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UnitedHealth Group, Inc. (UNH)

Q2 2007 Earnings Call

July 19, 2007 8:45 am ET

Executives

Stephen Hemsley - President and CEO

Tom Strickland - EVP and Chief Legal Officer

John Penshorn - SVP

Mike Mikan - EVP and CFO

Lois Quam - EVP and President of Public and Senior Markets Group

David Wichmann - EVP and President of Individual and Employer Markets Group

Ken Burdick - CEO of UnitedHealthcare

Simon Stevens - President

Analysts

Melissa Mullikin - Piper Jaffray

Christine Arnold - Morgan Stanley

Greg Nersessian - Credit Suisse

Scott Fidel - Deutsche Bank

Matthew Borsch - Goldman Sachs

Josh Raskin - Lehman Brothers

Sheryl Skolnick - CRT Capital

Peter Costa - FTN Midwest Securities

Tom Carroll - Stifel Nicolaus

Charles Boorady - Citigroup

Presentation

Operator

Good morning. My name is Dennis and I will be your conference facilitator today. At this time, I would like to welcome everyone to the UnitedHealth Group Second Quarter 2007 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. (Operator Instructions).

As a reminder, this conference is being recorded. This call and its contents are the property of UnitedHealth Group. Any use, copying, or distribution without written permission from UnitedHealth Group is strictly prohibited.

Here is some important introductory information. This call will reference non-GAAP amounts. A reconciliation of non-GAAP amounts is contained on the investor information section of the company's website at www.unitedhealthgroup.com.

This call contains forward-looking statements under US Federal Securities laws. Such statements are subject to risk and uncertainties that could cause actual results to differ materially from historical experience and present expectations. A description of some of the risk and uncertainties can be filed in reports filed with the Securities and Exchange Commission from time to time, including the report on Form 8-K filed in connection with the company's July 19, 2007 earnings release.

Information presented on this call is contained in the earnings release and Form 8-K, dated July 19, 2007, which may be accessed from the investor information page of the company's website at www.unitedhealthgroup.com.

I would now like to turn the conference over to the President and Chief Executive Officer of UnitedHealth Group, Stephen Hemsley.

Stephen Hemsley

Good morning and welcome to our 2007 second quarter earnings call. This morning we will review our performance for the second quarter and first half of 2007, and update our outlook for the balance of the year.

Today, we again have a number of our executives available for your questions on the call, after which John Penshorn, Brett Manderfeld, Mike Mikan and others will be available to respond any additional questions.

Consolidated earnings were quite strong again this quarter. They reflected as I expect the full year and 2008 will do as well, the overall strength and adaptability embedded in our diversified business model. That business model is a strategic point of differentiation and has two dimensions.

First, we focus dedicated businesses toward well-defined and high potential healthcare markets. And second, we leveraged three exclusive core competencies, healthcare facilitation, access and quality, the use of complex technology and the application of clinical healthcare information.

Throughout periods of flux, this two-dimensional portfolio has consistently enabled us to adapt and succeed to economic downturns or changing market conditions, to perform well competitively and financially, and to remain focused on enhancing quality, affordability, simplicity, and access in American healthcare.

Our diversified businesses help to provide the consistency and stability that enable us to deliver the strong results you saw in the second quarter.

Net earnings per share increased 24% year-over-year to $0.87 per share, exceeding our previous estimate by approximately $0.06. Revenues increased 6% year-over-year, to just under $19 billion. Operating earnings increased 21% year-over-year, to more than $2 billion, and our operating margin expanded 140 basis points year-over-year, to 10.7%.

The consolidated medical care ratio of 80.5%, improved 110 basis points year-over-year, below the low end of our expectation for the quarter. On a full year basis, we now expect the consolidated care ratio to be in a range of 81% plus or minus 50 basis points, an improvement from our previous guidance.

Aggregate prior year reserve development in the second quarter was a net positive $100 million compared to $150 million, for the second quarter of 2006. Medical days payable excluding AARP, were 52 days, squarely within our expected range.

The second quarter operating cost ratio was 13.8%, which compares favorably with the 13.9% operating cost ratio in the second quarter of 2006. We continue to make steady advances in this area. We targeted full year operating costs falling in the range of 13.5% of revenues, plus or minus 30 basis points, excluding the 409A charge, and based on our updated revenue forecast for the year.

Cash flows from operations as reported for the quarter were $1.7 billion. Normalizing CMS payments to the respective periods, we achieved an equally strong $1.65 billion in cash flows. This is nearly 140% of second quarter net income.

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Our financial position remains exceptional, with the debt-to-total capital utilization ratio of approximately 28.5%, and available cash of $2.9 billion. In May, we closed on the $2.6 billion, five-year revolving credit facility and in June, we issued a $1.5 billion three-tranche bond offering, that was very well received by the marketplace. And both Moody's and S&P removed their negative outlooks this quarter.

Return on equity in the quarter was roughly 23%. As you know, we resumed our share repurchase activity in mid March and have spent approximately $2.4 billion through June 30. We expect to spend over $2 billion more in the second half of the year.

Further, we recognized some revenues earlier than planned due to the resolution of certain matters related to Medicare population eligibility and risk status. All of these relate principally to the current year operations and contributed approximately $0.02 per share, to the second quarter. These items were previously in our outlook for the second half of 2007.

As we said in the last quarter's call, we recognize the need to focus sharply on the fundamentals in order to continue improving performance, and we made considerable progress in the second quarter and first half.

Some examples: we continue to expand our proprietary care network, already the largest and broadest single network in the country. In the first six months of this year alone, we added 120 new hospitals, and 14,500, net new physicians, and other healthcare practitioners. We did so with a significantly reduced level of disruption compared to the prior year, which should translate into more favorable membership growth potential going forward.

