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HealthSpring Inc. (NYSE:HS-OLD)

Q3 2007 Earnings Conference Call

October 31, 2007, 10:00 am ET

Executives

Herbert Fritch - Chairman, President and CEO

Kevin McNamara - EVP and CFO

Analysts

Justin Lake - UBS

Michael Yuan - Bank of America Securities

Michael Baker - Raymond James and Associates

Matt Perry - Wachovia Capital Markets

Carl McDonald - CIBC World Markets

Darin Miller - Goldman Sachs

Charles Boorady - Citigroup

Josh Raskin - Lehman Brothers

Operator

Good morning. And welcome to the HealthSpring Conference Call to review its financial results for the Third Quarter and Nine Months ended September 30, 2007. The financial results were issued yesterday after the close of market trading.

If you did not receive a copy of the press release, you may find a copy under the Investor Relations tab on the HealthSpring website, www.healthspring.com.

Before we begin, HealthSpring wishes to express that some statements made in this call will be forward-looking statements, as defined in the Private Securities Litigation Reform Act of 1995.

Actual performance of the company may differ from that projected in such statements. Investors should refer to statements regularly filed by the company with the Securities and Exchange Commission for a discussion of those factors that could affect the company's operations and the forward-looking statements made in this call.

The information being provided today is as of this date only and HealthSpring expressly disclaims any obligation to release publicly any updates or revisions to these forward-looking statements to reflect any changes and expectations.

In addition, certain non-GAAP financial measures maybe covered in this presentation. These non-GAAP measures are reconciled to the most comparable GAAP measures in the press release or on the company's website.

At this time, I'll turn the call over to Mr. Herbert Fritch, Chairman, President and Chief Executive Officer of HealthSpring. Please go ahead, sir.

Herbert Fritch

Thank you, operator. We are pleased to report solid third quarter results and positive developments in our business that support well for 2008 and beyond. On the strength of these results and developments we are also pleased to increase earnings guidance for the full year 2007.

On the membership front we continued to grow during lock-in but at a slower rate than last year. We believe the main reason for the reduced pace is the increase in special needs plans competitors in a number of our markets.

We intend to counter this competitive effect in 2008 by introducing Chronic Care and Institutionalized Special Needs plans in all of our existing markets and believe we'll be in better position during the lock-in period next year.

The membership in the PDP product continues to be a bright spot as we benefit from our national expansion in 2007 and from being below regional benchmarks in 29 of 34 regions. As of September 30, 2007, we had 128,127 PDP members and that number continued to grow to 134,802 in our November 2007 plan payment report.

We are looking forward to future growth in PDP membership during 2008. Our 2008 bids remained below benchmarks in all of our -- in all 29 of our current regions and we're also below the benchmark in California. The region with the largest number of dual-eligibles and one where some of the larger incumbent plans were displaced.

Based on our bids, CMS preliminary estimates that are PDPs are eligible for an auto-assignment of approximately 117,000 additional members as of January 1, 2008.

A caution however, that prior experience suggests a substantial percentage of these new auto-assignments will select another PDP in the two to four months following this initial assignment.

On the medical expense side, we finished the quarter with Medicare MLRs of 81.8% and 81.9% excluding the PDP component. Although higher than our initial target of 80%, we have seen enough positive incremental results in Texas and Tennessee to reduce our guidance for the full year to a range of 80% to 81% MLRs on MAPD.

In our 2008 bids, we have attempted to mitigate the adverse cost trends we experienced in 2007 by among other things exiting unprofitable product lines in a limited number of counties particularly in Alabama and Tennessee re-contracting certain providers and in Tennessee establishing tiered provider networks.

The PDP product continues to perform better than expected. PDP MLRs for the quarter and year-to-date are confusing and will be discussed by Kevin in more detail later. We now project the full-year PDP MLR in the 83% to 86% range, which remains a little better than our original expectation. Given the growth in PDP membership expected for 2008 the positive MLR results experienced this year position us well for the future.

We are also pleased to have completed the Leon Medical Centers Health Plans acquisition on October 1st. We immediately benefit from an earnings secretion standpoint but also believe the Leon model will serve as a blueprint for customer-service oriented medical care that we can expand across our provider network.

In an increasingly cluttered competitive environment the ability to reduce disenrollment levels has become a key part of an MA plans ability to grow and prosper. Leon Medical Centers Health Plans disenrollment rates are half of the disenrollment rates experienced by the rest of our markets, in spite, of being in the highly competitive Miami market.

The Leon facilities are much better appreciated in person and we are finalizing plans to host our Investor Day in Miami in January, more to come on that event in the next few weeks.

We feel very positive about the addition of this asset to HealthSpring as it positions us for growth in 2008 and beyond, and with the growth of our standalone PDP business. We now have four major markets plus the PDP business providing diversification and insulation from a single market's temporary adverse trends.

The presence in the Miami market also helps dilute our exposure to political changes in the MA payment methodologies that reduce MA rates the fee-for-service costs because Miami-Dade County is one of only a handful of counties where Medicare Advantage benchmarks are equal to the underlying fee-for-service costs.

We also recently opened our second LivingWell Health Centers in Mobile, Alabama and expect to open two more centers during the first half of 2008. We continue to -- improve upon the LivingWell concept with each new opening and believe it represents a significant positive evolution and higher quality healthcare delivery to our members.

