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Aetna, Inc. (NYSE:AET)

Q2 2014 Earnings Conference Call

July 29, 2014, 08:30 AM ET

Executives

Thomas Cowhey - Vice President, Investor Relations

Mark Bertolini - Chairman, Chief Executive Officer and President

Shawn Guertin - Executive Vice President, Chief Financial Officer and Chief Enterprise Risk Officer

Analysts

Josh Raskin - Barclays

Justin Lake - JPMorgan

Matthew Borsch - Goldman Sachs

Kevin Fischbeck - Bank of America Merrill Lynch

Ralph Giacobbe - Credit Suisse

Scott Fidel - Deutsche Bank

Ana Gupte - Leerink Partners

Carl McDonald - Citi

Peter Costa - Wells Fargo Securities

Chris Rigg - Susquehanna International Group

Christine Arnold - Cowen

Dave Windley - Jefferies

Sarah James - Wedbush

A.J. Rice- UBS

Andy Schenker - Morgan Stanley

Tom Carroll - Stifel

Brian Wright - Sterne, Agee

Operator

Good morning. My name is Matt, I'll be your conference facilitator today. At this time, I'd like to welcome everyone to the Aetna second quarter 2014 earnings conference call. (Operator Instructions) I'd now like to turn the conference over to Tom Cowhey, Vice President of Investor Relations. Mr. Cowhey, please go ahead.

Thomas Cowhey

Good morning, and thank you for joining Aetna's second quarter 2014 earnings call and webcast. This is Tom Cowhey, Vice President of Investor Relations for Aetna. And with me this morning are Aetna's Chairman, Chief Executive Officer and President, Mark Bertolini; and Chief Financial Officer, Shawn Guertin. Following the prepared portion of the remarks, we will answer your questions.

During this call, we will make forward-looking statements. Risk factors that may impact those statements and could cause actual future results to differ materially from currently projected results are described in this morning's press release and the reports we file with the SEC, including our 2013 Form 10-K. We have provided reconciliations of metrics related to the company's performance that are non-GAAP measures in our second quarter 2014 Financial Supplement and our updated 2014 Guidance Summary. These reconciliations are available on the Investor Information section of Aetna.com. Please note that the inclusion of Coventry's results in the middle of the second quarter of 2013 impacts both the quarter-over-quarter and year-over-year comparisons.

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

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

Mark Bertolini

Good morning. Thank you, Tom, and thank you all for joining us today. This morning, Aetna reported second quarter operating EPS of $1.69 per share, a result that speaks to the strength of our diversified portfolio of businesses and our ability to succeed across many fronts.

Underlying our second quarter result; we grew medical membership by 385,000 members in the quarter, achieving a record 23.1 million members. We grew quarterly operating revenue to a record $14.5 billion, a 25% increase from the prior year, driven by strong organic growth and the Coventry acquisition.

We achieved solid underwriting results, driven by medical cost trends that remain moderate. We offset the impact of ACA mandated fees on our operating expense ratio through fixed cost leverage from growth, the realization of Coventry synergies and disciplined expense management. And finally, we continued to generate substantial free cash flow and aggressively deploy excess capital.

As we look to the remainder of 2014, we continue to project strong top line growth and solid operating performance. We remain confident in our ability to achieve our targeted high-single digit operating margin again in 2014, as our pricing remains disciplined and commercial medical cost trend remains moderate.

Based on our second quarter results, today we are raising our full year 2014 operating EPS guidance to a range of $6.45 to $6.60 per share from our previous projection of $6.35 to $6.55 per share. At the midpoint, this guidance represents 5% year-over-year operating EPS growth and a 14% CAGR since 2010, well in excess of both our diversified managed care peers and our low-double digit long-term operating EPS growth target.

At our Investor Conference in December, we highlighted the following elements of our growth model, built on the strength of our diversified portfolio of businesses. Specifically, we project that: Aetna's large group Commercial business can grow profitably; Aetna's Government business can be a growth engine; small group and individual represent an opportunity for future growth; next generation networks enhance the core business; and Coventry is highly accretive, enhances topline growth and strengthens our capital position.

I will now provide a brief update on how we are executing against some of these growth levers. Aetna's second quarter again exemplifies the strength of our diversified portfolio of businesses. Meaningful progress towards achieving our Coventry synergy goals as well as strong performance in our Group segment, allowed us to raise our operating EPS guidance range for the second time this year.

Beginning with our progress on the Coventry integration, we have discussed on previous calls that one of our primary goals this year is to accelerate more of the Coventry synergies into 2014 and achieve our targets early. Based on our progress to date and our current projections of operating expense savings, today we are raising our 2014 Coventry accretion projection by $0.05 to $0.10 per share to a range of $0.55 to $0.60 per share.

We continue to project $0.90 per share of accretion in 2015. This represents second increase to our 2014 accretion projection since closing the transaction, and is a testament to our focus and the strong execution of the Coventry integration team. I am pleased with the progress we have made, and we remain committed to achieving or exceeding our overall synergy targets.

Our large group commercial business has also had a strong start this year. Year-to-date, we have grown our large group commercial ASC membership by over 270,000 members, and we expect that large group commercial ASC growth will exceed 650,000 members by yearend.

Commercial ASC membership growth has been our historic yardstick for progress in this business. However, the continued conversion of self-funded membership into fully-insured private exchange membership is changing that equation, and making revenue growth a more meaningful metric.

At this early stage, as we look forward to the 2015 selling season for large accounts, we project that our large group commercial ASC membership will be fairly stable in the first quarter of 2015. However, we project continued fully-insured private exchange conversions will increase operating revenues from this important membership base next year.

We remain encouraged by plan sponsor interest in fully-insured private exchanges, and believe that more companies will evaluate alternatives to traditional employer-sponsored insurance, particularly as they address the continued implementation of the Affordable Care Act.

Additionally, we continue to work to develop our own proprietary exchange called, the Aetna Marketplace, which we believe will offer an attractive alternative to existing multi-carrier exchanges and the current defined benefit model for health benefits.

Moving on to our Government business. We grew membership in the quarter by over 100,000 members across both our Medicare and Medicaid platforms. On a year-to-date basis, we have grown our Government membership by over 230,000 members. This strong membership growth, combined with the inclusion of Coventry results, drove a 44% year-over-year increase in the quarterly Government premium revenue.

