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Health Net (NYSE:HNT)

Q2 2014 Earnings Call

August 06, 2014 11:00 am ET

Executives

Jay M. Gellert - Chief Executive Officer, President and Director

Analysts

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Justin Lake - JP Morgan Chase & Co, Research Division

Christian Rigg - Susquehanna Financial Group, LLLP, Research Division

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Joshua R. Raskin - Barclays Capital, Research Division

Ralph Giacobbe - Crédit Suisse AG, Research Division

David H. Windley - Jefferies LLC, Research Division

Ana Gupte - Leerink Swann LLC, Research Division

Christine Arnold - Cowen and Company, LLC, Research Division

Sarah James - Wedbush Securities Inc., Research Division

Operator

Welcome to the Health Net Inc. Second Quarter 2014 Earnings Conference Call. [Operator Instructions] As a reminder, this call is being recorded.

During this call, Health Net management will make forward-looking statements that are subject to certain risks and uncertainties. Risk factors that may impact those statement and could cause actual future results to differ materially from currently expected results are described in Health Net's filings with the SEC, as well as the cautionary statements in Health Net's press release issued in advance of this call.

In today's call, management will refer to adjusted days claims payable. This adjusted metric is not being presented in accordance with Generally Accepted Accounting Principles, or GAAP. Please refer to the Health Net's current report on Form 8-K as filed today with the SEC for reconciliation of this non-GAAP financial measure with the most directly comparable GAAP financial measure, days claims payable. The Form 8-K is available on the SEC website or via the Investor Relations page on the company's website.

I will now turn the call over to Jay Gellert, Health Net CEO.

Jay M. Gellert

Thank you, and good morning, everyone. Thank you for joining the call. We're pleased to report on a solid second quarter. It's a quarter that demonstrated ongoing growth in new programs and improved commercial Medicare ratio year-over-year and better-than-expected profitability.

Our second quarter 2014 GAAP earnings of $1.49 per diluted share were substantially affected by a onetime tax benefit we discussed on our earlier calls. However, excluding this benefit, the diluted EPS from our combined Western Region and Government Contracts segments was ahead of our expectations at $0.62 per diluted share.

The primary drivers of our second quarter performance were enrollment growth from the individual exchanges and Medicaid expansion, combined with solid MCR experience. MCR, in all 3 lines, were consistent with our earlier guidance as health care cost trends remained moderate.

The commercial MCR improved by 260 basis points in the second quarter of 2014 compared with the second quarter of 2013. As the new individual exchange membership matures through the year, our guidance assumes higher MCRs, consistent with the outlook we gave on the first quarter call. The MCR on our legacy commercial business was favorable, due to better pricing and ongoing favorable health care cost trends.

On our first quarter call, we noted that April and early May exchange enrollment news was very positive. As you can see from today's report, sequential commercial enrollment growth affirmed our earlier estimates. We added 160,000 commercial members in the second quarter of 2014, a 14.7% increase sequentially.

As with our first quarter exchange gains, these new members were concentrated in Silver plans with expected subsidy levels and risk profiles. Last week, Covered California released preliminary 2015 individual exchange rate. According to the state's data, increases averaged approximately 4%. It's notable, no new plans were added.

We are comfortable with our 15 positioning with Covered California. We believe it builds on our performance so far in '14. Our 15 plans offer expanded provider networks and ample plan options across the middle tiers. We're gratified that many providers came forward in recent months seeking to participate in our exchange plans.

Turning now to Medicare. The Medicare Advantage MCR improved by 90 basis points sequentially, consistent with seasonal patterns we've seen in recent years. Our 2015 MA bids are in. We believe they will produce improved margins next year.

Our state health plan performance continued to be strong. The Medicaid MCR was slightly more favorable than expected. It was higher year-over-year as the second quarter of '13 MCR benefited from retroactive reinstatement of premium taxes. We should note that there was a change by the State of California in the reimbursement methodology for ACA primary care physician enhancements.

A table detailing this impact and its effect on Medicaid premiums and health care cost is in the 10-Q, which we filed this morning. I should note this change in reimbursement methodology cause our ASO and other income line to be negative in the quarter, as the change reclassified the business from ACO to risk. ACO and other income will return to positive levels in the second half of '14.

Medicaid enrollment news continues to be positive. New enrollees from the 133 expansion population contribute significantly to our addition of 107,000 members in the second quarter.

With this strong performance, we've increased our full year Medicaid enrollment guidance by 50,000 people. The majority of this comes from the expansion population in California. Arizona is also growing its expansion enrollment. Let me now update you on our dual eligible business.

We added 2,000 new dual members in the second half, as we expected. Our guidance continues to assume substantial enrollment growth in the second half, primarily in Los Angeles County.

As of the end of July, we've enrolled approximately 8,000 new dual members in total. We are initially seeing a slightly less acute mix than expected. Our current indications is that -- are that we will meet our full year enrollment guidance of 38,000. Opt out rates of about 40% are consistent with our expectations.

Our state Settlement Agreement with California continues to provide stability as we transition into new state programs. The favorable performance in all our state health plans caused the settlement receivable to decline by approximately $40 million in the second quarter of '14, reaching approximately $10 million at June 30, 2014. This reduction is due to favorable MCR performance, as well as lower allocated G&A expenses and the reimbursement change I earlier referenced.

