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Executives

Thomas F. Cowhey - Vice President of Investor Relations

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

Joseph Zubretsky - Chief Financial Officer and Senior Executive Vice President

Analysts

Joshua R. Raskin - Barclays Capital, Research Division

John F. Rex - JP Morgan Chase & Co, Research Division

Ana Gupte - Sanford C. Bernstein & Co., LLC., Research Division

Justin Lake - UBS Investment Bank, Research Division

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Charles Andrew Boorady - Crédit Suisse AG, Research Division

Christine Arnold - Cowen and Company, LLC, Research Division

Scott J. Fidel - Deutsche Bank AG, Research Division

Doug Simpson - Morgan Stanley, Research Division

Peter H. Costa - Wells Fargo Securities, LLC, Research Division

Carl R. McDonald - Citigroup Inc, Research Division

Aetna (AET) Q4 2011 Earnings Call February 1, 2012 8:30 AM ET

Operator

Good morning. My name is KC, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Aetna Fourth 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 F. Cowhey

Good morning, and thank you for joining Aetna's Fourth Quarter 2011 Earnings Call and Webcast. This is Tom Cowhey, Vice President of Investor Relations for Aetna. And with me this morning are Aetna's Chairman, Chief Executive Officer and President, Mark Bertolini; and 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 this morning's press release and the reports we file with the SEC, including our 2010 10-K, our 2011 Form 10-Qs and our 2011 Form 10-K, when filed.

We have provided reconciliations of metrics related to the company's performance that are non-GAAP measures in our fourth quarter 2011 financial supplement and our 2012 guidance summary. These reconciliations are available on the Investor Information section of aetna.com.

Also, as you know, our ability to respond to certain inquiries from investors and analysts in non-public forums is limited, so we invite you to ask all questions of a material nature on this call. With that, I will turn the call over to Mark Bertolini. Mark?

Mark T. Bertolini

Good morning. Thank you, Tom, and thank you, all, for joining us today. This morning, we reported fourth quarter operating earnings per share of $0.97, a 54% increase over 2010. This excellent operating performance caps off a strong year for the company, our customers and our shareholders. For the full year 2011, Aetna reported operating earnings of $5.17 per share, a 40% increase over 2010.

In a few moments, Joe will review our detailed results and guidance, but first, I am going to discuss our 2011 highlights and our 2012 outlook. Aetna's fourth quarter and full year financial results are evidence of the rigor and discipline with which we executed our plan. Underlying these results, we ended the year with 18.46 million medical members, reflecting strong year-end growth from our Commercial ASC business, led by our national accounts franchise and continued growth in Large Group Commercial Insured accounts.

Favorable Commercial underwriting margin was the result of low medical utilization but also Aetna's continued pricing discipline, medical cost management and unit cost control, resulting in a full year 2011 commercial medical benefit ratio of 77.9%. Despite the pressure on reimbursement rates, our Medicare business posted another strong quarter and full year, demonstrating our ability to manage high-acuity populations and to design, benefit and premium structures that win in the marketplace.

We generated strong earnings in 2011, even as we continued to invest heavily in reform implementation, the move to a single claims-administration platform, compliance activities such as ICD-10 and our growing Accountable Care Solutions business. Our excess cash generation was also excellent in 2011, enabling us to complete 4 significant acquisitions, repurchase 45 million shares and institute a meaningful shareholder dividend.

We also continue to make major strides in executing in our long-term strategy of making healthcare more accessible and affordable. For example, our Accountable Care Solutions business signed 9 contracts and 6 letters of intent, and we have a robust and growing pipeline of additional opportunities. Our Accountable Care Solutions strategy, which seeks to enhance the core business by growing membership and obtaining the best unit cost in the marketplace, is beginning to show results. Our current contract implementations include opportunities to establish deep relationships, deploy Aetna technologies and create new health insurance products.

In January, in concert with Banner Health, we began enrolling members in a new Commercial Health Care product that provides members access to highly coordinated care from physicians and facilities in the Banner Health network. This Small Group product is focused on wellness and improving patient care through better coordination and information at a highly competitive price point.

Also in January, Aetna expanded its relationship with Carilion Clinic, launching new Commercial Insured and Medicaid products and beginning to assist in the administration of Carilion's Medicare program. The Carilion relationship now encompasses Commercial ASC, Commercial Insured, Medicaid and Medicare businesses, and is representative of the promise we see in our Accountable Care Solutions relationships. Medicity, our health information exchange acquisition, and a key element of our ACS strategy, generated approximately $115 million in new contract value in 2011. It continues to increase its contract revenue backlog, which is currently in excess of $200 million.

Our core business acquisitions, including Prodigy, PayFlex and Genworth's Medicare supplement product line are all off to strong starts, and on target to drive value for our customers and shareholders.

Looking to 2012, we will continue to advance our strategy and execute with the same discipline we exhibited in 2011. Aetna's strategy is designed to capitalize on the changing external environment, including the increasing role that consumers will play in taking charge of their own healthcare, and the role that providers will play in transforming our network relationships.

As we position Aetna for this future, we just launched a refreshed brand. And this spring, we will be launching our new consumer platform. These changes are representative of the investments we are making to engage consumers and providers, enhance the value of our health benefit and services offerings and ultimately drive membership and revenue growth. Aetna's refreshed brand reflects our goal of combining innovative benefits products, game-changing technologies in collaborative relationships with the provider community to create a system that is higher quality, more connected, convenient and cost effective.

As we stated at our investor conference in December, we are committed to improving our membership growth in our National Accounts business for 2013. While it is still very early in the national account selling season, we have a pipeline of new opportunities substantially greater than we had in early 2011, with fewer existing accounts at risk for lapse. We are focused on improving our discount position in our top 30 markets, which cover almost 80% of our total medical membership, and we are making excellent progress towards our goals. At the same time, we are also beginning to see a shift among buyers towards total net effective cost products, which are our strength. We remain committed to the total cost value proposition delivered by our integrated products, including our flagship Aetna One product and our CVS-Caremark-powered pharmacy offering.