We completed several high profile contract renewals including Adventist in Chicago and Kansas City, WakeMed in North Carolina, Banner in Phoenix and BOMA in Detroit. And on July 1, we initiated the marketing of our joint venture product with the West Penn Allegheny Health System, to improve affordability and quality in that region. We also have a standard contract template now in place with 85% of our doctors and 65% of our hospitals, and even more consistency and certainty in these important relationships.

Service performance on the legacy UnitedHealth operating platform is at an all time high. Our dollar accuracy rate on medial claims is running consistently above 99%, and we are developing and testing features for a next generation service model built for the consumer era.

We are excited about its prospects, even in its very early days. We continue to move forward the full integration of our acquisitions, including significant increases and resources dedicated to serving and strengthening PacifiCare's legacy operation. We have completed the in-sourcing of all our key data centers, servers and related technology infrastructure. We now have under our direct control the ability to optimize technology performance, quality and cost across our entire enterprise.

Let us now discuss in more detail our market groups starting with public and social markets. This area continues to be a significant growth and earnings driver for our company. We recognized that some 100 million Americans are expected to participate in some government program by the year 2016 and we're exceptionally positioned to service a strong share of them.

Ovations reported revenues of $6.9 billion in the second quarter, an increase of about $0.5 billion or 8% year-over-year, and down $300 million sequentially, solely due to the timing impact of Part D accounting, given the design of this program.

Total Ovations Medicare and actively marketed supplemental membership, grew by 40,000 members, including 10,000 in Medicare Advantage. Ovations' diversified product portfolio, including Medicare supplement, Part D, Medicare Advantage and Evercare Special Needs Plan, uniquely positions us to respond to market specific dynamics.

This portfolio supports by increasingly sophisticated and market leading approaches, the member engagement, targeted prevention and coordinated care. And we are getting greater traction in our clinical care and network initiatives, to improve quality of care and medical cost trends.

Many of these initiatives originated in Evercare and are leveraged across our entire Medicare population. The initiatives include: effective high-risk patient management efforts, such as local on-the-ground clinical resources, favored discharge planning programs, following acute hospitalization events, and targeted disease management programs.

In the quarter, we improved our cost structure by continuing to leverage the UnitedHealth networks for Medicare beneficiaries, and by reaching more members with our care management model. We also experienced the first year of applying our overall pricing and underwriting approaches to Medicare members acquired with PacifiCare.

We have been moving ahead with AARP to implement our new agreement, and continued to be enthusiastic about the growth prospects and potentials. We will be able to offer retiring seniors a unique suite of product choices that can meet their individual needs through a synchronized education, distribution and branding strategy, which will be in the market for 2008.

We are making significant progress in upgrading the training and certification of brokers in the Private-Fee-For-Service Medicare advantage program, as part of the voluntary agreement the industry reached with CMS in June. We intend to demonstrate compliance with the new CMS requirements in a matter of weeks and be back into the market.

We are also quite pleased with AmeriChoice this quarter. It was the overall membership growth leader for our company. AmeriChoice expanded by 205,000 members, including a successful launch of the TennCare program in Tennessee. At the same time, AmeriChoice improved both its operating and financial performances sequentially. Our combined 2007 revenue for public and social markets should approach $32 billion this year, $27.6 billion for Ovations and $4.4 billion for AmeriChoice.

We will now turn to our individual and employer markets. Second quarter net membership across this group declined by 55,000 people. The funded products were fairly stable, increasing 20,000 members overall. We were quite pleased to see our legacy UnitedHealthcare fully-insured business grow by 25,000 lives this quarter, but our PacifiCare AMS lines were down 60,000 net, as we continued the repositioning of these businesses.

Through the first half of 2007, we had an 81.5% medical care ratio in UnitedHealthcare. We expect the full year MCR to be in the 81.5% to 82% range. The most significant portion of this year-over-year increase relates to the impact of prior year reserves development.

Through the first six months of the year, UnitedHealthcare observed a meaningful swing in commercial reserves development, from a favorable prior year development in 2006 to unfavorable in 2007. We project that this will account for about 100 basis points to the full year competitive increase in the 2007 care ratio. We also have a strong orientation of larger case sizes, which naturally carries a lower medical margin in small groups.

Finally, net premium yields are turning up tighter than we expected, albeit within our overall underwriting tolerances. We estimate our annual net premium yield will settle out in a range of 50 to 70 basis points, less than originally projected for 2007, which reflects a larger than expected, waiting a new business with associated pursuit discount, high down trends that are greater and more competitive than we saw last year, and actions taken to increase medical care ratios in states where we project to drop below stayed minimum.

None of the items contributing to the increase in the full year medical care ratio are indicative of any actual overall increase in consumption in the broad health system. We have been and we will continue to price to maintain our margin in the managed risk based membership growth, in a mix as necessary to accomplish this.

Given the patterns we have seen and the actions we have taken, we now expect the total membership levels to essentially remain stable for the second half of 2007, for the risk and fee-based products across UnitedHealthcare and Uniprise. Estimated 2007 revenues for UnitedHealthcare are now expected to be $36 billion, as a result of the volume short fall already discussed.

We are improving our competitive position for our commercial businesses in two ways. First, we remain engaged in increasingly effective programs to contain medical costs, focused principally on efforts to direct people to the highest quality sources of care. Second, we are driving even greater innovation in our products, which we believe will stimulate profitable growth and attract quality membership with favorable retention prospects.

