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Executives

Mark Bertolini - Chief Executive Officer and President

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

Joseph Zubretsky - Chief Financial Officer and Executive Vice President

Thomas Cowhey -

Analysts

Ana Gupte - Bernstein Research

Joshua Raskin - Barclays Capital

Peter Costa - Wells Fargo Securities, LLC

Justin Lake - UBS Investment Bank

Charles Boorady - Crédit Suisse AG

Scott Fidel - Deutsche Bank AG

Matthew Borsch - Goldman Sachs Group Inc.

John Rex - JP Morgan Chase & Co

Kevin Fischbeck - BofA Merrill Lynch

Christine Arnold - Cowen and Company, LLC

Aetna (AET) Q3 2010 Earnings Call November 3, 2010 8:30 AM ET

Operator

Good morning. My name is William, and I'll be the conference facilitator today. At this time, I would like to welcome everyone to the Aetna Third Quarter 2010 Earnings Conference Call. [operator Instructions] I would now like to turn the conference over to Mr. Tom Cowhey, Vice President of Investor Relations. Mr. Cowhey, please go ahead.

Thomas Cowhey

Good morning, and thank you for joining Aetna's Third Quarter 2010 Earnings Call and Webcast. This is Tom Cowhey, Head of Investor Relations for Aetna. And with me this morning are Aetna's Chairman and CEO, Ron Williams; President, Mark Bertolini; and Executive Vice President and Chief Financial Officer Joe Zubretsky. 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, our first and second quarter 2010 Form 10-Qs and our third 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 third quarter 2010 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. One additional item of note, we would like to take this opportunity to invite you to our 2011 Investor Conference, which will be held at Aetna's headquarters in Hartford on March 4.

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

Ronald Williams

Good morning. Thank you, Tom, and thank you all for joining us today. This morning, we reported third quarter operating earnings per share of $1. Excluding favorable prior period development, third quarter operating earnings per share were $0.84, higher than the consensus estimate of $0.67 as the result of sound operating fundamentals. These results are a continuation of our strong performance in the first and second quarters, bringing our year-to-date operating earnings per share to $3.03. Our third quarter commercial medical benefit ratio was 80.5% or 82.2% excluding favorable prior period development.

Our performance this quarter, as in the first two quarters, reflects the favorable impact of the management actions we took to improve the underwriting margin profile of our business, as well as favorable utilization trends. We continue to deliver strong operating results. We are strategically positioning the company for future success with the goal of shaping more effective health care systems.

Over the past several years, we have been emphasizing three core elements of our strategy to shape more effective health care systems. 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.

Let me highlight some of the strategic successes we have had in these areas during the third quarter. First, with respect to deep customer insight, we continue to diversify our revenue streams by leveraging our medical management capability. This quarter, we were awarded a new Medicaid contract in Illinois commencing in the first half of 2011. This forward contract covers the aged, blind and disabled population in six counties. We are proud to have been chosen to serve this complex medically challenged population. With respect to information and decision support, our transparency, integration and engagement initiatives are designed to improve quality and lower total cost for our customers. By leveraging the power of technology to provide personalized evidence-based information, our goal is to create an information-driven marketplace.

In the quarter, Aetna's ActiveHealth was selected by the state of North Carolina to provide disease management, case management and wellness services to its 562,000 members, effective January 1, 2011. Notably, this contract involves ActiveHealth in helping foster a patient-centered medical home model for providers throughout the state. North Carolina is the first state where a state health plan is instituting a broad-based strategy to move members for a community-based patient-centered medical home model of care, and we are proud to be part of that effort.

Our strong third quarter performance provides us with an updated 2010 full year outlook. We now project a commercial medical benefit ratio of 81% to 81.3% and operating earnings per share of approximately $3.60. This revised outlook incorporates the prior period development reported in the third quarter, improved commercial underwriting margins and a revised view of SG&A spending. Joe will provide additional details on our 2010 outlook in a moment with some commentary on 2011. Mark will then provide an update regarding the key operational drivers of our 2010 performance.

First though, I would like to briefly comment on Health Care Reform. We are still awaiting further guidance regarding how key provisions of Health Care Reform will be implemented. As we have said, 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 this new law, the more comprehensive benefits required will result in higher costs for American consumers. We're actively involved in the regulation development phase of reform, and we are working collaboratively with the parties responsible for developing the regulations to provide our thought leadership and expertise.

We would welcome a renewed focus on discussing market-based solutions that address the critical issues of quality and affordability. In the 10 years I have been with the company, we have faced many challenges from our turnaround to the passage of Health Care Reform, and I have a great deal of confidence in 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 an information-driven health care marketplace.

