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Executives

Thomas F. Cowhey - Vice President of Investor Relations

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

Joseph M. Zubretsky - Chief Financial Officer and Senior Executive Vice President

Analysts

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Joshua R. Raskin - Barclays Capital, Research Division

Charles Andrew Boorady - Crédit Suisse AG, Research Division

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

David H. Windley - Jefferies & Company, Inc., Research Division

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

Christian Rigg - Susquehanna Financial Group, LLLP, Research Division

Douglas Simpson - Morgan Stanley, Research Division

Christine Arnold - Cowen and Company, LLC, Research Division

Carl R. McDonald - Citigroup Inc, Research Division

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Scott J. Fidel - Deutsche Bank AG, Research Division

Aetna (AET) Q1 2012 Earnings Call April 26, 2012 8:30 AM ET

Operator

Good morning. My name is Casey, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Aetna First Quarter 2012 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to Mr. Tom Cowhey, Vice President of Investor Relations. Mr. Cowhey, please go ahead.

Thomas F. Cowhey

Good morning, and thank you for joining Aetna's first quarter 2012 earnings call and webcast. This is Tom Cowhey, Vice President of Investor Relations for Aetna, and with me this morning are Aetna's Chairman, Chief Executive Officer and President, Mark Bertolini; and Senior Executive Vice President and Chief Financial Officer, Joe Zubretsky. Following their prepared remarks, we will respond to your questions.

During this call, we will make forward-looking statements. Risk factors that may impact those statements and could cause actual future results to differ materially from currently projected results are described in this morning's press release and the reports we file with the SEC, including our 2011 Form 10-K and our first quarter 2012 Form 10-Q when filed.

We have provided reconciliations of metrics related to the company's performance that are non-GAAP measures in our first quarter 2012 financial supplement and our 2012 guidance summary. These reconciliations are available on the Investor Information section of aetna.com. Also, as you know, our ability to respond to certain inquiries from investors and analysts in nonpublic forums is limited, so we invite you to ask all questions of a material nature on this call.

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

Mark T. Bertolini

Good morning. Thank you, Tom. And thank you, all, for joining us today. This morning, we reported first quarter operating earnings per share of $1.34, a solid performance following on the excellent results we saw in 2011. Our businesses are performing well, and the operating metrics we posted this quarter are testimony to our having achieved the correct balance between maintaining our margins and positioning for future growth.

We believe that our products are competitively positioned in the marketplace, and consistent with previous guidance we are pricing new and renewal business to a higher level of projected utilization for 2012. In short, we are pleased with our first quarter results and our sustained execution on the fundamentals.

As we look forward to the remainder of 2012, we expect top line and membership growth and strong operating performance. At this early point in the year and as we continue to watch our yields and trends develop through the first quarter, we believe it is prudent to maintain our current earnings outlook. As a result, we remain confident in our full year operating earnings per share guidance of approximately $5 per share. In a few moments, Joe will review our detailed results and our updated guidance. But first, I'm going to discuss our first quarter 2012 highlights and 2012 outlook and our progress in advancing our strategy.

Aetna's first quarter financial results are evidence of the rigor with which we manage the business. Underlying these results, Aetna grew Health Care premiums by over 6% this quarter, demonstrating growth across all our lines of business. As a result of Aetna's continued pricing discipline, medical cost management and unit cost control, we continue to maintain strong commercial underwriting margins. We continue to focus on striking a disciplined balance between margin and growth, erring on the side of margin.

Our Medicare business posted an excellent quarter as we added 44,000 members. More than 75% of our Medicare Advantage growth came from our group Medicare franchise, a testament to our strength in the segment of the Medicare Advantage marketplace. We ended the quarter as expected with 17.9 million medical members. Our membership results reflects previously projected decreases in our National Account business and our exit from the Connecticut Medicaid program, partially offset by growth in our Medicare, International and middle markets businesses.

We continue to be pleased with our membership traction across multiple business lines. As a result of this balanced membership traction, we are introducing year-end membership guidance of 18.2 million members, which represents growth of approximately 300,000 members over the remainder of the year. This projected growth comes from each of our major business lines and is driven by known wins in Commercial ASC, expansion in Medicaid and projected growth in Commercial Insured and Medicare in the latter part of the year.

In advancing our strategy, we remain focused on our long-term goal of making health care more accessible and affordable. To achieve this goal, we are focusing on growing the core business, adapting to the changing health care marketplace and deploying capital effectively. To accelerate growth in our core business, we have realigned some of our business units and added talent to our leadership team. In early March, we realigned our Medicare, Medicaid, public and labor and federal benefit planned businesses into one operating unit, Government Services. We believe this change will better serve our government customers, advance our retiree solutions and position us for the dual eligible opportunity. Kristi Ann Matus, who joined us in March as an Executive Vice President, is leading the Government Services businesses. Kristi joins us from USAA where she was a member of their senior leadership team.

At the same time, we also consolidated and realigned all of our Commercial ASC and insurance businesses into a Commercial businesses operating unit. This alignment will help us to focus on the needs of our Commercial populations and drive solutions that meet the growing needs of today's health care consumers. Frank McCauley is now Executive Vice President and Head of Commercial businesses.

We are seeing positive momentum in our core business, and we continue to focus on growing in a profitable and sustainable manner. In National Accounts, we remained focused on membership growth and are encouraged by the recent market response to our products. Our outlook for 2012 has improved due to better-than-projected first quarter membership, and several midyear additions. Moreover, while it's still very early in the 2013 National Account selling season, recent customer wins have increased our confidence in our ability to grow membership in 2013.

Certain customers who left Aetna to pursue alternatives primarily based on discounts, are beginning to return to our integrated solutions and strengthen this composition. New business opportunities are twice what they were a year ago, and we have had only minimal account lapses to date, far fewer than we had at this point in 2011, including fewer existing accounts out to bid. We expect to provide initial 2013 National Accounts membership guidance on our second quarter earnings call in late July.