For example, we grew our consumer direct health plan membership by 355,000 in the first half of the year. We recently launched vital measures, a program enabling individuals and families to earn credits toward lowering deductibles and out-of-pocket expenses by meeting key health goals, which are simpler and easier to understand for the consumers.

Employers can realize both cost savings and greater productivity; and vital measures bring those capabilities to smaller businesses that were previously available only to larger, self-funded employers.

In a few weeks, we will launch UnitedHealthcare's Edge, a new line of affordable benefits for small businesses that helps direct consumers to quality, premium network providers, particularly specialists. Aimed at the lower price point, but full benefit offering marketplace, Edge is designed to save employers up to 30% over traditional plans. We believe this product will enhance our small business offerings and compare favorably with the narrow network, respected access products that others offer in the market today.

For the Health Care Services segment in total, which includes UnitedHealthcare, Ovations and AmeriChoice, second quarter operating margins increased 160 basis points to 9.2% compared to 7.6%, for the comparable prior period last year. For the full year, we estimate operating margins for the Health Care Services segment will reach 8.9% compared to 8% for all of 2006.

Uniprise revenue increased year-over-year by 4% to $1.4 billion for the second quarter, with an operating margin of 14.3% compared to 16.4% for the comparable prior year period. That sequential quarter decrease in revenues of $31 million, stems from the normal reconciliation for large customers that purchases benefits under our retrospectively-rated, coverage arrangements. This is offset completely by a corresponding reduction in medical costs.

Uniprise's current operating earnings and margins reflect increased investment in three areas, increased technology development resulting in a higher amount of non-capitalized costs to support initiatives, such as real-time adjudication, the new product features, we just previously discussed. Exante Financial Services's functionality and healthcare affordability initiatives are advancing at an accelerating phase. We are advancing the consumer service experience and other product enhancements, including the spectrum of wellness offerings introduced this year, and service advancement including the strengthening of our Pacificare platform.

For the full year, we now see Uniprise revenues of approximately $5.8 billion, while it is still too early to comment on growth projections for 2008. Uniprise has had several impressive new client wins, and is doing well thus far in retaining the client base.

In the business-to-business market, Ingenix, Exante, and Specialized Care Services again all reported strong growth and profitability. Specialized Care Services added 1.8 million unique members year-to-date, and revenues increased 17% to more than $1.1 billion. This was substantially all organic growth.

Net operating margin for the quarter of 18.3% was consistent with expectations compared to 19.1% in the comparable prior year quarter, as it added a significant new public sector business, which carries a lower margin. In the coming months, we will have the full launch of the re-branding of all our individual Specialized Care Services businesses, as Optum Health. This effort is designed to fully integrate and simplify the SCS experience for consumers, and to convey the increasing sophistication, breadth and value for the clinical services it offers.

Ingenix revenues increased 32% year-over-year to $286 million, as momentum continued to increase at this young business, including the significant 31% increase in backlog, to a record $1.45 billion. Ingenix generated a 15.4% operating margin compared to 13.9% in the comparable prior year period, and rode the revenue and margin gains to a year-over-year operating earnings increase of 47%.

We continue to expect full year margins for Ingenix to reach or exceed 20%. Driving this growth is increased recognition by the health care industry that information and technology are essential to improving care outcome, and that Ingenix is uniquely positioned to build that critical need.

Exante saw a 60% growth in assets under management year-over-year, to more than $400 million, and nearly a 100% growth in electronic payments to providers, reaching $4.5 billion in the second quarter. Exante continues to gain momentum as a distinctive business for UnitedHealth Group.

Let me also update you on the continuing evolution of the company and culture that is coming of age. We are pleased to see that as a result of the changes made at our annual shareholders meeting, our corporate governance ratings from the proxy advisory firm ISS, is now the highest in our industry, and better than more than 90% of the S&P 500.

We also continue to strengthen the depths and experience of the executive leadership team, with key new hires in recent weeks including: Thomas Strickland, as our new Chief Legal Officer; Lori Sweere is head of Human Capital; Jud Sommer heading Government Affairs; and Don Nathan leading Corporate Communications.

Our new leadership team is placing great emphasis on strengthening and making durable our relationship with key stake holders, from brokers and consultants, customers, policy makers and alliance partners into the communities in which we live and work.

Let me now recap our 2007 outlook on a consolidated basis, excluding the 409A charge.

For 2007, we see consolidated revenues in the $76 billion range, which reflects a further softening of membership versus -- in the second half of the year, versus our previous outlook. The decrease in our revenue outlook will be offset by a better than expected consolidated benefit care ratio, which will be 81% plus or minus 50 basis points, for the full year. We are broadening our earnings per share outlook and raising it by $0.02 on the high end of the range of $3.43 to $3.48.

For the third quarter, we see earnings per share in a range of $0.91 to $0.93. Our operating cash flows for the year should be $6.2 billion, as we have previously stated. Capital expenditures should be between $800 million and $850 million. From positive elements, we would have expected to fall into the second half of 2007 came through early, and while we remain somewhat cautious in our discussions with you concerning the balance of 2007, we also remain quite positive and optimistic about our prospects and performance potential.

We will now close, if I could with some mid-year 2007 perspectives. When I look at our business at the half way point of 2007, compared to this time last year, there simply is no comparison. We had a very strong first half of 2007, despite a number of challenges, from $0.09 over the original 2007 guidance.