Our most recent contract award speaks to the strength of Aetna's value proposition, the power of our government and labor relationships and our Accountable Care Solutions capabilities. Effective July 1, Aetna has been awarded the Administrative Services Contract for the State of Maine's 33,000 employees and dependents, and a contract to develop a statewide accountable care network to service this membership. Aetna was selected based on our total cost value proposition and our ability to manage trend over a multiyear period. Aetna's technologies will enable providers to better coordinate care for this employee population, improving quality and controlling costs. This win is a clear demonstration of the shifting needs of private and public employers in controlling healthcare costs.

Medicare has been a strong growth driver for our business over the last 6 years, and we are encouraged by the results of the 2012 annual enrollment period. We continue to expect our Medicare business will grow by approximately 35,000 members in the first quarter of 2012, including approximately 30,000 Medicare Advantage members. We continue to be optimistic about growth in our Medicare business throughout 2012.

We remain focused on the Group Medicare opportunity as we work to leverage our national account and government and labor distribution channels, and the substantial opportunity to convert current Aetna Commercial members. We estimate that approximately $1.2 million Medicare eligibles currently reside within Aetna's Commercial membership, primarily within our Commercial ASC book, representing a $14 billion incremental annual premium opportunity, if we were to convert them to an Aetna Medicare Advantage product. In addition, approximately 150,000 Aetna Commercial members age into Medicare each year, representing another $2 billion in annual premium opportunity. As we continue to build on our Group Medicare franchise, we will continue to leverage our existing relationships and new opportunities to drive membership growth.

Regarding Medicaid. Since we acquired our Medicaid business in 2007, we have more than doubled the revenue base and have been expanding into the aged, blind and disabled and long-term care populations. Our strategy is to provide solutions for states looking to manage complex medically challenged populations, and in so doing, to earn a reasonable return.

At the end of 2011, as previously announced, we exited the Connecticut Medicaid program, which resulted in the loss of about 100,000 members. Partially offsetting this exit in the first quarter, we expect to add about 20,000 Medicaid members. This includes growth in Virginia from our MajestaCare startup, a plan that we developed in partnership with the Carilion clinic. The program launched on January 1 and is expected to expand midyear. In Texas, we've added a new partner, Christus Health System, that will launch its Medicaid startup in the Nueces service area on March 1. Looking ahead, we are engaging with a number of states that are interested in pursuing managed care for high-acuity aged, blind and disabled, long-term care and/or duly eligible beneficiaries.

Our Medicaid business currently manages over 90,000 aged, blind and disabled numbers. Included in this total are the 17,000 insured ABD members that we added during 2011 to our contract with the State of Illinois. We also currently manage over 10,000 long-term care members in the state of Arizona and expect to expand our membership in 2012 in Delaware and New York. Approximately 16,000 of our ABD and LTC members in Arizona are dual eligibles, and we have managed this program successfully for the past 6 years.

The needs of these acute populations will be served by overlapping capabilities, and we view them as pieces of the same opportunity. We believe on this track record of managing medically complex populations, with our integrated medical, pharmacy and behavioral health capabilities, positions us well to improve the care of these individuals. We look forward to continuing to work with state and federal officials to find actionable solutions that improve the quality of care while reducing total costs.

Through effective capital deployment, we continually look for ways to enhance shareholder value. We recently closed a reinsurance transaction with the Vitality Re III, the latest in the series of these types of transactions. And as a result, we are increasing our subsidiary dividend and excess cash flow guidance for 2012. Joe will discuss our updated capital guidance in further detail in a few minutes.

As we enter the presidential election year with political crosscurrents, we remain focused on our core business and on implementing the Health Care Reform legislation enacted in 2010. We are preparing for competition on the exchanges in 2014, and for the expansion of Medicaid eligibility. While the Accountable Care Act will be impacted between now and 2014, as a result of decisions by the Supreme Court, the outcome of the elections or deficit reduction actions, we believe that certain provisions of the law, including many of those which have already been implemented are unlikely to change. We are preparing our company to meet the requirements of the law and the needs of newly eligible members, and we remain focused on opportunities to improve the legislation in the future.

In summary, I am pleased with our fourth quarter and our 2011 performance. We are also encouraged by our early indications for 2012. In Commercial Insured, continued growth in our Large Group accounts; in Medicare, prospects for sustained growth; in national accounts, increasing traction for our value proposition; in Medicaid, good momentum in our existing markets; and in Accountable Care Solutions, continued progress in reshaping the network model.

Further, I am confident in our strategic direction and our execution, our ability to return to membership growth beginning in the second quarter of 2012, building on the strong momentum we exhibited at the end of 2011, and our 2012 operating EPS projection of approximately $5 per share.

I would like to thank all of our employees for their dedication in meeting the needs of our customers. By focusing on sound fundamentals, creating new approaches to satisfy customers and generating significant excess capital, we believe that we can continue to create value for our customers and our shareholders. I will now turn the call over to Joe Zubretsky to provide insight into our fourth quarter results and our 2012 outlook. Joe?

Joseph Zubretsky

Thanks, Mark, and good morning, everyone. Earlier today, we reported full year 2011 operating earnings per share of $5.17, a 40% increase over 2010. Our 2011 results are a testament to our focus on operational and financial execution across all aspects of our business, as we completed the repricing actions we began in 2009 and return to membership growth in our Large Group Commercial Insured business. We generated record excess capital of $3 billion as we executed innovative reinsurance transactions, reduced working capital needs and deployed the excess capital to deliver value for customers and shareholders.

We enhanced our capabilities in Medicare with the acquisition of Genworth's Medicare Supplement business, and reentered the Medicare Advantage marketplace. We expanded operations and entered new geographies in our Medicaid business. We made significant progress in improving our relative/provider discounts, which will enhance our competitive position in the 2013 national account sales cycle. And we formally launched our Accountable Care Solutions business by combining existing Aetna capabilities with the capabilities and technologies obtained through our strategic acquisitions.