Our financial strength and flexibility provide a strong foundation for future success and we have a seasoned leadership team. In that regard, it gives me great pleasure that Mark Bertolini will become CEO of Aetna in a few weeks. Mark and I have worked closely together over the past seven years in running this company. Mark has developed a reputation as a thoughtful strategist and is an individual dedicated to strong operational execution. In addition, he has taken a leadership role throughout the reform effort, and I know that experience will serve him well in his new role.

Mark and Joe, and my management team, will continue to strive for industry-leading performance. I will remain at Aetna full time in the role of Executive Chairman until April of next year. As Executive Chairman, I will chair the Board of Directors, continue to work closely with Mark on strategy and transition the relationships I have developed with various important constituencies to Mark. In addition, I would like to thank all of 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 to provide insight into our third quarter financial performance and our 2010 outlook. Joe?

Joseph Zubretsky

Thanks, Ron, and good morning, everyone. Earlier today, we reported third quarter operating earnings per share of $1, an increase of 45% compared to the prior-year quarter. Excluding prior period reserved development, operating earnings per share was $0.84. Third quarter operating earnings of $420 million were 36% higher than the prior-year quarter. This was a result of higher commercial underwriting margin due to improve underlying performance and favorable prior period development, partially offset by lower commercial membership.

Other key highlights of the quarter include a commercial medical benefit ratio of 80.5% or 82.2% excluding favorable prior period development. A Medicare medical benefit ratio of 84.9% and a business segment SG&A ratio of 18.5%. I will now discuss the drivers of our third quarter financial performance, starting with operating margin and its key components.

Third quarter before tax operating margin was 8.7%. Excluding prior period development, the operating margin was 7.4% before tax or 4.8% after-tax. Third quarter revenue of $8.5 billion included a 2.5% year-over-year decrease in Health Care revenue. This was driven by a 2.6% decrease in Health Care premium, which reflected a net decrease in commercial premium of approximately 5%, resulting from a volume decline of approximately 11%, a rate increase of approximately 11% and a 5% decline for mix associated with product, geography and customer market segment.

Health Care premium also reflected a 3.3% increase in Medicare premium and a 17.6% increase in Medicaid premium related primarily to membership gains. In addition, third quarter fees and other revenue declined 2.7%, primarily due to lower fee yields, reflecting a competitive pricing environment.

Our third quarter total medical benefit ratio was 81.8%, which included $107 million before tax of favorable prior period reserved development. This amount related to second quarter dates of service across all products, including $90 million in Commercial, $6 million in Medicare and $11 million in Medicaid.

Our third quarter commercial medical benefit ratio was 80.5% or 82.2% excluding prior period development. This favorable result was due primarily to lower underlying utilization. Our third quarter Medicare and Medicaid medical benefit ratios were 84.9% and 88.8%, respectively. The Medicare MBR decreased by 50 basis points year-over-year, while the Medicaid MBR increased by 220 basis points. The year-over-year increase in the Medicaid MBR was partially driven by unfavorable experience in one contract. On a full year basis, the Medicaid business is tracking with our expectations.

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 September 30, consistent with the second quarter. We continue to project days claims payable to be in the low 40s over time. Group Insurance operating earnings were $34.6 million during the quarter, representing a year-over-year increase of 3.9% in line with expectations.

Our business segment operating expense ratio of 18.5% was better than expected due to the impact of changes we made to our defined benefit pension plan, the delay of some spending now projected to occur in the fourth quarter rather than the third quarter and disciplined expense management. With respect to the defined benefit pension plan, we elected to freeze the plan as of December 31, 2010, while enhancing the employer contribution to our 401(k) plan to make our retirement benefits more appealing to a broader employee base. This change lowered our pretax expenses by approximately $21 million in the third quarter.

Turning now to membership. We ended the quarter with 18.5 million medical members, a sequential decline of 74,000. This contraction reflects a decline of 112,000 commercial members, of which 82,000 were insured and 30,000 were ASC. The commercial decline was driven by economic attrition of approximately 70,000. A decrease of 2,000 Medicare members and an increase of 40,000 Medicaid members, of which approximately 15,000 were from new contracts in Pennsylvania and Florida. The remainder of the increase was due to increases in eligibility and enrollment throughout the remainder of our footprint states.

The final area of financial performance I will comment on is our investment performance and management of capital. Third quarter net investment income on our continuing business portfolio was $170 million, relatively consistent with the prior year. Our portfolio position is strong with an unrealized gain position on the continuing business portfolio of $1.1 billion before tax at September 30.

