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Aetna (NYSE:AET)

Q1 2011 Earnings Call

April 28, 2011 8:30 am ET

Executives

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

Thomas Cowhey - Vice President of Investor Relations

Joseph Zubretsky - Chief Financial Officer and Senior Executive Vice President

Analysts

Joshua Raskin - Barclays Capital

Peter Costa - Wells Fargo Securities, LLC

Justin Lake - UBS Investment Bank

Carl McDonald - Citigroup Inc

Charles Boorady - Crédit Suisse AG

Scott Fidel - Deutsche Bank AG

Ana Gupte - Sanford C. Bernstein & Co., Inc.

John Rex - JP Morgan Chase & Co

Doug Simpson - Morgan Stanley

Kevin Fischbeck - BofA Merrill Lynch

Christine Arnold - Cowen and Company, LLC

Operator

Good morning. My name is Jenny, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Aetna First Quarter 2011 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to Mr. Tom Cowhey, Vice President of Investor Relations. Mr. Cowhey, please go ahead.

Thomas Cowhey

Good morning, and thank you for joining Aetna's First Quarter 2011 Earnings Call and Webcast. This is Tom Cowhey, Head of Investor Relations for Aetna. And with me this morning are Aetna's Chairman, 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 2010 Form 10-K. Pursuant to SEC Regulation G, we have provided reconciliations of metrics related to the company's performance that are non-GAAP measures in our first quarter 2011 financial supplement 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 nonpublic forums, so we invite you to ask all questions of a material nature on this call.

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

Mark Bertolini

Good morning. Thank you, Tom, and thank you all for joining us today. This morning, we reported first quarter operating earnings per share of $1.43. Excluding favorable prior period development, first quarter operating earnings per share was $1.14, $0.17 higher than the consensus estimate of $0.97. These results reflect strong operating fundamentals across all aspects of our business, including discipline pricing, medical cost management, expense discipline and strong cash flow generation.

Our first quarter 2011 Commercial medical benefit ratio was 77% or 79.8% excluding favorable prior period development, a result of disciplined execution of our pricing, our medical cost management strategy and lower than projected utilization. Based on these results and our outlook for the balance of the year, we have increased our full year 2011 operating EPS projection from $4.20 to $4.30 and are updating our full year medical membership outlook to approximately 18.4 million medical members, pro forma for the acquisition of Prodigy Health, which we announced this morning.

Further driven by our strong earnings profile, working capital improvements in some of our nonregulated businesses and our Vitality Re capital management transactions, we now project increased excess capital generation in 2011 with projected dividends from subsidiaries increasing to $2.4 billion from $1.7 billion. In a few moments, Joe will provide more detailed results on the quarter and will review our updated 2011 guidance.

I would like to provide some commentary on our progress related to our strategic and operational priorities during the first quarter. At our recent Investor Day, we discussed the 3 components of our strategy to create shareholder value: Advancing the core business, emerging business growth and deploying capital effectively. I would like to comment on 3 important aspects of our core businesses. Aetna's National Account value proposition, as we are in the midst of our 2012 selling season; our broker compensation strategy, as its successful execution is critical to our large account fully insured franchise; and the outlook for our Medicare business in light of the sanctions imposed by CMS.

Our national accounts franchise continues to be an important part of our core business. And as we are currently engaged in the 2012 selling season, we are getting ample opportunities to convey our value proposition to the market. We believe in keeping people healthy by providing access to affordable quality care and promoting preventive care. We are focused on empowering members to live healthier lives. This total cost management approach includes: Consumer engagement through effective plan designs and convenient yet powerful online tools such as our payment estimator and mobile applications; Integrated Care management, including our active Health Care engine; and our new alliance with CVS Caremark, integrating Pharmacy and medical benefits.

At our Investor Day, we highlighted the power of our Consumer tools and our integrated solutions. The value we deliver through our product designs was recently highlighted in our seventh annual study of our Aetna Health Fund Consumer Directed Health Plans. In this study, we were able to demonstrate that plan sponsors who replace their previous plan options with Aetna Health Fund experienced lower annual cost trends over 5 years, reducing savings of nearly $21.5 million per 10,000 members. While it was too early in the selling season to give you a January 2012 national accounts membership outlook, we are committed to improving our performance in the 2012 sales cycle based on the value proposition that I just described.

In early 2011, catalyzed by Health Care Reform, Aetna instituted a series of changes to broker compensation. While we have made different commission changes based on specific products and geographies, the following representative changes were instituted: First, for individual products, we reduced commissions for all new business. This change was needed to keep the individual product affordable, and was made concurrent with similar changes by many of our competitors.

Second, for small group products, we de-linked broker commissions from the increases in premium moving to a per employee per month commission. While this has little impact on our 2011 financials, it should demonstrate a benefit in 2012 and beyond. We are not alone in making this change for this product. In fact, in many geographies, this change was instituted by some of our competitors in advance of Aetna's implementation.

Third, for large group products, defined as accounts with more than 50 employees, Aetna and our broker partners moved to service fee model allowing these customers to negotiate fees directly with their broker or consultant. Some of our competitors have also followed our lead and moved to this model in selected geographies.

We continue to believe the service fee model is the best course for commissions for large groups as it promotes efficiencies and increases transparency. However, in a handful of jurisdictions where concerns have been expressed over our actions, we have taken prudent measures to adjust our strategy. As always, Aetna is committed to working with state regulators and producers to make sure that we and our producers implement the service fee model in an appropriate fashion.

Aetna's updated earnings and membership guidance fully captures the projected impacts from the implementation of our core commission strategy, as well as any changes due to market conditions or regulatory concerns. On balance, our plans are tracking with our expectations, our renewals in markets where we implemented the service fee model are strong and we are committed to executing a strategy, while maintaining a stable membership base and risk profile.