With today's reported results, over the last 5 years, Aetna has produced compound annual operating EPS growth of 12.3%, the highest among our multi-line managed care peers. This execution is evidence of our focused strategic direction and our disciplined approach to managing our business portfolio, which allows us to drive sustainable, profitable growth across multiple product lines.

For 2011, operating earnings were nearly $2 billion, representing a pretax operating margin of 10.2%, which is a 220 basis point improvement over 2010. With this full year result, Aetna has exceeded its high single-digit operating margin target and produced a return on capital approaching 14% and a return on equity approaching 18%, both significantly in excess of our cost of capital. These results reflect strong performance across all product lines, a continued result of low medical utilization, disciplined execution of our pricing and medical cost-management strategies and unit cost controls.

We ended 2011 with 18.46 million medical members, a 229,000 member increase from the end of the third quarter, and slightly above our prior guidance. Commercial Insured membership was flat in the quarter, as continued momentum in our Large Group insured business was offset by other membership declines. Commercial ASC membership increased 64,000 in the quarter, including positive momentum in our national account business. Medicare membership increased by 153,000 in the quarter, primarily from the acquisition of Genworth's Medicare Supplement business. And we also added 11,000 Medicaid members in the quarter, with growth primarily in Texas.

Fourth quarter 2011 revenue increased less than 1% year-over-year to $8.5 billion, primarily due to higher fees in other revenue and higher healthcare premium, more than offsetting a decline in net investment income. Fees in other revenue increased primarily as a result of the inclusion of revenues from our 2011 acquisitions. In addition, our underlying Health Care administrative fee yields increased, benefiting from higher Pharmacy Benefit Management fees.

The increase in Health Care premium included a net decrease in Commercial premium of 1% due to volume declining by about 5%, partially offset by a 4% increase in premium yields, resulting from a 5% increase in rates, partially offset by a small decrease in mix due to changes related to customer market segment, product and geography. Health Care premium also reflected relatively flat Medicare premium due to lower volume in our Medicare Advantage business, almost entirely offset by the addition of the acquired Medicare Supplement membership. We also posted a 31% increase in Medicaid premium, primarily related to membership gains.

Our fourth quarter total medical benefit ratio was 80.7%, including $98 million before tax, a favorable prior period reserve development. Favorable prior year reserve development in all of 2011 was $207 million, including $171 million in Commercial.

For 2011, the Commercial MBR was 77.9% or 78.8%, excluding prior-year development. As we analyze our 2011 performance, we estimate that over 20% of the favorability in our medical costs was the direct result of management actions, including contracting improvements that will have continued benefit as we move into 2012.

Our Commercial MBR includes a prudent 4-year estimate of minimum MLR rebates. Fewer than 20% of our core commercial pools are in rebate status for 2011, and these pools represent approximately 35% of the corresponding premiums. Our estimated rebates are highest in our Large Group business, followed by individual and lowest in our Small Group business. A high percentage of our rebate exposure is concentrated in just a few of the pools, as we priced our 2011 book of business before the rebate regulations were known.

For 2011, and adjusted for favorable development, our Medicare and Medicaid medical benefit ratios were 84.5% and 87.8%, respectively, both excellent results. We continue to reinvest in innovation to improve health care delivery for our customers, to capitalize on opportunities for profitable growth and to improve productivity. Our fourth quarter 2011 business segment operating expense ratio was 21.4% as expected, reflecting seasonal spending on open-enrollment activities, the addition of fee-based businesses with operating expense ratios higher than the company average and incremental investments to fuel growth. Our full year business segment operating expense ratio was 19.8%, in line with our guidance.

For the first time in our financial supplement, we are reporting our operating expense ratio for our insured Health Care business. Using this ratio, which has been stable over the last 2 years at just over 12%, investors can now begin to track the impact of service-only businesses relative to insurance-based businesses on our business segment operating expense ratio.

In the quarter, our tax rate was 38.6%, bringing our full year rate to 35.5%. This fourth quarter result reflects a nonrecurring provision related to a legacy state tax matter. Absent this onetime tax provision, operating EPS in the fourth quarter and full year 2011 would have been higher by $0.07 per share. We expect that our full year tax rate in 2012 will be approximately 35%.

The final area of financial performance I will comment on relates to our investment portfolio and management of capital. Fourth quarter net investment income on our continuing business portfolio was $139 million, as declining yields continued to create downward pressure on earnings. At December 31, the continuing business portfolio had a net unrealized gain position of approximately $1 billion before tax, and is well positioned from a risk perspective. Our average yield in 2011 was 4.8%, a 45 basis point decrease from 2010.

Our capital generation was very strong in the quarter. We started the quarter with $570 million in cash at the parent, net subsidiary dividends at the parent were $850 million. We used $460 million to fund acquisitions. We repurchased 14.4 million shares for $585 million. After other net uses, including our shareholder dividend, we ended the quarter with approximately $100 million in cash at the parent. Our basic share count was $349.7 million at December 31.

Our capital generation in 2011 was excellent, including record net dividends from subsidiaries of $3.05 billion. Our capital generation allowed us to deploy $1.6 billion on strategically important acquisitions, which are performing well with integration processes that are on track, to repurchase $1.8 billion of our shares at an attractive $40 average share price, contributing 14% to our operating EPS growth in 2011, and to institute a meaningful shareholder dividend.

For the fourth quarter, Health Care and Group Insurance operating cash flow reflects receipt of only 2 monthly payments from CMS. Full year 2011 operating cash flow for these segments was approximately 1.4x operating earnings, a very strong performance. In addition, an enterprise-wide focus on operating cash management allowed us to reduce our cash balance by $1.2 billion in 2011 and reinvest this previously uninvested cash into higher-yielding instruments.