A key driver of the growth in our Government business has been our Medicare Advantage products, where we organically grew our membership by 17% from the same period last year. While 2014 and 2015 rate pressures present a meaningful challenge, we remain committed to the Medicare Advantage program, and we are executing on our plans to solve this funding gap in order to continue to offer value to our customers.

11,000 baby boomers become eligible for Medicare each day and Medicare spending is projected to exceed $1 trillion in 2020. We believe we must move boldly to bring managed care to traditional Medicare, applying new care management models that bring together doctors, data, payment and incentives for better and more cost-effective care.

This is the core purpose of our Accountable Care Solutions initiative. And we continue to believe that over time, we can: operate profitably with rates at parity with fee for service; enable better quality care at an improved cost; and help to solve one of our nation's most pressing fiscal issues.

Continuing with the Government business, our Medicaid franchise continued to perform well, producing strong operating results and growing by 79,000 members during the quarter, of which 45,000 were related to ACA expansion.

Additionally, we added approximately 17,000 dual-eligible members through our participation in the Ohio and Illinois demonstration projects. We are pleased to have the opportunity to serve this population and continue to project that dual-eligible members will contribute approximately $500 million to our operating revenues in 2014.

Shifting to the public exchanges. Last year when we discussed our public exchange strategy, we stated that our objective was to gain sufficient exposure to better understand how this population would behave and whether we could earn an appropriate return on capital over the long-term. We also stated that we would actively manage our exposure to this business, as we furthered our understanding of this new market opportunity.

We believe we achieved these goals, as we ended the quarter with nearly 600,000 public exchange members. As open enrollment is now closed, we project that we will end the year with just over 500,000 public exchange members, which will represent about 2% of Aetna's projected yearend 2014 medical membership.

It is worth reminding investors that nearly two-thirds of our public exchange membership had April or May effective dates. As a result, our medical cost experience for this population is not yet mature enough to draw conclusions about its profitability. At this time we continue to project that our total individual business will be a modest headwind to 2014 operating earnings.

Looking forward to 2015, we have chosen to approach the second year of this program with a continued focus on geographies, where we believe we can drive a highly competitive cost structure and provide the best value to our customers. Following our strategy, we have chosen to enter into one new state in 2015, the state of Georgia.

And otherwise our footprint will remain similar to what it was in 2014. We continue to believe this footprint and approach will allow us to manage risk in the near-term, while positioning us favorably over the long-term.

Moving on to our ACO and next generation network strategy. We continue to execute on our strategy of collaborating with our provider partners to transform the network model from one of episodic acute care to patient-centric population health management. By aligning incentives with providers, we are leading the way toward improved health for our members and a lower overall cost of care.

Our collaboration with Banner Health speaks directly to these successes. In 2013, the second full year of our Aetna Whole Health product collaboration, we saw: an improvement in cancer screening rates, including cervical and colorectal cancer screening; a reduction in the percent of diabetic members with poorly controlled blood sugar levels; a reduction in radiology services of approximately 9%; an increase in the generic prescribing rate by almost 4%; and a reduction in avoidable admissions by approximately 9%.

Collectively, these actions drove a 5% decline in costs for Aetna Whole Health members served by Banner Health Network. By partnering with providers like Banner Health Network, we are building a simpler, more integrated system that enables true population health management, creating healthier communities and a healthier world.

Finally, I would like to make a few comments about our long-term growth outlook. At our Investor Conference in December, we articulated our goal of doubling our operating revenues by the end of the decade, backed by the strength of our diversified portfolio.

Based on our updated guidance, we are now projecting we will grow operating revenue in 2014 by over $10 billion. This projected growth is driven by our strong organic membership growth in public and private exchanges, Medicare Advantage, our dual-eligible contracts, and Medicaid expansion, and continued trend leverage as well as the inclusion of Coventry.

We have already made excellent progress toward reaching our goal of $100 billion of operating revenues by the end of the decade. As we continue to execute and drive transformation in the Health Care marketplace, we are focused on making this goal a reality.

In summary, I am pleased with our results year-to-date, and I am confident in: our strategic direction and our ability to execute; our ability to achieve Coventry synergies and our accretion goals; the power of our diversified portfolio to drive growth; and our 2014 operating EPS projection of $6.45 to $6.60 per share.

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

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

Shawn Guertin

Thank you, Mark, and good morning, everyone. Earlier today we reported second quarter 2014 operating earnings of $610 million and operating earnings per share of $1.69. Aetna's operating results continue to be supported by strong operating revenue growth and cash flow as well as solid operating margins, a result of prudent pricing, moderate medical cost trend and a disciplined focus on operating expenses.

I'll begin with some comments on overall performance. Our topline performance continues to be very strong. We grew operating revenue by 25% over the prior-year quarter to a record quarterly level of $14.5 billion, driven by strong organic growth as well as the Coventry acquisition.

We also grew medical membership to a record 23.1 million members, adding 385,000 new members during the quarter, with growth in our Commercial and Government businesses, as well as the inclusion of membership from the InterGlobal acquisition. The second quarter of 2014 represents Aetna's ninth consecutive quarter of medical membership growth.

From an operating margin perspective our businesses are performing quite well. Our second quarter total Medical Benefit Ratio was 83.1%, bringing our year-to-date total Medical Benefit Ratio to 81.8%, a very good overall result.

Our operating expense ratio improved from the same period last year to 17.6%, despite the inclusion of ACA fees. This outstanding result was driven by fixed cost leverage from growth, Coventry synergies and disciplined expense management.

Our pre-tax operating margin was 7.6%, consistent with our target operating margin range, putting Aetna on track to achieve high-single digit operating margins in 2014. This result would represent Aetna's fifth consecutive year of achieving or exceeding this goal, despite an increasing mix of lower margin Government business.

From a balance sheet perspective, we remain confident in the adequacy of our reserves. We experienced favorable prior period reserve development in the quarter across all of our core products, primarily attributable to first quarter 2014 dates of service.

Our reserve growth exceeded our premium growth, and days claims payable were 47 days at the end of the quarter, stable sequentially and higher by two days year-over-year. Similar to the first quarter, our elevated level of days claims payable in the second quarter was driven by membership growth, primarily in public exchanges. We project this metric to return to a level more consistent with our recent historical experience over the balance of the year.