In Medicaid, we see strong momentum and are pleased to have been recently awarded contracts in 2 significant procurements in Missouri and Ohio. In the first quarter, our Missouri Medicaid business was selected as 1 of 3 plans to administer services in all 3 regions statewide starting July 1. We have operated in parts of Missouri for 14 years and look forward to continuing to provide quality programs and services across the state.

At the beginning of April, the State of Ohio announced that we were awarded a new Medicaid risk contract in all 3 regions of the state. It was a very competitive process and Aetna was the highest scoring plan in each of the 3 regions. This win is another testament to the strength of the Aetna Medicaid value proposition and we are excited to be able to serve the State of Ohio and its citizens.

The Ohio win also positions us well as we prepare to submit bids for Ohio's dual eligible demonstration pilot program. High acuity populations remain a focus of our Medicaid expansion strategies and we continue to work in partnership with states to serve these members. The health care marketplace continues to wrestle with the prospects for judicial or legislative change to the Affordable Care Act. At Aetna, we continue to focus on compliance with the law and delivering solutions that meet the long-term needs of our customers and members. If the Supreme Court decision changes the law, we will work with Congress, the Administration and others to develop alternative solutions that promote market stability, ensure broad access and improve the affordability of the health care system.

Meanwhile, Aetna continues to move forward to address the nation's health care quality and cost challenges. Today's health care system is not working. It's expensive and disconnected and the quality of care varies unacceptably. To help address these growing issues, we are driving change in how we interact with providers and consumers through our emerging businesses.

Aetna has differentiated itself in the area of provided collaboration by commercializing the concept of accountable care organizations and formed a new business unit called Accountable Care Solutions under the leadership of Joe Zubretsky. Our Accountable Care Solutions business continues to develop innovative provider partnerships based on clinical excellence and payment reform.

In our model, an ACO is more than a risk sharing or performance payment contract with a provider. The installation of an entirely new platform allows providers to engage in database population management rather than traditional acute episodic care management. Our suite of world-class technology tools, combined with Aetna's intellectual capital, is the enabler which allows us to partner with providers to deliver a cross-structured advantage and launch products across all lines of business.

We have signed 9 ACS contracts and currently have 16 letters of intent with over 180 leads in the pipeline. These partnerships are strengthening Aetna's position in local markets and catalyzing growth in our core business. We project by the end of 2012, under our new and existing agreements, we will have meaningful medical membership service by our Accountable Care Solutions relationships. To meet the changing needs of today's health care consumer, we are also developing new capabilities to empower our members to live healthier lives.

In the first quarter, we launched CarePass, Aetna's new consumer platform. CarePass is an easy-to-use web-based solution that improves convenience and leverages mobile technologies. Consumers can manage their health and their health care on a variety of devices whenever they want and wherever they are. The first implementation of our CarePass digital platform is our recently launched updated version of the iTriage smartphone application.

iTriage harnesses health care information in an efficient and personalized way, bringing together provider search and appointment scheduling, health reference resources and a secure personalized electronic health record. Its core features are not Aetna specific and are direct to the consumers at large. In addition, we are developing value-added enhanced features for Aetna members. Most importantly, this new technology is free for anyone to download to their smartphone device from their resident application store.

We are very excited about the power and flexibility of the CarePass platform and its ability to help drive growth in our core business. In fact, we expect these investments will enhance our Accountable Care Solutions strategy as we use tools such as iTriage to connect consumers with our provider partners.

The third major component of our growth strategy is capital generation and deployment. For the full year we are on track to generate net subsidiary dividends of approximately $1.7 billion, which we will deploy for the benefit of shareholders through our shareholder dividend, pursuing attractive acquisition opportunities and buying back additional shares.

In summary, I am pleased with our first quarter performance and expect continued strong performance in 2012. We remain committed to our operating model premised on financial discipline. We are seeing good momentum in the following businesses: National Accounts, where value proposition is beginning to resonate; Medicaid, where we expect growth in our existing markets and are gaining access to new markets; Medicare, as we look to grow in the group and individual marketplaces; Commercial insured, where we continue to see prospects for growth, primarily driven by our large group accounts; and Accountable Care Solutions, where we are driving innovative change and see a robust pipeline reflecting the value that providers see in our differentiated offerings.

Further, I am confident in our strategic direction and particularly, our execution; our ability to manage through the legislative and regulatory changes associated with Health Care Reform; our ability to grow membership over the course of 2012; our 2012 medical trend outlook; and our 2012 operating EPS projection of approximately $5.

I would like to thank all of our employees for their dedication in meeting the needs of our customers. By focusing on sound fundamentals, creating new approaches to satisfying customers and generating and deploying capital responsibly, we believe that we can continue to create value for our customers and our shareholders.

I will now turn the call over to Joe Zubretsky to provide insight into our first quarter results and our 2012 outlook. Joe?

Joseph M. Zubretsky

Thanks, Mark. And good morning, everyone. Earlier today, we reported first quarter 2012 operating earnings per share of $1.34. This result was driven by solid execution on business fundamentals and generated excellent operating and parent company cash flows as evidenced by our Commercial medical benefit ratio, which was below 80%; pretax operating margins, which were 9.4% at the high-end of our targeted high single-digit range; our reserve position, which increased by a higher percentage than premiums; and operating cash flows, which were well in excess of operating earnings.

We also returned to revenue growth this quarter, posting a 6% year-over-year increase, reversing the recent top line trend. We continue to price with discipline, actively manage medical cost for superior quality and cost outcomes and strive for administrative efficiencies to deliver profitable growth for our shareholders.