Our outlook for 2012 remains largely unchanged from what we shared with you at our investor conference in December. We continue to project first quarter medical membership of 17.9 million members, consistent with previous guidance. We continue to project a commercial medical benefit ratio at 81.5%, plus or minus 50 basis points. Our projected Commercial MBR for 2012 reflects a prudent estimate of our trend yield spread for 2012, including the impact of crediting favorable experience to our experience-rated accounts, the absence of prior-period development, which as a matter of course, we do not project to recur, and a small impact from changes to our commission structure.

Based on our full year 2011 experience, we are narrowing the guidance range for our Medicare medical benefit ratio to the mid-80s. Our 2012 MBR projections reflect underlying medical cost trends that we expect to be 6.5%, plus or minus 50 basis points, as compared to our 2011 trend, which we now believe was below 5.5%, the low end of our previous guidance.

We remain vigilant and continue to actively monitor the environment and our experience for indications of any change in utilization. Further, we are pricing new and renewal business based on the expectation of a higher and more normal level of utilization in 2012. While we continue to see the favorable impact of unit cost improvements, we expect this to be more than offset by pressure from higher utilization, a wear off of the favorable COBRA impacts experienced in 2011 and lower benefit changes for 2012.

With respect to specific medical cost trend categories, our guidance is unchanged. We continue to project our full year 2012 business segment operating expense ratio to be approximately 18.5% to 19%, reflecting productivity improvements, but also continued in substantial investments in the cost of compliance; including approximately $50 million for Health Care Reform activities and $40 million for ICD-10 compliance, with combined cash expenditures of over $150 million on these 2 items; transaction-related expenses, including the implementation of our arrangement with CVS Caremark and our 2011 acquisitions, and investments in building our Accountable Care Solutions business.

We look forward to providing investors with relevant metrics and more visibility on our Accountable Care Solutions business as it grows. Aetna has a continuous focus on effective capital management. By generating and deploying capital, we seek to enhance our EPS growth rate and increase returns, a critical third component of our long-term strategy to create shareholder value.

One of the innovative ways we have generated capital has been through our Vitality transactions, including the third Vitality reinsurance transaction, which closed last week. Therefore, for 2012, we are now projecting net dividends from subsidiaries of approximately $1.7 billion and deployable capital of approximately $1.35 billion. At this time, our share count guidance remains unchanged.

For the full year 2012, we are confident in our projection of a before-tax operating margin of 8.5% to 9%, approximately $1.75 billion of operating earnings and operating earnings per share of approximately $5.

As we look beyond 2012, we believe our portfolio of businesses is well positioned to generate shareholder value, by growing earnings at target margins and maximizing returns on capital. By growing the core business, supplemented by emerging business growth and effective capital deployment, we are confident in our ability to generate low double-digit operating earnings per share on average over time.

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

Thomas F. 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

We'll go to Josh Raskin with Barclays Capital.

Joshua R. Raskin - Barclays Capital, Research Division

Appreciate the comments Mark made about the national account selling season and also certainly understand that it's very early. But maybe you could help us with the messaging -- sort of what is Aetna's message to the consultants this early in the year as we think about sort of 1/1/13 selling season? What's changed relative to last year? And maybe any way to quantify how you're sizing your discounts relative to maybe where you were a year ago?

Joseph Zubretsky

Sure, Josh. I think a couple of messages. First, on discounts. On discounts, we are messaging that in 24 of our top 30 markets, we will be within 200 basis points of the market leader. And that is a huge improvement over prior years and gets us within the range where we can -- we believe our medical management programs can overcome the discount -- the unit price discount advantage in that market. Secondly, what we're seeing is, is we're seeing significantly more inbound opportunities. And we have much less going outbound this year. So from a standpoint of in and out, we see a much better mix in this year we've been than the prior 2 years. And then I would say in the last piece is that we're seeing more of an interest as employers have played through the discount game for the last 2 or 3 years, more interest in total cost, as we begin to analyze the results are just playing on unit price discounts.

Joshua R. Raskin - Barclays Capital, Research Division

And so Mark, when you talk about 24 of your 30 markets within 2%, what was that last year, do you know?

Mark T. Bertolini

I don't have those numbers off hand, but it was -- it has been improving. And you should know that the discount databases that are used are usually 1.5 years lagging. So what we're doing is we've talked to the consulting houses about updating on a realtime basis, as we have signed contracts in place to move that -- move our results ahead quicker.

Joshua R. Raskin - Barclays Capital, Research Division

Okay. And when you talk about interest in -- more interest in the total cost savings, and that's where your advantage is, how do you sort of compare yourself or benchmark yourself with the other national account providers? Do you guys feel like you're leaders there, you're in line with the leaders? How -- what's the message there?

Mark T. Bertolini

I think the benchmark that we use is in the Large Group insured market. We've had consistent growth over the last 3 quarters and continue to see that happen, which is the ultimate validation of our total cost proposition in putting a price in the marketplace where we are completely at risk.

Operator

We'll take our next question from John Rex with JPMorgan.

John F. Rex - JP Morgan Chase & Co, Research Division

I just want to come back to your trend commentary, so kind of both '11 and '12. And maybe you can help us understand kind of -- really, we'd want more precision what you're implying in terms of a raise. So about 100 basis points kind of on the face of -- in terms of acceleration in '12 Commercial trend. But are there elements that you would say we should pull out as we think about the '11, so if we pack the related elements of this, it would be nonrecurring in '12. I guess, my -- I think it would seem to me that the spread would actually be a little wider than 100 basis points in terms of the acceleration when you incorporate those elements. Is that your view?

Mark T. Bertolini

Well, John, let me -- I'll have Joe take you through the details. But what we see happening in 2012 versus 2011 and '10 is more of a driver coming out of utilization than out of unit price. And I'll let Joe take you through the details of how we roll those numbers up.

