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Aetna (NYSE:AET)

Q4 2010 Earnings Call

February 04, 2011 8:30 am ET

Executives

Mark Bertolini - Chief Executive Officer, President, Director, Member of Investment and Finance Committee and Member of Executive Committee

Thomas Cowhey - Vice President of Investor Relations

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

Joseph Zubretsky - Chief Financial Officer and Senior Executive Vice President

Analysts

Ana Gupte - Bernstein Research

Joshua Raskin - Barclays Capital

Peter Costa - Wells Fargo Securities, LLC

Justin Lake - UBS Investment Bank

Sarah James - Wedbush Securities Inc.

Matthew Borsch - Goldman Sachs Group Inc.

Carl McDonald - Citigroup Inc

Charles Boorady - Crédit Suisse AG

Scott Fidel - Deutsche Bank AG

David Windley - Jefferies & Company, Inc.

John Rex - JP Morgan Chase & Co

Doug Simpson - Morgan Stanley

Kevin Fischbeck - BofA Merrill Lynch

Operator

Good morning. My name is Vicky, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Aetna Fourth Quarter and Full Year 2010 Results Conference Call. [Operator Instructions] And at this time, I would turn the conference over to Mr. Tom Cowhey, Vice President of Investor Relations. Mr. Cowhey, please go ahead.

Thomas Cowhey

Good morning, and thank you for joining Aetna's Fourth Quarter 2010 Earnings Call and Webcast. This is Tom Cowhey, Head of Investor Relations for Aetna. And with me this morning are Aetna's Chairman, Ron Williams; Chief Executive Officer and President, Mark Bertolini; and Senior Executive Vice President and Chief Financial Officer, Joe Zubretsky. Following their prepared remarks, we will respond to your questions.

During this call, we will make forward-looking statements. Risk factors that may impact those statements and could cause actual future results to differ materially from currently projected results are described in Aetna's 2009 Form 10-K, our first, second and third quarter 2010 Form 10-Qs and our 2010 Form 10-K, when filed with the SEC. Pursuant to SEC Regulation G, we have provided reconciliations of metrics related to the company's performance that are non-GAAP measures in our fourth quarter 2010 financial supplements and our 2011 guidance summary. These reconciliations are available on the Investor Information portion of aetna.com.

Also, as you know, Regulation FD limits our ability to respond to certain inquiries from investors and analysts in non-public forums, so we invite you to ask all questions of a material nature on this call. One additional item of note, we would like to remind you that we will be holding our 2011 Investor Conference at Aetna's headquarters in Hartford on Friday, March 4.

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

Ronald Williams

Good morning. Thank you, Tom, and thank you all for joining us today. This morning, we’ve reported fourth quarter operating earnings per share of $0.63, bringing our full year operating earnings per share to $3.68. These results reflect strong operating fundamentals across all aspects of our business. This morning, we also announced we increased the company's cash dividend from $0.04 per share annually and declared a quarterly dividend of $0.15 per share.

This increase in our dividend will still allow us to make ongoing investments in our core business, maintain a robust share repurchase program and pursue our strategic diversification initiatives. This increase is part of Aetna's continuing commitment to enhance total return for our shareholders and is testimony to our continued confidence in our strategy, our financial profile and our cash flow.

We had many operational, financial and strategically important accomplishments in 2010. We entered into a long-term Pharmacy Benefit Management Agreement with CVS Caremark, which further enhanced Aetna's market-leading integrated value proposition for our customers. We announced the acquisition of Medicity, a leading health information exchange company to bolster our health care information technology strategy. We expanded our Medicaid footprint by launching operations in Florida and Pennsylvania and winning a fully insured aged, blind and disabled contract in Illinois. Our ActiveHealth business won a contract to cover 500,000 state employees and their beneficiaries in North Carolina, which includes facilitating the rollout of a Patient-Centered Medical Home model of care statewide.

We achieved our short-term goal of a high single digit pretax operating margin. Solid financial results are not only important to our shareholders, they enable us to continue to reinvest in the health care system and further our goal of empowering people to live healthier lives. And finally, we had an excellent capital management year issuing $750 million of debt, generating approximately $2 billion of cash flow to the parent company and launching the industry's first collateralized reinsurance transaction that was financed by health insurance linked to debt securities.

We not only delivered strong operating results in 2010, but we also strategically positioned the company for the future. We smoothly transitioned the leadership of the company to Mark Bertolini, we successfully implemented the first phase of Health Care Reform, and we began to execute our diversification strategy with our recent acquisition of Medicity. I have great confidence in this company. We have a solid management team in place, a winning strategy, and I see many opportunities ahead.

2010 will be remembered as a year that brought historic changes to the health care and health benefits industries. Aetna has been a leader throughout the reform process, and we continue to work closely with the industry and with federal and state governments on thoughtful health policy change. We are confident in our ability to continue to manage our business through the changes brought about by this law, while focusing on creating value for our customers and shareholders.

Reform presents certain challenges for our industry, but we believe there are still many new opportunities to provide solutions to address the unmet needs of health care consumers at a variety of levels. The Medicaid population is expected to continue to grow, and we continue to offer innovative solutions to states in these areas. We expect to see some states move to implement exchanges, and those that are market based could provide additional growth opportunities. We also expect the federal government to continue to push for health care information technology investment and believe we are well positioned to take advantage of this accelerating trend.

One of Aetna's strengths is our company's diverse business portfolio, including a range of risk products, a significant non-risk benefits business, participation in government programs and an increasing global presence. Over the last decade, we have been focused on building a portfolio of complementary businesses with a strategic geographical footprint. We believe that Aetna's array of products and capabilities and our strong capital position gives us great flexibility as we evaluate post-reform business opportunities.