Our experience with the Gallatin, Tennessee LivingWell Health Center confirms that the concept is an effect of tool in reducing disenrollment rates.

From an earnings perspective we are pleased with the $0.39 earnings per share for the quarter, although the fourth quarter is subject to the most seasonal variation in medical costs. Assuming continued utilization in line with historical experience and after giving effect to the Leon Medical Centers Health Plans acquisition we are increasing our 2007 full year earnings guidance to $1.40 to $1.45 per share.

With that, let me turn the call over to Kevin to review the financial details of the quarter before we open the floor for questions.

Kevin McNamara

Thanks, Herb. Prior to discussing our third quarter results I'd like to remind everyone of the update we made to our second quarter numbers subsequent to our last earnings release call we held with you back in August.

As reported in our second quarter earnings release and discussed with you on our call in August, we received preliminary notification from CMS in July regarding a retroactive rate adjustment amount for 2006.

We have referred to this payment at the end the year for the prior year payment. At the time of our earnings release we were reviewing and analyzing the preliminary retroactive rate adjustment information with an expectation of recognizing additional premium revenue in the third quarter ended September 30, 2007, upon the completion of our analysis.

As noted in an 8-K filing on August 9th and our second quarter 10-Q filed on August 14th, we completed our analysis prior to filing the 10-Q for the second quarter and gave effect to the retroactive rate adjustment in our second quarter results filed with the SEC.

This adjustment resulted in the following changes to our previously discussed press release numbers. One, Medicare premiums increased by $15.5 million, two, Medicare medical expense increased by $3.6 million, three, Medicare MLR improved from 81.9% to 79.3%, and diluted earnings per share increased by $0.14.

Moving to the current quarter, we reported third quarter net income of $22.4 million or $0.39 per diluted share, compared to a prior year reported EPS of $0.54. The prior year third quarter results include a for-the-year in-the-year retroactive risk adjustment payment of $12.3 million or $0.12 per share after providing risk sharing and income tax expenses.

No similar payments were recorded in the 2007 third quarter because we are accruing for-the-year in-the-year payment in 2007. Significant factors impacting third quarter 2007 results were one, a 13.6% year-over-year and a 1.1% sequential growth in our Medicare Advantage membership, two, a 45.2% year-over-year and 8.5% sequential growth in our PDP membership, three, a 3.3% increase as adjusted in the PMPM rates for our Medicare Advantage members partially offset by a decline in the PMPM rates for our PDP members.

For the nine months ended September 30, 2007, our Medicare Advantage rates were up 5.4% versus the prior year, four, the previously discussed erosion in our Medicare Advantage MLRs albeit at a moderated rate from that experienced earlier in the year.

Five, a negative impact on operations in the three months ended September 30, 2007 of $3.5 million as a result of adjusting the company's estimate of amounts due CMS for the 2006 Part D plan year to amounts set forth in the final settlement notification from CMS.

Six, a moderate increase in SG&A expenses in the third quarter of 2007, compared with the prior year's third quarter and seven, investment income of approximately two times last year's third quarter.

Additionally, I’ll spend a few minutes at the end of my comments discussing the Leon acquisition and related financing, which were completed on October 1st. Before I do that, let me now spend a few minutes on each of the factors driving the current quarter's results.

With respect to membership, we reported 126,616 Medicare Advantage and 128,127 PDP members at the end of the third quarter reflecting healthy growth on both a year-to-year and sequential quarter basis. As we've done in prior quarters you can find by market membership details within the body of the earnings release.

On a year-to-date basis we have increased our Medicare Advantage membership by 13.6% and appear on track to achieve 10% to 15% annual membership growth before giving consideration to grow from the Leon acquisition.

PDP membership is up 44.4% year-to-date, which is significantly higher than our expectations at the start of the year. We continue our strategy of targeting the dual-eligible population for PDP membership growth receiving our share of this population principally through the auto-assignment process.

We rolled out our PDP product nationally at the beginning of this year and as a result the majority of our PDP membership growth in 2007 consists of members residing outside of our core MA markets.

We are pleased that our year-to-date growth has exceeded our goals and we continue to grow this membership base. As of CMS’ November payment report our PDP membership stood at 134,802. MA membership reported in this payment report was 126,849 reflecting continued growth albeit at a significantly slower pace in the PDP membership growth.

While these reported numbers vary slightly from our membership used for accounting recognition purposes due to a number of reconciling items. We’ve found that the CMS numbers serve as a good proxy for relative growth.

Commercial membership was 12,453 at September 30, 2007. As previously disclosed we had a number of groups choose not to renew during the past year and as such, we projected our commercial business will represent approximately 3% of our overall revenue in 2007 and is likely to decline as a percentage of revenue going forward.

We currently expect a further significant step down in our commercial membership on January 1st and this fact coupled with the Leon acquisition will likely result in a 2008 commercial revenue mix of less than 1%.

Total revenue in the third quarter was $366.3 million, an increase of $22.5 million or 6.5% versus the prior year third quarter. After adjusting the 2006 amounts to exclude the $12.3 million of retroactive risk payments recognized during that quarter, Medicare Advantage revenue was up 17.9% or $47.8 million to $315.2 million, compared to $267.4 million in the prior year.