Joseph Zubretsky

John, embedded in our 6.5% plus or minus, 50 basis point trend outlook for 2012, we projected an increase in utilization to be more in line with what we consider to be a normalized utilization pattern, which if you think of it as 2008, that will be offset by the impact of our continued progress in obtaining lower unit cost increases year-over-year. In fact, we have some unit cost decreases in our provider portfolio. And then some of the exogenous factors, you have the wear off of the significant favorable COBRA impact that benefited 2011. You have lower benefit changes in 2012. And lastly, there's a days intensity factor in 2012 as it's a leap year, more Mondays and Fridays, et cetera. So if you process those exogenous factors against the underlying fundamentals, you can see how we're projecting 6.5% compared to 5.5% year-over-year.

Mark T. Bertolini

And, John, to your point on the impact of Health Care Reform, that -- we see that as about a 30 basis point impact.

John F. Rex - JP Morgan Chase & Co, Research Division

On '11, is that right? So that'd be kind of a nonrecurring into the '12? Or it's still there, but it's not incremental?

Mark T. Bertolini

Not incremental.

John F. Rex - JP Morgan Chase & Co, Research Division

Is that correct?

Mark T. Bertolini

Right.

Joseph Zubretsky

Yes.

John F. Rex - JP Morgan Chase & Co, Research Division

And then could you just tell us, in terms of your utilization commentary. So what your bed days -- what your Commercial bed days per thousand were running in '11? Just kind of a rough up-down percentage?

Joseph Zubretsky

We have not given specific guidance on that, but Commercial bed days were down year-over-year.

Operator

Next, we'll go to Ana Gupte with Sanford Bernstein.

Ana Gupte - Sanford C. Bernstein & Co., LLC., Research Division

Just wanted to follow up on the trend deal spread question, moving more to the spread portion of it as a follow-up. So I'm trying to understand, do you -- firstly, what trend are you seeing right now? It sounded like you said full year '11 came in at 5.5%. So is that -- are you at 5.5% right now? And then building off of that, and given the timing of when you priced your book for 2012, you must have priced a significant portion of it at about 7.5% trend, because that was what you were projecting earlier in the year. So that would be at least 100 to 150 bps spread. So what is exactly being priced in on these experience-rated accounts in the back half of 2011? And what's the average spread? And am I thinking about this correctly?

Joseph Zubretsky

Ana, you're absolutely correct. If you recall, back in April of 2011, we had a projected trend for the year. Again, all our trend numbers are the full annual impact of medical cost year-over-year trend. Then when we updated in July, we had lowered it to 7%. And then by the end of the year, we're down to 6%, and now we're 5.5%. So granted, as you're pricing 2012 member months in the middle of last year into later part of last year, you're pricing into a declining trend. Now we have not necessarily pulled through any of that favorability to our 2012 results. As we've said, we're still guarded against an uptick in utilization. It's a competitive environment. And with an experience-rated book of business, crediting back that favorable experience to your experience-rated accounts is the competitive dynamic in the marketplace. We priced about 45% of our member months by the beginning of the third quarter. And right now, we're about -- 75% of our member months are priced into 2012. So if you're suggesting there is some upside to 2012, granted if that spread feature continues and trend doesn't come in at 6.5%, clearly, there is, but we're comfortable with the 6.5% trend number.

Ana Gupte - Sanford C. Bernstein & Co., LLC., Research Division

So again, just following up on the likelihood of that upside being realized. It sounds like med tech and hospitals and labs are not coming in very favorable in terms of their projected 2012 volumes. Nonetheless, the Street seems to be looking at some volume upticks, and there's a trade that's going on. Can you comment on what you're seeing in outpatient right now?

Mark T. Bertolini

We have not seen any meaningful increase in utilization or trend across any of the sectors. I can tell you that in October, we saw a small bump in Pharmacy, which we thought what might be a leading trend, but it really was the restocking of ADD drugs into the market that have been in short supply for a number of months beforehand, and that was spent through. And again, utilization was fine in November and December. So we haven't seen anything sizable happen in the marketplace, so we believe it's behaving as it has been and consistent with our 6.5%, plus or minus 50 basis points for 2012.

Operator

We'll go to Justin Lake with UBS.

Justin Lake - UBS Investment Bank, Research Division

Joe, you mentioned broker commission changes, can you walk us through the specifics there and share what the MLR impact of broker commission changes were year-over-year?

Joseph Zubretsky

Sure. In 2012, in our forecasted Commercial MBR guidance, the removal of broker commissions from the premium structure will impact the MBR by approximately 30 basis points.

Justin Lake - UBS Investment Bank, Research Division

Okay. So that's in the Large Group segment, for the most part, where you're removing commissions?

Joseph Zubretsky

That is correct.

Justin Lake - UBS Investment Bank, Research Division

Okay. And then just getting -- following up on John's question previously, the impact if you pack the cost [ph]. The 30 basis points just sounds a little bit low relative to what I heard from others. So that's the full impact of what we've heard -- what the cost of preventative care, as well as some of the removals of annual and lifetime limits was only about 30 bps. Is that a lot lower than what you expect coming into the year?

Joseph Zubretsky

It is. It also includes Mental Health Parity. Let's not forget that one. But, yes, it's lower than our expectation. But we do expect that to uptick slightly into 2012.

Justin Lake - UBS Investment Bank, Research Division

Uptick in terms of Mental Health Parity or the overall cost?

Joseph Zubretsky

Just all in. All in.

Operator

We'll Will go to Matt Borsch with Goldman Sachs.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Could you tell us -- update us on what you're seeing in terms of Commercial pricing? And maybe which product segments, if any, you can point to where it's become more or perhaps less intense in terms of the price competition?