Our financial position, capital structure and liquidity all continue to be very strong. As of September 30, we had a debt-to-total-capitalization ratio of under 31.6% as we issued debt to pre-fund a portion of a debt maturing in 2011. Our liquidity remains strong as well. We started the quarter with $100 million of holding company liquidity. During the quarter, we issued $750 million of 10-year 3.95% senior notes in anticipation of debt maturing in 2011. Third quarter dividends and other sources of funds to the parent were $716 million. We deployed these sources to fund $526 million of share repurchases, cover fixed charges of $45 million, contribute approximately $330 million after-tax to our defined benefit pension plan and reduce our outstanding commercial paper by $215 million.

During the quarter, we repurchased 17.8 million shares. Our basic share count was 400.1 million at September 30. Through the end of the third quarter, we have repurchased 33 million shares year-to-date for $1 billion. We ended the quarter with holding company liquidity of approximately $450 million.

For the third quarter, Health Care and Group Insurance operating cash flow was $186 million or $515 million excluding the pension contribution. This result reflects the return of excess Medicare payments we received in 2009. Year-to-date, Health Care and Group Insurance operating cash flow, excluding the pension contribution, represented 104% of operating earnings excluding pension expense. As we previously guided, due to various timing items, the full year 2010 cash flow is projected to be about 100% 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 approximately $3.60, a $0.50 increase from the midpoint of our previous guidance range. This increase reflects the favorable development reported in the third quarter, improvements in commercial risk underwriting margin and an impact of the change in our retirement plans and lower SG&A spending. We project 2010 year-end medical membership to be approximately 18.4 million members, consistent with previous guidance. This reflects a decrease in commercial membership, primarily ASC from continued projected economic attrition. The decrease in commercial members is expected to be partially offset by growth in Medicaid. We now project that total company revenue will be down by slightly less than 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 at the low-end of our previous range of 8% plus or minus 50 basis points; a 2010 commercial medical benefit ratio of 81% to 81.3%; and a 2010 Medicare medical benefit ratio that is in the high 80s. For the full year, we also project: a business segment operating expense ratio below 19%, which is slightly lower than our prior guidance; a full year before tax operating margin in excess of 7.5%; and a debt-to-capitalization ratio of approximately 30%. In summary, we are pleased with our third quarter performance and are confident in our outlook for 2010.

Turning now to 2011. We are in the midst of developing our 2011 operating plan and are factoring the potential impact of the new regulatory environment into our analysis. We are not prepared to share specific 2011 operating earnings per share guidance at this time. In general, there are a number of challenges to confront with respect to 2011. We expect to see a decline of approximately 550,000 to 600,000 members in the first quarter of 2011, with the majority of the loss from large account ASC customers. This is due to lower account retention due in part to competitive pricing and the continuing impact of economic attrition. The membership for the remainder of 2011 will be highly dependent on the state of the economy and employment.

Earnings in the 2010 benefited significantly from favorable prior period reserved development, which we, as a matter of course, do not project to recur. We are also expecting the extremely low interest rate environment to continue and while we have an outline of minimum MLR [medical loss ratio] regulations, offered by the NAIC [National Association of Insurance Commissioners], there are still many issues that are not finalized.

In the midst of these challenges, we continue to develop our 2011 plan, which will include favorable impacts from expense actions to adjust our cost structure to be aligned with our membership projection, continued pricing discipline with a focus on pricing to forward view of medical cost trends and rigorous execution of medical management and quality initiatives, including targeted provider recontracting.

As the fourth quarter progresses, we will continue to work through our planning process for 2011, incorporating evolving views of Health Care Reform in the uncertain economy. We will provide detailed 2011 guidance on our fourth quarter call in early February, and we will elaborate further at our March 4, Investor Day.

I will now 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 third quarter operating performance, starting with pricing and underwriting. We have continued to maintain our discipline in these areas with the objective that our pricing decisions reflect our projected medical cost trend.

During the quarter, the positive spread between our premium yield and medical cost trend continued to improve. This achievement demonstrates that the management actions we put in place to price to trend and achieve our target margins have worked. Last year, we indicated that achieving a sustainable positive spread between our premium yield and medical cost trend would take two years. Our results demonstrate that we have reached that milestone earlier than we had projected.

Next, with respect to medical quality and cost management. The actions we initiated last year to improve the management of our medical costs are also working as planned. The results of our previously discussed actions and strategies, as well as the lower utilization that we experienced in the first three quarters of 2010, contribute to our projected annual 2010 medical cost trend at the low end of the previously guided 8% plus or minus 50 basis points range. This projection includes an impact from the mandated benefits required by Health Care Reform and reflects inpatient cost trending in the high single digits, outpatient cost trending at the high single to low double digits, physician cost trending at mid to high single digits and pharmacy costs trending at high single digits.