Finally, I would like to thank all of our employees for their dedication in meeting the needs of our customers. It is through their efforts Aetna will continue to be successful in 2011 and beyond.

I will now turn the call over to Mark. Mark?

Mark Bertolini

Thank you, Ron, and good morning. As Ron just mentioned, this morning we announced fourth quarter operating EPS of $0.63 and full year 2010 operating EPS of $3.68. Our full year Commercial Medical Benefit Ratio of 80.6%, or 80.9% excluding favorable prior-period development, and our full year pretax operating margin of 8% underscore the favorable impact of the management actions we took to improve the underwriting margin profile of our business, as well as favorable utilization trends.

Due to a strong result in 2010 and the positive momentum from our performance, our 2011 initial operating EPS projection is $3.70 to $3.80, slightly higher than our 2010 results. We are pleased with this initial outlook, developed through a rigorous planning process that needed to reflect a variety of near-term challenges, including all aspects of implementing Health Care Reform and managing through what is still a difficult economy.

Further, our dividend announcement today is a reflection of the confidence we have in Aetna's outlook and is a testament to our strategic positioning. Solid, predictable cash flows are one of Aetna's strengths, and this cash flow has allowed us to return capital to our shareholders as well as invest in initiatives that further transform the health care system, an outcome that benefits consumers, the economy and our shareholders.

Focusing on 2011, the assumptions underlying our plan include: a decline in medical membership to approximately 17.8 million in the first quarter, with membership flat for the remainder of the year; medical costs trend higher than we experienced in 2010 due to a return to a higher and more normal level of utilization, the impact of reform mandates and the expectations for a normal flu season, partially offset by lower COBRA impacts and continued provider contracting improvements; pricing to an appropriate margin, reflecting trend and the marketplace, which is, on balance, rational; continued expense discipline; and generation of holding company cash used to invest in advancing the effectiveness of the health care system and enhancing total shareholder return, including our dividend announcement.

Supporting our 2011 expectations is our intense focus on the following operational and strategic imperatives: health care quality and total costs; consumer engagement and customer focus; complying with Health Care Reform and making the necessary changes to succeed in this new environment; Medicare business process changes to satisfy our most important customer; continued implementation of our CVS Caremark agreement, providing immediate value to our customers and shareholders with this new integrated product; and making strategic investments to continue to position Aetna for the future.

Health care quality and total costs are paramount as we continue to focus on competitive medical costs through facility re-contracting, reimbursement policies, concurrent and retrospective review and integrated case and disease management, among other initiatives.

Consumer engagement and customer focus are also key imperatives. By offering the right benefit designs, effective provider networks, health and wellness programs and information tools, we believe that our members can make more informed decisions about purchasing affordable health care products and solutions. Our recently acquired Medicity platform, in concert with our ActiveHealth applications, are important assets in advancing consumer engagement.

Being compliant with and helping our customers with the impacts of Health Care Reform is essential. We remain focused on both the immediate and the long-term impacts to our business and our customers. We are very engaged in this implementation to ensure that we are compliant with the law and identify the strategic business opportunities that will emerge as the result of reform. We are confident that Aetna is well positioned to be successful in the post-reform environment.

An example of this post-reform positioning is our approach the commissions going forward. While brokers have been, and will remain, key partners with Aetna, we have been consistent in our conclusion that the minimum MLR [medical loss ratio] requirements in the Health Care Reform law would and have catalyzed changes in broker compensation arrangements.

Generally, our framework for creating transparency in our commission structure has been: first, where possible, to ensure transparency to allow larger customers to continue to negotiate fees directly with their broker or consultant; second, to restructure commissions so they are decoupled from annual health care inflation, improving affordability and driving future operating efficiencies; and third, to reduce the level of commissions to improve the affordability of our offerings. We have made a series of changes for 2011 and believe we can execute these changes while maintaining a stable membership base and risk profile.

As you know, in April 2010, CMS suspended our ability to market to and enroll new members in all Aetna Medicare Advantage and Standalone Prescription Drug Plan contracts. We continue to work diligently on process and other improvements to meet the standards set by CMS and have devoted substantial personnel and resources to this effort. CMS has granted us an extension of our limited waiver of these sanctions to allow us to continue to enroll members into existing group plans through March 31, 2011. Our estimate of the impact of the sanctions has been incorporated into the full year 2011 operating earnings per share and membership projections that I just provided.

We are also strategically repositioning our business portfolio. Two examples of this repositioning include our CVS Caremark relationship and our acquisition of Medicity. We commenced operations with CVS Caremark under our long-term strategic relationship on January 1. As discussed previously, 2011 will be a transition year in this relationship. We now project that the benefits of this arrangement will be greater than the 2011 transitional expenses, and therefore contribute modestly to operating EPS in 2011, which has been incorporated into our full year guidance. We continue to project that the CVS Caremark transaction will contribute $0.30 of operating EPS in 2012. We remain very confident that this arrangement is an outstanding solution for our customers and shareholders.

The recent acquisition of Medicity also highlights our strategic diversification efforts. Medicity's platform furthers the adoption of health care applications that contribute to administrative simplicity and affordability in health care, a key issue for consumers, patients and providers. Medicity's unique platform and its application-based design enables the rapid development and deployment of new software to further these goals. Specifically, applying ActiveHealth's tools to Medicity’s leading-edge platform will accelerate solutions that facilitate delivery system reforms, including Patient-Centered Medical Homes and Accountable Care Organizations. Better information and enhanced connectivity will also support the deployment of new reimbursement strategies, which hold the potential to transform health care delivery and positively impact the value of the health care system.