At the end of the first quarter, we had 17.9 million medical members, a decline of 544,000 members from year end 2011. This result is consistent with our previous guidance but emerged in a slightly different mix than we had projected. Commercial ASC membership decreased by 450,000 in the quarter, slightly better than our previous guidance, primarily due to better-than-expected open enrollment results and some new account wins; Commercial Insured membership decreased by 40,000 in the quarter, driven by declines in our federal employees business and certain clients converting to an ASC relationship with Aetna. Medicare membership increased by 44,000 in the quarter, with Group Medicare Advantage sales the primary driver; and Medicaid membership was down 98,000 in the quarter, primarily driven by the exit from the Connecticut Medicaid program.

First quarter 2012 revenue generation was strong, increasing by 6.2% year-over-year to $8.9 billion, primarily due to higher Health Care premium and higher fees and other revenue. The increase in Health Care premium included a net increase in Commercial premium of approximately 3.5% due to a 6% increase in premium yields, all resulting from rates with no impact from mix. These gains were partially offset by volume, declining by about 2.5%. Health Care premium also reflected a 17% increase in Medicare premium, primarily driven by membership growth in Medicare Advantage and the addition of Genworth's Medicare Supplement business. We also reevaluated our Medicare premium estimates and we made appropriate adjustments to those in the quarter.

We posted a 9% increase in Medicaid premium as growth in our Illinois ABD program, as well as in Pennsylvania and Texas, more than offset the impact of the exit from the Connecticut Medicare program. Fees and other revenue increased by 6.7% year-over-year as a result of the inclusion of revenues from our 2011 acquisitions. Our first quarter total medical benefit ratio was 81.5%. Our Commercial MBR with 79.9% in the first quarter, an excellent result. Medical cost in 2011 have developed largely as reserve at the end of the year, resulting in no significant prior year reserve development occurring in the first quarter of 2012. This is the direct result of the stabilizing medical cost trend we observed in the fourth quarter of 2011.

Throughout 2011, Aetna's Commercial trend assumptions decreased by over 250 basis points from the midpoint of our original guidance. That meant we were consistently reserving, forecasting and pricing into a declining trend environment, which led to favorable reserve development and margin expansion. Currently, we believe that the trend estimate supporting our reserves in the fourth quarter 2011 has stabilized and that we have made prudent assumptions regarding medical cost trends for 2012.

Our days claims payable were 44 days at the end of the quarter, flat sequentially, and our Health Care cost payable increased 5.7% compared to sequential premium growth of 3.7%. We continue to invest in innovation through improved Health Care delivery for our customers, to capitalize on opportunities for profitable growth and to improve productivity.

Our first quarter 2012 business segment operating expense ratio was 18.8% as expected, reflecting the addition of fee-based business, which have operating expense ratios higher than the company average, largely offset by shifts in our membership mix and continued execution of our expense initiatives. Our operating expense ratio for the insured Health Care business was 11.4% in the quarter, down 50 basis points year-over-year.

The final area of financial performance I will comment on relates to our investment portfolio, management of capital and cash flow generation. First quarter net investment income on our continuing business portfolio was $160 million, as declining yields continued to create downward pressure on earnings. At March 31, the continuing business portfolio had a net unrealized gain position of approximately $1 billion before tax and is well positioned from a risk perspective.

Our capital generation was very strong in the quarter. We started the quarter with $100 million of cash at the parent, net subsidiary dividends to the parent was $633 million. We repurchased 7.4 million shares for $344 million. We paid down $276 million in Commercial paper. After other net uses, including our shareholder dividend, we ended the quarter with $100 million in cash to parent. Our basic share count was 347.4 million at March 31.

At the end of the quarter, we entered into a new 5-year $1.5 billion credit facility in the consortium of 20 domestic and international banks. The new credit facility replaces the 5-year revolving facility that was due to expire in early 2013. The facility was attractively priced, provides us with financial flexibility and backstops our Commercial paper program.

Our financial position, capital structure and liquidity all continue to be very strong. At March 31, we had a debt-to-total capitalization ratio of approximately 29%. We continue to target a risk-based capital ratio of approximately 300% of company action level.

Operating cash flow generation was excellent for the first quarter. Health Care and Group Insurance operating cash flow was approximately 2.3x operating earnings and benefited from an extra monthly Medicare payment in the quarter. Excluding the additional payment, the ratio was approximately 1.3x, above our onetime target and support our strong operating fundamentals.

Moving to our 2012 outlook. We are now projecting year-end medical membership of 18.2 million members, reflecting growth of 300,000 members over the next 3 quarters. This is driven by projected midyear additions to our Commercial ASC membership and a significant ramp in Medicaid membership. We also project adding members in the latter part of the year in our Commercial insured and Medicare businesses.

In Commercial ASC, we are projecting momentum in the back half of the year. We project adding approximately 150,000 members. This includes 2 large ASC customer wins for July 1, one of which is the previously announced State of Maine account. In addition, we expect a network access client to add approximately 75,000 ASC members throughout the remainder of the year.

In Medicaid, we see strong momentum and expect to add approximately 100,000 members through the end of the year. Our new Missouri contract is projected to add 50,000 members in 2012. Further, we expect to add 50,000 Medicaid members in 2012 due to ASC expansions in Florida, Texas and Virginia.

We continue to project growth in our Commercial Insured business over the remainder of the year, and we also continue to project growth in our Medicare business as our group, individual and Medicare Supplement franchises build momentum. Our projected Commercial medical benefit ratio and Medicare medical benefit ratio guidance remains unchanged.

Aetna's 2012 MBR projections reflect underlying medical cost trends that we expect to be 6.5%, plus or minus 50 basis points, as compared to a 2011 trend, which remains below 5.5%. Higher utilization is the primary driver of the projected 2012 trend increase, and we are closely watching our trend yield spreads as they continue to develop. The projected components of 2012 trend remain unchanged.

We continue to project that our full year 2012 business segment operating expense ratio will be approximately 18.5% to 19%, reflecting productivity improvements but also continued in substantial investments. Accelerating efficiency gains from our expense initiatives, including our voluntary early retirement program, are projected to help reduce the impact of seasonal expense increases toward the back half of the year.