Going forward, we are focused on impacting medical costs through facility recontracting, reimbursement policies, concurrent review and integrated case and disease management among other initiatives. Specifically, we are leveraging systems and our workforce to find and manage the impactable portion of the costs for the 3% of the members who generate 50% of medical costs, while continuing to improve outcomes. By offering the right benefit designs, effective provider networks, health and wellness programs and information tools, we believe that our members can make more informed decisions on purchasing affordable health care products and solutions.

A brief update on our agreement with CVS Caremark. We announced our long-term strategic relationship with CVS Caremark in July of this year. This arrangement is an outstanding solution for our customers and shareholders. By maintaining control of clinical functions, while outsourcing the CVS Caremark, those functions that benefit from their economies of scale and technologies, we are creating a world-class solution that we believe will be unparalleled in the industry. As we continue to describe the power of this unique offering to our customers, we are confident that it will improve our competitive position in the marketplace and specifically improve the retention of our pharmacy membership over time. The integration and necessary state regulatory approvals are on track for an end of the year commencement. We are still on target to incur $0.06 per share in integration costs for 2010.

Now turning to our CMS sanctions. As you are aware in April 2010, CMS suspended our ability to market to and enroll new members in all Aetna Medicare Advantage and Standalone Prescription Drug Plan contracts. We do not expect these sanctions to be lifted until after the start of the open-enrollment period on November 15. We take this issue very seriously and had devoted additional personnel and resources to fully meet the needs of this important customer. However, it is important to note that the segment most impacted by these sanctions is our individual Medicare business. CMS has granted us a limited waiver of these sanctions to allow us to continue to enroll members into existing group plans through December 31, 2010.

From a financial perspective, our estimate of the impact of the sanctions will be incorporated into our full year 2011 guidance when given. The impact to our Medicare membership has been incorporated into the membership projection for the first quarter of 2011 that Joe discussed. After the effective mitigating actions we intend to take, we project the impact of the CMS sanctions on 2011 operating EPS will be no greater than $0.10 per share.

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. The recent NAIC votes is just one step closer to final MLR regulations. We continue to be engaged on a range of issues, including grandfathering, rate review guidelines and the impact from mandated benefits, and we continue to appropriately price our products in alignment with underlying medical costs. We are focused on creating market-based solutions to address our customer's number one priority, which is the affordability of quality health care.

Our Health Care Reform implementation team remains focused on both the immediate and the long-term 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 law and identify the strategic business opportunities that may emerge as a result of reform. We are confident that Aetna is well positioned to be successful in the post-reform environment. We remain committed as we have been in the past to be part of the solution.

Finally, I would like to thank Ron Williams and the board for their confidence in me, and I would like to thank Ron for his leadership of Aetna. Over the last 10 years, Ron has built a strong culture that and guided by values and by a focus on the people who use our services. Over the last seven years, Ron has provided me with important insights and development in preparation for the opportunity ahead. And for this, I offer him my sincere thanks.

Aetna has exceeded over the past 157 years by shifting to meet the needs of the market. We have a brand that will carry us into a new era for our country and our industry. This company is poised to lead our industry into the future of health care. I am honored to have been name Aetna's next Chief Executive Officer, and I will work diligently to navigate this challenging environment on behalf of our customers, our shareholders and our employees.

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

Thomas Cowhey

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

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from John Rex, JPMorgan.

John Rex - JP Morgan Chase & Co

As you look at your own results in 2010 and particularly on the utilization side, can you help us understand maybe what you're seeing in your own book, in terms of what may be more secular impact in terms of the lighter utilization versus it being all just about the economy or maybe, say, are you the view that it is all just about the economy?

Ronald Williams

This is Ron speaking. I think there clearly is an interaction between the broader macro environment but also the actions that we've taken to improve many of the more intensive case management, disease management types of programs, which are designed to prevent unnecessary care in the context of the member being able to get the services they need in a lower cost setting or to be able to actually avoid hospitalization. I'll ask Mark to provide a little more color on that.

Mark Bertolini

John, we have been seeing since the third and fourth quarter of last year a decline through the various sectors of health care utilization, primary care, pharmacy, lab, radiology, ultimately specialists and hospitals, a sort of a wave of decline in utilization. And we believe that, that is somewhat attributable to the high unemployment rate and people running off of benefits in COBRA over time. But we also have had an impact in the areas we identified last year around what we call the intensity. Utilization in certain areas of the provider mix where we focus programs to get at what we thought was unusual or high utilization based on the economy, prior to 2009.