We expect that the balance will be 0 by the end of the year. Let me now review our news today about the proposed expansion of our relationship with Cognizant Technology Solutions.

Today's release notes that we have signed a letter of intent with Cognizant that we expect will lead to a comprehensive business services collaboration. We've referenced the potential for such an arrangement for some time. We believe we will reach a final agreement with Cognizant by the end of the third quarter.

There are required regulatory approvals we must obtain before we can implement the transaction with Cognizant. Our current expectation is that we will be through with them in the first half of '15. It's our intention that this expanded relationship will accomplish several goals.

It will create new opportunities for innovation in products and services. It will strengthen our technology platform and allow us to use our capital more efficiently. In short, it will substantially enhance our capability to serve customers by using state-of-the-art technology, which we believe to be an essential component for future success.

In addition, as we've noted before, we're targeting $150 million to $200 million in G&A annual run rate savings to be achieved over a 3-year period. There will be approximately $50 million to $60 million of net cash cost associated with preparing for the new agreement. They will be incurred between now and when we receive regulatory approval sometime in the first half of '15. We'll outline all of this in more detail when we sign the final agreement.

As a result of our strong second quarter, let me summarize guidance changes for our combined Western Region and Government Contracts segments. We're maintaining full year diluted EPS guidance from the combined segments of at least $2.22. I note, at the same time, we're raising our full year guidance for average shares outstanding from 77 million to 80 million diluted shares. This is due to a delay in the resumption of a share repurchase program, but for the higher share count, we would have increased our full year guidance for the combined segments. Our expectation is that full year '14 after-tax income from those segments will be approximately 3.5% higher than prior guidance and will fully compensate for the higher share count.

We believe we're maintaining a prudent outlook for the balance of the year. You can see evidence of this in our reserve posture. The sequential reserve increases resulted in second quarter '14 adjusted days claims payable rising 1.3 days to 64.4 days compared with the first quarter of '14. They were up 6 days from the second quarter of '13.

We expect DCP to move lower during the second half, as claims get paid out at expected volumes from the new membership and overall enrollment growth moderates. We received questions on reinsurance risk adjustment and risk corridor.

At the end of the second quarter, the net receivable for all 3 of these items totaled approximately $100 million and is in line with our full year expectations. On a net basis, this amounted virtually all for reinsurance. As the amount of risk adjusted payable from California and the risk corridor receivable primarily from Arizona are approximately equal.

Operating cash flow in the second quarter was a small negative, due to the missing June Medicaid payment of approximately $300 million. Since the end of the second quarter, we've received these payments.

In closing, I want to thank our associates for all their hard work in this period of remarkable and unprecedented growth. The challenges are there every day, and they've been meeting them with great dedication and perseverance. We believe we are on the path for substantial growth, greater efficiency and improved financial performance.

The steps we've taken in exchanges, Medicaid expansion, the duals pilot, are driving growth. Our expanded relationship with Cognizant has the potential to provide the foundation for additional new business opportunities, technological leadership and greater efficiencies.

Because of this, we believe we're well-positioned for the rapidly changing world of health care. We look forward with genuine excitement about the future, and we thank all of you for your support. Thank you. And let's open up the Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Matthew Borsch from Goldman Sachs.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Maybe you could talk about in more detail what you were seeing over the course of second quarter in terms of utilization trends. And I don't know, I know you can't speak to other company's results, but hospital company tenant has a number of facilities in your market, and they're seeing higher volumes. So I'm just wondering if there's -- you can help us parse the view there, if you think that's all ACA coverage.

Jay M. Gellert

First of all, we have seen nothing different than really what we thought at the end of the first quarter, which is flat utilization. If anything, we're seeing slight reduction in inpatient authorizations that the rest of it seems pretty much in line. We don't do all that much business with tenant. So that wouldn't be determinative of our experience, but if you look at our numbers, because of the dramatic growth, we are spending more on services in '14 than '13. And that could be consistent with what some of the hospital companies are seeing. So I don't think there's a contradiction between what some of the providers are seeing and what we're seeing when you take into consideration the full implementation of the Affordable Care Act in the markets we're in.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

And can you talk, I realized you're not at the point where you give '15 guidance. But can you talk a little about the degree of further coverage expansion you would expect directionally in 2015, given how much of the population has come in and what you think will happen as we go into next year?

Jay M. Gellert

Well, there remains some significant volume still coming this year in terms of the Medicaid expansion, particularly in California. So I think we'll see some continued growth there, and we've already begun to see it in the start of the third quarter. So the revision we've made, I think, reflects continued reduction in the uninsured, particularly in California, but also in Arizona. I'd expect significant uptake in Arizona in the exchange in terms of the entire market. I'd also think that from what we're hearing in the community, that there's some good uptake opportunity in California, too. Many people were skeptical, and I'm waiting to see how it all worked. I think there's an area that it's really worked well in California. So I -- while we don't have exact numbers yet, and we'll probably indicate those more clearly in our next quarter call, I think we would expect some more uptake in Medicaid this year, and then some not insignificant uptake in the exchange of next year.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

If I could ask one last question on your Cognizant outsourcing arrangement. How -- I realized that's still pending, but how have you gotten comfortable that, that is something you can do at an acceptable execution risk? Given that I think this type of arrangement, correct me where I'm wrong, but is fairly unusual for the managed care industry, if not unprecedented. Do you -- I'd assume you've looked at that work in other areas. Can you just touch on that?

