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Aetna, Inc. (NYSE:AET)

Q4 FY07 Earnings Call

February 7, 2008, 8:30 AM ET

Executives

Jeff Chaffkin, CFA - VP and Head of IR

Ronald A. Williams - Chairman and CEO

Joseph M. Zubretsky - EVP and CFO

Mark T. Bertolini - President

Analysts

Carl McDonald - Oppenheimer

Matthew Borsch - Goldman Sachs

John Rex - Bear Stearns

Charles Boorady - Citigroup

Doug Simpson - Merrill Lynch

Scott Fidel - Deutsche Bank

Peter Costa - FTN Midwest Securities

Justin Lake - UBS

Joshua Raskin - Lehman Brothers

William Georges - JP Morgan

Gregory Nersessian - Credit Suisse

Operator

Good day and welcome to Aetna's Fourth Quarter 2007 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Jeff Chaffkin. Please go ahead sir.

Jeff Chaffkin, CFA - Vice President and Head of Investor Relations

Good morning and thank you for joining Aetna's fourth quarter 2007 earnings call and webcast. This is Jeff Chaffkin, Head of Investor Relations for Aetna, and with me this morning are Aetna's Chairman and CEO, Ron Williams; and Joe Zubretsky, Executive Vice President and Chief Financial Officer. Following their prepared remarks, we'll be pleased to respond your questions. Joining us for the Q&A portion of this call is Mark Bertolini, President and Head of Business Operations.

During the 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 expected results are described in Aetna's 2006 10-K filed with the SEC and in 2007 10-K to be filed with the SEC. Pursuant to SEC Regulation G, we have provided reconciliations of metrics relating to the company's performance that are non-GAAP measures in our fourth quarter 2007 press release, fourth quarter 2007 financial supplement and our guidance summary. These reconciliations are available on the Investor Information portion of the aetna.com website.

Also, as you know, Regulation FD limits Aetna's ability to respond to certain inquiries from investors and analysts in non-public forums. So Aetna invites you to ask all questions of a material nature on this call.

Now, let me turn the call over to Ron Williams. Ron?

Ronald A. Williams - Chairman and Chief Executive Officer

Good morning. Thank you Jeff, and thank all of you for joining us this morning. We have completed another successful year at Aetna. I am very pleased with both the company's strong financial performance in 2007 and the initiatives we launched to position us for continued future profitable growth.

On today's call, I would like to share some of our highlights from 2007 plus provide a high level outlook for 2008. Joe will then provide additional information on our fourth quarter and full year 2007 financial performance, and a more detailed view of our outlook for 2008.

In 2007, our accomplishments were the direct result of our differentiated strategy and solid execution by our talented and dedicated work force. Earlier this morning, we reported operating earnings per share of $0.88 for the fourth quarter of 2007, an increase of 13% over the fourth quarter of 2006. For the full year 2007, we reported operating earnings per share of $3.49, an increase of 20% over 2006.

Our success last year was driven by a number of factors. We delivered strong revenue growth driven by solid membership gains. Our intense focus on managing, both health care quality and cost helped to produce solid underwriting results, as did our disciplined pricing reactions and continued favorable medical cost experience.

We continued to make progress on operating expense efficiencies, and our disciplined capital deployment initiatives continued to yield positive results. The strategic initiatives we undertook during 2007 have laid a solid foundation for continued strong performance for Aetna in 2008. The four dimensions of our strategy, segmentation, integration, consumerism and operational excellence continue to be the key elements of our success.

First, with regard to segmentation, both at the customer and market level, we remain focused on increasing and strengthening the discrete customers markets we serve, and expanding the geographies in which we operate to continue to diversify our opportunities for profitable growth. We achieved organic net medical membership growth of 168,000 members for the fourth quarter and 730,000 members for the full year.

Including our acquisitions of Schaller Anderson and Goodhealth Worldwide, we grew total medical membership to 16.9 million members during 2007. Also, in 2007 we took important steps to continue to expand and diversify our business. We expanded our marketing activities for small group, individual and Medicare advantage product offerings into additional states.

The business relationships we formed with AARP and the HR Policy Association will provide us with future growth opportunities in the pre-65 and post-65 retirement populations. Our acquisition for Schaller Anderson provides us with robust capabilities to serve the Medicaid market, and Goodhealth Worldwide expands our expatriate products into international markets, demonstrating our ability to grow inorganically as well as organically. And we continue with our effort to bid on the TriCare government sponsored program for military personnel and their dependents.