John Rex - JP Morgan Chase & Co

And so in that context, what are you incorporating in terms of '11 med [medical] cost trend view? You said your kind of pricing year '11 in line with that view, how much do you expect your cost to go rise in '11? And maybe bring into that both the impact of reform and just some rebound on utilization?

Mark Bertolini

So John, we do not expect the low utilization to go forward into 2011. We expect it to be increased by certain factors, including Health Care Reform and increasing benefits associated with Health Care Reform. Also, with a return to some normal utilization due to the economy, although we watch the interplay between utilization and the unemployment rate very closely. So depending on how the economy recovers could have an impact. So we're assuming a higher level of utilization and definitely not expecting the same kind of trend we're seeing in 2010.

John Rex - JP Morgan Chase & Co

So it would be fair, I mean, you say, kind of back to the 8% midpoint of the 8% plus/minus 50 bps is what you're assuming? Or a bit higher than that?

Mark Bertolini

We're not giving any guidance on 2011 on trend at this time.

Operator

We'll take our next question from Joshua Raskin, Barclays Capital.

Joshua Raskin - Barclays Capital

Just first, the prior period reserved development that you called out for the full year. How much of that is actually prior year and not intra-year? And then, maybe if you can talk a little bit more about the competitive pricing actions you're seeing in the ASC market for 01/01, is it fair to assume that those our other large national plan?

Joseph Zubretsky

Josh, this is Joe. All the prior period development, the $107 million was off of the second quarter dates of service. So it was intra-year and restates the second quarter performance, and I'll let Mark answer the second question.

Mark Bertolini

Josh, on the pricing actions we're seeing on national accounts, we've seen certain sectors of the national marketplace get very focused on short-term costs, particularly around -- and hard dollar savings that they can bring to the P&L as they manage their own operating expenses. That relates both to discounts and fees, particularly on buy-ups. And in those areas, where it is competitive, we have found some plans have been willing to take more risks and performance guarantees than we had and we have maintained our pricing discipline going forward.

Joshua Raskin - Barclays Capital

Just you have sort of think back last couple of years, it seems like Aetna was willing to take a little bit more risk on their fees, historically. Is this a function of you guys pairing back that appetite for risk and the market sort of caching up? Or is this a real inversion where the other carriers are changing the way they think about taking this?

Mark Bertolini

It was our belief that moving into that 2009 economy that was too unpredictable in the economy to predict the trend going forward and to guarantee that the rate that others are willing to do so.

Operator

We'll take our next question from Christine Arnold, Cowen and Company.

Christine Arnold - Cowen and Company, LLC

First, on pension expense, you said that you froze the pension expense and a $21 million benefit in the quarter. How do you expect pension expense to change next year versus this year?

Joseph Zubretsky

Christine, the is Joe. When you freeze the pension plan, you get a longer amortization of the unamortized actuarial loss. So going forward, our pension expense, the financing component of our pension expense will reduce. Think of it as the old amortization schedule was roughly nine years and the new amortization schedule is approximately 30 years.

Christine Arnold - Cowen and Company, LLC

But does this mean that your pension expense will decline year-over-year in 2011 versus '10?

Joseph Zubretsky

While the valuation hasn't yet been done for December 31, most likely, it will decrease, yes.

Christine Arnold - Cowen and Company, LLC

Even with the decline in the discount rates?

Joseph Zubretsky

Well, we've had good growth in assets. Think of -- if you look back at the valuation at the end of last year, we had about a $700 million deficit. The assets grew by roughly that amount and the discount rate decreased by 100 basis points, increasing the liabilities by an equal amount. So the pension deficit has actually stayed pretty consistent year-over-year, asset growth, offsetting the growth in the liability due to lower discount rates.

Christine Arnold - Cowen and Company, LLC

And then when you said that Medicare Advantage and PDP will be no more than a $0.10 drain, does that include actions you're taking to reduce the SG&A or is that exclusively the results of looking year-over-year and losing profitable memberships?

Joseph Zubretsky

Christine, that's after the effects of all mitigating actions, including marketing expenses, SG&A actions and the like.

Operator

We'll take our next question from Justin Lake, UBS Investment Bank.

Justin Lake - UBS Investment Bank

First, for Ron, given you've spent a ton of time in D.C., representing the industry during the reform debate, I'd just like to hear your thoughts on the implications of yesterday's election and how that might change the implementation of reform going forward?