Jay M. Gellert

Sure. Let me make 4 points. First of all, while as a comprehensive arrangement, it's unusual to unprecedented. In terms of the various towers or the various individual elements, there's activity in each of them. So I think that the unprecedented part is viewing it in a more comprehensive way. Secondly, we worked with them for 3 years, and they've had a very significant involvement, particularly on the IT side, for us. So I think that that's given us a lot of confidence in 2 ways. One, confidence with their work; but two, confidence that they're very familiar with our system and how it works. That leads to the third point, which is a critical one, which is that we are going to basically move our people and our systems to them. So it won't involve either a system or personnel change at the point of transition. So this has been really organized with the concept that there'll be ongoing stability through the transition. That's a critical element of this. And fourth and finally, I think that we -- both companies will invest -- have invested a lot and will invest a lot both in the interim before the -- we reach the full implementation of the contract and have made, I think, built cushion in terms of the first year of implementation to make sure that we're not rushing for results, and we're giving ourselves enough room for stuff happens. So I think those are the 4 things that have given us confidence. Again, their experience, our experience with them, the way we're doing the transition, probably very, very important, and the fact that we're being -- preparing both financially and operationally by kind of doing some double kind of positioning in the first year to make sure that we don't have trouble. And I think that is the way we handle with their support, the transition this year. And I think that, that was a critical element in our success, both in terms of Medicaid and exchange transition.

Operator

Our next question comes from the line of Justin Lake from JPMorgan.

Justin Lake - JP Morgan Chase & Co, Research Division

Just a follow-up on the outsourcing agreement. Can you tell us would you expect the benefits to be in '15 and '16 from the agreement? And then, on the $50 million to $60 million cost [ph], I'm curious as to why you're incurring such significant cost before you actually get the regulatory approval?

Jay M. Gellert

Let me answer the questions in the order you asked them. I think we expect the gains to be ratable, $150 million, maybe over the 3 years in a ratable way. I think we'll be more conservative in terms of our first year expectations just for the reasons that I articulated with Matt, but I think we feel comfortable with that as our expectation in terms of the arrangement. With regard to the $50 million to $60 million. As a result of moving forward with this arrangement, items we've previously, would capitalize, now need to be expensed. So a good portion of that is a result of that. Plus, in addition, we are spending a lot of money to make sure that the transition is seamless. I mean, we are -- I think that the point that Matt made is really a fundamental one. Spending a little more on the front end to make sure that we have no disruption. As I said, we did in terms of planning for the 2014 ACA implementation; we believe to be critical. So I think those are the 2 kind of fundamental reasons for that.

Justin Lake - JP Morgan Chase & Co, Research Division

Got it. And then can you just -- and if you were to look at that $150 million to $200 million of run rate savings by '17, can you break it down into a few buckets and tell us where those savings are coming from? For instance, headcount, especially given that you're moving your people over there; so we can get some more color and confidence as to where the [ph] savings are coming from?

Jay M. Gellert

I'd rather not be specific about that until we give -- until we have the call where we announce it. I will make one point, though. I think that the -- that what this does that's really important to us is it gives us a partner who can spread technology investment more broadly, and that that's a tremendous advantage for us because we believe that being on a single system that is state-of-the-art and also can match with surround innovations that are going on throughout the whole health care industry is going to be a critical element to success. That is something that this arrangement will yield. That will -- it's hard to do as a single company, whatever size you are, but the tremendous skill that our partner has, their knowledge of our system and their interest in broadening the activity makes that probably the critical benefit we'll get both economically, as well as from an operational and competitive positioning standpoint.

Operator

Our next question comes from the line of Chris Rigg from Susquehanna Financial Group.

Christian Rigg - Susquehanna Financial Group, LLLP, Research Division

The first question is just on the share count guidance. I know you've moved it up because you've delayed share repurchase, but it's still not clear to me, are you assuming share repurchases in the 80 million share count?

Jay M. Gellert

Yes, we are. I believe that our share count at this point is a little over 81 million. So you can back into the amount we're assuming.

Christian Rigg - Susquehanna Financial Group, LLLP, Research Division

Sure, okay. And then, I know you talked about utilization staying down and not seeing any trend inflection here, but on the Medicaid business itself, would you say that the utilization is tracking above the traditional population and that's just being offset by the higher assumed pricing? Or is it actually more in line with what you've seen historically in TANF and chip?

Jay M. Gellert

No. I would say it's higher than historical, but in line with the rates that the state established.

Christian Rigg - Susquehanna Financial Group, LLLP, Research Division

Okay. And then lastly, on the DCP. I know you're saying it's going to come down in the back half of the year, but what's sort of the right level that you guys are assuming over the long term?