In addition, two weeks ago, we announced Aetna's alliance with Magic Johnson Enterprises. This relationship will combine Aetna strengths as an experienced and innovative health care company with Magic Johnson Enterprises knowledge of diverse communities in key urban areas.

Our shared goals among others are to help reduce the number of uninsured, particularly among entrepreneurial urban businesses and their employees, and promote racial and ethnic equality in health care. This is consistent with our strategy of identifying opportunities in new market segments.

Integration, the second dimension of our strategy plays an important role in our membership growth expectations in 2008 and beyond. The integration of our products and services helps increase health care quality for our members and control cost for our customers. It is a value proposition that is resulting in new revenue growth opportunities.

In the fourth quarter of 2007, we continued to generate membership gains across our pharmacy, dental and behavioral health products. Pharmacy membership increased by 63,000 in the fourth quarter. Commercial and dental added 42,000 net new members and behavioral health increased by 192,000 members.

Large national account customers in particular are increasingly seeking an integrated benefit solution. By integrating medical, dental, pharmacy, behavioral health and other services, we can create a complete view of the member, which we believe helps improve quality and control cost. This holistic approach is resonating well in the marketplace, which validates our value proposition, and gives us conviction to continue investing in this integrated approach, as it will be an increasing point of differentiation for us in the future.

Consumerism is the third key dimension of our strategy. We continue to advance Aetna's leadership in this area. We expanded our membership in consumer-directed health plans, bringing our total to 994,000 members at the end of 2007, an increase of 47% from 2006. We also expanded Aexcel, Aetna's performance-based network to a total of 35 markets, effective January 1, 2008. These markets contain 73% of Aetna's total medical membership and we currently have 632,000 members enrolled in this program.

In addition to our own initiatives, I and several other members of our senior management team have been actively involved in policy discussions with key business groups, Congress, governors and state officials to develop solutions for the uninsured, as well as drive the movement toward more transparent and useful information for consumers.

Operational excellence is the fourth dimension of our strategy and is embedded in everything we do. There are three financial metrics that best demonstrate our operational rigor and accomplishments, our medical benefit ratio, our operating expense ratio and our pre-tax operating margin.

Our commercial medical benefit ratio of 79.2% for the fourth quarter and 79.5% for the full year reflected solid underwriting discipline and our focused efforts in the area of medical management. Furthermore, our operating expense efficiency continued to improve as we achieved a 40 basis point decline in our operating expense ratio for the fourth quarter to 19% and a 60-basis point reduction for the full year 2007 to 18.2%.

We have demonstrated consistent progress in reducing our cost as a percentage of revenue, even as we continue to make investments to profitability grow our business and enhance our technology infrastructure. The combination of solid underwriting results and operating efficiency led to a pre-tax operating margin of 10.8% for the fourth quarter and 11.1% for the full year in excellent result.

We expect 2008 to be another year of solid membership increases and strong earnings per share growth, based on disciplined pricing and medical management, operating efficiency and effective capital deployment. We believe our operating model gives us the flexibility to adapt to potential changes resulting from the political environment as well as from a slowing economy.

Our expectation for 2008 net medical membership growth is based on a very strong January 2008 selling season. We now expect between 550,000 and 600,000 net new members in the first quarter 2008 as compared to our preliminary guidance of at least 300,000 members. While the majority of this growth is driven by success in our national accounts ASC business we are expecting growth across other customer markets. This positive start to the year gives us greater confidence in our view of full-year net medical membership growth which we are raising to a range of 800,000 to 850,000 members, an increase from our preliminary guidance of growth in excess of 650,000.

This improved outlook is a result of favorable retention, strong enrollment gains and solid new sales across our customer markets, further evidence of the value of our diversification and segmentation strategy. Our guidance for 2008 operating earnings per share is $4, consistent with our preliminary guidance, we are committed to making the appropriate investments in people, processes and technology to deliver a differentiated brand experience to our constituents and to sustain our growth rate over the long-term.

In summary, I am very pleased with our 2007 performance and encouraged by our early view of 2008. Our strong growth and constituent feedback confirms that Aetna is delivering on our commitments, creating preference in the market and is well positioned for continued profitable growth in 2008. I'd like to remind everyone that we will be hosting our Investor Conference in New York on March 14th. We look forward to seeing you there and sharing more details of our strategy for profitable growth in 2008 and beyond.