In summary, I am pleased with our 2010 performance and very confident in our initial 2011 operating earnings per share projection of $3.70 to $3.80. By focusing on sound fundamentals, pricing with discipline, creating new approaches to satisfying customers and generating significant excess capital, we can continue to create value for our customers and shareholders.

I will now turn the call over to Joe Zubretsky to provide insight into our fourth quarter, our full year 2010 financial performance and our 2011 outlook. Joe?

Joseph Zubretsky

Thanks, Mark, and good morning, everyone. Earlier today, we reported fourth quarter operating earnings per share of $0.63, an increase of 58% compared to the prior-year quarter. We also reported full year operating earnings per share of $3.68, an increase of 34% compared to 2009. Operating earnings for the full year of $1,555,000,000 represents a year-over-year increase of over 25%.

Fourth quarter highlights include: a Commercial Medical Benefit Ratio of 80.7%; favorable prior-period reserve development in the Commercial and Medicaid product lines; and excellent parent company cash flows, with approximately $1 billion of subsidiary dividends to the parent in the quarter. As a prelude to analyzing our 2011 projections, let's recap the drivers of our fourth quarter and full year 2010 financial performance, starting first with operating margin and its key components.

Full year 2010 pretax operating margin was 8%, a 160 basis point improvement over 2009, due primarily to higher Commercial underwriting margins. This underwriting margin improvement was the result of management actions to re-price our business, lower utilization and favorable prior-period reserve development, partially offset by lower Commercial membership. This full year result achieves the high single digit pretax operating margin we previously targeted.

We ended the year with 18.5 million medical members, a decline of 446,000 from 2009. This decrease reflects a loss of 611,000 Commercial members, mostly fully insured and almost half of which were a result of economic attrition. We also added 153,000 Medicaid members, approximately 40,000 of which were from new contracts in Pennsylvania and Florida.

Full year 2010 revenue declined 1.9% to $34 billion, primarily due to a decline in Health Care premium. This decline included: a net decrease in Commercial premium of 4.4% due to lower volume and mix related to product, geography and customer market segment, partially offset by increased rates. Health Care premium also reflected a 2.8% increase in Medicare premium and a 16.8% increase in Medicaid premium that is related primarily to Medicaid membership gains.

The second key component of operating margin results is medical cost. Our fourth quarter total Medical Benefit Ratio was 83%, including $104 million before tax of favorable prior-period reserve development. This development was primarily from third quarter incurred medical costs and included $88 million in Commercial and $16 million in Medicaid.

Our full year 2010 total Medical Benefit Ratio was 82.3%. Favorable prior-period reserve development in 2010 related to prior years was approximately $118 million. The full year 2010 Commercial Medical Benefit Ratio was 80.6%, favorable to previous guidance. This favorable result reflects management actions to improve underwriting margins, lower underlying utilization and favorable prior-period reserve development. Our full year Medicare and Medicaid Medical Benefit Ratios were 87.3% and 87.5%, respectively, both in line with our expectations. The Medicare MBR increased by 20 basis points year-over-year, while the Medicaid MBR decreased by 110 basis points. 2010 medical cost trend ended the year at approximately 7.5%, in line with our previous guidance range.

We continue to reflect appropriate assumptions regarding medical cost trend, operating metrics and payout patterns in setting reserves for estimated health care costs. Days claims payable were 42.3 days as of December 31. We continue to project days claims payable to be in the low 40s over time.

Group Insurance operating earnings were $21 million in the quarter, compared to a loss of $14 million in the fourth quarter of 2009. In both quarters, we adjusted our long-term disability reserves by using a lower discount rate, reflecting declining yields in the investment portfolio supporting this business.

The third key component of operating margin is operating expense management. We continue to invest in our future so we can capitalize on marketplace opportunities for future profitable growth, while also improving productivity and ensuring that we appropriately serve the needs of our customers. The full year 2010 business segment operating expense ratio was 18.9%, which is in line with our prior guidance and reflects seasonal fourth quarter spending, as well as expenses related to the CVS Caremark implementation and other major programs.

In the fourth quarter, we also incurred transaction costs of $66 million pretax, primarily related to our CVS Caremark and Medicity transactions. In addition, we recorded a severance and facilities charge of $47 million pretax, related to continuing efforts to improve and streamline our cost structure. These items are excluded from our operating earnings as reported.

The final area of financial performance I will comment on is our investment performance and management of capital. Full year net investment income on our continuing business portfolio was $711 million, in line with expectations as asset growth was offset by declining yields from lower interest rates. We maintained a well-diversified portfolio, while managing to total return, with a bias to book yield and preservation of capital.

At December 31, the continuing business portfolio had a net unrealized gain position of approximately $700 million before tax. Our financial position, capital structure and liquidity all continue to be very strong. As of December 31, we had a debt-to-total capitalization ratio of 30.7%, and our risk-based capital ratio was in line with our target of approximately 300% of company action level.

Our liquidity gives us financial flexibility. Full year 2010 subsidiary dividends to the parent were in excess of $2.1 billion, and we repurchased 52.4 million shares for approximately $1.6 billion during the year. Our resulting basic share count was 384.4 million at December 31. We ended the quarter with holding company liquidity of approximately $550 million, which we used to finance the Medicity acquisition in January 2011.

For the full year, Health Care and Group Insurance operating cash flow, excluding the pension contribution, was just under $2 billion, or 1.2x 2010 operating earnings, excluding pension expense. This was in line with our expectations.