Jay M. Gellert

Well, I think when all of the business stabilizes, we would expect it to go back to our previous levels. We -- to the earlier question, I believe, Matt asked, I don't think that's necessarily going to happen immediately because I think we'll have another kickoff at the start of '15, but that's where we think it will get to, when the new business flattens out. Hopefully, we won't ever get there, but that's kind of, I think, the thinking we have.

Operator

Our next question comes from the line of Kevin Fischbeck from Bank of America Corporation.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

I just want to confirm, the $50 million to $60 million that you expect to spend in front of the outsourcing, that's not in your guidance anywhere that will be...

Jay M. Gellert

Yes. What we wanted to do was indicate that we don't have the final numbers until we design the final agreement, and then we'll present them all, but we wanted to give people an order of magnitude; so that it was understood. And again, for our technology operations, we're not allowed to capitalize anything between now and the time it transfers. So that reflects some of the normal capital, which we would otherwise be doing.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Okay. And I didn't get a chance to go through the 10-Q, I apologize, but I just wanted to see -- because it sounds like there's a few things going on with this ACA doc payment reclass because -- is it, in any way, impacting your Medicaid MLR guidance?

Jay M. Gellert

It has a de minimis effect on MLR guidance. It has a de minimis or effect on run rate. It has some effect on the bring down of the settlement because it increases revenue significantly, and therefore, the 3.25% is applied to it.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Okay. So that's what the issue is. So is there a way to kind of quantify that because I guess, it was like minus, as far as your other income number was minus $6.5 million versus positive before to like a $10 million swing type thing or...

Jay M. Gellert

No, I think in terms of its impact in the quarter here is that 1 comes [ph] down, I think by about $8 million, and the other goes up by about $10 million. So $10 million or $11 million. So it has about a $2.8 million effect, which is the same as the previous 3 quarters done the other way. So it doesn't have a -- it doesn't affect net income. It minimally affects MLR. My point was, the only thing it really affects is the settlement account, disproportionately.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Disproportionately, okay. And so that doesn't really, I guess, change your view about, in any way, the kind of the long-term earnings opportunity within the Medicaid or the business underneath the risk share? It just kind of means you're going to get to full booking of the earnings a little bit sooner than you would have otherwise?

Jay M. Gellert

That's right; that's right. That, and the point I made about the G&A allocation methodology, which we didn't change as provided in our agreement. Those 2 things have no effect on our overall performance. They end up, though, bringing down the settlement count earlier than it otherwise would have come down.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Okay. And then, I guess, just last question on the outsourcing. Just because -- it seems like this has been going on for a long time. I just want to understand, I guess, I appreciate you wanting to be -- you wanting to be disciplined about how you roll this out, but just want to understand kind of in your view, what's been the main issues about why it's taken them a while to announce it? And -- just trying to understand what kind of regulatory approvals will you need to get before you can actually implement it? I wasn't -- it wasn't clear. I haven't seen anything like this before. So it wasn't clear why a state would have to approve what you're trying to do.

Jay M. Gellert

Well, any -- first of all, so to your second question, I'll answer your first question. To the second question, any change in contractual relationship in any part of the administrative services in California requires regulatory approval. So there's nothing unique about this. We saw it in terms of the claims outsourcing and some other stuff that we've done. So that's -- this is not unique in that context. In terms of your first question, let me go through 3 points, I think, that are really relevant. First of all, I think a lot of people who did system reconfigurations or transitions in advance of the Affordable Care Act have found that they have to reconfigure them again because they were built for a business model that was somewhat different. So I think one of the things that both our partner, and we believed, is we wanted to get through this transition in terms of the business model. So we made sure that the agreement we developed was forward-looking, not backward-looking. Secondly, I believe that we went through a very long process to make sure that the transition is seamless and not disrupted. So I think in a case where you'd do something like this, where you're moving into someone's platform or the business is already in place. You would end up conceivably being able to move faster. In this case, I think we really are constructing a unique business structure here where we're, for all intents and purposes, starting a new arrangement. And I think the planning process really demanded that we do that in order to make sure that this was workable. The final point, and we said this before, is that we definitely did not want to do this simultaneously with the initiation of the Affordable Care Act and the dramatic business chain. We thought that was too much to do all at once. So I think that -- those are the 3 reasons why the arrangement took so long. I think that it is really important to us that this, on the one hand, give us the savings and the business performance and the ability to be really moved to a technologically leadership position; but at the same time, that it not disrupt the core business on any way and that, from start to finish, it improves service to our members and improves our ability to work with our providers. And I think that, that -- this planning process lead us to that end. One final point is, I think we couldn't have done it faster, anyway, because Jim Woys who lead this effort brilliantly, was previously involved in TRICARE, and that's how long it takes to plan a TRICARE transition, too. So that's his sense of timing in terms of doing something major.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Well I guess, maybe just to follow-up on that as far as the approval -- regulatory approval process. Is there anything within that, that you get worried at all that some component of this might not be approved? How standard is this? Or how much of a discussion you've already had with the state about what you're doing ahead of time?

Jay M. Gellert

Well, we haven't had the discussion ahead of time because we're still working on finalizing the details. We've -- let me highlight 3 things that I think are important. One, as I said before, it's constructed in towers so it -- so that, in effect, we could move forward with some parts of it sooner than others, and a lot of it is very traditional, I guess, I'd say. So that's point one; and then, the second thing is, I think, to kind of answering your second question with your first question. I think the depth of planning and the degree of -- are kind of duplication in terms of the transition process. I think it's really going to be critical. And I think that the work we've done over the course of the last, as you said, 3 years, I believe will be critical in terms of convincing the state of the positive nature of this -- of what we're proposing to do.