Finally, the last item I would like to discuss about our core business is the outlook for our Medicare business in light of CMS sanctions. Medicare has been a key strategic growth area for Aetna for several years. In April 2010, CMS suspended our ability to market to and enroll new members in all Aetna Medicare Advantage and stand-alone prescription drug plan contracts. CMS has extended our limited waiver on these sanctions to allow us to continue to enroll member into existing group plans through May 31, 2011. Our estimate of the impact of the sanctions has been incorporated into our full year 2011 operating earnings per share and membership projections. We continue to work diligently and deliberately on improvements to meet the standards set by CMS and to position the business for further success in the future.

Moving to the second component of our strategy to create shareholder value, growing our emerging businesses, we have also made some excellent progress. Accountable Care Organizations are generating significant excitement in the marketplace, and Aetna is determined to be a leader in this area through our Accountable Care Solutions business. As discussed at our Investor Day, Aetna has already established pilots with 47 primary Care practices for Medicare Advantage collaboration. These pilots include the use of embedded nurses, personalized Care management, advanced technology connecting providers and financial arrangements, encouraging quality Care at a lower cost.

In these pilots, Aetna promoted the use of personal health records, activated active Health Care engine to identify actionable gaps in Care and coordinated access with specialists, hospitals and community social services. Our results have been extremely encouraging, with a 31% decrease in acute bed days and a 34% decrease in subacute bed days for the target populations.

Aetna has also one of the first national plans to have executed an accountable care solution in the Commercial market. Combining the capabilities from Medicity, ActiveHealth and Aetna, we announced the first quarter an initiative with the Carilion Clinic, the largest Health Care provider in Southwest Virginia, serving nearly 1 million people. When consummated, this relationship will provide comprehensive of clinical and administrative support through integrated delivery of our health information technology solutions, administer employee benefits for 18,000 Carilion employees and their dependents, pursue the joint management of a Medicaid contract in Virginia in 2012 and launch a new joint commercial product with the unique payment model, designed to incent the delivery of improved value to our customers.

Aetna's Accountable Care solutions were developed independent of the ASC regulations recently established by CMS and represent a broader application of this new delivery model. As we look out across the spectrum of Accountable Care opportunities, we feel we are uniquely positioned for success, building on our existing capabilities and relationships. Aetna is a clinical thought leader and has a dedicated customer channel focused on hospital employees, serving over 125 clients with approximately 750,000 members in 2010.

Medicity is the nation's largest health information exchange and its extensive provider system client base will drive future collaboration opportunities. Aetna's provider relations are excellent as recently recognized by the Verden Group. As we look to partner with providers, our culture and reputation will be a competitive advantage and our pending acquisition of Prodigy Health offers Aetna an additional low-cost platform to enable future hospital system collaboration.

We are actively engaged in expanding our Accountable Care initiatives and expect Carilion to be the first of the series of Accountable Care announcements in the coming months. We believe we have the technology, resources and capabilities to be a leader in this emerging business. Further, as we build out our Accountable Care footprint, we see an opportunity to link back to our core business, developing next-generation narrow network products based on Accountable Care providers. This new network model can present customers with affordable options focused on quality and cost.

We have also had success in our International business this year, including 2 recent product launches: First, we launched a new suite of international health care plans for employers with globally mobile employees. These products provide wellness tools and resources such as our health risk assessment, as well as increased flexibility in coverage options. Second, we recently launched an individual expatriate product in China. Building on our success in the group marketplace, this is Aetna's first product for individuals in China and represents an exciting new opportunity for our International business. We plan to build upon these successes with future product offerings as we bring our technology, capabilities and expertise to global markets.

In terms of the third component of our strategy, deploying capital to enhance shareholder value. In January of this year, we completed the acquisition of Medicity for approximately $500 million, enhancing our health Information Technology platform. This morning, we announced the acquisition of Prodigy Health for $600 million. Prodigy is the largest independent third-party administrator for self-insured employers and health plans, serving over $1.3 million individuals and adding approximately 600,000 medical members to Aetna. This acquisition is in keeping with Aetna's strategy of diversifying its product offerings and adding new revenue streams. Prodigy will strengthen Aetna's offerings for mid-sized, small businesses and segments of the market that are primarily price focused. As I just mentioned, Prodigy will also complement Aetna's Accountable Care initiatives. We expect Prodigy to benefit from access to our provider contracting capabilities and our CVS Caremark pharmacy arrangement. This acquisition is another example of deploying capital to grow our business over the long run.

I would also note in the first quarter, we spent approximately $250 million buying back shares and our first enhanced dividend is payable tomorrow. Based on these actions alone, Aetna will have deployed $1.4 billion in capital this year, part of our continuing commitment to enhance shareholder value through effective capital deployment.

Before I turn the call over to Joe, I want to take a moment to share with you some of my goals as the recently appointed Chairman of Aetna. Aetna has nearly 160 years of history, rich with innovation, adaptation and resilience. As Chairman, I am personally focused on executing our strategy in creating shareholder value. But I am also focusing in the organization on 3 goals: First, building on the best of the company's rich history, while paving the way for changes that will help Aetna thrive and prosper in the future. Our core business is the heart of a strong franchise, and it acts as both a source of capital and a platform off which we can grow new initiatives, leveraging our existing scale and capabilities. Innovation within and around this core will be a cornerstone of our success in the future.

Second, America needs real Health Care Reform that makes quality Health Care more affordable, not just accessible. Aetna has been advocating for change in Health Care since 2005, when we were the first national health plan to support an individual coverage mandate. We are intimately involved in the Health Care Reform process. And while there is much work left to do, we will be actively involved in the public and private sectors as a thought leader in shaping better Health Care systems here and around the world.