Second quarter operating earnings exceeded $2 billion, with strong cash flows. Our instincts were right to prefer the Medicare network based offering and to be more thoughtful on Medicare privacy for the service product version, even if it costs us some 2007 revenues. We are excited about our expanded and renewed, long-term relationship with AARP. Really the most respected enterprise representing American seniors, and which will come to market powerfully for 2008. We believe the approaches that we are taking in the commercial risk market by premium designation, vital measures, and edge will put us ahead of the curve and the meaningful changes that are taking hold there. And a methodical recalibration of our overall commercial business is underway, as we drive consumer product offerings, which now stand over 2.2 million members

Our positioning for state driven business opportunities is exceptional. We are able to announce today that we have been awarded the Empire State Pharmacy business for 2008, which will translate into well over $1 billion of 2008 revenues, and this is pending new contract completion, and final approval.

Our Tennessee program is another early example. Our network development is strikingly more effective in both retention and expansion, and at much quieter market levels. We are getting real traction in contract standards, clinical integration, premier designation, and pay-for-performance.

RxSolutions, our PBM, that is taking in all our senior PBM business, and parts of our employer business, and we continue to invest in this platform. It is performing above our expectations operationally. RxSolutions will handle about $13 billion in drug purchasing this year, and will process over 300 million adjusted scripts, that represent roughly half of our overall PBM business.

Our service levels, and technology productivity, and quality are strongly ahead of 2006 performance levels and in areas where we need to focus such as the PacifiCare, we are now on it intensely.

Exante is growing above our expectations. It has introduced four new account- based products this year, and is gaining significant momentum in the electronic payment space.

Our enterprise service businesses, such as Ingenix and i3, are performing above plan this year, and we have the revenue pipeline and backlog growth to stay on these growth trends for 2008. We fully expect the merger with Sierra to close before the end of 2007; and I am comfortable with how we are proceeding and the time table that we are proceeding on.

Now we have made significant strides over the last year in the advancing of governance; social responsibility; external affairs capacity, and culture within our enterprises. We consciously focus on our important external relationship, introduce new executives, and challenge some of our historical focus.

Virtually all these items, I should note, are ultimately about profitable growth of further building a unique franchise, with ambitions of improving the American health care experience. When you consider what we were dealing with at this point last year, at the same time, we were managing the first year PacifiCare integration and Part D demands. It is clear that we've put an enormous amount of difficult work behind us, achieving some important accomplishments and that our current efforts will show results in 2008 and beyond.

As I said at the outset, our diversified business model enables us to adapt respectively for widely varying market conditions, and to create and seize opportunities in every part of a $2 trillion healthcare market. It means we can sustain strong results overall, even as we work through challenges and difficult parts of our business.

We will have more to say about these matters at our Investor Day, on December 4th in New York. We continue to aspire to help improve the quality and affordability of healthcare, as we move into the second half of 2007, and on to 2008 with great optimism.

Thank you. And we will now move to questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question will come from the line of Melissa Mullikin with Piper Jaffray.

Melissa Mullikin - Piper Jaffray

Good morning. Can you walk through on what approvals and regulatory processes remain prior to being able to close this year's acquisition? And then I have a follow-up on, just a question on what was your basic share count for the quarter? Thanks.

Stephen Hemsley

Sure. I think Tom Strickland is probably best position to respond to that.

Tom Strickland

Right now we are waiting the final approval from the Department of Justice, that process is underway and we expect it to be resolved early in the fall. In addition, there are additional hearings in the State of Nevada next week and we are hopeful that the final approvals with the Nevada Insurance Commissioner will take place, again sometime within the next 30 to 60 days.

Stephen Hemsley

Thanks, Tom. What were your second questions in share counts?

Melissa Mullikin - Piper Jaffray

Yeah. What was the basic share count in the quarter?

Stephen Hemsley

Mike?

Mike Mikan

1.3, 17.6 shares.

Melissa Mullikin - Piper Jaffray

Okay. Thanks.

Stephen Hemsley

I think that was precise enough, Mike. Next question?

Operator

Your next question will come from the line of Christine Arnold with Morgan Stanley.

Christine Arnold - Morgan Stanley

Good morning. You said that the Uniprise business had several wings and you feel like you are retaining business. Could you give us a sense for how much has been completed on that, what your incoming versus outgoing RFPs look like, and some sense of net wins versus a year ago?

Stephen Hemsley

Yeah, we obviously can't respond to specific company names and things like that. In terms of providing, I think a good but broader response tranche bond.

Mike Mikan

Yeah. Hi, Christina. I think we can characterize this year's inbound RFP activity as comparable in pattern to prior years; it is developing about 10 to 15% less than the pipeline for last year, which again was 10 to 15% below the pipeline of the prior year.

As we continue to see a decline in the inbound RFP pipeline, we fully believe we see all that comes to open market bid in a large client sector of that which is coming to bid a less and less is actually changing vendors a defining portion is actually moving from one company to another within that context we continue to perform exceptionally well. Our closed ratios have improved and our retention has increased over the prior year. And that gives us some positive outlook towards the 2008, effective date selling season.

Christine Arnold - Morgan Stanley

So, when you said your retentions are parallel to where your RFPs were versus a year ago. And how many of those have been closed?

Mike Mikan

You are asking what percentage of our existing book of business went out to bid this year versus a year ago.

Christine Arnold - Morgan Stanley

Yes. And how much of that has made a decision and you retained it?

Mike Mikan

Right, the amount of our book of business that went out of bid this year was slightly higher than past year's, driven primarily by a typical three year renewal pattern that culminated this year. Virtually all of that large case business, the large pieces of that, has been resolved and retained. So the bulk of the risks, that we had inherent in that modest increase has been retained going into the '08 of season. So, we are through the consecutive.

Christine Arnold - Morgan Stanley

Okay. Thank you.

Mike Mikan

Next question?