Ronald Williams

Well, I think we have to start with the recognition that the current law is a law of the land that we're very focused on working with the regulators today on the implementation of the final elements of the law. I think one of the things that has changed even before the election is the closer you get to really working with the customers and the corporations and employers and really understanding the impact on affordability and choice and the ability of people to keep what they have, I think what we're finding is that the regulators are balancing these points of view in a way that's resulting in an attempt to make certain people can keep what they have. But at the same time, the law is implemented fairly and effectively. So I would start with -- really, our focus right now is really on this whole regulatory domain. When it comes to the future Congress, I think we'll have to see what unfolds. I think that we are likely to see a reflection of more market-based solutions that give consumers more choice. And I think that's one of the things that consumers seem to be saying when they put on their voter hat is more market-based solutions, which we think is good for the sector.

Justin Lake - UBS Investment Bank

And Mark, I know you deal a ton at the state level, any thoughts on 10 State and House's swing, the Republican way, and what the implications there could be?

Mark Bertolini

I think, Justin, that it will be an education effort that we will need to gear up for new governors and appointed insurance commissioners that now will come into play. So we've invested, and I invested over the last couple of years, a lot of time in getting people up to speed at the insurance commissioner and governor level, state-by-state. And I think we have to renew that effort and refocus that effort. We believe they will also be interested in market-based solutions and the impact on their local state economies, including their own Medicaid and state employee populations. So we are gearing up for those conversations, as we speak.

Justin Lake - UBS Investment Bank

And just second question on the membership outlook for the first quarter next year, you laid out the decline, talked to national accounts and Medicare Advantage as being two pieces of that. We've been reading about some market exits. I think there was announcement out of New Mexico, as well as Michigan. Just wondering what you're thinking for commercial risk for first quarter in terms of both, are you seeing any improvement in group attrition or retention rates? And the impact of these market exits, what they might have in terms of membership for next year?

Mark Bertolini

We're not giving any guidance on 2011. But I can tell you that as a normal course of business, Justin, we go in and out of markets as we evaluate our performance by segment, by market throughout the year. And so those exits that you've seen are a part of our normal course of activity related to whether or not we believe we can be competitive in certain markets. I think you noticed in Michigan that there was some action taken relative to the competitiveness of that market by the Attorney General and the Feds regarding some provider contracting issues. We will continue to do so and where we see a rational and appropriate regulatory environment, we will remain in those markets and when we will believe it's not in the interests of our customers or our shareholders. We will exit.

Operator

We'll move to our next question from Matt Borsch, Goldman Sachs.

Matthew Borsch - Goldman Sachs Group Inc.

Just a little bit more on the pricing environment you're seeing, if I could, and I wanted just to understand if the headwind there is mostly with jumbo accounts? Or does it go down into the self-funded middle market, if there's any concentration? Is there any regional characterization? And are we talking about multiple carriers or one in particular, not that I expect you to name them, but one in particular that's driving it?

Mark Bertolini

Matt, the pricing environment remains rational across the board and in large part. There are certain aspects of the lower end of national accounts where we see more competitive behavior around discounts. In the jumbo accounts, they tend to be much more sophisticated buyers and interested in the longer term, have the wherewithal to sustain their strategies around health benefits where smaller employers of the lower end of national accounts tend to have more difficulty. Competitors, I wouldn't name any, but there aren't that many.

Matthew Borsch - Goldman Sachs Group Inc.

And on the risk side, though, would you characterize the environment as having any of these dynamics there or not? And just if I could ask one other question relative to that, would you characterize your commercial price increases overall going into next year as about the same as they were or higher or lower a year ago going into 2010?

Mark Bertolini

Again, we're not giving 2011 guidance. However, in the commercial risk environment, we do see the market as being rational and continues to be rational across the board. The commercial market is about total costs and that is our value proposition in the ASC market as well. And so it's all about what the out the door premium is or out the door cost.

Ronald Williams

One thing that, Ron's speaking, that it's worth perhaps commenting is that it's fair to say that our pricing in 2010 did reflect some catch-up, and I think that's probably one thing that's worth pointing out.

Operator

We'll take our next question from Kevin Fischbeck, Bank of America Merrill Lynch.

Kevin Fischbeck - BofA Merrill Lynch

I guess, Mark, I would love to get a sense of as you assume the CEO role, what your top priorities are going to be? Heading into next year, generally, I mean, I guess, we can talk about as a risk to Health Care Reform, but even kind of outside of that, what are your top key objectives for next year?