Third, as a corporate citizen, Aetna has certain responsibilities. One of these responsibilities is to help reestablish the credibility of corporate America by having leadership which is approachable, tangible and real. Our company's leaders and our actions can set an example for others.

These goals are ambitious, but Aetna has a talented and diverse employee base, which is ready for the challenge and I look forward to working with them every day to make these goals a reality as we endeavor to create value for our shareholders, customers and employees.

In summary, I am pleased with our first quarter performance and I would like thank all of our employees for their dedication in meeting the needs of our customers. I am confident in our strategic direction on our updated full year 2011 operating earnings per share projection of $4.20 to $4.30. By focusing on sound fundamentals, pricing with discipline, creating new approaches to satisfying customers and generating significant excess capital, we believe that 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 first quarter results and our full year 2011 outlook. Joe?

Joseph Zubretsky

Thanks, Mark, and good morning, everyone. Earlier today, we reported first quarter operating earnings per share of $1.43, an increase of 46% compared to the prior year quarter. Excluding prior period reserve development, operating earnings per share was $1.14. Operating earnings were $560 million, representing a year-over-year increase of 30%. This reflects higher commercial underwriting margins from favorable development of prior period Health Care cost estimates and improved underlying performance, partially offset by lower Commercial Insured membership. This result also reflects an excellent quarter in our Group Insurance business, driven by higher disability underwriting margins and higher than expected net expect investment income.

First quarter highlights include: $174 million of favorable prior period reserve development in the Commercial, Medicare and Medicaid product lines. A Commercial medical benefit ratio of 79.8%, excluding favorable development. Group Insurance operating earnings which were 51% higher than the prior year quarter, and excellent Parent Company capital generation with approximately $700 million of subsidiary dividends to the parent in the quarter.

The first quarter 2011 pretax operating margin was 11.4%, a 270 basis points improvement over 2010 due primarily to higher commercial underwriting margins. This underwriting margin improvement was the continuing result of the actions management had taken to replace our business in 2010, lower than projected utilization and favorable prior period reserve development. The favorable development accounted for 210 basis points of the year-over-year increase in the pretax operating margin.

We ended the first quarter with 17.8 million medical members, a decline of 674,000 from year end 2010. Consistent with our previous guidance but emerging in a slightly different mix than we had projected. Commercial ASC membership was down 456,000 members sequentially, better than our previous guidance due to better-than-expected open enrollment results.

Commercial Insured membership was down 193,000 members, a slightly higher decrease than previous guidance, due primarily to larger than expected losses in our Small Group business as a result of the competitive pricing environment. Medicare membership was down 38,000 from year end 2010 due to the impact of CMS sanctions, consistent with previous guidance. We also added 13,000 Medicaid members in the quarter.

First quarter pharmacy membership decreased by approximately 850,000 members, comprising commercial membership losses of approximately 650,000 and a remainder from our Medicare business, primarily as a result of CMS sanctions. Our CVS Caremark relationship, which significantly improves the value of our Pharmacy product offering, was not consummated and announced in time to have a meaningful impact on our 2011 pharmacy selling season. We are confident this membership trend will improve and our CVS Caremark platform integration continues to be on track.

First quarter 2011 revenue declined 2.3% year-over-year to $8.3 billion, primarily due to a decline in Health Care premium and included a net decrease in Commercial premium of 2.5% due to a volume decline of 7.5% driven by lower Commercial Insured membership, partially offset by a 5% increase in premium yields resulting from an 8% increase in rates offset by mix changes related to product, geography and customer market segment.

Health Care premium also reflected a 7.3% decrease in Medicare premium due to lower volume and a 41.2% increase in Medicaid premium that is related primarily to Medicaid membership gains and geographic expansions.

Health Care fees and other revenue were flat year-over-year due to membership-related volume decrease, largely offset by increased Pharmacy revenues from our new CVS Caremark relationship and the inclusion of revenues from Medicity.

Moving on to medical costs. Our first quarter total medical benefit ratio was 79.2%, including $174 million before tax of favorable prior period reserve development. This development was related to 2010 incurred medical costs and included $143 million in Commercial, $25 million in Medicare and $6 million in Medicaid. Note that since this favorable development relates to 2010 dates of service, it does not impact our 2011 minimum loss ratio rebate position. The Commercial MBR was 77% or 79.8% excluding favorable development. The favorable Commercial prior period development of $143 million is due primarily to 2010 medical cost trend emerging better than projected due to lower-than-expected utilization.

Adjusted for favorable development, our first quarter Medicare and Medicaid medical benefit ratios were 86.8% and 90.4%, respectively, with Medicare performing slightly better than our expectations. Adjusted for development, the Medicare MBR decreased 270 basis points year-over-year, while the Medicaid MBR decreased by 90 basis points. 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 44.9 days as of March 31, which was down 2 days year-over-year and was consistent with our expectations for the quarter. We continue to project days claims payable to be in the low 40s over time.

Group Insurance operating earnings were $42.9 million in the quarter compared to $28.5 million in the first quarter of 2010. This increase was primarily due to higher disability underwriting margins and higher net investment income in the first quarter of 2011.

Finally, with respect to operating expense management, we continue to invest in our future to capitalize on marketplace opportunities for future profitable growth and improved productivity, while ensuring that we appropriately serve the needs of our customers. The first quarter 2011 business segment operating expense ratio was 18.7%, up 60 basis points year-over-year. This reflects the impact of lower Commercial membership, Information Technology spending related to ICD-10 and Health Care Reform and the inclusion of Medicity, partially offset by productivity and other improvements.

The final area of financial performance I will comment on is our investment performance and management of capital. First quarter net investment income on our continuing business portfolio was $166 million, a decrease of $20 million year-over-year. This result was slightly better than our expectation due to yields that were better than projected and outperformance in some of our alternative asset portfolios. This favorable result has been incorporated into our updated full year guidance, which I will discuss in a moment.