Turning to cash flow and capital. Operating cash flows remain strong. Health Care and Group Insurance operating cash flows were 1.7x operating earnings year-to-date, driven by higher premium receipts from pricing actions designed to recover ACA mandated fees and taxes, and the effect of growth in insured membership.

As we consider the remainder of 2014, it is worth noting that the September payment of Aetna's portion of the health insurer fee, estimated at approximately $600 million, will pressure our third quarter 2014 cash flow metrics. We continue to project that our full year 2014 Health Care and Group Insurance operating cash flows will exceed our 2014 operating earnings.

We also continued to aggressively deploy capital to create shareholder value, repurchasing over 3 million shares in the quarter for $255 million and distributing over $80 million through our quarterly shareholder dividend.

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

Beginning with our Commercial business. Our commercial membership grew by nearly 280,000 members during the quarter, driven primarily by public exchange membership growth of approximately 360,000 members, partially offset by the previously disclosed departure of a large self-insured customer.

Absent the growth in public exchange members, our commercial insured membership was roughly flat sequentially, a result that continues to speak to our commitment to fair and financially responsible pricing, where we favor margin over membership and price to underlying medical cost trends.

As a result of our prudent pricing posture and moderate medical cost trends, our commercial insured business has continued to generate high-single digit pre-tax operating margins this year. Our Commercial Medical Benefit Ratio was 80.6% for the quarter, and 78.9% year-to-date, a modest improvement over the first half of 2013 that we believe positions us to achieve the lower half of our projected Commercial MBR range of 79% to 80% in 2014.

Medical cost trends continue to be moderate and emerge consistent with our previous range of projections, despite pressure from new Hepatitis C treatments. We remain vigilant in examining our experience for evidence of an unexpected uptick in medical cost trends, and based on our year-to-date experience, we project that Aetna's standalone 2014 commercial medical cost trend will be in the lower half of our 6% to 7% range.

Also, with respect to our public exchange business, we would note that we have not accrued any specific payables or receivables for the federal risk adjustment or risk corridor programs. While we have more data on this new membership than we did at the end of the first quarter, we still have little data with respect to the April and May cohorts, which represent nearly two-thirds of our public exchange membership.

We have conducted various scenario analyses using available data, and we remain comfortable projecting that the earnings impact of our total individual business will be a modest headwind to our operating earnings in 2014. With respect to the federal reinsurance program, our receivable based on known claims was approximately $50 million at the end of the quarter.

Another important growth lever is our government franchise. Our f grew by over 100,000 members in the quarter, consisting of: Medicare Advantage growth of 12,000 members; Medicare Supplement growth of 17,000 members; and Medicaid growth of nearly 80,000 members primarily from ACA related expansion and approximately 17,000 dual eligible members related to our participation in the Ohio and Illinois demonstration projects.

The Coventry acquisition, combined with strong organic membership growth, drove total second quarter 2014 government premiums to a record $5.2 billion, a 44% increase over the prior-year period. Our Government Medical Benefit Ratio was 86.5% in the quarter, an excellent result and a year-over-year improvement of 180 basis points. Drivers of this year-over-year improvement include actions impacting revenue and medical costs designed to solve for the Medicare Advantage funding gap, including the health insurer fee.

Finally, I would like to comment on our Group segment. Group operating earnings increased both sequentially and year-over-year due to higher underwriting margins reflecting improved experience in our life and disability products. As we look to the remainder of the year for this business, we project that underwriting margins will return to a level more consistent with recent historical experience.

Moving on to the balance sheet. Our financial position, capital structure, and liquidity all continue to be very strong. At June 30th, we had a debt-to-total-capitalization ratio of 36%.

Looking at cash and investments at the parent, we started the quarter with $100 million. Net subsidiary dividends to the parent were $643 million. We repurchased over 3 million shares for $255 million and paid a shareholder dividend of over $80 million. After other uses, including settlement of short-term financing obligations, we ended the quarter with $100 million of cash at the parent, representing our core liquidity. Our basic share count was 354.6 million at June 30th.

As a result of our second quarter performance, we are increasing our full year 2014 operating earnings per share guidance to a range of $6.45 to $6.60 per share, from our previous projection of $6.35 to $6.55 per share.

This increased guidance range reflects aggregate performance across our diversified portfolio of businesses that is generally consistent with our previous range of projections and gives us a higher level of confidence in our full year outlook; supplemented by an additional $0.05 to $0.10 of projected operating expense synergies from the Coventry acquisition.

Our updated 2014 guidance is also influenced by the following additional drivers. We now project that our yearend medical membership will be approximately 23.4 million members, an increase of 300,000 members over the remainder of the year. Drivers of this projected increase include the previously disclosed TRS commercial ASC win that we expect to add over 400,000 members in September 2014 and continued growth in government membership, partially offset by declining individual membership.

Based on our full year membership projections and year-to-date results, we now project that our full year 2014 operating revenue will be at least $57 billion. We continue to project our full year Commercial Medical Benefit Ratio will be 79% to 80% and our full year Government Medical Benefit Ratio will be 85% to 87%, noting that our year-to-date performance points towards the lower half of those projected ranges.

We continue to project our operating expense ratio will be approximately 18.5%, noting that our updated Coventry synergy guidance implies relative improvement as compared to our previous projections. We now project our pre-tax operating margin to be approximately 7.5%, consistent with our high-single digit target. We now project operating earnings to be at least $2.3 billion.

Based on our updated operating revenue projection, we now project net dividends from subsidiaries will be between $1.5 billion and $1.6 billion, approximately $100 million to $200 million lower than our prior projection, as additional capital to support premium growth is held at our regulated subsidiaries.

Correspondingly, we now project excess cash flow to the parent to be between $1.1 billion and $1.2 billion. Despite this change in projected excess cash flow to the parent, we continue to project that our full year 2014 weighted average share count will be in the range of 359 million to 360 million shares.

In closing, we are pleased with the strength of our second quarter results and our improved 2014 outlook, which at the mid-point, represents 5% operating EPS growth, in spite of the many challenges facing our industry in 2014.