For 2012, we are projecting net dividends from subsidiaries of approximately $1.7 billion and deployable capital of approximately $1.35 billion, including amounts deployed in the first quarter. Considering our first quarter repurchases and capital guidance, we have updated our share count guidance to a range of approximately 350 million to 353 million weighted average shares.

As we look to the remainder of the year, we would expect that sequential operating earnings per share could be lower than what we reported for first quarter 2012, consistent with the pattern we reported in 2011. This is a function of the seasonal nature of our business where medical cost tend to the highest in the second and fourth quarters, and administrative spending increases to support open enrollment toward the end of the year.

For the full year 2012, we are confident in our projection of a pretax operating margin of 8.5% to 9%, approximately $1.75 billion of operating earnings and operating earnings per share of approximately $5. The 2012 fundamentals of Aetna's business remain strong. Looking beyond 2012, we believe we have the winning strategy in the marketplace. Our core business is executing. The environment is stable, and we are well positioned for sustainable growth. Our emerging businesses continue to work to transform the network model, improve our cost structure and drive additional membership growth.

Finally, our capital generation remain strong. Combined, we believe our core business, supplemented by emerging business growth and effective capital deployment will enable us to generate low double-digit operating earnings per share growth on average over time.

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

Thomas F. Cowhey

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

Question-and-Answer Session

Operator

And our first question comes from Matt Borsch with Goldman Sachs.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

So I want to ask a question about what you're seeing in terms of you talked quite a bit about the cost trend side stabilizing in line with your expectations. On the pricing side for the Commercial fully insured business, in particular, what are you guys seeing because we've had some of the nonpublic and the public companies refer to markets where price competition is intensified and to some degree, pointing to the adaptation to health reform MLR rules as part of the driver?

Mark T. Bertolini

Matt, Mark. A couple of points. First, in the fourth quarter, given where we saw reserve development, and Joe will talk a bit about gross versus net development, we always report net development, we do not see trends decreasing anymore. And so a large part of our proprietary development in prior years is we do not see trends decreasing. For 2012, our guidance has been that our trend, our pricing trend, will be overall 6.5% plus or minus 50 basis points. And given that we have 1 month that's 85% developed and then the last month only 15% to 20% developed, quite frankly, we see nothing in utilization indicators one way or the other to predict that, that number is the wrong number. And those are our pricing trends. So in the marketplace, as a result of that, we do not see any abnormal competition other than what we normally see in sporadic markets around the country where competitors occasionally take more aggressive pricing stances, but we still see the market as largely rational. But everybody is sort of feeling for the bottom here where trends stop decelerating and starts to tick up, and quite frankly, we don't have enough information in the first quarter to come up with a prediction as to where that trend number is right now.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Got it . Just one follow up, if I could. Can you talk about your Ohio Medicaid contract win in the context of where you're going as the dual eligible opportunity may unfold more broadly, and you think about doing that organically versus maybe taking on a partner?

Mark T. Bertolini

Well, at this point in time, we like what we've seen in both Missouri and Ohio. The Ohio win was an important one for us. All 3 regions in Ohio, top scores in all 3 regions but more importantly, they're about to put out the RFP for the duals in the state and we believe we are ideally positioned. As you know, we have a big footprint in Ohio, including a large portion of the retiree, state of retiree population, so we like the Ohio opportunity. Again, we always are looking for opportunities in the Medicaid space, and depending on whether or not we believe it's appropriate for our shareholders, given our long run deal of margins and the opportunity in that market, and we continue to make a prudent decision as to whether or not to grow organically or inorganically.

Operator

Our next question will come from Josh Raskin with Barclays Capital.

Joshua R. Raskin - Barclays Capital, Research Division

I guess, and I appreciate your comments earlier, Joe, around the lack of development. But I guess I'm just sort of struggling to think about the change. We've seen 9 consecutive quarters of pretty significant development, i.e. $100 million to $200 million per quarter. I guess, I'm just trying to understand what exactly has changed and was this impacted by your strategy, your pricing strategy, due to the minimum MLRs or is this just we're still assuming inflection in trend and we're not going to release reserves until we see definitive proof that, that did not happen? I guess just a lot of questions around what exactly was the difference this year versus last year, around the development?

Joseph M. Zubretsky

Sure, Josh. The difference is quite simple actually. If you recall when we began the year, we guided to a medical cost trend of approximately 8%. We ended the year with a full annual trend of 5.5%, a 250 basis point reduction from our original projection. So all during the year, we are consistently reserving, pricing and forecasting into a declining trend environment, which expands margins and produces favorable prior period development. What you're really seeing right now is exactly what we called trend decelerating, the decelerating slowing, bottoming and then potentially upticking into 2012 as predicted to 6.5%. And so at some level, your trend assumption inside your reserves is going to be perfectly accurate and that's what you're seeing off of our fourth quarter 2011.

Joshua R. Raskin - Barclays Capital, Research Division

I guess, Joe, I think of it as in 2011 you had $218 million of PPRD that's related to the prior year. In 2010, you had $175 million that related to the prior year. And now it looks like we've got none related to the prior year. So I understand that the inflection in trend and that causing you to say, Hey, we got it right. So should we think about relative to prior period -- or prior year prior period reserve development, that there was just slightly less conservatism or pad built into last year's number, is that a fair way to think about it?

Joseph M. Zubretsky

No, I would say that the trend assumptions underlying the reserves were decelerating very, very quickly in the past 2 years. Very quickly. I mean 250 basis points from the beginning of the year to the end of the year in 2011 alone, that's dramatic. And if you're reserving into that, it's bound to produce material amounts of favorable prior period development. One other point I will make, and that's this whole gross versus net issue, if we were to produce the 10-Q, 10-K roll forward schedule at the end of the first quarter, we would still reflect $170 million of reserves rolling off of 2011 into '12. But because we only report to you the amount that impacts the P&L, net of the amount reestablished, that's what gives rise to no significant prior period development in the P&L in the quarter. But our reserve conservatism remains consistent. We take that same approach that we always have in the past, the difference is moderating trend versus significantly decelerating trend.