Now I will turn the call over to Joe Zubretsky, who will discuss our financial performance for the fourth quarter and full year of 2007, and provide additional detail regarding our outlook for 2008. Joe?

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

Thank you, Ron, and good morning. Earlier this morning we reported after-tax operating earnings of $454.5 million for the fourth quarter of 2007 or $0.88 per diluted common share. This represents year-over-year increases of 7% and 13% respectively. Our fourth quarter 2007 after-tax operating earnings included $439.6 million in earnings from health care, an increase of 7% over last year's fourth quarter, $37 million from group insurance which is 24% higher than the prior year's quarter, $11.4 million from large case pensions, an increase of 28% year-over-year and $33.5 million in corporate interest expense compared to $26.8 million in the fourth quarter of 2006.

For the full year 2007, total operating earnings were $1.8 billion, an increase of 11% over 2006 and operating earnings per share of $3.49 represented a 20% increase over the full year 2006. Aetna's fourth quarter results include the impact of our Schaller Anderson and Goodhealth Worldwide acquisitions which closed in the third and fourth quarters respectively. For the fourth quarter and full year 2007, these acquisitions did not have a material impact on our operating earnings or net income. As I analyze our financial results I will note where the inclusion of these acquisitions impacted operating metrics.

Our net income for the fourth quarter $448.4 million included $6.1 million of after-tax realized capital losses. For the full year, net income was $1.8 billion which reflected $41.8 million release of reserves related to discontinued products in our Large Case Pensions business as well as $47.9 million of after-tax realized capital losses primarily due to changes in interest rates.

For the fourth quarter 2007 our diluted weighted average share count was $516.3 million, a 5% decrease from the fourth quarter of 2006 due to continued share repurchase activity.

Turning now to the key drivers of our financial performance, let me first address our operating margin for the fourth quarter and full year of 2007 and its key components, revenue, health care cost trend and operating expenses.

In the fourth quarter, our pre-tax operating margin on total revenue was 10.8% which represents $693.9 million of pre-tax earnings. For the full year our pre-tax operating margin on total revenue was 11.1% which represents $2.8 billion of pre-tax earnings. These results demonstrate management discipline across all aspects of our business including pricing rigor, health care, quality and cost management, and operating expense control.

We continue to execute our strategy for profitable growth as evidenced by the strong top-line growth we achieved in 2007. As a result of solid membership increases, disciplined pricing actions and contributions from acquired businesses, total revenues increased 13% in the fourth quarter from $6.3 billion in 2006 to $7.2 billion in 2007. Health care segment revenues increased 15% year-over-year or 12% excluding the impact of acquisitions. For the full year total revenues increased 10% from $25.1 billion in 2006 to $27.7 billion in 2007. Health care segment revenues increased 12% year-over-year or 10% on an adjusted basis. Premiums in our health care segment increased 15% year-over-year in the fourth quarter or 13% excluding the impact of acquisitions. And for the full year 2007, premiums in our health care segment increased 12% year-over-year or 11% excluding those acquisitions.

Our fourth quarter commercial premiums increased 10% over 2006. This resulted from the 5% volume growth and 6% rate increase, partially offset by 1% decline from the effects of product mix. The full year growth for total commercial premiums was 7%.

The benefits of previous investments in expanding our Medicare footprint are fueling year-over-year premium growth in that business. Medicare premiums increased 40% compared to the fourth quarter last year and 45% for the full year 2007. Medicare Advantage membership is 57% higher than the year-ago quarter based on membership gains achieved in the first quarter of 2007, resulting from success in group Medicare private fee-for-service.

Fourth quarter 2007 consolidated fees and other revenue of $799.1 million increased 11% over the prior year quarter, 4% excluding the impact of acquisitions. This was driven primarily by equal contributions of rate and volume increases. For the full year 2007, consolidated fees and other revenue of $3 billion increased 7% compared to 2006, 4% excluding those acquisitions.

Turning to our health care cost experienced in the fourth quarter and full year of 2007. Our commercial medical benefit ratio was 79.2% in the quarter, 90 basis points higher than the fourth quarter of 2006 ratio of 78.3%. Most of the difference is attributable to $42 million of favorable reserve development in the fourth quarter of 2006. We ended 2007 with a commercial medical benefit ratio of 79.5%, which is 20 basis points higher than the full year of 2006 but in line with our expectations of performance and product mix.