Before we discuss 2011 guidance, I would like to spend a moment on an issue related to our Medicare Advantage business, Risk Adjustment Data Validation, or RADV, audits. Industry-wide, a number of Medicare Advantage plans are currently subject to open RADV audits, including two Aetna contracts being audited for the 2007 payment year. Due to the importance of this issue to Aetna and the industry, we are disputing these audits with CMS. Aetna is working directly, and through our national trade association, America's Health Insurance Plans, to address our concerns, including submitting comments on the draft audit process and methodology proposed by CMS. We are also aware that other independent third parties have commented on these issues. We believe that our financial statements reflect appropriate provisions for Medicare premium estimates, including potential liabilities, if any, relating to the two RADV contract audits currently in process.

I will now discuss our 2011 guidance. We project full year 2011 operating earnings per share to be $3.70 to $3.80. This represents projected results that would modestly exceed our 2010 operating EPS.

The change in operating EPS from 2010 actual to 2011 projected, at the midpoint of the range, is due to several factors, including: first, a decrease of $0.18 per share due to the absence of the 2010 favorable prior-year reserve development, which we do not, as a matter of course, project to recur; second, a projected year-over-year underwriting margin decrease of approximately $0.20 per share, due to the impact of minimum MLR premium rebates, the continuing impact of Medicare sanctions and lower membership. These impacts are partially offset by the continuing benefit of our pricing actions, Medicaid growth and the 2011 impact from CVS Caremark. Third, due to the continued low interest rate environment, we project that retained net investment income will decrease, reducing 2011 operating earnings by approximately $0.20 per share compared to 2010. Fourth, we project that the net impact of the pension changes we made in 2010 will increase 2011 operating EPS by roughly $0.20 per share. Fifth, we project that the net benefit of our operating expense actions will be an increase of about $0.10 per share in 2011. And finally, we project that the net impact of a lower weighted average diluted share count on full year 2011 will be an increase of approximately $0.35 per share.

Our 2011 projections include total medical membership of approximately 17.8 million members at the end of the first quarter, consistent with our prior guidance. The projected first quarter decline in total medical membership from year-end 2010 is approximately 680,000, from a year-end membership base that was approximately 90,000 members higher than we had previously projected. This first quarter decline includes: a decrease of approximately 150,000 Commercial Insured members, a decrease of approximately 510,000 Commercial ASC members, a decrease of approximately 40,000 members in Medicare and an increase of approximately 20,000 members in Medicaid.

Total net medical membership is projected to be flat over the remainder of the year, an outlook which is based on current economic conditions. We project that full year total company revenue will be down slightly from 2010. With respect to Medical Benefit Ratios in 2011, we project a Commercial Medical Benefit Ratio of 82% plus or minus 50 basis points and a Medicare medical benefit ratio that is in the high 80s.

Our 2011 Commercial MBR projection includes the estimated impact of MLR rebates, assumes no prior-period development and incorporates a prudent estimate of our trend yield spread for the year. Our 2011 MBR projections reflect pricing to an appropriate margin to reflect underlying medical cost trends that we expect to be in the 8% plus or minus 50 basis points range.

This reflects medical cost trend higher than we experienced in 2010 due to a higher and more normal level of utilization, the impact of reform mandates and the expectations for a normal flu season, partially offset by lower COBRA impacts and continued provider contracting improvements. With respect to specific medical cost trend categories, our guidance is unchanged from the third quarter of 2010.

We also project a business segment operating expense ratio of less than 19%. This includes increases due to negative fixed cost leverage from membership declines and the impact of the Medicity acquisition, offset by productivity gains and continued general expense management. We also project a full year before tax operating margin of 7.5% to 8%.

Consistent with our earnings guidance and sound operating fundamentals with respect to cash flow and capital, we project that: our 2011 operating cash flow will be greater than our 2011 operating earnings; dividends from regulated subsidiaries will be approximately $1.7 billion, including the benefit from the collateralized reinsurance transaction we previously announced; excess cash flow to the parent, after fixed charges and the increased dividend, will be approximately $1.2 billion; and our debt-to-capitalization ratio will be approximately 30%.

Our full year operating earnings projection is approximately $1.4 billion to $1.5 billion. Based on our estimate of approximately 384 million weighted average diluted shares, we project full year 2011 operating earnings per share to be $3.70 to $3.80.

I would like to close with a focus on our capital management strategy. In early January, we completed the first-ever collateralized reinsurance transaction that was financed by health insurance linked securities. This transaction freed up $150 million in statutory capital to use at the parent company for general corporate purposes. This transaction allowed us to effectively replace equity capital with capital having an after-tax cost of less than 3%. We expect this to be the first step in a larger program.

Further, this morning we announced that we increased the company's cash dividend from $0.04 per share annually and declared a quarterly dividend of $0.15 per share. Our first quarterly dividend will be paid on April 29 to all shareholders of record on April 14.

We are initially targeting an annual yield of about 1.75% and a payout ratio on earnings of approximately 15%. Our confidence in our 2011 outlook, our long-term growth strategies and our cash generation capabilities have enabled us to implement this increase. We expect to pay this dividend without inhibiting our existing capital deployment strategies, which include targeted acquisitions and our annual share repurchase program.

Efficient capital deployment continues to be a critical piece of Aetna's strategy, and today's announcement is another step in the evolution of that strategy. Whether we are unlocking shareholder value by using innovative vehicles such as the Vitality Re transaction, returning capital to shareholders through our dividend or share repurchase programs or executing disciplined M&A transactions, Aetna's management team is committed to deploying its capital to create shareholder value.

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

Thomas Cowhey

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

Question-and-Answer Session

Operator

The first question comes from Scott Fidel with Deutsche Bank.