Joshua R. Raskin - Barclays Capital, Research Division

Okay. The roll forward comment is extremely helpful. And then I guess I would take from that, you don't see any potential need today at this point, where you have to start adding to reserves to get back to a specific level of modestly adverse conditions?

Joseph M. Zubretsky

I'll point to 2 statistics that support our reserve levels for the quarter. Obviously, reserves have to include our best estimates, but our reserves are up nearly 6%, in premiums we're up only 4%, and our days claims payable of 44 suggests that there's a solid balance sheet supporting our financial results for the quarter.

Operator

We'll take our next question from Charles Boorady with Crédit Suisse.

Charles Andrew Boorady - Crédit Suisse AG, Research Division

I'd like to get more granularity on medical trend and market response to Matt's question on pricing, you talked a little bit about trend and it's early to get a read on the 1Q trend. I had a data point, just major joint replacements given that 83% of the U.S. market has reported now. And what they're saying is that it looks like the year-over-year growth has ticked up quite a bit sequentially when you put that data together from all the sellers of hips and knees, it looks like the year-over-year growth ticked up quite a bit sequentially in the first quarter even when excluding the leap year effect. And I'm just curious, what percent of procedures do you get prior notification or require prior approval on, and whether you're seeing a pickup in procedure volumes, or do you think what the manufacturers are giving us is maybe false indicator, maybe there's inventories of hips and knees being built in the channel and not really a pickup in that procedure volume? Can you give us a sense for what kind of read you have on that?

Mark T. Bertolini

On the specific implants and medical devices piece, there's been a lot of discussion lately about inventory buildups and restocking because -- for the last year or so, because utilization was dropping so fast, hospitals weren't restocking some of their inventory. So I think there's a bit of an inventory impact to some of the device stuff you're seeing in the numbers. The way we look at it is that in our 2012 trend estimates, we see the outpatient arena going from mid- to high-single digits to high-single digits. And we see the physician piece going from low- to mid-single digits to mid-single units. Those are the 2 biggest changes that we see this year, year-over-year.

Charles Andrew Boorady - Crédit Suisse AG, Research Division

Got it. And Mark, in terms of the headset, you said it's a little early to get the full first quarter read. Can you give us a sense for your dashboard on medical trend, like how much of the procedure volume to actually get a prior notification or prior approval for versus what you find out about sort of x post?

Mark T. Bertolini

I've met -- most of joint replacement procedures are going to get a prior approval. So from both personal experience and other experience, I know that we get that kind of prior approval. So we have really good dashboards on that. I mean we have down to outpatient, a vertebral repair numbers in our statistics. So our statistics go very, very deep, much deeper than they did as a result of our 2009 as we have very good visibility on where the market is going. And from a utilization standpoint, we don't see anything that's alarming in the marketplace, but we have to watch trend develop through the quarter because what we're feeling for is bottom of the deceleration of the trend environment. Not saying that it's accelerating, if we projected that in our pricing, but so far we can't say it's continued to decelerate, so we think that we may be a bottom and we're feeling for that and that's part of our caution here in the first quarter.

Charles Andrew Boorady - Crédit Suisse AG, Research Division

The destocking we saw in ICDs, did you also think that was happening with hips, knees?

Mark T. Bertolini

Hospitals are doing it across the device environment, at least the hospital people I talk to. Now my data point is as good as your 1 data point, so I think you'd have to talk to the manufacturers themselves.

Operator

We'll take our next question from Ana Gupte with Sanford Bernstein.

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

So just following up again on the prior development and, Joe, you talked about the $170 million that sounds like you've just put back into your balance sheet. Is that net of medical loss ratio rebates and when you actually did your filings, did this come in line with your expectations or was there anything either favorable or unfavorable on the Small Group definition provider capitation, international, that made it deviant from what you had originally anticipated?

Joseph M. Zubretsky

No. The number I gave you on the gross development, had we prepared the roll forward schedule, is unaffected by any rebate estimates.

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

So that is net of rebate, is what you're saying then?

Joseph M. Zubretsky

No. It's unaffected by any rebate.

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

Unaffected altogether, all right. Then also just going forward into the loss ratio story, I think we had talked about potentially there being still some headroom in certain geographies and where you may be able to adapt a pricing strategy that could still allow you to optimize your margins. As you filed your statutory reports, how does that look for you going forward, are you pricing now pretty much 2 floors?

Joseph M. Zubretsky

The first thing I would say about the exhibit we filed with the NAIC is that it was a prescriptive form. We followed the prescriptive form to the letter. It may or may not accurately reflect rebate amounts that ultimately will be paid. And I would caution you there's some major definitional differences between that form and what will ultimately be used to calculate the rebate. So I caution you on using that information to infer anything about the results. We continue to have a very disciplined and rigorous approach to rebate pool management. As you know, we can hit target margins in many of our products operating above the minimum, which means there is room for favorability in our financial results. We don't disclose the amount, but since many of the pools operate above the minimum, improved performance can fall to the bottom line this year, as well as last year.

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

And just finally, if I could sneak one in. On the trend, on the 6.5%, you have headwind that you're projecting on utilization. You talked about unit cost improvement, are those built into that, and are you seeing those develop out the way you'd anticipated?

Joseph M. Zubretsky

Well, as Mark said, it's early in the year, and so we see nothing in the early data, as incomplete as it is, to suggest that our forecast of the 6.5% plus or minus 50 basis points is inaccurate. We're pricing to that level. We're forecasting at that level. And as experience emerges in the second quarter, we'll update you as to where that experience is going. But we're pricing to that level right now and nothing in the early data suggests that we're wrong.