Contributing to this increase was the 3.3% increase in PMPM rates on our MA members coupled with the 14.1% growth in member months. As we project out the year-end, please remember that full year Medicare Advantage comparisons will reflect retrospective risk adjustments related to prior-year final settlements of $15.2 million recorded in the second quarter of 2007 and $5.7 million recorded in the fourth quarter of 2006.

Additionally, the third quarter of 2006 included for-the-year in-the-year retroactive risk adjustment payments of $12.3 million related to the first half of 2006. In 2007, we accrued for this payment during the first half of the year.

PDP premiums were $26.9 million in the third quarter of 2007, an increase of $4.4 million or 19.6% versus the third quarter in 2006. A decline in bid PMPM rates was more than offset by the 45.2% increase in PDP membership.

I caution however, that actual reported PMPM rates will vary substantially from this bid rate when risk corridor and other periodic adjustments under the Part D program are taken into account.

Commercial revenue declined by $19.2 million or 63.8%, membership was the primary driver of the decline. Fee revenue for the quarter decreased $1.7 million, as compared to the third quarter of last year. The decrease was primarily the result of the loss of the AHC Management contract at the end of last year. For the first nine months of 2006 the AHC contract accounted for $3.5 million of fee revenue.

Investment income was up just over 100% due to the significant increase in cash balances coupled with higher overall yields, please note that we expect investment income to decrease on a sequential basis as a result of the settlement of $103.7 million with CMS for 2006 Part D activity and the use of approximately $56 million of cash held at unregulated subsidiaries together with the $12 million of funds deposited in escrow as a source of funds to acquire Leon Medical Health Centers Health Plans on October 1, 2007.

Additionally, we expect increases in interest expense in future quarters as a result of our borrowing $300 million under our new credit facility, more on that later.

Before I discuss our medical expense in the quarter, let me review the impact of the 2006 Part D settlement on our results. As we noted in our earnings release we received notification from CMS this month that our obligation to CMS to settle certain Part D payments for the 2006 plan year amounted to $103.7 million.

As a result of adjusting our estimate of amounts due CMS for the 2006 plan year to amounts set forth in the final settlement notification from CMS we recognized a negative impact on operations in the current quarter of $3.5 million, which increased our MLRs by approximately 440 basis points in the PDP business, 60 basis points in the MAPD business and 100 basis points on the total Medicare MLR for the three months ended September 30, 2007.

We anticipate that CMS will offset the settlement amount against premium payments in the fourth quarter of 2007. Combined medical expenses of $288.3 million, an increase of $31.8 million or 12.4% versus the prior year's third quarter.

With respect to the components and the relative metrics MA medical expense was $258.3 million, an increase of $43.2 million or 20.1% versus the comparable prior year quarter.

On a PMPM basis, MA medical expenses were $682.26, an increase of $40.66 or 6.3% versus $641.60 in the prior year third quarter and that's after adjusting the prior year statistic for the effect of recording retroactive risk adjustments previously discussed. The MA MLR on a reported basis was 81.9% for the current quarter versus the prior year 76.9%.

However, this comparison is apples and oranges as the prior-year MLR reflects the receipt of a risk payment, whereas the current year reported does not. On an apples-to-apples basis the current year is 81.9% MLR would compare to 79.6% in the prior year, reflecting erosion of 230 basis points.

Approximately 60 basis points of the erosion in the MLR year-over-year is attributable to the previously discussed 2006 Part D final settlement with the remaining 170 basis points being attributable to medical trends.

PDP MLR deteriorated versus the prior-year's third quarter coming in at 80.2% versus 60.8%. On a year-to-date basis our PDP MLR is more comparable with that of the prior year, finishing at 88.8% versus the prior year's 81.9%.

Adjusting the year-to-date PDP MLR to exclude the effect of the 2006 Part D reconciliation that we recorded this quarter results in an MLR of 87.3% versus 81.9% for the prior year. The increase is due to lower PDP premiums this year per bid design. We still expect our PDP Part D results to improve over the balance of the year and have refined our guidance for an annual PDP MLR in the range of 83 to 86%.

SG&A expenses for the quarter were $40.2 million an increase of $2.3 million or 6.1% versus the prior year. The increase in the current quarter was primarily the result of an increase in headcount. As a percent of revenue, SG&A was flat quarter-to-quarter. As noted in prior calls, we expect SG&A to be seasonally weighted to the first and fourth quarters as a result of the marketing costs associated with shortened open enrollment period.

That being the case, we expect SG&A both in terms of dollars and as a percentage of revenue to increase next quarter, but to finish the year on an annual basis at or below 12% of revenue as we've targeted throughout the year.

The increase in percentage of revenue terms will not be as pronounced due to the inclusion of the Leon operations during the fourth quarter of 2007. They have historically operated at much lower SG&A expense as a percentage of revenue.

Moving to the balance sheet and cash flow. Our balance sheet at September 30, 2007 reflected cash and cash equivalents of $409.8 million. Unregulated cash was $90.1 million.

Days claims payable decreased to 38 or by one day sequentially compared to 39 at June 30, 2007. Please note that the Q3 press release references a days claim payable statistic of 40 for the 2007, second quarter. It actually was 39 as reported in our third quarter 10Q and press release.