As we look to the rest of the year, we remain focused on delivering on our plans to offset the Medicare Advantage rate pressures, integrating Coventry as we continue to invest to achieve or exceed our updated 2014 synergy targets, collecting or solving for the ACA mandated fees and taxes, and executing on our exchange strategies, both public and private.

As we continue to execute on these key focus areas during this challenging time for our industry, we are increasingly confident that we can achieve our 2014 projections.

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

Thomas Cowhey

Thank you, Shawn. The Aetna management team is now ready for your questions. We ask that you limit yourself to one question, so that many individuals as possible have an opportunity to ask their questions. Operator, the first question, please?

Question-and-Answer Session

Operator

Our first question comes from Josh Raskin with Barclays.

Josh Raskin - Barclays

Just a question on the commercial book. I'm just trying to parse out the MLR on the commercial book on a year-over-year basis deteriorate a little bit relative to the first quarter. And I guess I'm just trying to figure out what some of the drivers were there. It looks like maybe the exchange membership came in a little bit stronger than you thought. So it might be helpful to sort of give us a ballpark of what are the exchange MLRs that you're seeing?

And then, if you could give us a sense as to the total lives and you're just sort of rolling that forward in 2015. Similar footprint would you expect, plus Georgia, maybe slight growth in public exchanges or what are the thoughts on that book in 2015?

Mark Bertolini

I'll give you the high points, and then I'll have Shawn talk to some of the details in the Commercial business. But first and foremost, the core Commercial business is behaving as we expected and doing well. We see rational pricing in the marketplace and as we mentioned both in the Commercial MBR and in the trend, we expect to be in the lower half of our ranges.

And when you look at that trend number, it will be in the lower half of 6% to 7%, where we ended last year 5.5% to 6% is at the lower end of our raise that we saw or expected in our pricing for 2014, of which we've now priced 95% of our business. And so we believe that our margins are great and that we have some ins and outs in the diversified portfolio, and I'll let Shawn speak for those issues.

Shawn Guertin

Yes, you're right, Josh. Obviously, the MBR is up year-over-year. It is important to keep in mind that there are various items that can affect the comparability of the Commercial MBR in any particular quarter. And I think, first, as Mark alluded to, the most important thing is to look at this from a fundamental perspective. And we're actually quite pleased with our year-to-date performance and the trajectory that puts us on for the full year.

Inside that number, the majority of our Commercial MBR is obviously our core employer commercial groups business. And that business had a very good quarter, and in fact the MBR on this actually down from the second quarter of 2013. So when you look to the bridge from Q2 2013 to Q2 2014, there is a few things that are worth mentioning.

As noted in the press release, there was less prior-period development this quarter than the prior-year quarter. As I mentioned in the prepared remarks, overall prior-period development was quite healthy and favorable. So this isn't something that we're particularly concerned about.

As you alluded to in your question, given the late growth that we saw in public exchanges, we've continued to accrue results for our individual business cautiously. In addition, the way the GAAP dictates that we accrue for the reinsurance program, which is based on known claims only, that create some front half of the year MBR pressure. All else being equal, we'd expect to see these results improve in the back half, as more cases reach the individual reinsurance detachment point. Clearly, Sovaldi continues to be a pressure item.

And finally, I would say, we did see some variation in the quarterly MBRs in some of our smaller commercial businesses such as international and student health, which can happen from quarter-to-quarter. We expect the results from these business to improve in the second half the year, as a result of actions that we've already begun to take in the second quarter and we'll be taking in the third quarter. So at the end of the day, we still feel very good about what we're seeing on core medical trend year-to-date and our ability to come in the lower half of our full year guidance range of 79% to 80%.

Josh Raskin - Barclays

And you didn't mentioned it, so I've assumed there is nothing material to talk about, but anything on the impatient trend side? Are you seeing any change in terms of admissions or bed days or anything like that?

Mark Bertolini

Bed days are stable, but down. And so we don't see any shift there in trend year-over-year, as a matter of fact behaving very well. And our expectation for the year is that we move from mid-to-high single-digit increases in outpatient and are seeing that, as more business moves from impatient to outpatient. But the impatient admissions days are stable-to-down.

Operator

Our next question comes from Justin Lake with JPMorgan.

Justin Lake - JPMorgan

First, I just want to follow-up on Josh's question, around the Commercial MLR. Shawn, you gave some color around, and look what's down like seasonality in the exchange business. So can you give us a little more detail there just in terms of what are the exchange MLRs going to look like for the year and how are they being booked in the second quarter versus how they're going to roll for the third quarter to fourth quarter that might explain some seasonality? It sounds like it might be somewhat similar to part A?

Shawn Guertin

There is an aspect of this, again, related particularly to reinsurance. What I would say is we've continued to book that cautiously here at the beginning of the year for a number of reasons. We would continue to project for the full year that this business would be a modest headwind to earnings, really a by product at the MBR that we open that we book.

But to the point of your question, all other things being equal, some of the mechanics around sort of the booking of this reinsurance based on known claims would create a back half MBR for the health insurance exchange business, that's lower than what we've booked in the first half.

Justin Lake - JPMorgan

Could you give us any order of magnitude, Shawn, where it's going to be? I think the questions coming up, because it looks like the first half of the year the MBR was approximately flat, you're looking for it to improve back half of the year on a year-over-year basis, which is typically not the seasonality we've seen, but in terms of just the typical commercial book seasonality. So I think there is some confusion around that. And if you could help us kind of map through, how this is going to impact the overall MBR trend, it might be helpful?

Shawn Guertin

So this reinsurance mechanic, if you sort of compare it to this GAAP, it carried away a booking based on known claims too. If you just booked a pro forma sort of full year estimate each month, that is straining the MBR in the first half of the year versus that other basis, 800 basis points, 900 basis points, maybe even up to a 1,000 basis points, depending on how you want to look at it. So in essence, we've sort of taken that strain at the beginning of the year, and that will sort of work back to sort of what we expect for the full year by the end of the year.

Justin Lake - JPMorgan

So 800 basis points to a 1,000 basis points essentially higher MBR on just the exchanges in the first half and why not in the second half, and that will explain some of that seasonality difference.

Shawn Guertin

That's correct. And that's, again, that's all other things being equal. And that's just the reinsurance sort of reversing itself.