Mark T. Bertolini

In 2012, Ana, 30% of our trend is based on utilization, 70% on unit cost. And we have, as demonstrated by our emerging success in National Accounts, been effective at getting better pricing out of our provider contracts.

Operator

We'll take our next question from David Windley with Jefferies.

David H. Windley - Jefferies & Company, Inc., Research Division

I want to turn to SG&A. Understanding the first quarter was in your guidance range, but if I look at the 2011, your admin ratio over the course of the year rises several hundred basis points, or couple of hundred basis points. And so I wanted to get some perspective on how much is seasonal, how much was acquisition influenced, and as I think about 2012, what kind of perhaps acquisition synergies and other efficiency initiatives might keep that in a tighter range as we progress through the year?

Mark T. Bertolini

Thanks, David. Mark Bertolini. I would offer just the summary comments and then Joe can give you some of the details behind them. We are very much focused on productivity, both through our operating leverage as we begin to grow in 2012 but more importantly, in getting ready for exchanges and having an affordable price point in the marketplace. So we have a number of programs going on. And I can have Joe describe for you the details in our projections for 2012.

Joseph M. Zubretsky

So Dave, let me give you some details. I'll remind you that in our original guidance, last year, we produced a 19.8% SG&A ratio and if you want to conduct -- or construct a simple bridge between that and the midpoint of our guidance range this year, we have 40 basis points of inflation; 40 basis points reduction due to revenue mix, mostly Medicare; the impact of acquisitions, as you suggested, is 30 basis point increase since most of our acquisitions were service-based businesses. All of that offset by 140 basis point decrease due to productivity. We're working very hard at a productivity line. Now in terms of what to expect for the balance of the year. Last year you saw a natural progression in our SG&A ratio from the beginning to the end of the year, an increase due to the normal seasonal pattern of our spending, which is back-end loaded due to IT spending late in the year and spending on open enrollment. This year, that natural seasonal progression will be muted by the increasing productivity gains, which build over the year, which will flatten the SG&A ratio from the beginning of the year, Q1, to the end of the year, Q4. You'll see a flat SG&A ratio.

David H. Windley - Jefferies & Company, Inc., Research Division

So okay, so I was going to get you on that last -- so flattish, can you give us a basic range of what you think beginning to ending of the year, top to bottom would be on that range?

Joseph M. Zubretsky

No. I Would just tell you that each quarter can be anywhere from 10 to 30 basis points, above or below the quarter before. But think of it as flattish for the balance of the year, again putting a point on the seasonal pattern of our spending hasn't changed, it's just that productivity gains increased from the beginning to the end of the year flattening that curve.

Operator

We'll take our next question from Peter Costa with Wells Fargo Securities.

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

Just to explore that SG&A question a little bit further. Can you give us some confidence that you're going to get to that 140 basis points of improvement in productivity gains on your SG&A, considering your SG&A is actually up as a percent of revenues this year, year-over-year, this quarter year-over-year?

Joseph M. Zubretsky

I have high confidence in the number. We generally do not forecast SG&A and productivity savings until they are scored, which means there is a detailed plan in place for, let's say, an IT enhancement that may help us reduce headcount. Clearly, the voluntary retirement program we put in place is already baked. So that's just a run rate that is waiting to emerge in the financial results. You can bank that one. And so we have a high degree of probability and confidence in the SG&A number we've given.

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

So how is it that it's not already improving a little bit this quarter?

Joseph M. Zubretsky

Year-over-year, you have the impact of acquisitions and you have some artifacts in the numbers. But I would just look at the full year result, and 140 basis points is a good number.

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

Was there something onetime or something that changed significantly this first quarter?

Joseph M. Zubretsky

Not to my knowledge, no.

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

Okay. And then can you tell us what pension expense did to your earnings this year over last will do to your earnings this year over last year?

Joseph M. Zubretsky

A minor impact year-over-year since the financing component of our pension spend is, basically, is being amortized over a very long period of time and there hasn't been much movement in the surplus or deficit in the pension plan.

Operator

The next question will come from Chris Rigg with Susquehanna.

Christian Rigg - Susquehanna Financial Group, LLLP, Research Division

Just to beat this trend message to death one last time. So you commented about in 2011 the trend decelerated over the course of the year fairly rapidly. Then we come in to 2012 and I think you're trying to say, if I understand it, that at this point it's just too early to tell, and that you're not sure one way or another whether there's been a material change versus sort of the fourth quarter run rate. Is that fair?

Mark T. Bertolini

Let me be very clear on this. We do not see trend decelerating any further. We picked the number at 5.5% for the end of the year. For the full year, we do not see it decelerating any further. And that could be for a number of reasons. That's what we see right now. That could be because the fourth quarter we've blown through the deductibles and people are spending more in the fourth quarter. But what we see in the reserve development is that there isn't any further trend deceleration. What we don't know yet is what's happening in the first quarter because we have priced at 6.5 plus or minus 50 basis points and because almost half of our reserve picks for the quarter are still estimates, we have no reason to believe it's higher or lower than that number.

Christian Rigg - Susquehanna Financial Group, LLLP, Research Division

Okay. And then just in terms of the Medicaid business normalizing for the PPD, that was sort of the outlier in terms of pressure there. Can you just give us a little more color what you're seeing at this point?

Joseph M. Zubretsky

In the Medicaid business for the quarter, the loss ratio was a little higher than we'd like to see for 2 reasons. 2 plans in particular had some isolated large claim activity. We actually believe that those large claims may be partially recovered by reinsurance, but we did not take account of that in the quarter. And the other thing you're seeing is the increased mix of our Illinois ABD program, which has a higher medical loss ratio than the core book of business. Those 2 impacts created the loss ratio uptick in the quarter.

Operator

We'll take our next question from Doug Simpson with Morgan Stanley.