Year-to-date, the medical claims liability is down $3.8 million. This is attributable to an approximately $8.7 million reduction in the commercial claims liability in line with the reduction in our Commercial business.

The Medicare claims liability is up in line with the business and changes in the pharmacy and other components of the medical claims liability approximately offset one another. In the 10-Q for the third quarter, we will begin including a schedule detailing the components of the medical claims liability.

Operating cash flow for the quarter was a source of $40.8 million or 1.8 times net income for the current quarter versus a source of $53.5 million or 1.7 times net income, in the prior year third quarter. In both cases is adjusted for an early payment at the CMS premium.

On a year-to-date basis, cash flow from operations was $62.3 million or 1.1 times net income compared with $98.3 million or 1.6 times net income for the nine months ended September 30, 2006.

The main drivers of this variance were. One, an $8.8 million negative variance related to our accrual of premium amounts from CMS associated with current-year rate adjustments. Two, a $9.6 million negative variance related to our pharmacy and entry into the Part D business in 2006. Three, a $6.1 million negative variance related to the runoff of Commercial medical claims on groups no longer covered in 2007. Four, a $6 million negative variance related to the timing of incentive compensation payments. And five, a $5.6 million negative variance related to the timing of tax payments.

We do expect annual cash flow from operations to exceed net income for the year.

As Herb, mentioned during his comments. We were pleased that we completed the Leon Medical Centers Health Plans acquisition on October 1st. We are excited about what this transaction brings to our Company and believe there will be positive synergies between our two organizations.

Already, we are learning a great deal about their high level of customer service and hope it will have a positive impact on our member retention and growth going forward. Reviewing a few of the deal specifics, the acquisition purchase price consisted of $355 million in cash at closing.

As part of our transaction, we also entered into an excusive long-term provider contract with Leon Medical Centers an operator of five Medicare-only medical clinics located throughout Miami-Dade County.

The provider contract includes a risk-sharing arrangement, whereby both HealthSpring and LMC will share equally in the surplus or deficit of the health plan relative to targeted medical loss ratios, which are initially set at 80%.

The transaction consideration also included the issuance into escrow of approximately 2.7 million HealthSpring shares at closing, that will be released from escrow in the event that Leon Medical Centers completes two additional medical centers before November 2009.

It is anticipated that these shares will not appear in our fully diluted share account for EPS purposes, until the centers are closer to completion. Although, we do not intend to break out the Florida market results going forward, let me spend a few minutes commenting about the expected ongoing financial impact of the acquisition.

And the related $300 million term loan and $100 million unfunded revolver we negotiated to finance part of the transaction. As we mentioned during the call announcing the transaction, much of the filing data relating to the health plan is available publicly through statutory filings.

Let me give you a few highlights that I think will share some light on what we expect the impact will be on our fourth quarter financial results.

The plan generated approximately $160 million in revenue for the six months ended June 30, 2007. Membership has continued to increase since that point, although at lock-in it is tough to see significant growth.

We expected the current revenue run rate of approximately $80 to $85 million per quarter is achievable. Medical costs in this business have continued to improve throughout the year. And we anticipate that our contractual risk-sharing MLR target of 80% is achievable for the fourth quarter of 2007.

In line with the experience of our other markets, we would expect that open enrollment marketing expenses would increase SG&A during the fourth quarter of this year, albeit from a lower starting point for Leon.

Below the operating income line there is some other significant costs related to the Leon acquisition that we wanted to make sure are taken into account. We will see a sizable increase in amortization expense related to the acquisition because of the intangible assets that were created in the deal.

While the analysis will not be finalized until the completion of the opening balance sheet, on an annual basis, we currently expect to see between $10 and $11 million in incremental annual amortization expense beginning in the fourth quarter of 2007.

On October 1, 2007 the Company also entered into a new $400 million five-year credit agreement, which is comprised of $300 million in funded term loans and $100 million unfunded revolving credit facility. Proceeds from the term loan were used to finance a portion of the $355 million in cash costs of the Leon acquisition.

These loans carry interest on the basis of a base rate or a LIBOR rate, plus an apple go or margin, which is tied to the Company's consolidated debt to EBITDA leverage ratio. The initial margin is 250 basis points.

In addition, the Company is responsible for the commitment fee on the unfunded revolving credit facility, which is also tied to the leverage ratio and is initially set at 50 basis points.

While the interest expense we will record during the fourth quarter of 2007 will fluctuate based upon the movement of LIBOR rates for the next two months, we expect to see Q4 interest expense in the range of $6 to $6.5 million, inclusive of unfunded revolver commitment fees and the amortization of deferred financing fees associated with the new credit facility.

Finally, as I mentioned before, we should also see a sequential decline in our interest income due to the fact that we used approximately $56 million in cash from unregulated subsidiaries in addition to the $12 million escrow from our balance sheet to finance the remaining cash portion of the purchase price and associated transaction expenses.

It is our current intention to pay down this debt ahead of the required amortization payments. That being said, we would expect interest expense to step down over time so long as interest rates do not move significantly against us.

The net of the Leon operations and the amortization and interest expense should result in an accretion of approximately $0.01 to our fourth quarter 2007 earnings per share. We expect an organic growth of the business, debt repayments, and SG&A leverage will dramatically improve the accretion from this transaction in 2008.