Operator

Our next question comes from the line of Josh Raskin from Barclays.

Joshua R. Raskin - Barclays Capital, Research Division

First question, just a quick one on the Medicaid, on the health insurance fee as it applies to the California Medicaid portion. Are you guys accruing for that reimbursement at this point? Have you actually got something in writing from California?

Jay M. Gellert

Yes. We've gotten from the state a presentation on how they plan to handle it and are accruing in line with what they've presented to us.

Joshua R. Raskin - Barclays Capital, Research Division

Okay. So it's possible that others have not gotten that because others are not accruing it? Or they're waiting for written something?

Jay M. Gellert

Well, we have a letter. So I assume they got it, too. It's possible that -- so I don't know what others are doing, but I know that we have a letter and that we have a presentation. And so I think we feel comfortable accruing it.

Joshua R. Raskin - Barclays Capital, Research Division

Okay, perfect. Second one, just on the commercial MLRs, and maybe my next 2 questions are kind of related just around the exchanges. I don't know if you guys are comfortable explicitly saying what you're accruing in terms of an MLR on the exchanges, but if you look at your guidance, the MLR for the year will be down 235 basis points. We're estimating about $1 billion of that $5.6 billion is exchanges, and so caught 18% of the total. So doing the math, it would imply pretty significant decline on the existing business. Or is it just simply you're accruing an MLR in the 83% range for the exchanges as well?

Jay M. Gellert

The legacy business is -- has a significant MLR improvement in the 100 to 150 bp range. We're accruing the overall individual business in around -- at around the 80% range. And so when you put that all together, you get to the point of what we've presented as guidance.

Joshua R. Raskin - Barclays Capital, Research Division

So you're exchange MLR is actually lower than the 83% overall?

Jay M. Gellert

Yes.

Joshua R. Raskin - Barclays Capital, Research Division

Okay. Which brings me to my last question, then I guess. Based on that surprise, is that if I look at your 3R receivables on a year-to-date basis, I think we're at about $170 million or so. I think you've probably generated somewhere around $275 million of premium in the first half. So on a relative basis, you guys are screening as high. I know a bunch of that $110 million is reinsurance, but maybe you could walk through what gives you comfort on risk adjusters and risk corridors of $50 [ph] million combined, in light of the fact that your MLR, on the individual business, you're accruing is actually very low.

Jay M. Gellert

Yes. First of all, the -- we're only accruing in total $100 million. So -- and what I said in my presentation is that we have a risk adjuster payable, which is, I guess, you'd say a negative accrual, and a risk corridor receivable that are virtually equal, but the entirety of our accrual is $100 million. Let me make 2 other points, too, which I think are important. One is nearly half of our business is in quasi-capitation arrangements. So if the accrual is off by any amount, which we don't believe it is, that -- then those would adjust consistent with it. In terms of the reinsurance and the other stuff we've done, it's consistent with our claims assumptions. So to the degree that the numbers, which are $100 million, not the higher number you've quoted, are in any way inconsistent. It would -- the claims reserve accrual would also be inconsistent. So you have those 2 things, which make our number one. We believe very -- a very conservative. I think we're one of the few peoples who have really articulated the concept of a risk adjuster payable rather than a receivable; but secondly, because of the cap arrangement and our linking it to our claims experience, to the degree there was any -- that in this potentially unpredictable area, there were any change. We backstopped it in a couple of very significant ways.

Joshua R. Raskin - Barclays Capital, Research Division

Okay, Jay. Could you just help me theoretically, I struggle with the idea of having that risk adjuster payable meaning that you're getting what you believe to be better risk than the overall. But yet, you have a corridor receivable, meaning that your overall experiences is worse than your targeted margin, correct?

Jay M. Gellert

Yes, and the reason is, as I said on my script, the payables in California, the corridor receivables from Maryland, Arizona, as we've all along said, California didn't continue existing health plans. Arizona did. Arizona, in fact, had among the 5 lowest penetrations in terms of ACA compliant business. So that's the reason for it. So I think it's the tale of 2 markets that leads you to that. And the final point, I guess, I'd make is when you look at the reinsurance number that we've assumed, particularly that not related to the capitation arrangements, when you play it out, it's well below the $10 billion that's allocated for reinsurance in terms of when you extrapolate it in its entirety. It's well below the $10 billion that is available in reinsurance overall. That was an exhausting answer.

Operator

Our next question comes from the line of Ralph Giacobbe from Crédit Suisse.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Just want to go back to the outsourcing and just make sure I understand sort of the timing of the $50 million to $60 million of cost. You said sort of that's not in guidance is part of that because you -- do you expect that, I guess, in 2014? Or should we expect that to be sort of in '15 when you get the approvals, and that it could be sort of offset or netted against some level of benefit from the actual savings?