Our Medicare medical benefit ratio was 86.5% in the quarter compared to 83.8% in the year-ago quarter. For the full year 2007, our Medicare medical benefit ratio was 86.8%, 160 basis points higher than the prior year as we expected. The difference in both the quarter and full year is primarily due to higher mix of Medicare advantage, particularly group private fee for service and an increase in the standalone PDP medical benefit ratio.

Our total medical benefit ratio which includes commercial, Medicare and Medicaid products was 80.3% in the fourth quarter of 2007 compared to 78.8% in the prior year quarter, and 80.4% for the full year 2007 compared to 79.9% in 2006. These favorable results reflect our continued commitment to managing medical cost utilization through our dedicated medical management processes as well as our continued ability to maintain pricing in line with medical cost trend.

Our reserving practices remained consistent and appropriate and we ended the year with $2.2 billion of health care cost reserves. The year-over-year growth in reserves is consistent with the growth in our health care premiums.

Days claims payable were down 2.1 day sequentially to 44.2 days. The decline was primarily due to a speed-up in claim turnaround times and the inclusion of the Schaller Anderson acquisition for a full quarter.

Our medical cost trend in 2007 was stable and consistent with our guidance of 7.5% plus or minus 50 basis points. In major health care cost categories we are in line with our expectations.

The third key component of operating margin results is operating expense efficiency. We continued to realize efficiencies during the fourth quarter and achieved an operating expense ratio of 19%, representing a 40 basis point improvement compared to the fourth quarter of 2006. Our expenses were sequentially higher due to the operational ramp up for our strong January membership gains. For the full year 2007, our operating expense ratio of 18.2% represented a 60 basis point improvement over the prior year. This improvement came despite a 20 basis point increase from our recent acquisitions and their service revenue base profiles.

We continued to leverage our infrastructure in 2007 by growing revenue in core markets and products, driving down unit cost with technology and business process improvements all while investing for future profitable growth by building new product platforms, expanding markets and implementing new system capabilities.

This brings me to the second driver of our financial performance, investing for profitable growth. During the quarter, we grew our medical membership organically by 168,000 members, including 152,000 new commercial members and 14,000 new Medicaid members. With the inclusion of Goodhealth Worldwide's approximate 58,000 members, our medical membership was 16.9 million at December 31st.

Our segmentation, expansion and diversification strategies continue to gain traction and contribute to our profitable growth. For example, we achieved strong growth in both insured and self-insured membership during the fourth quarter. Of the 168,000 members we added organically, 80,000 were insured members and 88,000 were self insured or ASC members.

We continue to see consistent growth in our middle market customer segment, with an increase of approximately 50,000 members in the fourth quarter. Diversified growth also came from government accounts in a large ASC association case.

A point of emphasis; while we continue to grow membership in the unreserved segments of the population we also continue to realize meaningful growth from our core markets in a rational but very competitive environment. In 2007 we added over 250,000 members in our middle market customer segment.

The third and final area of financial performance I will comment on is our management of capital and its accretive deployment. This includes our cash flow dynamics, our holding company liquidity, how we deploy that liquidity in the quarter and our capital structure. Our fourth quarter 2007 operating cash flow measured on a GAAP basis for health care and group insurance was $684.1 million representing 156% of GAAP net income for the quarter. Full year operating cash flows were $2.4 billion or 135% of net income.

In the fourth quarter we generated approximately $58 million of holding company cash flow in line with our expectations. We issued $700 million of 30-year notes at 6.75% coupon which combined with cash generated from operations and our September 30th liquidity position provided us with $960 million that was available to fund $348 million of share repurchases, the repayment of $430 million of commercial paper and the acquisition of Goodhealth Worldwide all while maintaining $100 million of holding company liquidity.

For the full year 2007, we repurchased 33.2 million of our shares for $1.7 billion. Our basic share count was 496 million shares at December 31st, down from 500 million at September 30th. Our capital position continues to be strong with a debt to total capitalization ratio of approximately 25%. While we are comfortable with the target ratio at this level we will consider taking additional capital actions over the next 12 months to increase our leverage to 30%. This could include the issuance of hybrid security subject to market conditions. These actions would serve to reduce our weighted average cost of capital, enhance returns on common equity and diversify our funding sources.