Scott Fidel - Deutsche Bank AG

First question is, if you can talk a little bit about some of the macro assumptions that are built into your guidance. So the unemployment rate assumption, which this morning dipped down to 9%, and then your view on interest rates and what you're thinking about in terms of improved attrition for 2011?

Ronald Williams

Scott, I think we got your question, but you're breaking up. I think the question's centered around macro assumptions around unemployment interest rates, et cetera. I think, broadly, the assumption are really current economic conditions. I'll ask Joe to give you the specific details here.

Joseph Zubretsky

Scott, we projected no improvement or deterioration in the unemployment situation domestically. And generally, we forecast using the yield curve that exists at the time we do our forecast.

Scott Fidel - Deutsche Bank AG

Just on the International business and plans to expand there, if you can give us an update on, are you considering any acquisitions there or any near-term plans for market expansions on the international front?

Mark Bertolini

Sure, Scott, this is Mark Bertolini. I'd spent the first week in December in China and have spent some other time internationally looking at opportunities around the globe. And our customers overseas are very interested in our technology platforms and our ability to help frame how disease management and case management can help them expand capacity. As you know, in international markets, they've covered the issue of how to pay for access, but access is now limited by virtue of the fact that the budgets are strained by what's going on with chronic disease around the globe. So very interested in disease management, services, technology platforms in every area, China, India and in Europe.

Operator

John Rex with JPMorgan.

John Rex - JP Morgan Chase & Co

I want to talk about membership a little bit and look, I mean, what you're guiding to is just where you said it would be last quarter also in terms of attrition. But it just stands out again against what we're seeing in terms of stabilization across the rest of the group. To be fair, you guys were kind of gainers when everyone else was losers on membership. But can you give us a little more color on what's happening, particularly in these ASC books. I know it's a lot of repricing on the insured, but particularly on ASC and whether these -- are any of these are Aetna One customers?

Mark Bertolini

First of all, there were no Aetna One customers. So I can tell you that, that product continues to grow as a set within our product offerings. The ASC market continues to be competitive from the standpoint of people being willing to take risk on trend. And as I mentioned in our last call, we believe that the levels of trend that people were expecting for guarantees were not levels that we were willing to guarantee. And so we have shied away from those and have been willing to let business go, if indeed, that was on the cost of winning that business. Overall, we also saw some lapse in our network rental business, which was largely the big difference between what we expected to lose in January and what we actually lost.

John Rex - JP Morgan Chase & Co

And just on core trend, did you say that for -- you now sized 2010 at 7.5%, I know 7.5% is what you said last quarter, but I would assume it's kind of lower than that given how the 4Q came in.

Joseph Zubretsky

It's approximately 7.5%, but you're right. It's at the lower end of any range that you would project.

John Rex - JP Morgan Chase & Co

So within that, I'm just thinking about the context you provided for rolling forward. Is there anything you're seeing right now that would indicate claims volumes is accelerating as you move into the new year?

Mark Bertolini

Well, we haven't seen anything, but it's too early to tell. We're still working through the trends for this year. But our expectation, as we said in the talking points, is that we'll see some return to normal utilization. We'll see a return to normal flu season, which we had a very low flu season last year compared to a normal flu season, and a lowering impact of COBRA. So we see -- we think it’s legitimate to go up to 8% plus or minus 50.

Operator

Justin Lake with UBS.

Justin Lake - UBS Investment Bank

Just first question, Joe, on your comments around RADV. I'd just be curious if you can give us any color as far as the -- it sounds like you've taken some reserve there, maybe size that for us and talk potentially about the implications should the industry be unsuccessful in getting some change made to this preliminary methodology here as far as would you have to take any charges going forward, et cetera?

Joseph Zubretsky

Well, Justin, as I said in the prepared remarks, as you know, Medicare premium requires a variety of estimates to be made as you close your books. And as we made those estimates in this quarter as in past, we considered all exposures related to any CMS audit, including RADV audits in that calculation. We feel comfortable with our balance sheet positions at this time. Going forward, I mean, this is a major industry issue. I think you saw the note the other night, where CMS is at least willing to discuss and negotiate different methodologies. As you know, there's lots of value tied up in the extrapolation, the sampling, the definitions of what constitutes quality information, and we have teams of people that are working diligently on that exercise, and the industry will put its case forward.

Justin Lake - UBS Investment Bank

And is there any size you could provide us as far as what the reserve you’ve taken there is?

Joseph Zubretsky

No, I think you saw our Medical Benefit Ratio a little bit higher in the fourth quarter. That included any reserve adjustments or premium estimates that we make.

Justin Lake - UBS Investment Bank

On the Commercial MBR guidance, any color you can give us on the impact of MLR floors? And as you look out ahead, with an 82% MLR out there, how much potential do you see there for upside should, let's say, cost trend continue to be more modest than what we're projecting for 2011 versus having to be rebated back?

Joseph Zubretsky

The way we think about the Commercial MBR guidance for 2011 is the 80.6 reported ratio for 2010, if you remove the benefit of prior-period development, you get to just about 81, and so we have a 100 basis point deterioration year-over-year. That includes both the impact of MLR rebates and a cautious outlook on our achievement of trend yield spread for the year. We are not parsing out the impact of MLR rebates at this time and may or may not in the future. What was the second part of your question, Justin?

Justin Lake - UBS Investment Bank

Just thinking about that 82% MLR going forward. There's some question about whether if there is a trend decline or, let's just say, trend doesn't normalize higher in 2011. How much of that would be capped from those levels versus having to be rebated out? Is there any thought or kind of color you can give us on whether you think of a 100 basis point decline in trend how much you might be able to retain versus rebate?