We have maintained a well diversified portfolio, while managing to total return with a bias to book yield in preservation of capital. At March 31, the continuing business portfolio had a net unrealized gain position of approximately $637 million before tax.

Our financial position, capital structure and liquidity all continue to be very strong. As of March 31, we had a debt to total capitalization ratio of 28.3% and our risk-based capital ratio was in line with our target of approximately 300% of company action level. Our excess capital generation and liquidity gives us financial flexibility. We started the year with approximately $550 million in cash at the parent. First quarter 2011 subsidiary dividends to the parent were approximately $700 million. Early in January, we closed the Medicity acquisition for $500 million. We repurchased 6.7 million shares for $250 million during the quarter. We repaid $450 million of maturing long-term debt, and we ended the quarter with a holding company cash balance of approximately $100 million. Our basic share count was 379.5 million at March 31.

For the quarter, Health Care and Group Insurance operating cash flow was $642 million or 1.2x first quarter 2011 operating earnings. This was in line with our expectations. With respect to our 2011 guidance, we are increasing our full year 2011 operating earnings per share guidance to a range of $4.20 to $4.30. This guidance increase is driven by the positive prior period development, which we experienced in the first quarter, increasing operating EPS by $0.30. Favorable underlying performance at our Commercial and Medicare business lines offset by lower Commercial Insured member months, increasing operating EPS by $0.15 per share. The remainder of the increase is driven by favorable net investment income through the first quarter, increasing our full year forecast.

Our 2011 projections now include total medical membership of approximately 18.4 million members, pro forma for the acquisition of Prodigy Health, which we expect to close in the second half of 2011. Excluding the acquisition, total net medical membership is projected to be flat over the remainder of the year.

With respect to medical benefit ratios in 2011, we project a Commercial medical benefit ratio of 81%, plus or minus 50 basis points and a Medicare medical benefit ratio that is in the mid- to high-80s.

Our 2011, Commercial MBR projection includes the favorable development reported in the first quarter, and as a matter of course, assumes no future prior year development, and incorporates a prudent full year estimate of our trend yield spread, which was positive in the first quarter but is projected to be slightly negative for the remainder of the year. As a reminder, for the last 3 quarters of 2010, our Commercial medical benefit ratio averaged 80.4% and our guidance for 2011 implies a Commercial medical benefit ratio higher than that average. This projected pattern is consistent with our continued commitment to pricing to an appropriate margin, the estimated impact of minimum MLR rebates and our view of moderating medical cost trends.

Our 2011 MBR projections reflect underlying medical cost trends that we expect to be in the 7.5% plus or minus 50 basis points range. Lower by 50 basis points from our previous guidance for 2011 and 50 basis points higher than our 2010 medical cost trend of approximately 7%, as we stated for development. 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 a normal flu season, partially offset by lower COBRA impacts; and continued provider contracting improvements. The decline in trend versus our previous guidance is driven by lower than projected utilization. With respect to specific medical cost trend categories, our guidance is unchanged except for a slight decrease in physician trend, which we now project to be in the mid-single digits.

We also continue to project a business segment operating expense ratio of less than 19%. This includes the impact of negative fixed costs leverage for membership declines and the impact of the Medicity acquisition, offset by productivity gains and continued general expense management. Our business segment operating expense ratio projection contemplates the impact of our commission strategy.

We now project a full year before tax operating margin of approximately 8.5%, the increase from prior guidance as a result of our improved earnings projection. We expect 2011 to be another excellent capital generation year, exceeding our results in 2010 due to our operating performance and continued capital management activities. As evidence of this focus on capital management, later today, we expect to close our second collateralized reinsurance transaction that will be financed by health insurance linked securities. This transaction will free up an additional $150 million in statutory capital to use at the parent company for general corporate purposes.

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. We are increasing our estimate of dividends from subsidiaries to $2.4 billion from $1.7 billion. This is primarily a result of higher projected earnings, working capital improvements in some of our nonregulated businesses and includes the benefit from our collateralized reinsurance transactions. This $700 million increase in projected subsidiary dividends will enable us to finance the $600 million acquisition of Prodigy Health out of existing cash flow, while continuing to provide $1.2 billion in excess capital for the parent for the full year, which will be available for acquisitions, share repurchases and other uses consistent with prior guidance.

Finally, we project that our debt-to-capitalization ratio will be approximately 30%. I would like to provide an update on our deployment of excess capital. In early January, we acquired Medicity for $500 million, providing the platform for our health information technology and accountable care solutions offerings. This morning, we announced the acquisition of Prodigy Health for approximately $600 million. Prodigy is the nation's largest independent third-party administrator, providing TPA services to 1.3 million individuals and offering a full array of medical management services to self-funded employers and health plans. The transaction will bring to Aetna approximately 600,000 medical members and approximately 450,000 pharmacy members. Prodigy had over $200 million of revenues in 2010, and has a strong record of growth and success. Strategically, Prodigy represents an opportunity to better serve the growing portion of the marketplace focused on low-cost service models. The TPA operating model is highly flexible, with customizable options with respect to networks, customer service and care management programs. Having TPA capability provides Aetna with an alternative product offering attractive to certain self-funded customers looking for a low-cost program. It also complements our accountable care solutions initiatives. The combination of Prodigy's low-cost administrative platform and network with Aetna's strong network capabilities and portfolio of ancillary products is a natural synergy in this transaction.