Operator

We'll go next to Matthew Borsch with Goldman Sachs.

Matthew Borsch - Goldman Sachs

Maybe sort of continuing on the same thing here, just trying to understand your outlook now really on the operating cost side. So am I correct in the math that if you're going to do 18.5% for the full year on the operating cost ratio that it's going to be at or above 19% in the back half of the year. Can you just address that, if that's correct and what's driving that?

Shawn Guertin

I think mathematically that has to be correct. And again, there is some, we talked about this last quarter, some of the investment spending that we're electing to make behind our Medicare business and our consumer businesses. And typically, we certainly see sort of the back half pressure on the SG&A ratio, whether it's related to open enrollment activities or getting ready for membership the next year.

Matthew Borsch - Goldman Sachs

So is that going to be weighted towards the fourth quarter than what we should expect?

Shawn Guertin

They typically march upwards from third quarter to fourth quarter. That's right.

Matthew Borsch - Goldman Sachs

And then, I guess lastly on the ratios, is it also correct in thinking about the government ratio below 85% in the back half of the year is that really driven in large part by the Drug Plan seasonality or other factors?

Shawn Guertin

We certainly will get the PDP seasonality, but I think the Government MBR in the first half of the year is actually fairly similar to the second half of the year.

Operator

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

Kevin Fischbeck - Bank of America Merrill Lynch

I just want to make sure I had understand, I guess to go into the guidance. Here it looks like you guys raised the revenue outlook, you took down the MLR for both commercial and Medicare, you kept you G&A ratio the same and you're only raising the guidance for the Coventry synergies being accelerated. Can you talk about, I guess, what else the delta is there? Why the raises more than just the acceleration of the synergies?

Mark Bertolini

I think it's just too early in the year, with all the moving parts we have around public exchanges, finishing or finalizing the funding gap in Medicare related to the Medicare Advantage rates. It's too early in the year to get aggressive there.

Kevin Fischbeck - Bank of America Merrill Lynch

Is there something just mathematically that that's the plug in there that you're taking it more conservative, because you're taking the commercial MLR down, so it feels like you're not necessarily factoring in higher MLR on the exchanges per se?

Mark Bertolini

Part of what we saw in the second quarter of the year was better results in group, largely around life, which last year was a headwind for us. And so we're not projecting life to remain as positive through the remainder of year.

Kevin Fischbeck - Bank of America Merrill Lynch

You made a comment earlier that you expected the Group business to be more similar to historical profitability. Wasn't sure, if that meant that 2013 was usually low, when you thought '14 to be better than that, or you were saying that for the rest of the year Group will be less than as we look over last year.

Shawn Guertin

Kevin, clearly, we had some stream last year in a couple of quarters related to our Group business. So what I would say is a more historically consistent level of performance would produce a better result in '14 than '13 than our Group business. So the commentary again was, the output, we're just not assuming that the outperformance that we saw in the second quarter is going to replicate itself in third and fourth quarters.

Kevin Fischbeck - Bank of America Merrill Lynch

There is nothing specifically that you're highlighting as an issue for that beyond just it's early and you want to be conservative?

Shawn Guertin

Absolutely not. Absolutely not. That business is performing very well.

Operator

We'll go next to Ralph Giacobbe with Credit Suisse.

Ralph Giacobbe - Credit Suisse

Just harp on I guess the Commercial MLR. You mentioned I think Shawn that the core MLR was down. Is that right? And when you say core is that just less the PPRD, that's sort of accruing other reinsurance and Hep C. I am just trying to understand that what's sort of the definition of the core, what are you stripping out?

Shawn Guertin

So let me go back, and I will sort of amplify a little bit on what Justin was asking about. I mentioned three specific businesses that, for lack of a better term, that I will call non-core. And when I am thinking about our core, I'm really thinking about our core group employer baked business. When you look at that business sort of by itself, without these three businesses that I'll mention, the MBR is down.

We do have three businesses, the public exchange business, I mentioned international and student health that had some variation here in the front half of the year and it's actually improvements in all of those businesses that are accruing to what we're seeing or what we're forecasting for the second half of the year.

Ralph Giacobbe - Credit Suisse

And then just wanted to ask about the National Accounts selling season and maybe how that's progressing. You've seen any greater uptick in RFP activity, I guess into 2015? And would you expect to see greater disruption in the commercial market next year or do you see most employer sort of staying put?

Mark Bertolini

We see a lot of activity, particularly in looking at private exchanges. We saw a lot of looking, but no buying and a lot of employer standing pat as they evaluate whether or not it's worth making changes with carriers for 2015. We will continue to see some conversion from self-funded administered business, two fully insured private exchanges, but not necessarily on the scale we saw last year.

Operator

We'll go next to Scott Fidel with Deutsche Bank.

Scott Fidel - Deutsche Bank

First question, just Shawn, just back on the Commercial MLR again. Do you have an estimate of how much the lower reserve development impacted the Commercial MLR year-over-year in terms of the comps? And then just my follow-up question is just on the small group market, and Mark, maybe interested, if you can give us an update on how you think you see the pricing environment there heading into 2015. It looks like that some of the rate filings have been coming out over this summer that, we have some of the non-profits with pretty low proposed rate increases in small group for 2015, and just interested on how you guys are thinking about that next?

Shawn Guertin

Scott, so I'll take the first one and then turn it to Mark on the Commercial MBR. Again, the mathematical impact of sort of the accounting value of prior-period development year-over-year is about a 150 basis points even of itself. But I want to be really clear, we had very healthy PPD this year and in fact the aggregate PPD is very similar year-over-year, it's just a little bit different, as it's distributed by product, so it was a little bit less on commercial this year. So overall PPD, again, looks fine. It really is sort of this accounting timing issue across quarters.

Mark Bertolini

And to relate to small group, Scott, we are seeing still a rational pricing environment. We are not seeing a lot of dumping yet, as some people have predicted. I think people want to see whether or not the public exchanges work. We did see a 2 percentage decrease year-over-year of small groups, offering insurance to their employees from 44% to 42%, and that has been a normal trend.

So we haven't seen any over dumping in the public exchanges and having employees plan their own coverage. We do see small group moving into a private exchange model over the next couple of years, and will be actively engaged. We have launched an Aetna Marketplace for small group already in the 2014.