With respect to our 2007 guidance, we are increasing our previous release GAAP EPS guidance to $1.40 to $1.45. Revised guidance includes amounts resulting from the acquisition of Leon Medical Centers Health Plans on October 1, 2007.

Additionally, guidance includes the $0.05 charge we took during the second quarter of 2007, resulting from the impairment of intangible assets.

Key assumptions behind this guidance are yearend membership in the MA business of 153 to 154,000, PDP membership at yearend of approximately 135,000, revenue of approximately $1.55 billion. MLRs in the MA business of 80 to 81%, PDP MLRs of 83 to 86% a weighted average share count of 57.4 million and a tax rate of 36%.

As we did last year, we intend to provide detailed 2008 guidance during our Investor Day. Stay tuned for all the details, but we are currently planning for the event to be held in Miami in January. And we'll include a tour of the Leon facility.

Operator, that concludes our prepared remarks. We can now open the line for questions.

Questions-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) We go first to Justin Lake of UBS.

Justin Lake - UBS

Thanks, good morning.

Herbert Fritch

Good morning, Just.

Kevin McNamara

Good morning.

Justin Lake - UBS

A couple of questions. First and I know -- I know it's a little early to talk about '08 independent firms, but just, I am sure, now that we've started marketing.

I'd be curious to hear your thoughts on how you see the situation shaping up, especially around commission structures.

And your thoughts around how impressed people are being for 2008 and also around benefit.

Herbert Fritch

Well, I think it's slightly more competitive, I guess is the way I'd put it. I mean it certainly hasn't decreased in terms of the number of competitors.

There are more SNIP plans and special products. And I think, in some markets commissions are flat and some others are being bid up a little bit.

Justin Lake - UBS

Okay. So flat to up, I know you particularly in Alabama and a little bit in Tennessee, compete with United Healthcare on the HMO product.

And they're going to have an AARP offering out in 2008 for an HMO. I'm just curious how you think the impact of that might be for your business.

Herbert Fritch

Yes. It's really had to say. We're certainly seeing a lot of advertising for it. Pure speculation on my part, but I think ours has a pretty loyal following that currently is mostly in our supplements that United underwrites.

I expect that's where a lot of their members are going to come from would be my guess.

Justin Lake - UBS

Right. And just finally, a question around medical costs. You took down your -- looks like the third quarter, if you ex out this Part D reconciliation showed some stability from a medical cost standpoint versus the issue the issue you saw in the first half of the year.

As you think out to the fourth quarter. And you did take down your guidance for the full year. I'm just curious as to how much of that do you think is just the impact of Leon versus further improvement in medical costs in '07?

And then, have you had a chance to kind of really sit back and think about how much -- how much your bid for '08 were able to reflect those higher costs in 2010 as in the first half of '07. And how you think it rejected of MLR might progress.

Kevin McNamara

Justin, I'll take part of that and let Herb take the rest. With respect to Leon and you can back into the other math. I mean we've got Leon loaded in at the target 80% in the fourth quarter.

Justin Lake - UBS

Okay. So that would account for some of the benefit, but not all.

Kevin McNamara

The rest would be trend. And I'll let Herb go from there.

Herbert Fritch

Yes. I don't think, Justin much has changed on the bid component compared to what we've discussed in the past. We didn't get all of the costs increase on the MAPD into our bids.

If there is any new news, I guess it's that similarly on the PDP bids not similarly in the opposite direction. We've had actually better experience this year than we anticipated and that better experience didn't get reflected in our bids for 2008 either.

Justin Lake – UBS

Got it. Thanks a lot.

Operator

Thank you. We go next to Michael Yuan, Bank of America.

Michael Yuan - Banc of America Securities

Hi. Thank you. A question on, Leon. I know some of the financing has changed since your initial assumption of the LIBOR 200 or LIBOR 250 and it slow little earlier. Do you still expect that to add $0.15 next year?

Herbert Fritch

You know, we're going to get -- give very detailed guidance on 2008 in January, but as we sit and work through all the intricacies of that and refine our calculations we still think we'll see at least $0.15 from that.

Michael Yuan - Banc of America Securities

Great. And then just on the re-contracting in Tennessee, what percentage can you actually re-contract. And how long do you think that will take to complete?

Herbert Fritch

The re-contracting has largely been around our physician engagement models, organizing doctor groups and getting them onto models that involve greater incentives. We've increased substantially this year.

I'd say we're up from 10 to 15% up to close to 40%. We expect, we'll by next year -- we'll have well over 50% of our members and physicians under those models in Tennessee.

Michael Yuan - Banc of America Securities

Great. Thank you.

Operator

Thank you. We’ll go next to Michael Baker, Raymond James.

Michael Baker - Raymond James and Associates

Yes. I was wondering, given recent developments of one of your competitors in Florida, if you've thought about a more aggressive market expansion going forward in that region?

Herbert Fritch

You know, we are trying to undertake some more significant expansions, but with the timing process at CMS you're getting pretty late right now to expand market areas for January of 2009.

And to start something from scratch right now you'd probably be looking at January 2010.

Michael Baker - Raymond James and Associates

Thanks for the commentary.

Operator

Thank you. We’ll go next Matt Perry, Wachovia Capital Markets.