We expect the Prodigy acquisition as funded to be mutual to 2011 operating earnings per share and modestly accretive to our 2012 results, with attractive returns as the transaction synergies are realized over time. Both the Medicity and Prodigy transactions are strategically significant for Aetna and represent product expansions to fuel our growth. We have the resources to complete both of these acquisitions, while maintaining our enhanced shareholder dividend, our 2011 share count guidance and a debt-to-capitalization ratio target of approximately 30%.

Also as previously announced, tomorrow, shareholders of record on April 14 will be receiving their first increased dividend payment of $0.15 per share. 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.

Our full year operating earnings projection is approximately $1.6 billion to $1.65 billion. Based on our estimate of approximately 384 million weighted average diluted shares, we project full year 2011 operating earnings per share to be $4.20 to $4.30. We are pleased with the outlook for 2011, and our prospects for long-term earnings growth are also excellent. As we have said previously, our core business and capital deployment can generate operating earnings per share growth of 10% or more on average from 2010 through 2013. We continue to work diligently to achieve both our short-term and longer-term goals.

With that, I will now 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]

Question-and-Answer Session

Operator

[Operator Instructions] At this time, we will take our first question from Josh Raskin with Barclays Capital.

Joshua Raskin - Barclays Capital

I appreciate you taking the question upfront. My question, I guess, revolves really around the impact of reform and I guess I'm cheating because it's kind of a 2-parter, but I didn't really hear much talk around rebates. So I was wondering if you could talk a little bit about if you saw any real impact and maybe what your strategy is. I know you guys have talked about mitigating the impact throughout the year. And then there's the second question. Also on reforms, just the impact of the under 26 year-old dependents and maybe what that did to membership in the first quarter?

Mark Bertolini

Josh, Mark. Thanks for the question. I will answer it broadly, and I'll ask Joe for some specifics, next. I would say that we have incorporated within our future guidance and within the current quarter appropriate adjustments for rebate accruals as we look at across all the pools, across on the markets where we'll be impacted by rebates. So we are fully accrued and we believe we are appropriately having our guidance where we believe to be the rebate impact. And Joe?

Joseph Zubretsky

Sure. Josh, as we've expressed previously, we're managing approximately 250 rebate pools across the country. We remind you that there are adjustments to the MBR that we report to compare to the MLR. And those can be up to 400 basis points. So the calculations are done. We calculated on a full year basis and recorded 1/4 of the estimate in the first quarter, and we'll adjust that over time. With respect to the rebate pools themselves, as we have said, we will comply with the regulation and we will either distribute rebates checks if in fact a rebate pool is in rebate status. Or we do have the opportunity to manage those -- that rebate capital in a different way to get the premium back to customers in a different way. And we'll do that as the situation presents itself.

Joshua Raskin - Barclays Capital

I guess the question really, Joe, is, are you guys doing that now? Have you seen enough in the first quarter in terms of the favorable trends and the improved guidance where you would start thinking about managing those rebates?

Joseph Zubretsky

It's a little too early as you know. Rebate is an annual calculation, so even if you're having good experience in a pool this early, you really do have to wait and see how it emerges. So I would say that the second quarter would be the key quarter for estimating whether a rebate pool is in rebate status.

Joshua Raskin - Barclays Capital

And the under 26 year-olds?

Mark Bertolini

And the under 26 year-olds, Josh, we have not seen any dramatic impact on our Student Health business, in students moving either to or from Student Health as a result of the under 26. A number of our employers have offered the program. And today, it's a little early to look at the impact of cost. But we have projected that to be a relatively small amount.

Joshua Raskin - Barclays Capital

But nothing in terms of your commercial book where you're seeing higher, I guess, would technically be in-group growth than expected because of those additions?

Joseph Zubretsky

We believe that the age 26 phenomenon had an impact of less than 100,000 members in our Commercial membership.

Operator

And we will go next to John Rex with J.P. Morgan.

John Rex - JP Morgan Chase & Co

Just wanted to go back to your utilization commentary, and I think you mentioned that the one category that change was physician for you. But more specifically, if you can think about kind of the Commercial Medicare categories and kind of what you were seeing in the trends in terms of, particularly in bed days in those categories. And just any other color commentary on what you mentioned about docs.

Joseph Zubretsky

John, I'll make 2 comments. With respect to bed days, we continue to see bed days per thousand decline 2011 over 2010, but at a slower rate. And with respect to physician, we believe it's due to increased preventive utilization due to the new federal mandates. But we are seeing those 2 phenomenon, but subtly.

John Rex - JP Morgan Chase & Co

All right. And within the categories, was it similar in terms of Medicare and Commercial, you were seeing bed day -- that you're seeing bed day declines in both?

Joseph Zubretsky

We're having very good utilization experience in our Medicare book presently, yes.

John Rex - JP Morgan Chase & Co

Okay. And just as it relates to weather in the 1Q, did you think that was a significant a factor on the physician side at least?

Joseph Zubretsky

We believe it had some impact, but we're not seeing the same dramatic impact we experienced in 2010.

John Rex - JP Morgan Chase & Co

Okay. And just can you -- on acuity, some of the companies have noted that they're seeing some acuity creep also. Have you noted any of that as it relates to length of stay?

Joseph Zubretsky

Not discernible, no.

Operator

And we'll hear next from Christine Arnold with Cowen and Company.

Christine Arnold - Cowen and Company, LLC

I'd like to walk through your capital availability. If you're going to get $2.4 billion in dividends, you've already got $700 million, that leaves $1.7 billion to get. Plus you had $100 million at the parent in the quarter, so that's $1.8 billion minus $600 million deployed for Prodigy. Means you'll have $1.2 billion to deploy if you keep $200 million at the parent, you can repurchase or acquire $1 billion worth. Is my math right?