Mark T. Bertolini

Matt, I think the pricing environment remains very rational. And I think that what we have seen -- and here's a way I'd ask you to think about it. What appear -- what could appear to be aggressive pricing really in a number of cases could be people keeping business where they know the underlying utilization and costs, particularly in experience-rated cases. What the MLR limits have done has allowed us to price into a smoothing kind of model over time and use the rebate pools to improve retention going forward each year. And so as people think about experience rating it, if you have a very profitable account, then you want to price it at a reasonable increase to keep it and a competitor comes in, you'll know the floor at which you can price, including your target profit margin, given the experience-rated nature of the case. So it appears to be aggressive pricing, but I would argue it's people having very good understanding because of the MLR pools, and the rebates and the quality of the book of business and what cases to keep. So I would argue that we're seeing rational pricing. We see episodes of what our sales people would call aggressive pricing to retain business. I would argue that a lot of that is based on better knowledge and modeling at what the book of business is because of the MLR pools. And then from time to time, we have certain competitors that misbehave in certain sectors, but it's not anymore unusual than it's been in the past.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

So would you summarize that -- the directional impact of the MLR regulations has been effectively to push the industry towards what is really much more experience rating in terms of behavior?

Mark T. Bertolini

Sure. It's caused us to understand the pools much more in much more detail.

Operator

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

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

You talked a bit about the Accountable Care Solutions business in the press release and at your investor day. I was wondering if you could give us a little more color on some of the economics that Aetna receives from these arrangements, and how you think about returns as you pursue that versus returns in the core managed care business?

Joseph Zubretsky

Kevin, our ACO strategy, our Accountable Care Solutions business, is all about strengthening the core. Ultimately, it will all be -- the benefit will all be accounted for in growing and expanded membership and a best-in-class cost structure in various markets. So what we're doing is we're leading with our intellectual property and our technology capabilities: ActiveHealth, Medicity and the like. Packaging a management solution that allows a provider system to engage in patient population management rather than acute episodic care management, in exchange for a great contract with risk sharing and co-branded launch of new products: Medicare, Medicaid, Individual Small Group and Large Group Commercial. So ultimately, it will be accounted for in growing membership and a best-in-class cost structure, which will, in our view, dis-intermediate the discount strategy that's engaged in, in various of these markets.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Okay. So you're thinking about it more from -- more than just the -- I guess, the pure economic, there's also a strategic membership focus that you're getting in addition to that?

Joseph Zubretsky

It's mostly that. And now clearly, we're all in favor of monetizing the technology acquisitions we made like ActiveHealth and clinical decision support and Medicity, with its health and information exchange tools, and this will help monetize those asset purchases. But the real game here is growth in membership and best-in-class cost structure.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Okay. And if I could raise the question on rebates. We have a year under our belt now with the rebate accounting. Obviously, you've given us some good color here in the quarter about the rebate position. Can you give us some color about the Commercial MLR that you guys reported in 2011 on a GAAP basis? And what the differential is there between that number and what you guys are booking from a rebate basis? What's the spread between those 2 numbers?

Joseph Zubretsky

Well, we're not going to disclose specifically what are -- if you're asking what our rebate numbers are. But the way I would think about it is, first of all, as you know, from a definitional perspective, there's some allowances, differences between the MLR and your MBR, most significant of which are: the allowance for taxes; second, quality improvement expenses, which now includes ICD-10 and credibility adjustment. And those should not be short-changed, because most of our pools, nearly 80% of them, are not fully credible. So you do get credibility adjustments. And so our view is there's between 300 and 500 basis points of difference between your MBR and your MLR. And that's the way to reconcile the production of the result that we just produced and completed here in to the minimum MLR rules.

Operator

We'll go to Charles Boorady with Crédit Suisse.

Charles Andrew Boorady - Crédit Suisse AG, Research Division

I'm wondering if you could share an example of how you've achieved lower unit cost growth with providers? And then just broadly, how much of the lower-cost growth came from a change in the structure, the payment or the relationship with the provider, for example, from bundling payments or risk sharing, versus how much came from simply negotiating lower rates on contract renewals?

Mark T. Bertolini

It's a mix of all of those, Charles. It would -- it first starts though with a group of individuals in the organization, who reverse engineer the hospital cost reports to get a very clear picture on how we -- what our pricing is versus those of our competitors. And there's a way to get at that information. We've done that virtually across all of our significant contracts, where we walk into the conversation with the database that is very clear. We don't have to take anybody's word for it, it's the information from which we begin to negotiate. Secondly, we have been willing to take these providers where we have significant differences to term. And we have done it in a very concerted way, in concert with the employers in the marketplace, by having kits available for them to help them understand that what the requested rate is on the part of the provider and the impact that would have on their costs as an employer into their employees. And what we've asked the employers is not to get engaged in the fight, but to at least hold our coat when we go into the fight. And by taking these contracts to term, we have brought a lot of people back to the table to a much more reasonable rate. A sort of vector off of that is, is when we get far enough into these conversations, there's very much an interest in where does this all go next and how long can we keep up this kind of negotiating stance. And that's where the Accountable Care Solutions team comes in. And we turn a lot of these relationships from -- on the edge of a term to a fundamentally different relationship, like we've done with Banner and a number of other players around the marketplace. And those conversations, and our provider contracting team, are now joined together to look for opportunities and build the pipeline for the ACS business on the basis of those kinds of conversations. So I'd say that's sort of the milieu in which we're negotiating our contracts these days.

Charles Andrew Boorady - Crédit Suisse AG, Research Division

This is a real, critical point, Mark. And I think you've been in this industry long enough. You know that the trend has been since BBA '97 have shifting Medicare costs to you and other commercial players and by extension to the employer sponsors. And I'm wondering, is this a turning point? Are we going to start to see that gap actually narrow of the spread above Medicare that you're paying? Or is it more that it just hit a wall, it might not exceed that, or -- kind of where is this headed? And I know it's hard to see too far into the future, given all the uncertainties, but in these negotiations with providers, how much room is there to continue to drive down that unit cost or at least that spread over Medicare?