Operator

We'll go next to Ana Gupte with Leerink Partners.

Ana Gupte - Leerink Partners

Just following up on the previous question and your response, Mark, on dumping. So on early renewals, to what extent are you seeing competitors willing to adjust pricing down just to get a slightly better margin than they would to discourage these employers from dumping? And might that place any pressure on pricing going forward?

Mark Bertolini

Again, we see a very rational pricing environment, Ana, but of course it depends by market and what trends are in local markets. But as far as we can see at this point in time, not a whole lot of pressure in small group. As a matter of fact, we've had a pretty reasonable year from a pricing standpoint and our Commercial MBR standpoint in small group. So we believe that it's a very stable market at this point in time. But we do not see it sustainable over the long-term, as small group employers stop offering coverage. And so we're evaluating alternatives to driving more private exchange membership in that segment.

Ana Gupte - Leerink Partners

And in addition to dumping in private exchanges, one of your competitors is talking about accelerating self-insured even in the down market, are you seeing that? And related to that, any pressure again to my previous question from newer entrants, co-ops, hospital systems that are coming in with insurance licenses both for '15 and then going forward?

Mark Bertolini

I think on the first part of self funding, we do offer that product. We don't see a whole lot of takers in that marketplace and we don't see it as a macro trend for our industry. As a matter of fact, if I am a small group employer, particularly in the sizes we deal with, which are in the 10 to 20 and even under range, figuring out whether or not I should do spec or agg reinsurance in any given year relative to my employee population, while I'm running my donut shop, doesn't make a whole lot of sense. And I don't want to have to make that decision each year.

And if I can find an alternative to offer my employees, a better product over time, I will do that. So I just don't think that that is a sustainable macro trend. I see it quite opposite, moving to private exchanges as long as private exchanges offer a stable and affordable experience over time. So that's how we would see that market shifting. And the second part of your question?

Ana Gupte - Leerink Partners

The second was on new entrants. So do you think that exchanges are encouraging competition from new entrants? Firstly into the exchange market and because risk is pooled, by definition they also move into an adjacency into small group or is that not happening at all?

Mark Bertolini

I think we will see new entrants. I think we will see hospital systems that are more willing to take risk, we're engaged in those. We see more joint ventures. Our innovation health plan with Inova, where we are doing joint ventures around risk and risk alone, not necessarily owning delivery assets or them owning risk asset.

So we do see that as an emerging trend and we have a lot of those conversations going on. As it relates to co-ops and smaller entrants, I think only time will tell as to whether or not they're able to generate sufficient cash flow and to generate enough risk-based capital to maintain their business over time.

Operator

And we'll go next to Carl McDonald with Citi.

Carl McDonald - Citi

On the core commercial risk loss ratio being down year-over-year, the industry fee alone should have dropped the loss ratio in maybe something between 200 basis points and 250 basis points or is it safe to assume that x the industry fee impact the core risk loss ratio would have been up pretty meaningfully year-over-year?

Shawn Guertin

Well, again mathematically, yes. But keep in mind that in that core commercial block, we had already expected, because of experienced rating for the MBR to first sort of reset that to a normal point, and then sort of have the health insurer fee collection in there. So, yes, sort of in isolation to your question, but I think you have to remember there is multiple moving pieces going on in that block, especially in the large group business.

Carl McDonald - Citi

And then on the exchange assumptions, how much do you worry that you should actually be booking a payable for risk adjustment? And sort of the root of the question is, across the industry you guys are an exception, but I look at a lot of companies booking receivables for risk adjustment. I don't see a lot of companies booking payables for risk adjustments. It seems like across the industry somebody is going to have an unexpected big deal in the second half of the year, and just be interested in your thoughts?

Shawn Guertin

As I mentioned in the remarks, we looked at and did a number of sort of scenario analyses. And certainly a number of those scenarios were scenarios where we would potentially have a risk adjuster payable, and sort of tested that again to sort of the conservative posture or the prudent posture rather that was taken in booking that. So we have contemplated that in sort of where we landed for the second quarter.

Operator

We'll go next to Peter Costa with Wells Fargo Securities.

Peter Costa - Wells Fargo Securities

I had a question about cost for next year in your expectations. Where do you expect Hepatitis C cost to be next year relative to this year? And then on hospital cost with hospitals showing declining bad debt, where you expect pricing for hospitals to be for you guys?

Mark Bertolini

Well, I think it's too early to tell on the hospital pricing, Peter, as we evaluate our plans for next year, but we always push on the pricing increases with hospitals. We've been aggressive over the last four years, five years in keeping it in very low single-digits, and have been successful in negotiating that, which usually generates a conversation about how do we share risk and how do we move into more value-based contracts, which we see in acceleration. So I think too early to tell there, but we will again be pushing pretty hard to maintain very low price increases.

The second part of your question, really where we see our cost for Sovaldi or any other of the Hep C drug is up. I mean we are already pricing for 2015. We are 20% into the pricing cycle. And we continue to see that as a cost driver, and now that we have a pretty good handle on what we've seen for the first two quarters and what we expect for the rest of the year. We've incorporated a healthy amount for that into our 2015 pricing.

Peter Costa - Wells Fargo Securities

Can you say how much you've incorporated? How much of a ramp up do you expect when these drugs become all oral?

Mark Bertolini

We're not prepared to give 2015 trend guidance.

Peter Costa - Wells Fargo Securities

And just maybe if one more shot at the way Kevin was asking the question before. You sort of changed your view on operating margin to be about or pre-tax operating margin to be about 7.5%, that's from previous, where it was at least 7.5%. So you sort of lowered that in every other statistic, the operating statistics seems to be improved in terms of your guidance. Why the lower guidance on pre-tax operating margin?

Shawn Guertin

Well, certainly, one of the things that's pushing that is, we continue to see increased revenue, a great deal of that revenue. If you think about things like duals and health insurance exchange membership is not in our guidance, making a great deal of money. And in fact some of it as I mentioned is in there creating a modest headwind thus creating a little bit of downward pressure on the op margin.

Operator

We'll go next to Chris Rigg with Susquehanna International Group.