Joseph Zubretsky

Yes, Christine. Let me give you the precise math. I believe your math is correct. We started the year with $550 million. I'll give you a full year view. We started the year with $550 million. Our dividends to the parent are projected to be $2.4 billion. After repaying interest, dividends, other fixed charges and a net debt decrease, that will leave $2.4 billion before financing our M&A transactions, which Medicity plus Prodigy expected at $1.1 billion, leading $1.2 billion. That's the precise math. And so yes, that capital is available for additional M&A, share repurchase activity or other corporate uses.

Christine Arnold - Cowen and Company, LLC

Does that include the repurchase you've already done or is that total repurchase of $1.2 billion of which you've already done some?

Joseph Zubretsky

Total.

Christine Arnold - Cowen and Company, LLC

Total.

Joseph Zubretsky

The way to think about it is we were able to keep our excess capital forecast at $1.2 billion and the increased dividend activity financed Prodigy.

Christine Arnold - Cowen and Company, LLC

Got it, got it.

Joseph Zubretsky

That's the simplest way to think about the change.

Christine Arnold - Cowen and Company, LLC

Okay. And then as a follow-up, I know it's too soon to say what 2012 enrollment looks like. I respect that. But can you give us a sense for what you're seeing versus the year ago with respect to existing accounts out to bid versus getting a look at somebody else's accounts?

Mark Bertolini

I would say that the balance is more in our favor this year than it was last year, that the season still remains very competitive, that discounts still matter in a number of markets and that we have, over the last 2 years, been addressing that discount disadvantage, getting it to a place where we believe we can be competitive in the marketplace again.

Operator

And next, we will hear from Ana Gupte with Sanford Bernstein.

Ana Gupte - Sanford C. Bernstein & Co., Inc.

I wanted to follow up on the Prodigy acquisition. First in the near term, are there any synergies here? Is the strategy related to, in addition to the membership, to provider contracting and/or SG&A?

Mark Bertolini

Ana, the Prodigy acquisition is helpful in a number of ways and there are synergies in the transaction, which we've reflected in the fact that it will be not accretive in 2011, but in 2012 will be slightly accretive. And we will go after those synergies. More importantly though, I think the opportunity here is, as we move into a market where employers will be considering at smaller levels to move to self-funding, that Prodigy will be an asset that we can use in that marketplace to offer a very affordable product which bring insurance to smaller employers, that 200 to 2,000 employer marketplace. And we also see it as a very valuable asset as it relates to our accountable care solutions marketplace where we have a large hospital vertical today where we can now use that TPA in the hospital vertical to offer more competitive products to smaller hospitals.

Ana Gupte - Sanford C. Bernstein & Co., Inc.

And then going forward, what does this signal in terms of your broader acquisition strategy? You mentioned a number of things as priorities at your Investor Day. Can you provide a list? Is Medicare and Medicaid at the top of your list? Where does just buying Commercial membership stand? And then finally, on vertical capability-type deals that you're doing with Medicity and the like?

Mark Bertolini

Well, I think, Ana, we're above. Our strategy remains the same. We look for assets that provide us capabilities, not just necessary mass or size. Prodigy offered us both. In this instance, with 600,000 Commercial members so that was a win for us. We continue to see the public sectors, the government sectors as important sectors for us, the HIT sector and international.

Operator

And we will hear next from Justin Lake with UBS

Justin Lake - UBS Investment Bank

Just wanted to follow up, first, on the broker commission strategy in large group. You mentioned backing off on asking brokers to collect commissions directly in a few markets. I was hoping we might get some color here, maybe in terms of what percentage of your markets you still have the strategy and maybe just in terms of maybe your membership footprint? And then also, kind of the impact there that you might have seen from a broker standpoint in terms of market share shifts.

Mark Bertolini

Justin, let me be very clear about our large group strategy. We do not ask brokers to collect commissions directly from their customers. What we've asked them to do is to get a certification from the employer that says they have talked about the commission and are allowing them, allowing Aetna to collect their commission on behalf of the broker. And that we transparently share that with them on a regular basis. So we are not asking them to collect it in any way, shape or form. We are collecting it for them. I would say that across the markets, we have had some places where certain state regulatory agencies have asked us questions about how we've approached it, more from the standpoint of the way they approve these kinds of changes, particularly in relation to filings. We are working through those issues. In areas where we don't have full agreement, we've made some changes to those strategies. And in some markets, which we expected, we have some pushback from the broker community, but we have incorporated that into our guidance. We continue to hold the course and make sure that we believe that this commission strategy in the way we work with our customers and our producers is important in the large group market.

Justin Lake - UBS Investment Bank

Okay. Just any color in terms of what percentage of your markets still have the strategy intact?

Mark Bertolini

The majority. The vast majority.

Justin Lake - UBS Investment Bank

Okay, great. And then second question, just wanted to get an update on CVS and a little color on the Prodigy accretion. So you previously said CVS was I think $0.30 accretive with a modest amount coming this year or so and the remainder coming next year. So should we think about that tailwind here for 2012 in the $0.20 ballpark? And then secondly on Prodigy, you said modestly accretive. I calculate a $600 million share repurchase as being about $0.15. Is that kind of ballpark for what you think you'll get from Prodigy next year?

Joseph Zubretsky

Let's go one question at a time. So first, with respect to CVS, yes, I would continue to believe it's at least $0.30 accretive in 2012 earnings. And yes, we are continuing to experience benefit from that in 2011 and we're sizing that currently at about $0.10 per share. Now, Justin, your second question about Prodigy, can you repeat that?

Justin Lake - UBS Investment Bank

Sure. You said that this is going to be modestly accretive. I just -- I did a back of the envelope thinking about a $600 million share repurchase and I think I came out to about $0.15 of accretion. Just curious if that is ballpark for what you think the Prodigy will add next year?