Mark T. Bertolini

In some cases, it's hit the wall, and they can't go any further. And they have the figure out what they have to do with the cost structure. I think in a lot of cases, it -- the ACS model, when we begin to share risk-adjusted revenue on Medicare, risk-adjusted revenue on dual eligibles in ABD and ultimately risk-adjusted revenue on the individual and small group market through the exchanges, you actually eliminate the cost shift. So the sooner we can get to a full arrangement, like we have in Carilion and a number of other players, where we've got the whole set of products on deck, and you're working with a risk-adjusted, symmetrical risk-sharing relationship, the need to cost shift goes away. And that's the beauty of this new model.

Charles Andrew Boorady - Crédit Suisse AG, Research Division

And does your technology or other capabilities allow you to gain any competitive advantage to this, Mark? Is this something that all payers are doing with providers? Or does that have any particular edge that would allow you to achieve a lower unit cost versus your competitors?

Mark T. Bertolini

This is the reason that we made the Medicity and a number of technology acquisitions. This is a tool set that comes together in what we call a technology stack that allows us to not only help providers communicate with each other and with us, but to begin to manage the risk across the whole range of products, not only for Aetna, but for any carrier relationship where they're at risk.

Operator

We'll go to Christine Arnold with Cowen and Company.

Christine Arnold - Cowen and Company, LLC, Research Division

I want a little more granularity, if your willing to give it, on that medical trend, less than 5.5% going to 6.5%. I think you said at your Investor Day, you expect 50 basis points less than buydowns. Can you fill in some blanks? How much do you expect unit cost to come down? Are you -- I think you said you're budgeting for utilization increase, like '08. So what kind of utilization increase are you looking for? And then can you explain and quantify the COBRA wear-off effect?

Joseph Zubretsky

Sure, let me see if I could take all 3 of those. First of all, in terms of unit cost versus utilization, if you think about the 5.5% trend, most of that -- 90% of that was unit cost. Utilization was negligible. In 2012, if you're looking at the 6.5%, think of 70% of it, 4.5% and 5%, as being unit cost and 1.5% to 2% or 30% of the total, being related to utilization. With respect to benefit buydowns, we estimate that they were approximately 300 basis points in 2011 and will be 250 to 300 basis points in 2012. And lastly, I think -- what was your last comment, COBRA?

Christine Arnold - Cowen and Company, LLC, Research Division

Yes. Could you explain the wear-off of COBRA? Because I think most of your competitors were saying, "We really didn't see an impact in 2011 from COBRA, because those subsidies wore off so much earlier." So if you could just explain and quantify that, that'd be great.

Joseph Zubretsky

Sure. We believe -- we estimate that the COBRA impact in 2011 was a negative 80 basis points -- a downward pull on trend of 80 basis points, and that will be negligible in '12, thereby creating an unfavorable impact year-over-year.

Christine Arnold - Cowen and Company, LLC, Research Division

So the negative -- okay. So nobody's going to be getting subsidies...

Joseph Zubretsky

That is correct. It had a benefit in 2011 that doesn't repeat in 2012, therefore, being unfavorable to 2012 trend.

Operator

We'll go to Scott Fidel with Deutsche Bank.

Scott J. Fidel - Deutsche Bank AG, Research Division

Interested if you can share your view on the California dual eligible integration plan and whether you would view this opportunity as meaningful enough that you would look to take any tactical or strategic actions to position that and then to participate in that contract?

Mark T. Bertolini

Scott, we do believe that there's some opportunity to take a look at California. However, the plan is not fully laid out nor is the timing. And as we look at our own capabilities, since we've been managing complex -- medically complex populations for a good time now, we believe we have all the tools. Our most significant concern related to dual eligibles is having the footprint geographically to have the opportunity to serve that population.

Scott J. Fidel - Deutsche Bank AG, Research Division

Okay. And are there ways that you could look to fill in that footprint geographically in California?

Mark T. Bertolini

There are a number of ways. And I would say that, that's anywhere from organic to inorganic.

Scott J. Fidel - Deutsche Bank AG, Research Division

Okay. And then I just wanted to ask a follow-up just on the Group Medicare opportunity. And maybe if you can discuss the pipeline of discussions that you're having with employers at this point and the potential to convert some of those into sales for 2013. And then is there a way to estimate, when you look at that 1.2 million commercial retiree population that you have -- how many of those members are in clients that you think would fit the profile of the type of accounts that would be interested to convert into Group Medicare?

Mark T. Bertolini

We're not sharing that number, but we do have a dossier in each and every case and an understanding of what it would take both economically and socially -- the social issues around moving the retiree population into that program. And so we're having those conversations as we speak. It's something we review on a quarterly basis. It's a very important opportunity for us.

Scott J. Fidel - Deutsche Bank AG, Research Division

Okay. And then just one quick one. Just on the quarterly earnings progression for 2012. Joe, any context that you wanted to add there in terms of seasonality. Should it look pretty similar to 2011? Or are there any investments or changes in business mix that you think can influence that in 2012?

Joseph Zubretsky

Well, we're not to give, obviously, quarterly guidance, but I think one of the leading indicators I would give you is the seasonal impacts of this business for the last couple of years were somewhat muted by the favorable trend, pricing into a declining trend. And so while the MBRs look pretty stable from Q1 through Q4, that seasonality impact is there. The accounts with high deductibles in our PPO book has grown from 15% to 22% over the last 3 years. The average deductible has grown from $700 to $1,400 over the last couple of years, and that continues to grow. So there should be a Q4 seasonal impact for medical cost. That, again, has been dampened by just very favorable utilization, as we've been pricing into a declining trend.

Operator

We'll go to Doug Simpson with Morgan Stanley.

Doug Simpson - Morgan Stanley, Research Division

Joe and Mark, appreciate the comments on trend. For the last several quarters, everybody sort of been expecting that utilization would ultimately start to uptick, and we really haven't seen it yet. Makes sense to think that at some point after the pullback, it would start to lift. But was just wondering if you could be more specific about your expectation for utilization to come back. Is that sort of based on what goes down, must come back up? Or is it -- is there something in the data that points you to that? And the question I'm trying to get at is, if people are seeing -- even if there's slower levels of buydown activity, they're still seeing their health care cost go up, probably more dramatically than what they're seeing in the wage line, so doesn't that sort of create a negative carry? And just -- can you just help us think through exactly why utilization would lift?