Matt Perry - Wachovia Capital Markets

Hi. Good morning. Just a couple of quick questions. First on your comments on special needs plans, I guess, could you give us any indication of, I guess, how actively you'll be marketing those during open enrollment, or is that more kind of a product to be concentrated on after open enrollment closes?

And then any indication of how many members, you think you'll be able to sign up in those products?

Herbert Fritch

I think it is probably -- well, not exclusively, more the latter. I think it's a product that we're going to try and really get focused on after open enrollment. I'd just comment that our growth during lock-in last year was a net of about 1,000 members a month. This year, we're more -- we're under 500, more in the 300 to 400-member range.

And I think our expectation is we had hoped to at least get back to that 1,000 member a month, kind of number, but we'll look at that more closely as we get more experience with the products.

Matt Perry - Wachovia Capital Markets

Okay. And then secondly, if I understood your comments correctly on PDP auto-assignment, you said you might be eligible for 117,000 but that some portion of those might choose other plans. Is there anything you can tell us about your experience in '07 that might allow us to at least ballpark what percentage of those 117,000, you might pick up in '08?

Herbert Fritch

Just based on a study on a much smaller number that we received last year, we lost about 10% before January and ended up over the next few months losing another 10% to 15%, although that was offset by new ads during those months post January.

Matt Perry - Wachovia Capital Markets

Okay. So you might be able to hold onto two-thirds or three-quarters of that amount, do you think?

Herbert Fritch

I think our expectation is 75% to 80% of them ultimately, but -- and again, we do expect, as we have this year. We've had net growth every month and we expect that will kind of come on top of that more or less new members.

Matt Perry - Wachovia Capital Markets

Okay. And then just lastly, am I thinking about '08 PDP per-member per-month revenues correctly, because it looks, simply just looking at your bids it looks like the average for '08 might be down $5 versus '07, so should we see kind of a $5 decline in PMPM in '08.

Herbert Fritch

You can sort of hard circle the $5. I think directionally they'll go down and I think order of magnitude they'll go down about half the level they went down from '06 going into '07.

Matt Perry - Wachovia Capital Markets

Okay, great. Thanks a lot.

Operator

Thank you. We are going next to Carl McDonald, CIBC.

Carl McDonald - CIBC World Markets

Thank you. I just had another question on the PDP. The risk corridor gets a little bigger for you in 2008 and relative to the commentary that the bid you submitted for 2008 didn't necessarily catch the fact that utilization costs have been a lot lower this year. Will that be a significant benefit for you next year? How would you characterize that?

Herbert Fritch

Yes, it sure helps. I mean, obviously, if you're having favorable experience you'd like to keep as much of the risk as possible so that should be a benefit.

Carl McDonald - CIBC World Markets

Any sense of the magnitude that you can give us?

Herbert Fritch

Well, I mean, I think you'd keep another 2.5% of the positive. In other words, if you have favorable experience you keep 5% of it as opposed to 2.5% before you start sharing a lot. I think everybody now is basing bids based more and more on actual experience, so I think the variation shouldn't -- 5% variation on your target would be a lot.

And I don't think we're anticipating seeing a whole lot, if any, risk corridor adjustments at the end of 2008, but we'll see. That continues to develop and we get smarter every month about that.

Carl McDonald - CIBC World Markets

All right. And I'd also be interested in your thoughts on whether you think -- or whether you see a durational effect in your Medicare business, Medicare Advantage, in terms of -- is there a significant difference in loss ratio for members, say their first 12 months versus members that have been in the plan for a longer period of time?

Herbert Fritch

We've been pretty vocal about --we do believe what's the case, and no, we absolutely think so and are suspect of business that's less than three years old of being mature to a steady, predictable point on loss ratios.

Carl McDonald - CIBC World Markets

And, any sense of what the magnitude is, difference in terms of loss ratio between the two?

Herbert Fritch

It's significant from what we've seen and I'll just -- I mean, we've seen variations by market as much as 15 to 20 points over a three-year period.

Carl McDonald - CIBC World Markets

And last question on that is, your sense of that because the members that you're signing up tend to be younger, healthier, or is it just the situation that members just need some time to figure out what the benefits are?

Herbert Fritch

You know this is all speculation and theory and I don't know that we've proved much. My theory has been that a huge part of Medicare expenses are incurred in the last six months of life and beneficiaries that are in end-to-life events typically aren't changing their insurance plans.

But I do believe that these are old people so the fact that even if they were healthy when you signed them up, after you've had them for a year or two, they start to incur the same kinds of diseases as the general population at comparable rates. And at that point, your medical management systems need to be in place.

Carl McDonald - CIBC World Markets

Thank you.

Operator

We are going next to Matthew Borsch, Goldman Sachs.

Darin Miller - Goldman Sachs

Good morning. This is Darin Miller sitting in for Matt. Question on SG&A, on an absolute level it was down sequentially. Can you provide some color on that?

Kevin McNamara

I'm not sure I follow you on that. On an absolute level it being down, Darin. I mean, it was up 6.1% in dollars.

Darin Miller - Goldman Sachs

It looks like in dollar terms it was down about $3 million.

Kevin McNamara

I don't follow that, Darin. I'll have to call you back offline on that.

Darin Miller - Goldman Sachs

Sure. I'll follow up with you on that. Texas Medicare enrollment looks like it was down sequentially.