Joseph Zubretsky

We're not giving the exact math on that. It is accretive as financed, and it does take a while for the synergies to ramp. So the synergy run rate ramps up late in 2012, but really manifests itself in the earnings stream in 2013.

Mark Bertolini

Justin, we compare the accretion against the repurchase alternative.

Justin Lake - UBS Investment Bank

Okay. So post all those synergies, we should see close to what you would have gotten on the share repurchase?

Joseph Zubretsky

Yes.

Operator

And our next question comes from Scott Fidel with Deutsche Bank.

Scott Fidel - Deutsche Bank AG

Just had a follow-up question on the CMS sanctions and an update on when you think the timing may perhaps get lifted. And maybe just more specifically, what are the some of the key milestones remaining that you need to achieve and how responsive has CMS been as part of this process since, clearly, CMS has a lot on their plate right now, so has there been any issues in terms of getting them focused on this?

Mark Bertolini

Thanks, Scott. We are getting close to a point where we can begin to go through the process of getting back into the marketplace with CMS. We have been working very hard on 3 aspects: One is the processes by which we manage the beneficiaries, an area where CMS has had a lot of focus over the last year as evidenced by actions they've taken on with other companies across the marketplace. Secondly, the people we have in place and probably, more importantly, the relationship. And we've worked very hard on the relationship at all levels across the organization. We believe that relationship is in a much better place and we believe that we are on track to get on to a place where we get out of sanction in the near term.

Scott Fidel - Deutsche Bank AG

Okay. And then just had a follow-up question just on Prodigy, and how would you view the estimated PMPM fees on that type of TPA business for both the medical and pharmacy blocks relative to your standard ASO business? And then how do we think about the margins on that business? Is that similar to what we think about ASO margins being or are there any variations in this particular block of business?

Joseph Zubretsky

Generally speaking, these low-cost PPO alternatives have administrative fees that are 20% to 25% below the fully integrated product lines of the major insurance companies, and that's what we see here. And the margins, yes, are consistent with the way ASC margins work in the insurance enterprise where very fair margin is earned on the administrative load and then really nice margins on all the ancillary product lines that are sold into the relationship including pharmacy.

Operator

And we will hear next from Charles Boorady with Crédit Suisse.

Charles Boorady - Crédit Suisse AG

On the Prodigy acquisition, you talked about the opportunity to move some of the smaller size employers into a self-funded offering. And I'm wondering with Prodigy, is it that you're buying capabilities in order to piece that sort of product together or is the opportunity to convert TPA lives into one of those products?

Joseph Zubretsky

It really is, Charles, a separate marketplace. Of the entire self-insured marketplace, we believe that on a employee basis, the TPA market is about 12 million employees large, which equates to about 27 million nationwide. So in and of itself, it is a market place that searches for a low-cost administrative platform or rental network and very low-touch and low-cost ancillary products with a very, very flexible administrative platform. So this is a different product line. But from time to time, we have a client base in that 100 to 2,000 lives that flips back and forth between solutions. When they do that, we now have a vehicle to retain that customer.

Charles Boorady - Crédit Suisse AG

Okay. So the answer is you're getting the product that you don't presently have in order to offer to your existing customer base, and on the other end that can offer offer at Aetna product to the Prodigy customer base, is that...

Joseph Zubretsky

What I'm saying is that this marketplace is a distinct market that we now have. But as our middle market customers flip back and forth between TPA options and insurance options, we now have a product to retain that customer. Otherwise, it would have gone into the market and gone to a competitor.

Charles Boorady - Crédit Suisse AG

Got it. Okay. And then strategically as you look to 2014 and where some of these customers might be thinking in terms of insurance exchanges, is this a bet that exchanges won't happen or is there an exchange angle with these customers as well?

Joseph Zubretsky

The real reform angle, I think Mark mentioned it before that if you believe that due to the excise taxes that may be passed on to the fully insured marketplace that the self-insured marketplace grows, now we have an additional product line to capture more share if that happens.

Operator

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

Carl McDonald - Citigroup Inc

First question. You've mentioned that the Small Group membership on the risk side was a little lower than you anticipated because of competitive pricing. So I just want to see if there is any change there in the view on the market.

Joseph Zubretsky

[Technical Difficulties]

Carl McDonald - Citigroup Inc

Sure. So I was asking on the -- you mentioned Small Group risk membership was down a little more than what you anticipated. You mentioned that was because of competitive pricing. So I just want to see if there was any change in your view of the competitive environment?

Mark Bertolini

Carl, I think the market remains largely rational. And I these are some of the markets where we have had, in 2009 and early 2010, some pricing issues. So the pricing catch-up is having the impact on the small group market.

Carl McDonald - Citigroup Inc

Okay. And then second question just on the general conversation about employers flipping between risk and ASO. Two detailed questions would be any sense of how much of your risk book today falls into that 100 to 2,000 lives that may be better served by being in a non-risk product? And then second, if you got an estimate of the dollar profitability difference between an employer that's in a risk product versus someone that's in a non-risk product but also buying stop loss?

Joseph Zubretsky

I think on the first question, we're not going to disclose any more detailed information about our membership, but we did on Investor Day give you a very good view of middle market and large groups, so I would focus on that, as your sizing. And second, as you know, even in a fully margined risk product versus a fully margined ASC product, the difference in contribution margin can be 5:1. And that's a very good estimate of the profitability differential between one and the other. However, on an ASC product that requires no regulatory capital, the return on capital and equity is very high.

Operator

And we'll hear next from Peter Costa with Wells Fargo.

Peter Costa - Wells Fargo Securities, LLC

On Prodigy, is there some plan on your part to provide stop loss coverage along with the TPA networks? And is there prior provider stop loss coverage with some of the Prodigy products out there?