Douglas Simpson - Morgan Stanley, Research Division

So maybe just to try to put all these comments together. It sounds like you feel good about 2012, where you are at this thus far into the year. But Q1 came in a little bit light at least relative to Street numbers and you didn't take up the outlook. So it seems like there's some confusion just around the quarter and the message, and I appreciate the comments on trend in G&A spending, but maybe just to pull together, could you characterize for us your level of confidence in your outlook? Should we think about the numbers that you put out there as -- are these reach, are these what you see as most reasonable, do you still think there's -- could these prove conservative? I think we're just struggling a little because you sound confident in the general trends but the first quarter did come in a little bit light where some of the peers have been beating numbers? And then maybe the seasonality was a little bit different than it should have been, we're just trying to understand those dynamics.

Mark T. Bertolini

So Doug, the first quarter came in light because so many people projected prior period development in their estimates. That's why the first quarter came in light. And what we're seeing about prior period development is that we had $170 million worth of gross rebate -- or gross reserves that we put back up based on the fact that we don't have enough visibility in the first quarter this year to understand whether or not that 6.5 plus or minus 50 basis points is good. And by the way, we're projecting growth through the remainder of the year of 300,000 lives as it rolls through the year. So we believe it is prudent at this point in time since we believe we're near bottom of trend deceleration to find out where we believe trend is headed before we start predicting things better than what we projected in our current outlook, which we are very confident of.

Douglas Simpson - Morgan Stanley, Research Division

Okay. And then maybe just a different direction, taking a little bit different direction. As we think about the Medicaid opportunity and the exchanges, obviously for the Pakistans in 2014. Can you just update us on your interest in potentially thinking about bulking up or adding selected assets through M&A over the next, call it, 12 to 18 months? How much of a priority is this? And how do you think about what are sort of the push points on whether or not you would pull the trigger on something?

Mark T. Bertolini

I think on any acquisition, and I'll let Joe comment in a moment here on Medicaid specifically, on any acquisition it has to make sense for our shareholders. There has to be a willing buyer and a willing seller at a price point that makes sense for us financially. And at this point in time, we haven't seen anything in that space from a price point that makes sense for us on the large national players. Joe, if you have any more comments.

Joseph M. Zubretsky

Sure, Doug. Certainly, Missouri and Ohio give us renewed confidence in our ability to grow organically in an open bidding process against intense competition and scoring very highly. So we do have renewed confidence in our organic strategy. And the second point I would make is we look at the components that one needs to configure in order to serve the dual eligible and high-acuity populations, pharmacy, product, a behavioral product and the ability to serve high-acuity populations, medical management being one of the hallmarks of Aetna, we actually believe we have the core capabilities to configure in a way that can meet the needs of this high-acuity population. That doesn't mean we may see the need to acquire something later. But we believe we could serve the frail elderly, the severely mentally ill and those types of populations with the assets we currently own. But it doesn't preclude us acquiring some capability later if we believe it serves the shareholders and our membership well.

Operator

Our next question will come from Christine Arnold with Cowen and Company.

Christine Arnold - Cowen and Company, LLC, Research Division

I'm still struggling with the reported trends on Commercial. If I look, year-over-year, we had a 300 basis point deterioration in the MLR on an underlying basis because you had a lot of PPD, second quarter related to first. You were saying throughout last year that you expect the trend to accelerate. Your payables grew in excess of your premiums, which suggest that you reserved assuming trend acceleration. So a couple of questions. One, prior period development, for it to be 0 is pretty rare, was it slightly positive or slightly negative? And if your premiums -- if your payables rose in excess of your premiums, why was the prior period development 0?

Joseph M. Zubretsky

A lot of questions in there. I think I'll answer the last one first. The numbers I gave you were the 3/31 reserves. We're suggesting that our reserve picks for the first quarter at 3/31. We grew, the reserves grew in excess of the premium growth sequentially. So it had nothing to do with the 12/31 estimates. It had to do with the 3/31 estimates.

Christine Arnold - Cowen and Company, LLC, Research Division

Right. If your payables grew in excess of your premiums the fourth quarter, shouldn't there have been positive development? I mean, throughout all of last year your payables grew faster than premiums. So the trend didn't re-accelerate in the fourth quarter, then you should have had positive development first quarter related to fourth, as you have in the last 2 years. So question, was prior period development slightly positive or slightly negative?

Joseph M. Zubretsky

No, we said it's not significant. It's not significant enough to report.

Christine Arnold - Cowen and Company, LLC, Research Division

But was it slightly positive or slightly negative?

Joseph M. Zubretsky

I mean, it was just insignificant to the result, breakeven.

Christine Arnold - Cowen and Company, LLC, Research Division

Okay. So exactly 0?

Joseph M. Zubretsky

Insignificant to the result. I mean, I can't comment further on that.

Christine Arnold - Cowen and Company, LLC, Research Division

Okay. Why was stock comp accruals down year-over-year?

Joseph M. Zubretsky

Why was -- can you repeat, please?

Christine Arnold - Cowen and Company, LLC, Research Division

Your stock compensation accruals was down year-over-year, could you help me understand why that would be?

Joseph M. Zubretsky

I'd have to take a look at that, and we'll have Tom Cowhey call you offline. I'm not aware that it was. But I don't know what you're looking at, but we'll take a look at it.

Christine Arnold - Cowen and Company, LLC, Research Division

Okay. And I guess I'm still confused about if your conference calls late last year assumed trend would accelerate and your reserve suggest that you reserved to an accelerating trend, I still don't get why there wasn't positive development first quarter related to fourth?

Joseph M. Zubretsky

I think what you're highlighting is at some point it has to turn. It decelerates, it bottoms and stalls, and then it grows. And we did say, I want to be very clear on this, and Mark made the point, we are calling for an increase, particularly in utilization trend, '12 over '11. So at some point it has to start turning up. And so catching the turn is really the trick here, and what we're suggesting is that the reserve pick was spot on as trend decelerated. We caught the bottom and now it's upticking and we are reserving into an increasing trend environment because that's our forecast.