Herbert Fritch

I believe it was about flat. I don't know that it was actually down but sure it didn't increase much.

Darin Miller - Goldman Sachs

And most of your other markets had modest increases. I was just wondering if there was anything going on that you can comment on that market.

Herbert Fritch

The Houston marketplace is the most competitive that we have and clearly our biggest competitor down there is probably the most aggressive in terms of benefits. And so I think that leads to a little slower growth in that market.

Darin Miller - Goldman Sachs

Okay. And I'm sorry if you've already commented on this. The higher outpatient costs you saw earlier this year, can you provide an update as far as an explanation that was driving that and steps you're taking to address that?

Herbert Fritch

Well, we're looking at some recontracting other authorization things. The trends have moderated somewhat. They're still higher than we'd like and still, I think, higher than physician or inpatient trends but they're not at the levels we were seeing earlier in the year.

Darin Miller - Goldman Sachs

Great. Thank you.

Operator

Thank you. We are going next to Charles Boorady of Citi.

Charles Boorady - Citigroup

Good morning. On a same-store basis here, MA enrollment guidance for the year, did that actually -- did you actually lower that same-store, excluding Leon, and if so, can you explain that?

Kevin McNamara

I think, Charles, it's what we alluded to -- the answer is yes. We lowered it slightly, I think, 1 to 2,000 lives, and the answer is just what I talked about. We haven't seen the same level of net enrollment growth during lock-in that we saw in prior years but we're still growing. It's not dramatic but it's slightly lower.

Charles Boorady - Citigroup

Okay. And the improved medical trends, did that reflect mix of Leon, bringing your expected trend down at all?

Kevin McNamara

No. That's fourth quarter. Leon's not in the results, but the annual, yes.

Herbert Fritch

For the annual, there is one factor. I mean, Leon is coming in -- I think we're projecting it at 80 for the fourth quarter, which is at the low end of the range.

Charles Boorady - Citigroup

Okay. And what percent complete are you on claims that relate to the period when you had a slight surprise on medical trends for earlier -- or earlier this year?

Kevin McNamara

We'd be -- earlier this year -- we pay very quickly, so with one month run-out, we're 80% complete and with two months run-out we're close to 90% complete.

Charles Boorady - Citigroup

So, in hindsight, was there anything new that you've learned for getting closer to 100% complete on the claims related to that period?

Kevin McNamara

I think the experience compared to when we made the announcement actually came in a little better than we were thinking. It's still not good, but it wasn't as bad as we thought.

Charles Boorady - Citigroup

In terms of diagnosing the root causes of it and whether that's something that is going to be more predictable going forward, or is it really unpredictable in hindsight?

Kevin McNamara

I'd say it was unpredictable in hindsight. I mean, it's a variety of smaller factors. It isn't just a single factor. It varies a bit by market. And we're trying to hone our routine analytical reports to pick up on these nuances but that outpatient component is a whole hodgepodge of things and probably is the most challenging to pin down. But I think we're getting better at it.

Charles Boorady - Citigroup

All right. Last question on the WellCare Group. Were you surprised by the magnitude of that search of 200 agents searching headquarters?

Kevin McNamara

I haven't talked to anybody that has seen that or anything like it coming. Yes, absolutely. Like everyone else in the industry, I think we're just staying tuned and try to figure out what's really going on.

Charles Boorady - Citigroup

How do you respond in terms of your own internal controls, government relations, etcetera? Is there any response that you take as a company when you see something like that happen?

Kevin McNamara

Well, actually, it feels pretty good. A number of months ago we hired a full-time chief compliance officer. She's been working with the Board to strengthen our internal compliance programs and I don't think we're doing anything differently because of WellCare.

I feel pretty good that we continue to strength internal compliance and make progress on that. We're not aware of any material issues by any means but it's just something we have to constantly pay attention to if you're dealing with the government.

Charles Boorady - Citigroup

Do you think the government will sort of reach out to the industry and communicate with you and others what kinds of things they took issue with so that corrective action can be taken, if necessary, in a constructive way as opposed to waiting to see if 200 Feds appear on your front lawn?

Herbert Fritch

We certainly hope so. I think we're all looking to find out the details of exactly what the issues are and obviously to the extent, we understand a little better we'll look awfully hard to make sure we don't have any. We're certainly not aware of anything now.

Charles Boorady - Citigroup

Are there open lines of communication with CMS on this? I recognize you wouldn't be able to share with us the specifics, the warrants were sealed but are they -- is there an open line of communication, given the magnitude of what's happened there?

Herbert Fritch

I'm not totally sure CMS is even aware of all the issues but we're asking everybody we can what's going on and not getting many answers yet from anybody.

Charles Boorady - Citigroup

Okay. All right. Well, thanks very much and congrats on the quarter.

Operator

Thank you. We are going next to Josh Raskin of Lehman Brothers.

Josh Raskin - Lehman Brothers

Hi. Thanks. Good morning. First question just on, as we think about 2008 membership growth, and if I look back over the Medicare Advantage membership growth. If we look back over the last couple of years, you guys have added organic growth somewhere in the 12 to 14,000 life range.