Jay M. Gellert

Well, it will be in '14 and '15. And we don't even, right at this point, actually know when it will be. It'll also be offset by capital, as I indicated, that we had previously planned to spend that we won't be able to capitalize. And we'll give you a complete view of all of that before we do it. So that number, though, doesn't assume savings in '15. So it's just the amount that would be spent in a combination of some preparatory work that was -- and in the -- and in with regard to various previously capitalized and can't be capitalized because of the accounting treatment here, but doesn't take into consideration any savings that would occur in '15.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Okay. And then just along the savings, just want to make sure on a P&L impact, is it as simple as taking $150 million to $200 million out of the SG&A structure and drop that to the bottom line?

Jay M. Gellert

Well, I hope so. I think the question is -- I think the savings will be real because the agreement is excess numbers. So the savings are real and knowable. The dropping issue depends on how competitive markets become, but there -- this won't be a case where we will say, "Well, we saved $150 million, but we had to reinvest $150 million. So we didn't get anything." Because in this case, all of those areas are cordoned off, and there's specific pricing that leads to the numbers that we've articulated for you.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Okay. And then just jumping over to sort of the duals. I think you booked a 60 MLR in the quarter. Maybe help us understand that, obviously, a pretty low number. Maybe help us with the timing aspect to that, where you expect that sort of MLR to normalize and when?

Jay M. Gellert

Well, we've guided to 88 overall, 86 this year, I believe. The reason is artificially loan this quarter is because the startup cost have no related premium. So in this quarter, you have relatively low premium revenue, but a lot more of G&A cost. So it's just a figment of transition, but with the guidance we've given you this year reflects the '14 transition year, and it reflects our anticipation that ultimately this ends up in the 88 to 90 range going forward.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Okay. All right, that's helpful. And then just my last one. Just on the California duals, I think there's some constituents that they're sort of trying to block the rollout through the courts. Maybe if you can give us an update on sort of what's happening with that? Where does it stand? And if you see any risks there?

Jay M. Gellert

Yes, thank you. Well, my understanding is that they saw it in injunction, which wasn't given. There's still stuff -- the legal process will continue. My understanding from the State [ph] is that they believe that they've fulfilled their responsibility and are comfortable that the dual project will roll out as anticipated.

Operator

Our next question comes from the line of Dave Windley from Jefferies.

David H. Windley - Jefferies LLC, Research Division

Jay, I was looking at the progression of your percentage of commercial membership and narrow network, and that does continue to move higher. What are your expectation -- confirm for me, I guess, first, that all your individual product is on that narrow network chassis, 100%. And then, where do you expect that to go over the next 2 to 3 quarters?

Jay M. Gellert

I think that it's more like 80% to 90% of it. There are few geographies where there wasn't really the narrow network option, but for all intents and purposes, I will confirm what you said. Our expectation is that the business would be about 60% in commercial narrow network by the end of the year, that all of the rest of our business is basically in a narrow network type structure. My belief is that over the long haul, and I think it's being joined by many of my colleagues now, that we will be all in various of kinds of tailored networks, that people will make choices that way and that, that will be a key element of the choice price kind of continuum. So I think whereas before, we would -- people would be asking us questions about tailored networks. I think 3 years from now, it'll be kind of analogous to indemnity. You'll be asking us how many people do you still have in indemnity.

David H. Windley - Jefferies LLC, Research Division

Yes, okay. And then in your prepared remarks kind of on this topic, you talked about expanded provider networks for your exchange products for next year, and you talked about providers coming to you to get in. But I guess, I'm interested in how that expanded network, say, answers maybe some of the questions from regulators about access. And then also, how it affects the efficiency of those networks for you?

Jay M. Gellert

Well, first of all, I'd tell you that the providers that are coming forward are efficient providers, who were -- wanted to see the whole ACA play out. So we are not adding providers who are -- who don't fit the regimen of the products that we're offering. I think they were being prudent in wanting to see exactly how they played out. They were concerned because in many ways, they were capitated providers. So they were going to be taking risk and then they didn't want to take it, given some of the scare kind of comments that they saw previously. When they saw it play out in California in this very positive way, they come back and said, "Well, this is business that we're used to doing. We want to do it." So I think that what that, that does is, as you said, it alleviates concerns about the scope of the network and it retains the efficient structure, which we built. One final point, I think the biggest risk in terms of complaints over scope and network, really come from people who are transitioning from on old full network product to a new narrower network product. Since the vast majority of our people are new and selected these networks as their choice, we have less pushback. So we're going to be able to offer them more choices without really having a pressing need to do that at this time.

David H. Windley - Jefferies LLC, Research Division

Okay, great. And then, my last question on sticking with exchanges. Your $100 million in accrual on 3Rs, are you booking on known claims on reinsurance? Or are you projecting? In other words, I guess another way to say that, how much more will you add in the second half? And then, can you help me to understand how that fits with an average, you quoted an average, not your own, but an average of 4% rate increases for California for next year. How do you glide path to a level of premium that will cover the loss of reinsurance eventually?