Chris Rigg - Susquehanna International Group

I actually wanted to step back and ask a big picture question here. Just in terms of, given the success of Coventry, do you think Aetna is kind of back at the point where they could get back into the deal market, and when you think about where the company could benefit most by M&A, whether it's commercial, Medicare, Medicaid or maybe some IT-oriented stuff. Could you give us a sense, where you think you're at and just some color as to where you could possibly benefit the most?

Mark Bertolini

We have not been out of the deal market. So we've been still active, particularly in international and the technology space, and we continue to pursue assets that we believe are important to our portfolio in enhancing our capabilities to meet both the consumer market and the ACO market. So we haven't been out.

I think if you're thinking about big M&A, we continue to want to meet our needs relative to Coventry. We have to finish the integration, which we are close to getting to. Our goal is to get to $0.90 per share as quickly as we can and declare victory and move on with running our business.

As you might guess, our integration is over, we're now in migration. And as you get into the migration part of the business, it's kind of hard to keep track of the different class. And we've seen some synergies in our analysis come out of the Aetna side of the business and little on the Coventry side of the business.

As it relates to sort of what we're interested in, it's definitely technology. And we believe that as we build a better engine around managing medical costs, we believe there is some more opportunity in commercial over time. And we have said and even when we did the Coventry acquisition, we said we thought that was going to be the last really big deal until we clear 2014 anywhere in the industry, and that's pretty much held true.

As we think about specialty businesses, as you think about for example, Medicaid, we believe we have all the capabilities we need in Medicaid. And we believe that purchasing any Medicaid plan at this point in time only buys us contracts and geographies that are temporal and short-term in their nature with their own inherent risks. And given current price earnings multiples, we believe that they are heavy prices to pay for the opportunity to try and keep a contract.

Operator

We'll go next to Christine Arnold with Cowen.

Christine Arnold - Cowen

A competitor indicated they had some Medicare advantage and Medicaid true-ups in the quarter. You didn't mention that. I'm assuming that didn't happen for you?

Shawn Guertin

I think what they were mentioning on that call had to do with revenue true-ups and typically during any given calendar year we would be refining our estimate of risk adjusted revenue base as we complete the submission to CMS. So we certainly had some positive favorability this year as we typically do in that space. But again, I think that's sort of par for the course in terms of how we proceed on that front.

Christine Arnold - Cowen

So it wasn't outsized relative to what we saw last year?

Shawn Guertin

Again, it's a little different than last year, because of Coventry being in this year. So we're working with a bigger base.

Christine Arnold - Cowen

And then, if you look forward to '15, it sounds like we're seeing stability in small group, your pricing at large groups seems like its pretty stable of public exchange next year. First of all, you've got some experience from first quarter, I know its not mature from second quarter new membership, but as we look at the public exchange membership, if it comes in worse than you expect this year, do you think you can book risk quarters. And since you've already bid on public exchange enrollment, how do we think about your options as things come in different than you expect in terms of '15?

Mark Bertolini

Sure. I think first of all, two-thirds of our membership came in April and May. So there isn't a whole lot of experience that we have. We did price into the market based on books of business, and all the credibility or uncredibility factors that we had based on each market, the size of the market, what we saw on the way of cost trends, and so our pricing on health insurance exchanges and the public exchanges is anywhere from flat up to over 20%, with an average somewhere in the mid-teens. So we believe we have it adequately covered. We won't know enough experience until the end of the third quarter, and I would expect by the end of the third quarter we've had some view on risk quarters and risk adjustors.

Christine Arnold - Cowen

Can you exit if you see something that makes you kind of scared with respect to maturity? When can you say I'm out for next year?

Shawn Guertin

Until September, the end of September, that the sign on the dotted line to be engaged in any markets.

Christine Arnold - Cowen

And do you think you could book a risk quarter? Things don't look like you hope they did?

Shawn Guertin

To the degree we have adequate enough information. It has to be known and quantifiable in order to book it. And right now, we don't have enough data to do that. But if we believe we do, we would expect by the end of the third quarter to have a better view on that.

Operator

We'll go next to Dave Windley with Jefferies.

Dave Windley - Jefferies

On membership, just checking the roll forward here. I have that you expect about 300,000 lives over the balance of the second half. I believe you're bringing in TRS at over 400,000 in Medicaid expansion and enrollment there should add some. So your kind of gross adds exceed that 300,000. Are the reductions related to your comments in the individual market, is that it, or are there other puts and takes there?

Mark Bertolini

So I think we will see some attrition in the health insurance fee exchanges for sure. We're already seeing it. And we expect that to continue through the end of the year. And then we're also seeing it in the large group, as large groups lay off employees, particularly on the financial services sector, we've seen some in group attrition in large groups and jumbo groups.

Dave Windley - Jefferies

And then on Medicare Advantage and some of the reinvestment in that business, I apologize if you've already mentioned this, but could you elaborate on kind of the specific targets for that investment and maybe what you're expectations are for stars movement in back half of this year.

Mark Bertolini

I would highlight to, first, we know what our funding gap is for 2015, so we got started early on it. And so we've made investments there to solve for that. And I would remind everybody that over the two years, '14 and '15, we expect that to be high-single digits funding gap. This year it was 800 basis points, so then that is probably what we would expect for '15.

And then secondly, it's definitely in stars ratings. We're gathering all the information and engaging with the provider community in ways that we need to do that. But we expect that our star ratings will improve year-over-year, the four-plus star ratings. This year we were at 62%.

Operator

We'll go next to Sarah James with Wedbush.

Sarah James - Wedbush

Does your $500 million in 2014 dual revenue include any MA revenue in Ohio? I think the passive enrollment on MA doesn't start until 2015. So just wondering what's included in that number?

Shawn Guertin

I think what you should be aware of is that we do have passive enrollment going on, and what you should be aware of is that we get, and when you're looking at the reports coming out of the states, we get a revenue number from the states, and then we have to enroll those individuals into Medicare Advantage, and that comes another number. It won't come all together until 2015.

Sarah James - Wedbush

So the $500 million doesn't assume a full allocation, but assumes some MA revenue?

Shawn Guertin

It assumes a full allocation, but as you're looking at the numbers and the reports coming out of the states, the way we get it is from both the state itself through Medicaid and then we apply in and enroll these people in Medicaid Advantage at the federal level.

Sarah James - Wedbush

And what do you assume for opt out on duals, for the amount of duals that are opting out of the MA portion and going with the Medicaid fee-for-service.