Joseph Zubretsky

Justin, as you know, it really depends. You have multiple hundreds of rebate pools that you're managing across all states and across all lines of business. And it actually matters a lot, whether the improvement experience or the deterioration of experience happens in a pool that's in rebate status or not. So it's very hard to forecast, but we think we have prudent actuarial estimates around the outcome included in our full year guidance.

Operator

[Operator Instructions] We'll take our next question from Peter Costa, Wells Fargo Securities.

Peter Costa - Wells Fargo Securities, LLC

Can you talk about the modest improvement in the CVS contract? Is that because you accelerated some of the spending for implementation into the fourth quarter, or is that something else that's changed?

Mark Bertolini

Well, it's largely related, Peter, to our ability to transition customers over to the new contracts earlier and have them onboard by January. And we'll continue to see that progress throughout the year as we get to the end of the year.

Peter Costa - Wells Fargo Securities, LLC

So was that increased cost in the fourth quarter for you?

Mark Bertolini

No, it was not increased cost to implement those contracts, those contracts are with our employers and it was just a matter of switching them over to the new CVS relationship. We had taken a cautious view on how quickly that could happen. It happened sooner than we thought.

Operator

Ana Gupte, Sanford Bernstein.

Ana Gupte - Bernstein Research

The question is about Medicity and your guidance for 2011 being neutral to earnings. I'm trying to understand if what your intent is, is really to boost Aetna's top line for more membership and improving margins to MBR and is that already embedded in your guidance? And so this a 2011 question, as well as are you thinking more broadly about stand-alone sales and can you articulate if that is to competing health plans to hospitals and anything else?

Mark Bertolini

Ana, Mark Bertolini. The Medicity acquisition is really based on our Accountable Care Solutions and our Patient-Centered Medical Home models. It is a platform. And that platform is one of the largest installed bases around the United States in the provider community, and we want to continue to leverage that as we think about our future reimbursement strategies, as well as offering applications like the ActiveHealth Care Engine and the Care suite on that application to providers to help improve the flow of their practice and to improve the quality of care that they offer, ultimately leading to cost. So we think it's a longer-term prospect, and so in 2011, it's really investing in that base, adding applications to it, getting it installed more fully in places. It's the buy-up opportunity for the providers at the provider level that will ultimately bring us longer-term returns.

Ana Gupte - Bernstein Research

So 2012, is there any upside? And then just thinking about other acquisitions in the health IT area, are you contemplating other opportunities and has this announcement of the dividend and the big share repurchase, which sounds like you intend to maintain, has that changed your capital deployment priorities from being more growth to more of a value name?

Mark Bertolini

There's a few questions in there. I'll answer the first one. 2012, we're not giving any guidance on 2012 yet, but I will comment that the dividend is a fairly small portion of our cash flow. We believe that we have, out of the cash flow remaining, plenty to invest in the business going forward in both acquisitions and organic growth as fits our strategy.

Operator

Charles Boorady with Crédit Suisse.

Charles Boorady - Crédit Suisse AG

Can you talk about your expense reduction efforts for 2011? And maybe talk a little bit longer term about how to square that with my expectations, at least, for some higher G&A spend as you look to expand your Medicaid footprint, and there are some pretty big RFPs out and coming out, but also lay the ground work for 2014.

Joseph Zubretsky

Sure, Charles. With respect to our outlook for SG&A, for 2011 as we said, our SG&A ratio should be approximately 19% or below and think of that as productivity gains being offset by the negative leverage of having some declining membership. So we were successful at least in offsetting the negative leverage with productivity gains, both numbers being approximately 40 basis points. So if we can stabilize membership as we project we will and continue along the productivity path, we are pretty optimistic that we'll be able to reduce this ratio over time. Now keep in mind as you suggested, there is pressure on the SG&A line from many different fronts. First of all, having a Medicaid installation is a very good spend, it's an investment worthwhile making. But there's increased pressure from regulatory initiatives such as reform, ICD-10 and the like, that has put pressure on the SG&A ratio. We are dealing with it as is the rest of the industry.

Charles Boorady - Crédit Suisse AG

Along those lines is will you do discounted cash flows and try to separate the maintenance CapEx from many investments you're making for new growth, including reform related opportunities? Can you separate for us, Joe, or can you even measure what of your G&A spend is tied to reform-related activities, including planned expansions in 2014?

Joseph Zubretsky

Sure. I can give you three data points that can at least help you understand some of the pressures on the 2010 numbers. For the full year, and much of this was disproportionate to the back end of the year, we spent $32 million on reform, $40 million on the implementation of CVS Caremark and approximately $30 million on ICD-10, which as you know, will be a multi-year program that will extend on through 2013. That will give you an idea of some of the large programmatic spending that's been putting pressure on the ratio.

Operator

Sarah James with Wedbush.

Sarah James - Wedbush Securities Inc.

When you gave some of the different moving pieces in guidance, one item there was sort of an amalgamation of underwriting margin, rebate, Medicare sanction and lower membership, so there's just a lot of moving pieces there. Is there any way that you can spike out sort of what you see as the larger portions of that and what are more minimal aspects to that $0.20 number?

Joseph Zubretsky

Sarah, I think we're pretty comfortable in the guidance we gave that the $0.20 reduction year-over-year is a combination of those factors, and at this point we've decided not to parse those out and be more specific than that.

Sarah James - Wedbush Securities Inc.

On the competitive environment, just what you're seeing as far as pricing goes across the industry, if it seems to be rational or impacted by what's going on with Health Care Reform?