Operator

Your next question will come from the line of Greg Nersessian with Credit Suisse.

Greg Nersessian - Credit Suisse

Hi, thanks. Good Morning. I just wanted to clarify the health performance in the Ovation segment. I think, you mention the risks payable that you quantified as having $0.02 impact on earnings in the quarter. But so, if I back that out, there was still a dramatic improvement in the Medicare MLR. I'm just trying to figure out how much of that is sustainable and what are the factors that are specifically attributable?

Stephen Hemsley

We try to address a little bit in the script about the terms of the traction that we're getting with respect to a number of the programs that we think Ovations brings to that space, uniquely a lot of them taken from the approaches to the market that Evercare has been very successful with, as well as the use of our network access on these programs. Simon, do you want to add to that or Lois?

Lois Quam

I'd just point to all factors among the range of things that are having an impact there. The first is, as you've just said Steve, is that we're now able to leverage and broaden the United Network across the country and deploy the best of PacifiCare, and the best of United in terms of our network management, first time into the full year. I reckon that we've obviously maintained a continued disciplined approach to our marketing distribution and operating costs.

Third, we took deliberately balance design to balance the benefit design, this being the second year which we've been able to apply our pricing and underwriting methodologies across the Medicare lives acquired through PacifiCare. And fourthly, and very importantly, we've seen enhanced care utilization and that has had a number of components, including being able to leverage elements of the Evercare model across our entire book. So, those factored amongst others means that we are seeing steadily improving performance.

Stephen Hemsley

And we've always, as I think we've said to you in the past, kind of taken a long-term view of these programs, and not just a year-by-year view, and as a result we manage them in a way that we think that the profitability of these are sustainable, given what we bring to those programs.

Greg Nersessian - Credit Suisse

I guess my question was more, if I look at you're components of your guidance, the commercial medical loss ratio, the guidance is between 81 and 82, and the overall medical loss ratio is 81, and which would imply that the Medicare medical loss ratio would be 80%. I'm trying to figure out if that is a sustainable level for that ratio; if there is something else going on there that we shouldn't sort of project going forward?

Mike Mikan

There are two important differences obviously between the medical cost experience in our Ovations portfolio and commercial portfolio, although we don't talk. The first is that we can link a significant portion of that Ovations medical cost to our overall Medicare Advantage reimbursement levels, either directly by capitation or indirectly by Medicare network contract.

And the second is that obviously the mix of services being used by senior members differs in important ways from the mix of services being used in the commercial population. So for example, we see a more pronounced impact on our Medicare Advantage costs as a result of recent litigation and cost increases from implantable cardiac defibrillators, sensing certain counselor therapist, and treatment of [macular] degenerations, all of which would have a higher utilization rate in the seniors' population.

Stephen Hemsley

I would just broadly say that we have made the points throughout the year that in our diversified model, we are getting strong performance out of observation and it is offsetting to some extent the commercial business this year. Next question?

Operator

Your next question will come from the line of Scott Fidel with Deutsche Bank.

Scott Fidel - Deutsche Bank

Thanks. First question is, if you could just talk about your pricing strategy in a little bit more detail and specifically, if in the back half of the year, you are looking for higher net yields and pricing than the first half, and also expectations around 2008, if you expect higher rate increases than you are seeing in 2007. Then, if I could just ask a follow up on your leverage expectations, and are you still comfortable at 25 to 30%, would you consider moving that up higher may be into 30 to 40% range?

Stephen Hemsley

Sure. I will hand this question over, but instead of baseline, we take pricing actions every quarter. We are looking at pricing at all times. We are pricing to preserve our margins and to respond to the forward outlook on medical costs. So, we take these actions at all times. We have the actions at all times. We have been moving them up and we do expect to improve. And Dave, can you offer some of the background?

David Wichmann

Sure. Thanks guys. Just to reiterate a couple of comments that, Steph we've made first our pricing strategy is been very, very consistent and our underwriting disciplines around that pricing strategy have been very disciplined, which focus on pricing to our forward view of medical cost trends. With your second question really related to are we looking for higher premium yields in the second half of the year and I'd suggest to you that, in the normal course of business, as we evaluate our pricing really on a quarterly basis.

We determine when and when not to adjust it, and in this case we have decided to adjust it up, really for two things. One, obviously, we have a modest short fall in yields relative to 2007; and the second is really just looking to 2008, which we expected to be largely the same relatively flat cost trend, year-over-year. There are a couple of items that have come forward; really in the tech agenda and also with breast cancer screening. We do expect that you will have higher day content and some other items. I'd suggest that there is going to be a modest uptick in trends in 2008, and because of all those factors, we have raised our pricing expectations for 2007.

Stephen Hemsley

And your second question, Scott.

Scott Fidel - Deutsche Bank

And I was just more around your debt to capital comfort level at this point. I know you talked that 25% to 30% historically. Is that still your comfort level or would you consider moving that up?

Stephen Hemsley

I think we discussed that a little bit in our last call and we have ambition to move it up, but Mike you want to respond?

Mike Mikan

Yes, Scott. We believe with our diversified business model, our strong cash flows at this company can sustain a higher debt-to-total cap ratio. We're working with the rating agencies as well as our Board. Right now, we're comfortable in our range and the guidance that we've given with the 30% debt-to-total cap, and we would seek to potentially, in the future, raise that maybe to a 35% range or so. But at this point, we're comfortable with 30% debt-to-total cap.

Scott Fidel - Deutsche Bank

Okay. Thank you.

Mike Mikan

Thanks.

Operator

(Operator Instructions). Your next question will come from the line of Matthew Borsch with Goldman Sachs.