And I think that was a little bit below what you guys sort of hoped would run at. Different reasons for different years, but I'm curious, as you think about '08, what are some of the pluses and minuses? How do you think about sort of that low-teen thousands of growth rate in terms of membership for '08?

Herbert Fritch

I think, in general, and we'll sharpen our pencils a bit as we do 2008 guidance but in general, Josh, I mentioned we emphasize for '08 more profitability and margins and a little less membership in a couple of respects, especially in Alabama and Tennessee and drop some unprofitable members in various products and counties. Not a huge amount, but in general, I think, while we're optimistic we can see EBITDA growth.

I think membership growth might be a little bit down from prior years.

Josh Raskin - Lehman Brothers

Okay. And that's sort of the respite better retention and some of this did roll out, is that a way to think about it?

Herbert Fritch

Yes. You know, we may well see a little different pattern, I think the things we did may actually reduce the January enrollment just based on transition, you know, going -- dropping a few members.

The sniff products are likely to be more lock-in related when we see that growth so it'll be the growth could be a little more evenly spread throughout the year as opposed to front ended the way it's been historically.

Josh Raskin - Lehman Brothers

Okay.

Kevin McNamara

Josh, better retention could potentially change that picture but we're not banking on that. We're not planning for a significant deterioration in attrition rates but we're certainly not planning for significant improvement, although we've committed a lot of resources to that area.

Josh Raskin - Lehman Brothers

Okay. I think, I get the color that you guys are talking about. And then, Kevin just a quick balance sheet account question for you. The two liability line items that I'm just curious on, the funds held for the benefit of members and then the risk corridor at CMS, I think I understand the risk corridors?

But could you just help me understand which buckets line up with sort of what the way CMS thinks of it? They think of it in sort of three buckets and you guys have it in two liability accounts, I'm just trying to reconcile those two.

Kevin McNamara

Yes. Once you've got, Josh and I guess, the basis of your question is where is the $103 million coming from?

Josh Raskin - Lehman Brothers

Yes.

Kevin McNamara

When you get the 10-Q you'll have a very detailed it shows you exactly where it's coming from. But in a nutshell basically the funds held for the most part is an in and out calculation. So a part of it comes out of that funds-held account but you're continually replenishing it during the year.

So, the $103 is going to become -- is going to come partly out of funds held, partly out of risk corridor. I believe the risk corridor number of that $103 is all but $9 or $10 million goes out.

Herbert Fritch

If you subtract 34 from that the balance comes out here.

Kevin McNamara

If you take, I just got the answer. If you take the $103 million.

Josh Raskin - Lehman Brothers

Yes.

Kevin McNamara

Subtract the $34 million risk corridor that's on the balance sheet in the current liabilities.

Josh Raskin - Lehman Brothers

Yes.

Kevin McNamara

The rest comes out of the funds held account.

Josh Raskin - Lehman Brothers

Okay.

Kevin McNamara

So, the long-term portion of the risk corridor relates to 2007 because you'll obviously settle that later on in 2008.

Josh Raskin - Lehman Brothers

And then, I guess, just. Okay. So that's helpful from a numerical standpoint. But coming back to the business, the risk corridors the remaining portion of that $70-ish million or so that is a function of your operations around the PDP -- around the Part D program coming in better than expected. That's just simply we've done better we owe part of it back to the government.

Kevin McNamara

That's the risk corridor piece, correct.

Josh Raskin - Lehman Brothers

Okay.

Kevin McNamara

What's in the funds held account is really just the positive accounting where you receive advance payments from CMS for low income subsidy and reinsurance and then you charge amounts against that as they're incurred.

None of those dollars ever go through P&L and so you just get a residual balance that sits on the balance sheet and continually moves.

Josh Raskin - Lehman Brothers

Okay.

Herbert Fritch

Those are components that we're not at risk for, so if the utilization is lower we have to give the money back, if it's higher we actually get reimbursed for that. And it covers the cost sharing of low-income members and then a reinsurance component that CMS rakes the risk for.

Josh Raskin - Lehman Brothers

Right. I guess.

Herbert Fritch

They front you the money so you can pay your clients.

Josh Raskin - Lehman Brothers

Right. Which certainly I understand, I was just trying to get at with a P&L impact we can take a look at the risk corridor balance sheet item, that's the one that really?

Herbert Fritch

That's correct. All the funds held activity is staying away from the P&L.

Josh Raskin - Lehman Brothers

Yes. Okay. Perfect. Thank you very much.

Operator

(Operator Instructions) We’ll go to Michael Baker, Raymond James.

Michael Baker - Raymond James and Associates

Yes. Just a follow-up. I was wondering if you could update us in terms of your plans for leadership in the marketing area given Craig's departure earlier this year?

Herbert Fritch

We have just recently hired someone here at corporate who was working with Craig for continuity's sake and I don't know that I'd term [Michael Pensley] his name, him as Craig's replacement necessarily but certainly in the short term for this open enrollment period he's working with Craig.

Michael Baker - Raymond James and Associates

Thanks.

Operator

Thank you. And with no further questions, I'd like to turn the conference back over for any additional or closing remarks to Mr. Herbert Fritch.

Herbert Fritch

Well, thanks. We appreciate your interest and look forward to talking to you again and seeing you down in Miami for Investor Day.

Operator

Thank you for your participation. That does conclude today's conference. You may disconnect at this time.

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