Shawn Guertin

I don't have the specific assumption. I know we talked actually about that concept recently. And I think, so far it's been behaving more or less consistent with what we expected to see, but we can certainly follow-up with a specific number on that.

Sarah James - Wedbush

Last clarification, just looking at your press release, it looked like you had $536 million in prior-period development in the Health Care segment in the first quarter, and then $532 million for the half. So just wondering, if you could reconcile those numbers?

Shawn Guertin

Yes. I mean, it isn't anymore complicated than we've had a small amounts of negative development, just going back to the last year, when it will be crystal clear. Overall in the quarter, we had favorable prior-period development. But when you look specifically at prior-year, we had a little bit of a negative, and again that's not atypical when large claims come in late and things like that.

Sarah James - Wedbush

Any clarity on what segment that was in?

Shawn Guertin

It wasn't particularly meaningful in any one segment. It's obviously, it's a fairly small number.

Operator

And we'll go on to our next question from A.J. Rice of UBS.

A.J. Rice- UBS

Just maybe real quick, slip a couple of things in. On the Medicare Advantage business, I know you're talking about the future and how you're trying to address the funding gap in the current year. Year-to-date the growth of membership has been more than you thought. I think you're up 17% or something. Can you just comment on, has that come in, in line with expectations? How has the MLR trend been on that?

Mark Bertolini

Well, we expected the risk scores to look like we expected them. They were in markets where we wanted that growth to occur. 80% of the growth were in markets where we had four-plus star rating. So we feel good about that membership. We do expect them to have higher MLRs in the first year, because we have a number of medical management actions we need to put in place to, number one, get more risk adjusted revenue information, but also to impact their care, improve the quality and lower the cost.

A.J. Rice - UBS

And just on your comments on private exchanges. It sounds like, maybe I'm reading too much into, and I know you guys have been one of the more optimistic ones about the long-term prospects for private exchanges. It sounds like maybe looking into next year, you're thinking maybe the growth moderates a little. It sounded like that. I just want to make sure I'm hearing it right. And then on your Aetna specific product, is that a full risk product or is that some other hybrid type of product?

Mark Bertolini

Well, the first comments around the expectations for next year were largely around the large Group National Accounts space. So I haven't commented about middle market or small group. And as we look at our own private exchange models, we will participate in some self-funded, but largely our exchange models are full risk.

Operator

We'll go next to Andy Schenker with Morgan Stanley.

Andy Schenker - Morgan Stanley

Just real quick here. Thinking, a lot of questions here about the exchanges, and you obviously talked about your pricing, 0% to 20%. In light of that pricing range, how should we be thinking about this product maybe in '15 and then still larger term? Obviously you're entering a new market. Is '15 the year where it's likely to swing to a positive earnings contributor? Or is it really going to be maybe flat for the first few years here and then longer term move more towards long-term earnings profitability?

Shawn Guertin

I think it's still to be determined. We need to obviously get '14 under our belt, get all of our rates approved, and sort of understand where we stack up competitively, and obviously what the enrollment looks like. So I think it's premature to sort of form any extreme conclusion about sort of 2015 at this stage.

Mark Bertolini

But I would say, we have price to margins that would generate an appropriate return on capital and continue to do so over time. So it's really what are the results show us and how do we need to adjust.

Operator

And we'll go to Tom Carroll with Stifel.

Tom Carroll - Stifel

So good discussion of MLR moving parts here today, thanks for that. I wonder if you could just further reconcile the idea of two-thirds of your exchange enrollment, right starting in the April, May, timeframe. So somewhat information flow delay relative to what we normally see, and the fact that you're pretty confident in your view about it, declining back half MLR. So I don't know, it sounds like to me that you might be a bit more comfortable with your exchange outlook than your tone or perhaps guidance suggests, I mean is that fair to assume?

Shawn Guertin

Yes. And Tom, I would say that what we can see feels okay, vis-à-vis sort of our pricing expectations, acknowledging what you said about the limited visibility. So I think sort of directionally, again, that's a true statement. But again, it is important to state that we still do have some degree of limited visibility given that growth. I want to back up on this, just this framework, just to make sure that I have been very clear on the year-over-year bridge and that you have a sense for what each of these pieces is doing.

When you think about the health insurance exchange business mixing in, and I'm now thinking about second quarter '14 versus second quarter '13, that's probably worth 50 basis points, plus or minus, by itself, and that's just the business and where it's being booked this year. And the other two smaller ancillary commercial businesses, student health and international are also worth about 50 basis points plus or minus year-over-year.

We talked about the other moving parts, which were sort of the PPD, Sovaldi and then the health insurer fee as a recovery item. So I just want to make sure that I have been clear about the magnitude. But I would go back again to your question, and say, that on the margins we certainly feel a little bit better than we did a quarter ago, but we still really need more information to form a firm conclusion.

Tom Carroll - Stifel

And then as a follow-up, and I realize it's very early on this, but any read on cost trends in the new Florida Medicaid program?

Mark Bertolini

Any new program, we always take the posture of booking that at a more cautious MBR than say our typical book we run at. So we've done that. And so we don't see anything that's particularly alarming yet, but keep in mind that's a relatively small piece frankly of our Medicaid business, but certainly a small piece of the whole company.

Operator

And our last question in queue will come from Brian Wright with Sterne, Agee.

Brian Wright - Sterne, Agee

Could you size the reinsurance payments you expect to receive in '14 for the public exchanges?

Shawn Guertin

We've currently booked $50 million based on what we know and what we have in experience.

Brian Wright - Sterne, Agee

And then that accelerates in the second half?

Shawn Guertin

Definitely.

Mark Bertolini

That should more than double in the second half that if you just think about the way this operates.

Thomas Cowhey

A transcript of the prepared portion of this call will be posted shortly on the Investor Information section of aetna.com, where you can also find a copy of our updated guidance summary containing details of our guidance metrics, including those that were unchanged and not discussed on this call.

If you have any questions about matters discussed this morning, please feel free to call me or Joe Zubretsky in the Investor Relations office. Thank you for joining us this morning.

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Source: Aetna's (AET) CEO Mark Bertolini on Q2 2014 Results - Earnings Call Transcript

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