Matthew Borsch - Goldman Sachs

Yes. Hi, thank you. Good morning. Let me just start by saying that, Steph, I think you're becoming CEO, is a very good thing for UnitedHealth Group. But I wanted to ask a question, if your thinking has changed about the industry at all with regard to cyclicality. But it seems to me that one of the problems you're dealing with right now, you're dealing with the tough end of cards, if you will, for the next two, three years. Would you agree with that assessment in terms of the buildup of competitive pressures, that you're seeing being markedly different from what we had a few years ago?

Stephen Hemsley

Actually Matt, I've always believed that there have been a lot of competitive dynamics in the marketplace. And I think we've seen those competitive dynamics become more intense over the last couple of years. But I'd say we're in the middle of those kinds of dynamics. So, you and I've never actually had a conversation about personal views of the space.

But I don't think they've changed from the perspective that I think, the space particularly in the commercial marketplace, has strong competitive dynamics. They are highly regional, and they are across multiple market segments. So, it is very difficult to generalize because of the meaningful segmentation. But if you're asking is there an increased intensity in competitive dynamics, I think that there has been increased intensity. But I'd say it's probably been over the last two years, and I think it continues, and I think it will continue for the next couple years, particularly given a relatively moderate medical cost structure in the marketplace.

We perform when there are medical cost challenges, because we really have the capabilities to deal with those challenges, since we think uniquely better than others. So, in a period of strong medical cost advancement, we've the capabilities, and the leverage and scale to be, we think, increasingly more effective, and that would be my response.

Matthew Borsch - Goldman Sachs

Yeah, that makes sense. If I just one quick follow up which is if I pause together your guidance on the commercial involvement outlook correctly. It looks like you're looking for total commercial involvement risk plus fee days to be down slightly for the full year. And I'm just wondering, what you can point to that you think will be significantly better in 2008, as compared to this year, if it's internal or external?

Stephen Hemsley

I'll let some others. But I'd tell you that I'm actually pretty encouraged with respect to the approaches, I think that have been taken to the commercial books of business. I think there has been a lot of fresh thinking about of the spectrum of products that are being brought there that I think there is a lot of fresh thinking with respect to specific market segmentation and I think we have a lot of opportunities to come a lot more affected in front end of our business, which is an area where I think it can be strengthen.

So, I think it can be more much more effective in the front end sales, marketing, local relationships, the new products that are coming to the market place that introduced we have a three major new products advancing and others are coming forward and the orientation to making sure that book of business stays vibrant and fresh is, I think very, very positive, Ken, you want to response to that.

Ken Burdick

Sure. Thanks Steve. Matt, I appreciate the question. Just to reinforce couple of other points that Steve made. We've had an improvement in small business meaning that the losses have been reduced from what we had seen over the past quarters, however, we haven't seen the complete reversal. We are excited about the new product line UnitedHealthcare edge and the modernization of our portfolio.

We also, as we've mentioned in last quarter's call, the vast majority of the AMS and PacifiCare losses are now behind us that has cycle through. Second point would be that, our individual business has temporarily stalled that had been a source of for propound growth in the past and will be in the future. We are awaiting a couple of key markets for approvals namely, Rhode Island and California and we will be launching an eight new markets in addition to those to the later half of this year, which gives us a good right path heading into 2008.

Matthew Borsch - Goldman Sachs

Great, thank you.

Stephen Hemsley

And Matt, if I can comeback and link those two if your question about view of the marketplace in total. I think that we are actually quite ahead, as you think about positioning of this book to move forward we are ahead in consumer products, we are ahead for agenda about affordability and price points on products.

And I think we are ahead in terms of the nature of the products that we're bringing forward and the elements that we haven't talked about, which is how are clinical engagement of facilitation is integrated with our networks and how the premium networks and so forth are tied into those products. I think that we will see over the next couple years that the actions that have been taken over the last couple years are really going to be quite productive.

Thanks.

Operator

Your next question comes from the line of Josh Raskin with Lehman Brothers

Josh Raskin - Lehman Brothers

Hi, thanks. Good morning. Just a quick follow-up its sounds like Steve, you said in your prepared comments that the pressure on the medical loss ratios disagree on the commercial side still relates a lot to the favorable development and those comments are very consistent with what you said last quarter, but it did sound as though included in the press release you talked about competitive pressure on renewals etcetera.

But I just want to reconcile that with your previous comments that said it didn't sound like you are seeing a real change in the marketplace right now. And I just want to make sure that what you are seeing in the second quarter is no different in what you saw in the first quarter or are there actually incremental change of things?

Stephen Hemsley

I think I'm going to repeat what I said may be, you tell me whether it's responsive or not. We see the competitive marketplace, competition to be intense, but we have seen it that way. We had as we start the year we project what our net premium yield would be, and they have come in 50 to 70 basis points less than we have projected. We've as this said, we take a very routine pricing actions on that each quarter or more often if we have to. And we've taken those actions, and so we're continuing from that perspective. I don't really think that to change in our approaches.

Josh Raskin - Lehman Brothers

Okay, that's what I want. And then could you just clarify what's your comment was when you said your instincts were right about the Medicare Advantage network product?

Stephen Hemsley

That we, as we really positioned as we entered 2007, and that position it takes place in 2006. As you think about the positioning of the benefit designs of the relative offerings across the Medicare space, we said that we preferred the network based versions of those offerings. But those offerings have we think greater value. They offer more potential to the recipient, and that they are more sustainable overtime because of that.

And as a result we orient more to those than to the Private-Fee-for-Service, and that just been our philosophy. And we think that was a good positioning because we think that the network based products have a longer-term value. Simon, do you want to offer anymore, no?