Mark Bertolini

I think the objectives are as follows: continued operating performance and execution against our plans; the base business fundamentals, as Joe mentioned earlier, are very strong; and that will provide capital and the ability for us to diversify revenue and earnings, which is something we'll talk about at a later date, at the March 4th conference. But we'll talk about how we see the world post-reform and the opportunities that we have developed. Joe, Ron and I over the last year or so as we anticipated the impacts of Health Care Reform on the business model. And then finally, we do need to be compliant with the law. We do need to understand regulations and find in all that regulation the best way to serve our customers and our shareholders. So those would be my top three priorities.

Kevin Fischbeck - BofA Merrill Lynch

And then I guess maybe as you can talk a little more about the Medicare CMS suspension, given the fact that we have a shorter selling season, a lot of company are talking about having a higher selling costs in Q4, is it appropriate to think about you potentially not having, I guess, by definition a "new normal" selling costs in Q4 because you can't market? Or are there going to be elevated costs regardless of the suspension?

Mark Bertolini

I would expect that, specifically related to Medicare, that we will see reduced distribution and marketing costs because we cannot market and be active during open enrollment.

Operator

We'll take our next question from Ana Gupte, Sanford Bernstein.

Ana Gupte - Bernstein Research

Just a little more granularity on the question around the elections, particularly related to these state basics changes. So with the outcome of the governor races potentially the insurance commissioner appointments, and then anything from the GOP [ph] control of the House, all these specific elements that you can influence to make these exchanges more industry-friendly? And does that change your sustainable margin expectations?

Ronald Williams

I think the comments that we've heard, as we've talked with different candidates for office around the country is clearly, the states are under budget pressures and the timing on the implementation of the exchanges is a challenge. How that will be unfold will be really up to the administration, with the new Congress to figure out what the capacity of the states are to really implement those. I think the other question that will be discussed and debated is really the structure of the exchanges as we have a more Republican governors who may have interest in different models. And I think the legislation permits different models, and so I think the question as to exactly how each state chooses to implement may very well tip it more toward a market-based solutions as opposed to others. But I think this is going to be a process that the administration is going to have to work out with each governor and each governor will have their own point of view in their area.

Ana Gupte - Bernstein Research

And then a follow up on the exchanges again, the result of Mutual and McDonald's and limited benefits in 3M on retirees. In the recent days, have you seen any change in the posture of the employers in different employer sizes on their likelihood of dumping employees, if you will? And are you having conversations with them, brokers in D.C., to preserve the integrity of the marketplace?

Ronald Williams

Well, I think it's fair to say that there is an awareness of both the unanticipated implications of some of the law and an awareness of the reactions of different types of employers who are struggling with understanding the clarity. For example, one of the things that I talked to a lot of employers about is the whole question of part-time employment and the automatic enrollment and how does that all work and how do their business models change as it relates to that. And so I think as you get closer and closer to implementation and really understanding the impact on the employer, both the administration, as well as the employers are working to find a path through this. And I think that that's the tone that as you really get down to the nitty-gritty, there are really choices that are going to have to be made. And I think there's a strong desire for people to be able to keep what they have and to make changes and ways that are reasonable and give consumers optimum choice. So I think that employer dialogue is extremely important, and we are hearing lots of input from our employers.

Operator

[Operator Instructions] We'll take our next question from Scott Fidel, Deutsche Bank.

Scott Fidel - Deutsche Bank AG

First, just a follow up on the CMS sanctions. And just wondering, how does that impact your ability to do acquisitions in the Medicare market, not that we're expecting you to do a Medicare deal eminently, but does that essentially restrict your ability to do M&A until those sanctions are limited?

Ronald Williams

The answer is, we do not believe that it would impact our ability strategically to pursue a particular type of acquisition. We're not commenting on whether we would have an interest in Medicare or not, it's really just a structural question that we're answering at this point.

Scott Fidel - Deutsche Bank AG

And then just a follow up, can you give maybe an initial view or framework on how much administrative expense, rationalization opportunity you see for 2011? And then, maybe touch on the longer-term opportunity, then maybe within that, just an update on activities around rationalizing of commissions relative to the minimum MLRs?

Joseph Zubretsky

Scott, we're committed to lowering our SG&A ratio over time. As you know, when we are growing membership and revenues, we showed a very, very good track record of decreasing our ratio by about 50 basis points a year over time. And once we get back on the course correction to grow membership again profitably, we believe that is a sustainable model. So not making any predictions for next year, at this early stage, but over the long term, it is our both desire and our plan to reduce our ratio over time.

Scott Fidel - Deutsche Bank AG

Then relative to commissions?