Jay M. Gellert

Yes. Okay, 2 or 3 key comments. First of all, that in terms of the nearly 50% that are on quasi-capitated arrangements, we're just basing it on the assumptions, which we originally started with them. We set a set of assumptions, but we -- but those -- but their actual payment will change when we get actually different experience to the degree we get it. So that's -- that is kind of just being booked in the traditional capitated arrangement subject to an adjustment whenever actual experience comes in. We believe it's right, but if it changed, it wouldn't matter. The rest of the population, as I said before, is linked to our claims experience. So to the degree that we're making certain assumptions in terms of completion factors and the like, we're making the same assumptions in terms of reinsurance, and to the degree those would be different in any way that we get a savings on the claims and a reduction in reinsurance or a higher claim level and a higher reinsurance. So it's -- so there's -- so that's the way we're building it because we think that that's the guidance we've got, that you really should build it based on the reserving experience and the payment structure upon which you're interacting with providers.

Operator

Our next question comes from the line of Ana Gupte from Leerink Partners.

Ana Gupte - Leerink Swann LLC, Research Division

I wanted to, again, just pursue the exchange line of questioning in your comments that this is obviously a capitated arrangement. I'm just trying to understand in light of all the commentary from some the other players, your competitors, that the experience have been pretty adverse, particularly in the first tranche. Is it that your experience is just better because California has done a state-based exchange, and for whatever reason, your pricing or whatever seems to be more favorable? Or is it that, if you exclude the capitation that you have, you would actually have experienced a much worse MLR? I'm just trying to figure out how you...

Jay M. Gellert

Fair [ph] question. I think our view, and I don't really have a -- I can't really comment on other people in other markets, but our view is that the key to this entire thing is whether people, "Let people keep their health plans." That -- and the reason for that is the following: that in most states, the people who were in the individual product in advance of the Affordable Care Act have been medically under written. So they were inherently a healthy population. If -- like our experience in Arizona, you kept them out of the pool, you would end up with a much more adverse pool than was originally anticipated. To the degree, they were capped out of the pool that would have an effect. Arizona has had one of the more negative effects, but we're still at a reasonable level. In California, everyone was in. There is -- there was no grandmothering of plans and the grandfathering was de minimis. So as a result, in the state of California, you had -- you have a risk pool in excess of 2 million people, and it's a risk pool that is the entirety of the individuals considering coverage. Combined with that is California had this incredible uptake. So as a result, particularly at the back end, they got a very normal mix. So we're in a situation where the combination of those factors, and the fact that this is the first time really tailored networks were offered to individuals, so that you had a lower base unit cost, made it work in California. We said from the start that states that, "Let people who are medically underwritten stay out", states that didn't have the ability to do tailored networks, states that didn't have viable exchanges and uptake, and states where there wasn't a large pool of new entrants. That in combination, those aren't going to be good states. California went 4 for 4 the other way, and so, while we'd like to take credit for our own genius, I don't think that's what it was. It was just really well-administered plan in conjunction with the Affordable Care Act. And so I believe if you talk to other people, they will affirm those experiential differences in terms of their working with the exchanges.

Ana Gupte - Leerink Swann LLC, Research Division

That's very helpful. So it's California, just in any case...

Jay M. Gellert

It's a Golden State.

Ana Gupte - Leerink Swann LLC, Research Division

It's a Golden State, yes, that's for sure. It sounds like it's going very well. On reinsurance, when you get -- when you book a receivable just so that you can keep your providers in the network, are you monitoring what they're seeing? And is there kind of a 2-sided risk arrangement with them so that a portion of that reinsurance goes to them? And what exactly are they going capitated against? Are they in inpatient procedures and services that they're...

Jay M. Gellert

No, no, they're going capitation against a budget target for all intents and purposes. That budget target was set, and it's adjusted based on their actual reinsurance risk adjuster experience. So we've built in a set of assumptions for which we're making interim payments. We'll make adjustments at the back end based on actual experience in our discussions with them just from the fact that they're positive about the experience and others are entering. I can say that it's workable both ways. So the net effect of that is that whatever their own experience is in terms of reinsurance and risk adjustment, they receive. And that the rate we give them on the -- on initial amount is interim.

Ana Gupte - Leerink Swann LLC, Research Division

Got it, okay. Then moving on to the commercial premium yield which seems to deteriorate it modestly from the first quarter. What exactly is being booked into that? And to what degree is this because, over time, small group or even large group are considering dumping into what is turning out to be a very successful public exchange experience?

Jay M. Gellert

It's really -- solely, the phenomena of the ratio of individual who are at a lower PMPM to the small group and large group. We've really not seen dumping, and we've really seen no change quarter-to-quarter in terms of the premium in the non-exchange business.

Ana Gupte - Leerink Swann LLC, Research Division

Got it. And then, one final one, if I may. The Medicaid MCR, it sounds like the expansion lives are going very well, and it seems to echo what others are seeing on experience. You've lowered your MCR guidance. Do you think this is kind of a onetime arbitration opportunity? Or would the state of California, they think about the REIT outlook potentially reduce the premium differential, which is almost 200% at this point?

Jay M. Gellert

There's a floor on the expansion of premiums. So to the degree they will -- it would change, it would be premised on actual experience. So it would not have an effect on basic profitability of that business. So we're not booking artificially inflated profits in that area because of the MLR floor that's included in the arrangement.

Ana Gupte - Leerink Swann LLC, Research Division

Which is 85% or so, right?