Simon Stevens

Nothing more than that.

Josh Raskin - Lehman Brothers

Okay. So, it sounds like more comfort with your ability to manage the cost, and maybe a slight excitement of the potential future for Private-Fee-for-Service is that what you talk about meaning sustainability

Simon Stevens

I think, that's going too far. We believe that Private-Fee-for-Services continue to be part of our portfolio for 2008. We expect it continue to grow in this product. But that said Steve as just pointed out we're not overweight or dependent on the Private-Fee-for-Services. And taking our multiyear, and multi product approaches we do, we see that our broader organizational asset including the strength of UnitedHealth network can obviously be deployed with particular advantage in our network based Medicare Advantage offerings.

Stephen Hemsley

Okay. If you just come back to the notion of networks, and the integration of care facilitation. What you can do for people with that we come back added in this, is it a cultural change in terms of what's the best for the senior for the consumer, the Medicare network based offerings have greater value, and greater long-term potential to serve the consumer, and that's why we value them.

Josh Raskin - Lehman Brothers

Okay. Thanks.

Operator

Your next question will come from the line of Sheryl Skolnick with CRT Capital.

Sheryl Skolnick - CRT Capital

Good morning, everyone. Okay I've one very minor question and then a real question if I may is, answer my real question first and I think get to the minor I will get that. We're focusing on the commercial business Steve, if I want to interpret your comments in your term correctly, I think I've heard you say that you're refocusing, you're reorganizing and you're repositioning that commercial business in the sense that it sounds like you've reviewed the product portfolio and recognized that significant important new products need to be brought to market as you say modernize the portfolio. I hear you also saying more about the leadership in the consumer directed side, but I guess what I'm getting at here is really two issues.

One, how big was the problem in commercial? How far behind the curve of keeping that product offering flexible up-to-date, customers service being what it needs to be, any or all of those important metrics. How far behind the curve might you be, because I'm getting the impression that you've lost the momentum and I'm getting that impression because your membership growth isn't all that robust.

So, I'm trying to reconcile that with your comments that you think that you're ahead of the curve and I'm am trying to also get a sense of whether there is sort of this renewed effort to position the commercial business, so that may be we won't have to see another year of if not membership deterioration than flat membership, but declining mix of members in terms of margins and profit dollars?

Stephen Hemsley

Yeah, there is a lot in that question, but in the broadest sense. First of all, I actually don't think we were behind in anyway and I don't want to create an impression like that at all. We have I think struggled with respect to being able to get a bead on commercial risk membership over the last couple of years. And I think across the industry based upon what I have observed and we do look, that has been more of an industry-wide situation and not at all unique to our enterprise.

What I might say it has been unique to our enterprise over the last couple of years is that, we had been more active in acquisition and when you are and you begin to reposition those books of business and I'll deal with them separately. You will have more loss and that loss will run through your net membership reporting and we do the best we can, I'm trying to separate that related to new acquisitions, because there is a refreshment of that book.

Most of the time those in our view need pricing potential and we know that going in. But I think to the core of your question is there, we behind in terms of product offerings or things of that nature. I don't think we are, actually we think that we are, unfortunately we will with the marketplace.

I think the marketplace needs to move ahead and I think we're pushing inside this organization to say, let's do what we think is right and let's put kinds of products in the marketplace, that we think the marketplace is looking for. I think Vital Measures is a good example of that. I think the edge product is a good example of that. I think the [blade] product is a good example of that. I think tighter integration of our ancillary services and engagement with our consumer services is a good example of that.

And I think we are pulling those things together and we are getting active in the commercial marketplace along bringing change and refreshment to that and that's why I think we are ahead. The service theme, I think we have, I believe that, a lot of that was related to PacifiCare, where I think we were more aggressive and perhaps too aggressive as we approach PacifiCare's platform, which was not as strong as our legacy.

We overlaid the UnitedHealth Group model on it and we've had to retrench to bring more resources back and I think that has been done. Our legacy platform, actual service this year over last has been markedly stronger and it is only going to get stronger. It is in a lot of new hands and we are taking service extremely seriously on the consumer and the provider side of it, so that needed to be addressed anyway. Am I answering your question, Sheryl?

Sheryl Skolnick - CRT Capital

Yes, you're. And I guess my, this little quick question is typically when we hear about Medicare and Ovations and Evercare, we hear from Lois, is Lois okay?

Mike Mikan

Lois, would you like to talk to Sheryl

Lois Quam

Sheryl, good morning. Thank you for inquiring about my health. Yes.

Sheryl Skolnick - CRT Capital

Okay, just wanted to make sure, you are still there.

Lois Quam

Yes. I'm very pleased to have such a strong team of people to work with. And as I think, I asked Simon Stevens, who he had worked with on the international business to join the organization earlier this year and as you can see he is making strong contribution.

Sheryl Skolnick - CRT Capital

Okay, excellent. Thanks very much.

Mike Mikan

Thanks.

Operator

Your next question will come from the line of Peter Costa with FTN Midwest Securities

Peter Costa - FTN Midwest Securities

Hi, you guys beat the numbers you sort of raise guidance, you bragged about the diversified model that you have, you're not getting value for it considering you guys have a similar evaluation to other health insurers, and your stock down today obviously because of the performance on the UnitedHealthcare business. Do you think about tying to capture some value for that diversity that you've in someway, have you thought about doing something to capture that value?

Simon Stevens

Well that's a subject. We obviously are very oriented to making sure that industries are appropriately rewarded for their interest in our enterprise. We look at various approaches to achieving that and it difficult to get into a specific conversation along those lines. I think some of the questions about capital leverage start to get at some of it. And I could only respond to tell you that we're, I think a very active organization.