Joseph Zubretsky

I think with respect to commissions, I think, again not discussing any particular strategies, but the three things you can do to sort of work your distribution costs harder and structure them in a more reform friendly way would be to reduce them, to decouple them from medical inflation and possibly even decoupling them from the insurance contract. And Mark and his operating team would contemplate any of those structures in order to have a more workable MLR formula.

Mark Bertolini

Scott, we have been talking with our brokers for about two and a half years about the impacts of minimum MLR regulation on their compensation. We're disappointed that the broker commissions are still included in the MLR calculation because that presents fewer options for us to deal with those costs within the context of Health Care Reform. So we are actively working. We have communicated very recently with our brokers about how we could structure some of these things come and we will be announcing shortly before the end of the year how we will impact commissions going forward.

Operator

We'll take our next question from a Charles Boorady, Crédit Suisse.

Charles Boorady - Crédit Suisse AG

Mark, you talked about your priorities over the course of the next year to continue to execute basically. Can you talk about longer-term strategic plans here on the heels of reform? And I know regs [regulations] are still being written, but specifically exchanges and how you think of positioning or repositioning Aetna with respect to the creation of these state exchanges? For example, would you see Aetna needing to become more localized, gaining share in some markets and maybe exiting some other markets based on where you see a business-friendly environment for these exchanges? Any other things you're thinking about in terms of strategy and positioning of Aetna for success over the next five to 10 years?

Mark Bertolini

Charles, we will be spending some time at the March 4 Investor Conference going over the strategy that Ron, Joe and I have been developing over the last year and a half. With Joe's promotion, which will be part of my taking on the CEO role, in November, Joe will be working on a number of significant strategic diversification issues as we move ahead, and we'll be able to talk about those in March. I wouldn't want to address them at this point in time. As it relates to exchanges, we like exchanges properly structured on market-based aspects. And so we would see the ability to have transparency into the marketplace and how it works everyday and the ability to make changes everyday to how we're presented in the marketplace vis-à-vis our competition, a very positive impact on the individual small group markets. Having said that, we need to get regulation to that point and to that point, state-by-state. A number of states have started already, but a lot of states haven't. And the level of funding and effort required to get them there remains to be seen as to whether or not we'll be ready by 2014. We do see an imperative on our part to have fewer plan designs, being fewer markets, where we believe we have an opportunity to succeed, to have an affordable model because it will be all about total costs. And so SG&A, benefit costs and the way we approach the market including distribution costs will all be important in determining that the affordability.

Charles Boorady - Crédit Suisse AG

How big of a bang should we be prepared for in March? You've been working on it over year. Are you thinking as radical as going back towards more of a diversified multi-line company, you refer to the long history of Aetna as an organization? Or is it to increase the focus on health care? You talked about diversification, I'm just wondering how far afield you're thinking?

Mark Bertolini

Probably March.

Operator

And we'll now take our final question from Peter Costa, Wells Fargo Securities.

Peter Costa - Wells Fargo Securities, LLC

A little bit on that line. Firstly, Ron, you and Jack Rowe did a great job turning around that years ago. And one of the things you did was to turn off the acquisitions of big blocks of medical members. My question is under Mark, and under sort of health reform driven consolidation that pretty much everybody expects, do you think that's going to reaccelerate for Aetna? Are you going to pick that up again going forward?

Mark Bertolini

We continue to look at acquisition opportunities across the spectrum and not commenting on any of the specific ones and including blocks of business. We do it where it is in the best interest of meeting our strategic need going forward, where it makes sense for return to our shareholders and where we can appropriately implement that acquisition in the organization.

Peter Costa - Wells Fargo Securities, LLC

And then the second question, with the growth -- the idea of Accountable Care Organizations and with medical loss ratio minimums sort of affecting what you can do from the SG&A side. How do see contracting with hospitals evolving sort of in the short term, and then over the longer term as hospitals maybe become more ready to take risks, have more structure behind?

Ronald Williams

Yes, I think one of the things that we recognize is that we have an enormous amount of capability and capacity to manage risk, to managed care management, disease management. And as we all work to understand what these ACOs look like, we think that we could have a role in helping them function effectively. I think we would reserve more discussion in detail to a future date. But I think that, given our strong emphasis on health information, technology, analytics, our care management tools and capabilities, that we think that as that unfolds, it will be an area we will watch closely.

Operator

And at this time, I will now turn the call back over to Mr. Tom Cowhey. Mr. Cowhey?

Thomas Cowhey

Thank you. We look forward to seeing you at our Investor Day in Hartford of March 4. 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

That concludes our conference for today, and we thank you for your attendance.

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