Mark Bertolini

Peter, Mark. We do already provide stop loss to middle-market employers and to large employers that are ASC with us today. So we have a large block of stop loss business. There is some other stop loss in this book of business, so we'll take a look at it. And if it's in the best interest of the customers to keep them there, we will.

Peter Costa - Wells Fargo Securities, LLC

Can you size that for me, about roughly what kind of an opportunity is that for you? And is that part of what you think is the accretion down the road?

Joseph Zubretsky

It could be, Peter. I think we've sized the stop loss premium that is placed by Prodigy at between $150 million and $200 million annually.

Peter Costa - Wells Fargo Securities, LLC

And that's outside of yourselves?

Joseph Zubretsky

That is correct. That is placed with other stop loss carriers.

Operator

And next, we'll hear from Kevin Fischbeck with Bank of America Merrill Lynch.

Kevin Fischbeck - BofA Merrill Lynch

You made a couple of comments today about how your acquisition strategy is focused as much if not more on adding capabilities than it is about just adding scale in the markets. But at the same time, you talked about how in the pricing dynamic, there is still a focus on network discounts. And I wanted to get a sense for why adding scale in front of that dynamic is not the first focus when you think about M&A.

Mark Bertolini

Great question, Kevin. I will respond first by making sure that our position on discounts is at purely discounts alone in the long run or even in the midterm does not provide the best total cost solution for the employer. However, in this environment where employers are buying on hard dollar savings, that is the bet some employers are making. Not the whole market, but some aspects of -- particularly the national account and key account market. So we believe that we have pursued more discounts, but will not pursue ultimate discounts even when we have scale where we have to give up other opportunities to control the overall cost of the case, as evidenced in the way we manage our risk business where we have the same provider contracts in place and the same dynamics in place. So we as an employer or a coverer of people with insurance premium, would not make the bet on pure discounts and we are making that case with our clients as we move ahead. However, where we can leverage our share to get the right kind of discounts where we can get close enough to use our other capabilities like medical management and disease management is where we will pursue our strategy going forward. So we will never have the best discounts in every market.

Kevin Fischbeck - BofA Merrill Lynch

Okay. And then I guess, if we just kind of go back to the guidance, I mean, what you've done here is in large part raised the guidance with the beat in the quarter, at least versus consensus, and it's similar to what other companies have done. And it sounds like everybody is being conservative. But can you just highlight maybe the top 2 or 3 things that kind of keeps your expectation for the rest of the year a little bit more conservative at this point?

Joseph Zubretsky

Well, without saying it's conservative, I'll tell you the things that we do watch out for and routinely monitor. One is the seasonality of the business. Keep in mind that seasonality utilization is back ended. That is a meaningful contributor to performance in the second half, always being worse in the first half. And utilization, a lot of us do not believe it can stay this low for very long. So you're looking for that resurgence of utilization, perhaps another mini inflection point and we're guarded about that. And so you use your pricing to hit your target margin to be commensurate with trend, but you're doing that very cautiously and very carefully.

Operator

And we'll take our last question from Doug Simpson with Morgan Stanley.

Doug Simpson - Morgan Stanley

Just a question on G&A. You mentioned the productivity gains I think during the earlier remarks. Can you just characterize for us sort of aside from the broker commissions, what have you done? What's worked? And where do you see if you do -- where do you see future opportunity to maybe chip away the expense line?

Joseph Zubretsky

Our productivity gains, there are really no headlines in there. We're constantly looking at our operations. We're constantly looking at the types of services we perform for customers, making sure we focus our energies and resources on the ones that create value and they're willing to pay for and decreasing our activity in the areas that are valued less. We're improving our use of technology, which reduces the amount of FTE you need for dollar premium, and we'll just add it constantly. We believe and our long-term goal is to have productivity gains annually at least to offset the impact of inflation in the G&A line.

Mark Bertolini

Doug, I would also add a couple of things. First, the cost structure of the organization is driven by where it operates. And so we have a portfolio analysis of all the geographies within which we compete, where we're looking at whether or not we're getting the right return out of those assets and those locations. And where we are not by segment, we will withdraw from those markets and have been doing so over the last couple of years. Secondly, we have been a bespoke company with a lot of employers around the products we develop. And as a result, we built quite a portfolio of products in the tens of thousands. And where we're moving is to a much more simplified and straightforward product set that offer people an opportunity to purchase at a price point where we can reduce the cost structure. So we have taken a rather wholesome work across the whole organization to look at how many products we're offering, what geographies are we in, are we getting the return on those investments. Where we are not, we have to have a plan in place to get back to the right level of return or we exit. So that will continue across the organization as we go toward 2014 where, as you know, price and affordability will be incredibly important.

Doug Simpson - Morgan Stanley

And there's been a lot of questions about scale and M&A, and maybe just wrapping those around the conversations here about productivity. How do you think that smaller plans are trying to position their cost structures? And if you had to take an educated guess about the potential for consolidation of some of the smaller nonpublicly traded plans out there, would you expect that to start to ramp in 2012, 2013? Do you think they sort of hang on and try to play through 2014? What should we be expecting in terms of consolidation among the smaller end of the market?

Joseph Zubretsky

It's already started.

Doug Simpson - Morgan Stanley

Okay. I mean, do you think we'll see a change in the volume of that or any way to characterize the next couple of years?

Joseph Zubretsky

I think, Doug, it has already started. A lot of the smaller plans are struggling with minimum MLR and credibility adjustments and having a statistically valid pool. They're struggling with the fixed cost of ICD-10 and Health Care Reform. And even if you're preparing for the exchanges and all the premium that you're bound to get, you have to have access to capital to finance it. So we're already seeing some of the smaller and regional local plans, particularly non-for-profits, reach out to the for-profit plans for consolidation opportunities. It's already happening.

Thomas Cowhey

Thanks, Doug. 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.

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