Mark Bertolini

Sarah, the market continues to be rational across the board. Again, we have pockets of irrational behavior or irrational from our point of view from time to time. We have heard of some competitors pricing to the MLR target going forward. We have considered that strategy and don’t consider that to be appropriate for us. So we continue to price to trend and appropriate profit margin and we'll let, call it, the cards fall where they may.

Operator

Josh Raskin with Barclays Capital.

Joshua Raskin - Barclays Capital

Question just on Medicare and sort of I guess Medicare Advantage particularly around strategy. MLRs, the past couple of years have been sort of 85 to 87. I've characterized that as maybe above industry averages. You've got the RADV audits as you're talking about. You're still in the CMS sanction. You've got membership declines in 2011. And so I'm just curious, what's the sort of dedicated strategy longer term? Do you guys think you need more scale? Or is this a business that you think is sort of secondary to your Commercial? Just how does it sort of fit in overall?

Mark Bertolini

Josh, Mark Bertolini. We continue to see Medicare as a very important line of business for us, both the Medicare Advantage and other lines of business. Remember, we have over 1 million members in our national account book that are supplemental, and we continue to manage those books of business. We see the strategies for moving ahead with Medicare even with revenue reductions as being focused on better provider contracting, better utilization management, tighter SG&A and changes in benefits where we need to do that. Ultimately, also we see the star ratings programs as a very important investment, which we are making as we move ahead. On the Medicare sanction, it's something that we're working very diligently on. We were out for the open enrollment period. So our point of view is let's make sure we are very ready, we have all our ducks in a row, so that when CMS comes back in here, they will see that we're ready to move ahead.

Joshua Raskin - Barclays Capital

Where did the fourth quarter earnings come in sort of relative to your expectations, what were the big pluses and minuses?

Joseph Zubretsky

Josh, can you repeat your question? Where did earnings come in compared to our expectations?

Joshua Raskin - Barclays Capital

Yes.

Joseph Zubretsky

I mean, I think all our metrics were completely in line with what we had anticipated.

Operator

Carl McDonald with Citigroup.

Carl McDonald - Citigroup Inc

I wanted to come back to the fourth quarter SG&A, as you mentioned the severance costs and the transaction costs weren't in that reported number. So were there any specifics that you could spike out in the G&A that pushed it up so much in the fourth quarter?

Joseph Zubretsky

I think, Carl, as I mentioned previously, we talked about when we gave guidance at the end of the third quarter for the balance of the year that there would be an uptick in spending in the fourth quarter due to these large programs, and in fact, we did incur the spending on those programs. So it's nothing more than that.

Carl McDonald - Citigroup Inc

So would you anticipate that seasonality to look the same in 2011 in terms of sort of a similar type of fourth quarter uptick?

Joseph Zubretsky

Typical, our spending is back-loaded to the fourth quarter. Our technology spend is particularly back-loaded to the year when we can get better unit costs. And usually and hopefully next year, we'll have open enrollment expenses on a successful enrollment year.

Carl McDonald - Citigroup Inc

Just on the commissions, my read of the market is you guys have been more aggressive than really anybody else out in the market. You do have one of the smaller individual businesses. So how do you think about risk profile with that setup? I think, historically, the concern has been you go under on commissions, you're going to keep all the sick members, but all the sort of newer more profitable members are going to go somewhere else where there's better commission.

Mark Bertolini

Carl, for the last decade we have made significant investments at the senior leadership level, both Ron and I in meeting with our brokers twice a year. So we've had a National Broker Advisory Council where we have been having this conversation about commissions as a result of the impact on MLR for over three years. So this strategy that we've put forward is something that we've talked about with our brokers. We have implemented it very carefully. We believe that we can execute against it without any risk to our membership for the year.

Operator

Matt Borsch with Goldman Sachs has our next question.

Matthew Borsch - Goldman Sachs Group Inc.

Could you just -- and maybe you mentioned this, do you have share repurchase in your guidance, and how much is reflected or is it simply the share repurchase that you've done to date?

Ronald Williams

Matt, we typically -- in order to get a good accounting of earnings per share, we typically take excess cash flow and allocate a portion of it to share repurchases just so you can see the benefit in EPS. We typical don't size that, although we did you an excess cash flow number for the year. So I think if you look at that cash flow number, you can model how many shares you can project that we would repurchase during the year or that we have at least the capacity to repurchase during the year.

Matthew Borsch - Goldman Sachs Group Inc.

Are you going to give us a target for the weighted diluted shares for the year?

Ronald Williams

I think we did that.

Joseph Zubretsky

384 million.

Matthew Borsch - Goldman Sachs Group Inc.

You alluded to hearing of some competitors pricing to the MLR thresholds perhaps, have you actually seen that? Is that something you're facing in the market? How widespread is it? Can you characterize if you're seeing that maybe a little more from public or not-for-profit companies?

Mark Bertolini

Well, we definitely did hear it from the folks in North Carolina. The Blues in North Carolina which said they were going to go ahead with that and actually took some of their rates down. The rest really is market talk that we're getting from our distribution network and hearing from other brokers and our own sales force. We don't have any documentation of such, and until we do we can't say definitely that it's happening.

Matthew Borsch - Goldman Sachs Group Inc.

Would you characterize the pricing environment as noticeably different today than it was, say, a year ago?

Mark Bertolini

Largely rational and continues to be rational.

Operator

David Windley, Jefferies.

David Windley - Jefferies & Company, Inc.

Would you be willing to spike out or separate the percentage of your commercial risk membership subject to 80% floor versus 85% floor?