Jay M. Gellert

Yes, yes, yes, ma'am.

Operator

Our next question comes from the line of Christine Arnold from Cowen and Company.

Christine Arnold - Cowen and Company, LLC, Research Division

Rate review is going to -- looks like it's going to make it on the ballot. How should we be thinking about that? It sounds like you're ask on the public exchange rates is pretty low. How much PPO versus HMO enrollment do you have? And how concerned should we be that if things develop differently, this will impede your ability to get rate increases? What's the outlook for that?

Jay M. Gellert

Well, first of all, the initiative doesn't cover a large group. So it really is only an individual and small group initiative. It's our sense that within the next couple of years, the vast majority of that business is going to go through the exchange. So we're really already going through a rate negotiation process. I think if you look at the California rates, they're compelling good and compellingly responsive. So I kind of almost think we're in rate oversight right now. And that the only fear I think that people have or expressed, is that the way the initiative could be structured, could be cumbersome and disrupt the success of what's going on now. But we are ready, are negotiating most of our rate, and I think that in our case, in terms of the PPO business, it does go through the Department of Insurance, and there's the unreasonableness and provision in law already.

Christine Arnold - Cowen and Company, LLC, Research Division

Okay. And then I'm having a hard time with your outsourcing agreement, kind of visualizing what this ultimately means for your products in the market. You said that this is going to enable innovations, a new business opportunities, an innovative products and services. I know you don't want to get into specifics until you announce it, but can you help me visualize what competitive advantage this might bring to you?

Jay M. Gellert

Yes, I think beyond the economic competitiveness, in other words, that will be reflected in pricing and stuff like that. The sense that we have is the following: that there are enormous innovations going on in terms of -- on the book, the provider and the customer side in terms of health care. The view we have is that the core to those being successful is a technology engine, your basic claims and process engine that is you have one. You don't have multiple systems. You have one that state-of-the-art, so it can connect with all the stuff that's going on. And you have one that's flexible, and that's structured in the old way where there were, basically, tables. That if you have those 3 things, plus you have somebody who's innovating alongside with you, who's doing a lot of these innovations on their own, you have a significant advantage over time over other people who are trying to do a one-off on their legacy system or multiple legacy systems and are really have an architecture that's not as new and responsive to the more flexible environment. So we think this is really kind of a fundamental change in the way that our industry works in over a couple 3 years. We'll be kind of a 21st century technology engine that can take advantage of this enormous innovation that's going on throughout the health care system. But the key to do that, I mean, the bottom line for that to be successful is 2 things: One, is you have to have a very efficient and single-course operating system, which will get out of this process that can both respond to capitation and fee-for-service and various types of arrangements, which is really critical. And secondly, you have to have the ability to invest to retain that competitive advantage, which we think is the benefit of a relationship with a broader provider of these services.

Christine Arnold - Cowen and Company, LLC, Research Division

Okay. And then final question for me. Hepatitis C, you guys were thinking you might have some resolution and how the State of California might want to deal with that by July. That's still ongoing, is there anything to report there?

Jay M. Gellert

Yes, the state has indicated to us, and they're working out the final detail, that they're going to take the Hepatitis C expenditures in our base out. And then, they're basically going to pay an incremental payment, somewhat like maternity, that as long as we follow their rules in terms of doing it, that that's the way they're going to handle it on a going-forward basis. So in effect, they're basically going to take responsibility for it, but not as an open checkbook, but as long as we conform to the requirements that they're employing in terms of a gist [ph].

Operator

Our next question comes from the line of Sarah James from Wedbush Securities.

Sarah James - Wedbush Securities Inc., Research Division

I had a clarification question on the reserves boost. It sounded like there could be 2 things going on. One was the boost related to revenue growth, but the second related to your comments on claims being paid down in the second half sounded like there could be a building claims inventory. Is there a building claims inventory?

Jay M. Gellert

No, there's not a build disproportionate, obviously, to the revenue, but what there is, is the view we have that in the first half of the year, there may be instances where because of the transition claims have come in slower, there may be circumstances where everything isn't intact and that until we get to a stable run rate. The effect of revenue growth is that it increases that to some degree. But all in all, I think what we're saying is that we're reserving. And I guess, what I'd call a prudent way, given the fact that this is a book, we've not had full experience with over time. So it's really a combination of revenue. Inventory hasn't changed, vis-à-vis, revenue, but it's also, some degree of a factor for the slow receipt [ph] of claims and a buildup in use through the course of the year.

Sarah James - Wedbush Securities Inc., Research Division

Got it, that's helpful. And last question here is what year does the outsourcing contract conclude? And is there an early exit option in the event of a change of control?

Jay M. Gellert

It's a 7-year agreement. We -- both parties have agreed that there is an early termination provision in the context of change of control. And as we said from the start, we -- both Cognizant and ourselves, recognize that there can't be a poison pill in that context. And so that's included in the agreement as we do it. I also, though, think that based on what we know now that, I think, there's going to be some really interesting opportunities. So there's also the option to continue it in the context of a change of control and expand it. So both options exist and both options will be in the final agreement, which we present before the end of the quarter, third quarter.

Operator

There are no further questions in the queue. This does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.

Jay M. Gellert

Thanks. Bye-bye.

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