Christine Arnold - Cowen and Company, LLC, Research Division

So let me just say what I think what happened. It looks like we had a seasonal uptick in medical trend fourth quarter. But we're not sure whether it's just seasonal or secular but it didn't come out great relative to what you reserved for and we're waiting to see whether it was seasonal or secular with respect to the uptick fourth quarter. Is that reasonable?

Joseph M. Zubretsky

No.

Mark T. Bertolini

No. We believe our trend was spot on for the fourth quarter. I would say a couple of things that I think you need to think a little differently about here, Christine, is that while we were projecting higher trend than we actually ended up seeing when we settled reserves each quarter, that increase in expected utilization was put into our pricing. And that should show up in our results, not necessarily in our reserves.

Christine Arnold - Cowen and Company, LLC, Research Division

You're not reserving to a higher trend, you were just pricing to a higher trend.

Mark T. Bertolini

We are pricing to a higher trend and we were reserving and selling our reserves based on the trend pick we had picked for the quarter.

Operator

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

Carl R. McDonald - Citigroup Inc, Research Division

Somewhat related to the last question. My understanding is reserves established at the end of the year were set assuming higher trends than the 5.5% or just slightly less than 5.5% that you've seen for the year. Is that not true, or where did you reserve -- the reserves that you established at the end of the year, what kind of a trend assumption were you factoring into that?

Joseph M. Zubretsky

The annual trend assumption that underlined our year end reserve calculation was 5.5%.

Carl R. McDonald - Citigroup Inc, Research Division

Okay. So you weren't assuming the trend pickup then?

Joseph M. Zubretsky

Not -- because reserves are accounting for the past, not the future.

Mark T. Bertolini

The future trend pick goes into our pricing. Now if you look at gross reserves, you could see some of that in the gross reserves because we set up in the gross reserves, up a cushion to pick up for turns in trends, but we reset that up. Took the gross reserves down, put them back up in the quarter, or the first quarter.

Operator

We'll take our next question from Kevin Fischbeck with Bank of America.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

I want to go back to your comment, Mark, earlier about the maintaining the correct balance between margins and growth. Was that meant to be an SG&A comment, a MLR comment, how should we be thinking about that because I guess in one reading it could be we're addressing SG&A for growth in 2013 and margins kind of will adjust to that, another one could be we are cutting pricing to maintain membership. I just want to see what that balance is.

Mark T. Bertolini

It's our target margin, including both the medical cost and the SG&A. And our target margins, our margins in the first quarter were 9.4%, which is high single-digits and higher than our current estimate for 2012 in total. And so as a result, we believe we are managing to an appropriate high single-digit target margin. We continue to invest to get our SG&A to a price point where, when the reserve -- when the exchanges come up, we are -- have an affordable product out on the exchange.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Okay. And then I guess last year, you gave some pretty good commentary about the rebate status of the different pools. Can you give us an update of where you are right now and where you expect to be in 2012?

Joseph M. Zubretsky

Our results include estimates of rebates in the pools that they're incurred. As we said many times, in 2012, our rebates will probably be lower than they were in '11. Since in 2011, our products were priced in into the market before the rules were actually known. But we're not parsing that out as part of our results. I would focus on the MBR because rebate accrual itself is not relevant. It's really the achievement of your MBR. You're either going to put the money in the price of your product and get it on the street immediately or you're going to pay in a rebate. So I would focus people on the quality of our MBR, which is at 79.9% was an excellent result for the quarter.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

So when you say that the MLR -- I'm sorry, the rebate, would be down in 2012 versus 2011 just because you now know the rules a little bit better, is it safe to say that your pricing strategies around rebates has been maintained from those 2 years, or is there any change in the pricing strategy that would adjust that?

Joseph M. Zubretsky

No change in the strategy, but we were in a position late in 2010 to tell our field organization to price the products and get them into the market as if the rebates didn't exist because we didn't know how they'd work. That gave rise to a handful of pools that actually had a significant rebate status. Those pools this year would be actually pricing closer to the mean, not at the mean, but we'd be pricing a lot closer to effectively get that money into the price of the product in the hands of our customers immediately who have been waiting for a rebate. So the strategy hasn't changed but the timing and the reaction to the pools, clearly we have better insights now having a year's worth of experience.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

And then United indicated they had some benefits, some regulatory clarification, did you see any of that?

Joseph M. Zubretsky

I think you're referring to an announcement of perhaps an accounting adjustment. Obviously, every quarter, we true up our estimates, experience moves around, so the pools move up and down. And we would've taken account of that in our quarterly results. But not significant enough to report.

Operator

We'll take our last question from Scott Fidel with Deutsche Bank.

Scott J. Fidel - Deutsche Bank AG, Research Division

The first question just on the first quarter estimate of trend in the context of that full year guidance of 6% to 7% and in terms of what you established as your reserve pick for the end of the quarter. Where specifically would you say your view of trend in the first quarter was, was it right in the middle of that full year range or more towards the 6% moving up from the 5.5% in the fourth quarter?

Mark T. Bertolini

So a way to think about this, Scott, is that in the first month of the year, we're about 85% developed. And the second month, we're about 70%, 65%, 70%. In the third month it's about 20% developed across our book of business. The rest are estimates. And so each month has a little different estimate based on the completion of that month in the actual results we're seeing through -- through our claims payments or reserves. So there isn't a number. We still believe that at this time, the 6.5%, plus or minus 50 basis points, is a reasonable estimate of full year trend.

Scott J. Fidel - Deutsche Bank AG, Research Division

Okay. So if we blend that, that would be just somewhere in the middle of that range, just sort of blending out those 3 months or bias towards the lower or higher end of that 6% to 7% range?

Mark T. Bertolini

It's too early to tell.

Joseph M. Zubretsky

Scott, we don't report our -- we report our annual estimate of trend. We don't report how it emerges quarterly. So you have to stay tuned for more information on that as the year progresses.

Thomas F. Cowhey

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

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