Joseph Zubretsky

In a way, I think you can ferret that out from the information we provide. We've said that our individual membership represented about 2.5% of our risk book of business. I think in the past, we've also given some indication that our small group membership was approximately 6%. And so I think you can assume the rest of it is large group or some of the other special programs that we write.

David Windley - Jefferies & Company, Inc.

Around the CVS relationship, can you give me a sense of if or when you expect to feel some benefit from that relationship in your new selling efforts. It sounds like you've moved quite quickly in transitioning existing clients. I'm wondering what kind of feedback you're getting in the selling effort around an integrated solution with CVS?

Mark Bertolini

Sure. In 2011 selling season, we were about to lose some key accounts in pharmacy. We were able to save those. I think that's an indication of the interest from the larger employer market. We are just entering the national account market for 2012. Too early to tell, but there is a lot of interest, and the clients we're talking to are quite pleased with what we've been able to structure with CVS.

Operator

Kevin Fischbeck with Bank of America Merrill Lynch.

Kevin Fischbeck - BofA Merrill Lynch

I guess, first question here. You mentioned that you don't believe that pricing to the MLR floor is the right strategy for you guys. Can you elaborate a little bit on that as to what you see is, as that not being the right outcome?

Mark Bertolini

First, we always believe that we should price to trend plus appropriate profit margin, and we continue to do so. In the event that we have rebates that we need to pay, we will handle those in the due course of business in appropriate ways that we believe advantage both our customers and our shareholders. So that is the approach we have taken. On the other side of it, pricing exactly to the MLR, if you miss on the high side, you lose. If you undershoot, you lose. So in the end analysis for us, we'd rather not be on the line, we'd rather be appropriately reserved for where we believe our pricing needs to be on the merits and fundamentals of the business. By the way, the MBRs that we target our pricing to along with the trend are different than the MLRs that actually get calculated, so that further complicates that math. And so we're just going to run our business the way we always need to run it, and then we'll deal with the rebates afterwards.

Kevin Fischbeck - BofA Merrill Lynch

And then, if you could just spend a minute on the reinsurance transactions. You’ve mentioned a few times that it's part of a larger plan. Any color on how big this could be? Or how long it will take for you to kind of reach the ultimate size of that plan, and why it make sense to do this in a staggered way rather than in one large transaction?

Ronald Williams

The way we characterize the capacity is that I'm comfortable having programs such as this represent anywhere between 10% to 15% of the capital structure, so you can size it that way. And we've made no pre-announcements as to whether we'd be in the market soon or later, but 10% to 15% would be our capacity, and there is nothing that would stop you from doing a larger transaction.

Operator

And we have time for one more question. We'll take our last question from Doug Simpson with Morgan Stanley.

Doug Simpson - Morgan Stanley

I was wondering if you could just give us any sense as to how much, if any, of the Commercial risk business will be impacted by credibility adjustments. And just how does that factor into the outlook?

Joseph Zubretsky

Doug, I don't have an exact size for you, but I can absolutely assure you, we had a lot of intense effort around the whole implementation of a financial infrastructure around managing the rebate exposure and feel comfortable that our actuaries have their arms around it and have adequately factored in credibility adjustments into our estimates.

Doug Simpson - Morgan Stanley

And then maybe just to expand a little bit on the collateralized deal. We're three years out from '08, can you give us any sense as to how the conversations are evolving with regulators about stat capital and if you look out a couple of years, you've indicated this is the first transaction you may consider similar deals going forward. Any way to size the magnitude of that opportunity and how you're thinking about capital levels of the subs over the next couple of years?

Joseph Zubretsky

Doug, as I said before, if you're referring to the Vitality Re transaction in that notional form of capital, we're comfortable as having that represent 10% to 15% of the capital structure, and this was done all under the advice, supervision and counsel of various state regulators and the rating agencies. So we're very comfortable about the financial integrity and documentation of the transaction.

Doug Simpson - Morgan Stanley

And then just finally on the dividend, it seemed like that was -- I'm sorry if you addressed this earlier, but it seemed like there was a change in tone with moving towards the dividend. Did something -- maybe just walk us through the thought process in moving to put forth the dividend because it sounded like historically you were a little more focused on the M&A and buyback opportunity.

Joseph Zubretsky

Doug, as we said many times, we routinely evaluated using excess cash flow in many ways. We also said that the capital plan should support a financial plan and a strategy, and we also said that in a very difficult economic environment and with looming reform until we had more certainty over what the future looked like that we would hesitate to make any major changes to our capital structure. Now that we have clarity around the company's financial profile and our strategy, we thought introducing a dividend gives us a very balanced allocation of free and excess cash flow to accommodate a variety of types of shareholders.

Ronald Williams

As we close the call, I want to remind you that after almost 10 years with Aetna in April, I will be leaving the company and the board of directors in my role as Chairman of the Board. It's been a great experience and a privilege to have led the company. Today, Aetna has a great culture based on the Aetna way and an engaged customer focus workforce. I leave the company with strong confidence in our strategy, our focus on quality improvement and medical cost trend reduction, our innovative products and services and the leadership team that will guide Aetna in the future. And I believe that our financial profile and cash flows will serve the company well as we transition through this stage of Health Care Reform. Thank you.

Thomas Cowhey

Thank you, Ron. We look forward to seeing you at our Investor Day in Hartford on March 4. A transcript of the prepared portion of this call will be posted shortly on the Investor Information section of aetna.com. If you have any questions about matters discussed this morning, please feel free to call me or one of my colleagues in the Investor Relations office. Thank you for joining us this morning.

Operator

And that does conclude today's teleconference. Thank you all for joining.

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