We think, I think you can tell from our merger and acquisition activity, and I think you can tell perhaps from the way we approach capital, which I think might be a little different than others that we're active in thinking along those line. And beyond that I don't think, I can respond to specifics other than to suggest that we think that we could do better and we're focused on that. Well, that's not much of an answer, but I can't really, I don't think get into a lot of specifics on a question like that.

Peter Costa - FTN Midwest Securities

Okay.

Operator

Your next question will come from the line Tom Carroll with Stifel Nicolaus.

Tom Carroll - Stifel Nicolaus

Hi, good morning. Thanks for taking my question. Quickly, just some clarification on the UnitedHealthcare medical loss ratio, you mentioned 100 basis points of the increase is really explained by the unfavorable development that you saw late at the end of '06. And then in the scripts, you talk about $10 million of favorable first quarter '07 development. So, I guess is it fair to assume that this late '06 unfavorable experience has completely gone? And then secondly, what's the probability of seasonal reoccurrence of this type of experience in your model?

Simon Stevens

Mike, do you want to address that

Mike Mikan

Tom if I get your question right or correct that the swinging prior year development that we forecast for the year is about 100 basis points, and that translate to about $300 million. We did not have prior year unfavorable reserve grew up from the prior year in the second quarter of this year. We did however have prior year favorable development last year in the second quarter similar to what we had in the first quarter. And so, the total impact for the year is about a 100 basis points year-over-year on the BCR and the net delta are the things that folks Steve and Dave Wichmann have talked about previously.

Tom Carroll - Stifel Nicolaus

Okay. So again may be could you talk about the second half expectations for this year and I know you've talked somewhat higher level on changes in pricing and expectations on enrollment and things like that. Again, do you think we see anything late this year?

David Wichmann

Tom. It's Dave Wichmann this time. So you asked two questions that I just want to make sure we close out. One is whether the ‘06 development is done or gone and we are not seeing that continue to advance. So, we believe in fact that it is. Second, with respect to whether this is going to repeat, we have taken into account in developing our estimates of 81.5% to 82% benefit care ratio or medical loss ratio if you will, the natural ware off of the deductible like we experienced last year.

So as you might recall during the fourth quarter of the year, we experienced a ware off of the deductible on our higher deductible or high deductible healthcare products and we have taken that into consideration. We feel quite confident in the 81.5 to 82% medical loss ratio.

Mike Mikan

And I would just follow on Tom that. We believe that we've adjusted our reserve methodology accordingly, so we do not anticipate that the same occurrence will occur in this second half as it did this year from last year in which we reported in the first quarter that we missed, we don't think that will happen again.

Stephen Hemsley

We will take one more question and then, through the balance of the day; John, Brett, Mike others will be available. So we would like to make sure that we respond and if you call us we will timely address the questions. But we can only do one now, so next.

Operator

This morning's final question will come from the line of Charles Boorady with Citi.

Charles Boorady - Citigroup

Hi, thanks. Good morning. Can you give us the seasonality of the med loss ratio generally for Part D this year for the four quarters? And if the guidance for a weaker 4Q this year reflects any change in the seasonality where we historically expect that to be and especially strong quarter for Part D? And so what you are baking into your assumptions for the 4Q?

Stephen Hemsley

That question could take 15 minutes to answer I think. So, may be you should, we will give you a response now, but if it's not enough, we will handle it offline. Is that okay?

Charles Boorady - Citigroup

Yeah. Really just the four quarters med loss ratios on a directional change from quarter to quarter and if the 4Q is not significantly improved for Part D is there some other reason why your fourth quarter guidance is lower than what we would have expected based on the first three quarters?

John Penshorn

Hey Charles, this is John Penshorn. You know, we don't disclose medical care ratio for Part D on a standalone basis. I think we've stated clearly that the seniors businesses hurl across the portfolio of Ovations are all having very strong years. And the fourth quarter outlook that we have here we think is appropriate in total, which includes the comments that we just made about fully accommodating in our models the expectations around medical costs in some of the high deductible products in the later half of the year

Mike Mikan

And we will see how that plays out

Charles Boorady - Citigroup

Steve would you make any '08 or beyond comments that company historically talked about 15% plus annual long-term EPS growth, do you think that's achievable over the next one to three years?

Stephen Hemsley

Actually, I would tell you as we look at the business, I think well we've been mostly about challenges and I like what's going on. I like the orientation that this leadership group is taking. I like the way that we are approaching the UnitedHealthcare business in terms of how we're looking at the commercial space. Obviously you have to like the positioning that has been taken by Ovations. I think the state business opportunities are really quite remarkable.

I don't know exactly when those fall in place, and the other is that the movement in terms of the enterprise services businesses that Richard Anderson oversee they are making meaningful contributions, and they're growing at striking rate.

So, I actually, I'm pretty gazed up about the business and the business issues, and I will go back to the theme that said, if you could have a sense what we are dealing with the middle of last year and the progress and where we're set to be back at this moment with the opportunities, we think are in front of us and some very difficult work that has gotten behind us.

We're back into the business, and I think you're going to see that in 2008. I think you're going see it profoundly in 2009 and beyond. So, I'm not all backing off on that.

Charles Boorady - Citigroup

Thanks.

Stephen Hemsley

Thanks.

Mike Mikan

Thank you.

Operator

Ladies and gentlemen, that does conclude our conference for today. You may all disconnect, and thank you for participating.

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Source: UnitedHealth Group Q2 2007 Earnings Call Transcript
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