Mark T. Bertolini

Boy, if I had that answer, we'd be all rich. We'd know which stocks to keep and which ones not, right? I think the issue for us is that when we think about utilization and forward utilization and trend for that matter, it's about how we price our business. And in an environment where you have rate review caps of 10%, there's no reason to bet on low utilization continuing. You need to price your products responsibly, so that you can continue to have stability in the market over time. And so while we don't see anything in the numbers right now that will cause us to say utilization's going to go up next quarter, we have to price responsibly to a number that we believe is appropriate, given the risk that we're assuming as an insurer.

Doug Simpson - Morgan Stanley, Research Division

Right, okay. Now that's very fair. And then maybe just to switch gears for a minute. Just -- you talked about the long-term care ABD and dual populations and your interest there. Maybe just flesh out for us how critical do you see a TANF presence to gaining access to some of these more chronic populations? And how do you think about navigating that landscape?

Mark T. Bertolini

In some states, it's actually easier for the state to implement ABD and dual eligible populations by just making an executive order or a regulatory change where -- versus having to do a legislative change. So we are now finding, state-by-state, where these states, for example, New Jersey, where it's simple enough to give it to the current contractors than having to create legislation to move it into new contractors. And so TANF can be very important depending on the state. It is not every state, but it's in enough states to have us have some interest and understanding what we need to do to build off the footprint for TANF in those states.

Doug Simpson - Morgan Stanley, Research Division

Okay. If you were trying to build out TANF, would you -- or is there a way you can do that with partnerships or JVs? Or do you think you need to own that piece of the pie?

Mark T. Bertolini

Well, there are whole hosts of things we do. And particularly, for example, there were 2 recent relationships we developed with Christus in Texas and Carilion in Virginia -- are examples of partnerships.

Operator

We'll go to Peter Costa with Wells Fargo.

Peter H. Costa - Wells Fargo Securities, LLC, Research Division

Your pension expense was a significant contributor to the improvement in earnings this year. Can you say what it's going to look like next year at this point? And then also, as we look at the new metric for operating cost that you're providing, you can see that it was up for the year, but then down on the fourth quarter. Where do you expect that to go? I presume that's going to show some of the cost saving efforts that you have been putting in place over the last year or so?

Joseph Zubretsky

All right, Peter, on the pension line, we ended the year in really great shape with our pension plan. When we filed the K, you'll see that the GAAP-based deficit was a little over $800 million. That's a little under $600 million using the tax rules, which means we're very well funded. We -- our discount rate, the value of the liabilities has gone up, because we're using a discount rate just below 5% now. That actuarial loss gets amortized into the income stream over 32 years, which means it's negligible. And so I think year-over-year, you'll see a flat pension expense from '11 to '12. So we're in great shape with the pension plan, well funded, no mandatory contributions due over the foreseeable future. And your last question was?

Peter H. Costa - Wells Fargo Securities, LLC, Research Division

Yes, on the new operating expense ratio that your providing, where you show the improvement in the fourth quarter, but frankly deterioration year-over-year. Can you describe what that's going to look like going forward?

Joseph Zubretsky

We did that primarily -- every time we have the ratio -- rather than having to go up and then explain that we've added a higher complement of service-based businesses to our portfolio, to just strip it apart, so you can see what the insurance-based businesses are producing. But if we can grow membership, as we believe we can, there is significant fixed cost leverage to obtain. And our goal is to drive that Commercial insured or the all-insured SG&A ratio down over time, as we grow membership.

Peter H. Costa - Wells Fargo Securities, LLC, Research Division

And where do you think you can get to a fully efficient sort of...

Joseph Zubretsky

We haven't given a forecast on that. I mean, we're confident in the 18% -- 5% to 19% we projected last year. And I always point people back a few years ago, when we hit our peak of nearly 20 million members that we had an SG&A ratio of 17.6%. And the correlation between membership in that ratio is quite tight. So if we can start growing back again to 20%, there's no reason why we should not be able to produce a ratio in order of what we produced in 2007 and '08.

Operator

We'll take our next question from Carl McDonald with Citi.

Carl R. McDonald - Citigroup Inc, Research Division

It sounds to me like there's been a change in tone towards the Medicaid business. And it sounds like the strategy previously had been, we're just going to grow this business ourselves. We don't need any help. Where now it seems like you're a lot more open to some potential combinations. Am I reading too much into that? Or is that the direction you're pushing us?

Mark T. Bertolini

I think we are, Carl, more focused on how do we take advantage of the increase in the market opportunity. I mean, the Schaller acquisition has more than doubled in size and has met and exceeded every expectation we had for it as an acquisition, but the game changed. And so our question is through a set of ACS partnerships, some organic growth and potentially, in the future, if it makes sense, inorganic growth, how we can we expand our footprint quick enough to take advantage of the market.

Carl R. McDonald - Citigroup Inc, Research Division

And on the Medicare business, I know you tried at least a couple of times to get bigger in that business, and it didn't happen. So knowing what you know about the business today, as well as the prices that are being paid for the assets, do you view a bigger Medicare presence is nice to have or crucial to have as you head into 2012?

Mark T. Bertolini

We believe that for the overall business, a bigger government presence is important going forward.

Joseph Zubretsky

And, Carl, I would also point to -- we're very clear in our prepared remarks, there is an embedded opportunity sitting in our Commercial customer base of over $14 billion, and we plan to convert our fair share of that.

Thomas F. Cowhey

A transcript to the prepared portion of this call will be posted on the Investor Information section of aetna.com, where you can also find a copy of our updated guidance summary, containing details of our guidance metrics, including those that were unchanged and not discussed on this call. If you have any questions about matters discussed this morning, please feel free to call me or one of my colleagues in the Investor Relations office. Thank you for joining us this morning.

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