying to understand a little bit the thought process around the specificity there.

James Murray

That $0.14 really isn't related to that particular question. That $0.14 is what's going to happen for the remainder of this year to move to next year. Coming back to your earlier question, we believe that each year stands on its own with respect to the claims runoff.

Doug Simpson - Morgan Stanley

And I think you may have given these so I apologize if I just missed them but could you remind us your state capital and RBC ratio at quarters and?

James Bloem

Basically, we're just around 400% of RBC. We have about $3.8 billion of total surplus, and the requirement is about $1.9 billion to $2 billion.

Doug Simpson - Morgan Stanley

And then just obviously it's still early here, but any read on the local market pricing backdrop or the chitchat ahead of reform implementation? Anything you can contrast between the different buckets, individual versus small group versus large group, in terms of your conversations with distribution channels? Any read sort of game theory looking out to next year and how competitors may be positioning?

James Bloem

One of the things that Mike referenced was a lot of the work that we're doing here at Humana around this whole initiative, we've got hundreds of folks that are working on this, one of the things that we are evaluating is how do we want to handle our pricing relative to the 80% and minimum MER in the HumanaOne or small group market. I will tell you that as we speak today and what we've seen over the last six months of 2010, is that the pricing environment seems as rational as I've seen it in a long time. I haven't seen anybody trying to accumulate membership. We've been watching for that very closely. It just seems like people are passing their trends along in the form of the premiums that they've come up with. We haven't seen any dramatic change or anybody trying to do anything to strategize around healthcare reform, and so that's something that we're watching extremely closely. It's something that we talk about every Monday when we have our healthcare reform update meeting, but I haven't seen a significant change in the marketplace.

Operator

Your next question comes from the line of Peter Costa with Wells Fargo.

Peter Costa - FTN Midwest Securities

On the commercial side, you're low MLR and your high SG&A almost a foregone conclusion I assume that you have to do something here before we get to the MLR minimums in terms of the Individual business. Can you talk about cutting broker commissions and the timing on when you'd have to let them know and what your expectation is for what that's going to take your business when you do that? And then the second question on Medicare, do you believe you can get to four or more quality stars in your PPO business? And how will you do that, what sort of timeframe? And what sort of things should we look for you to do between now and 2012?

James Murray

Sure. This is Jim Murray again. As it respects to the commissions, we have a long standing, positive relationship with the brokers that are a part of our distribution channel. Some of our competitors have come out and said that they're likely to change their commission levels starting in January, and we're likely to come out with something here shortly that would suggest that as well. One of the other teams that we have that's working on the healthcare reform is evaluating what we think the commission levels need to be going forward to make primarily the HumanaOne or individual book of business the model around that a lot more economically profitable for us as the company. Lots of evaluations being done. We've got some outside help in trying to figure out what might ultimately happen. One of the advantages that we have that others might have is that we have a significant array of different products that we can try to think through in terms of the brokers relationships with us as an organization. We've got Medicare products, we've got medical products, we've got all of the supplemental and Specialty products that we've talked about in the past; and we're rethinking our commission structures relative to all those lines of business and seeing whether or not we can, to the extent we have to lower permissions on the medical HumanaOne, perhaps we can do something differently in the others, and all those things are being discussed and evaluated. I will tell you that with our HumanaOne business, with a minimum medical expense ratio of 80% that we feel comfortable that we can change our administrative cost structure to get to a point where we're breaking even or producing a nice medical or a small medical margin, and that's why we've talked a lot in the past about cross buying and all those other lines of business that we would include with our medical relationships with those individuals. So we feel very comfortable over the next several years that our profitability in the HumanaOne space can be solid, and as Mike said on his call, we're looking forward to the $40 million or so eligibles that would participate in that marketplace. I've talked so much right now that I forgot your second question.

Michael McCallister

Second part is Medicare Advantage, can we get to four stars?

Peter Costa - FTN Midwest Securities

In the PPOs in particular.

Michael McCallister

It's harder because of what I said earlier, it's not as well organized, it's not as tightly managed. And so we think we can make good progress there, and I think we've got an awful lot of resources and commitment and investment going into that particular thing right now. Some of it is capturing data. What we know about this sort of thing throughout all of our space is that the data assets can always be better, and there's an awful lot of information that resides in position practices and elsewhere that we're not aware of that would reflect actually better performance. So we'll work really hard to learn what we can about what they are doing with patients. We will apply our clinical activities to improving those results, and at the end of the day, I think we will do fine in the PPO but it is harder. It's a bigger lift that it is in an HMO, that's for sure.

James Bloem

The only thing that I would add to what Mike said is that we're working with the regulators to try to refine some of what they're doing around the quality initiatives. If we had to dream some of the ways that they measure and what they measure would be changed to focus more on quality and outcome, and so that good work is continuing.

Michael McCallister

If you go through all those measurements for those star ratings, you would find very quickly that they were never designed for this particular purpose, and there's some things in there that although they're really interesting and probably nice things to measure, you would never use those to drive payment rates in a program like this because a bunch of them are not really healthcare quality type of things. They're much more consumer experience stuff, which is interesting, and we all work hard on that stuff. But that's not what this policy should be driving, but for the moment, it is what it is and we'll see if it changes.

Operator

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

Daryn Miller - Goldman Sachs Group Inc.

This is actually Daryn Miller sitting in for Matt. Can you just confirm what rate you pay in Medicare on out- of-network hospitals and doctors? Does that just default to the Medicare fee schedules?

James Murray

For most of our out-of-network is Medicare allowable, so yes.

Operator

And your final question today comes from the line of Sarah James from Wedbush.

Sarah James - Wedbush Securities Inc.

Can you walk us through some of the drivers in the individual reserve who sort of what were the big pieces there? And then second, on the deferred acquisition charge, what is the underlying change in renewal rates that's implied there? Or maybe what is the lifespan of a contract now versus where do you see it going?

James Murray

Well your question basically highlights a couple of things. One is there are an awful lot of variables that go into the determination of whether or not there was a DAC impairment, and then now what those individual incremental policy reserves will be. We don't get into what each of those are, but you've named a couple of them. A couple more would be the mandated benefits, as I mentioned in my remarks, the minimum MER, the fact that there's going to be rate reviews on how much rates are going to be allowed. So those are the types of things. No one of those things, if you knew one of them, you'd still be at a loss to figure out the whole thing because of the fact that there are so many of those that actuarially go into the determination of what the policy reserves will be and whether or not there's been a DAC impairment.

Operator

Okay, I turn the call back over to Mr. McCallister as there's no more questions.

Michael McCallister

Well, thanks for joining us this morning. I want to thank the Humana associates that are on this call for the great work they've done to bring us to where we are this year. We are optimistic about the remainder of 2010. We're anxious to enter the Medicare selling season later this year, and we're pretty optimistic about what our future looks like there as well. So thanks for joining us. See you next quarter.

Operator

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

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Source: Humana Q2 2010 Earnings Call Transcript
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