Our capital deployment priorities continue to be to finance organic growth, finance strategic acquisitions and repurchase our own shares in that order of priority. Disciplined evaluation of inorganic growth opportunities remains an important element of our strategy for achieving long-term profitable growth and we continue to maintain an active M&A pipeline. In this environment we believe it's important to say a few words about our investment risk and return profile. I am very pleased with the overall performance of our investments and believe that our disciplined investment strategy and diversification position us well despite the current volatility in the credit markets. Over 95% of our fixed income portfolio is investment grade, including treasuries, agency backed securities and municipal debt.

Our sub-prime exposures is less than 1% of the total, all of which is fixed rate and not subject to rate reset. Less than 21% is direct exposure to bond guarantors and the securities we do own that are credit enhanced are high grade and performing. We have no exposure to collateralized debt obligations or collateralized loan obligations. Our structured securities are limited to residential and commercial mortgage-backed securities, the residential portfolio is all AAA rated and government agency-backed while 83% of the commercial portfolio is AAA rated.

We continue to monitor market events and believe that our investment strategy is on very solid ground. Before we move to the Q&A session I would like to recap 2007 and provide some additional guidance for 2008. We had many notable financial successes at Aetna in 2007, we had organic net medical membership growth of 5%. Our consolidated revenue grew by 10%. We maintained a stable commercial medical benefit ratio and we realized significant operating efficiencies.

In addition, we achieved our target leverage of 25% debt to total capitalization, we effectively deployed our capital making two key acquisitions as well as purchasing approximately $1.7 billion or over 6% of our outstanding shares during the year. All of these successes contributed to our operating earnings per share growth of 20% over 2006. Given another strong year of financial and operational performance, we continue to have confidence in our ability to sustain this momentum in 2008. We will continue to monitor the slowing economy and the resulting lower interest rate environment and continue to reflect the impact of these external factors into our planning assumptions for net membership growth, realized premium yields, utilization trends and net investment income.

Based on this, for the full year 2008, we project medical membership growth to now be in the range of 800,000 to 850,000 members which exceeds our prior expectation of an excess of 650,000 net new members. Within this guidance we now expect our Medicare advantage membership growth to be approximately 140,000, the majority of this Medicare growth will be from the conversion of 100,000 members from ASC to a fully insured group private fee-for-service product.

We are projecting a higher percentage of our commercial growth to be from ASC arrangements than we previously projected. We also project double-digit health care revenue growth, a medical cost trend of 7.5% plus or minus 50 basis points, a premium yield that is in line with medical cost trend, a commercial medical benefit ratio of less than 80% with a total medical benefit ratio below 81.5%, and operating expense ratio showing an approximate 50 basis point improvement year-over-year, a pre-tax operating margin that is lower than 2007 primarily due to the above average growth in Medicare, particularly group private fee-for-service, and operating earnings per share of $4 or growth of approximately 15% which is based on an approximate 505 million diluted weighted average share count.

For the first quarter of 2008, we are now projecting net medical membership growth to be between 550,000 to 600,000, an increase from preliminary guidance of at least 300,000 net new members. We expect the commercial medical benefit ratio to be less than 80% and operating earnings per share to be $0.92.

In summary, we are very pleased with our 2007 results along all three dimensions of our financial performance; managing to our target margins, investing in profitable growth and accretive capital deployment. We are well positioned for continued profitable growth in 2008, and we are confidant that we can continue to deliver solid financial results and value to our shareholders.

With that, I will turn the call back over to Jeff. Jeff?

Jeff Chaffkin, CFA - Vice President and Head of Investor Relations

Thank you Joe. The Aetna management team is now ready for your questions. We ask that you limit yourself to one question and one follow up so that as many individuals as possible have an opportunity to ask their questions. Operator, the first question please?

Question And Answer

Operator

Yes. Thank you. We'll go first to Carl McDonald, Oppenheimer.

Carl McDonald - Oppenheimer

Great, Jeff [ph]. Thank you. Just had a question on the commercial risk business. In 07 looks like you added about 330,000 lives, can you give us any insight into how that breaks down by segment? I know you mentioned the middle market was strong, but it wasn't clear if that was ASO or on the risk business, and also some insight into individual and the student business?

Ronald A. Williams - Chairman and Chief Executive Officer

In the... good morning, Carl. In the context of 07, the way I'd try to characterize it is that the middle market was one of our strongest performers relatively speaking, followed by the national account segment, would be kind of the 1, 2, 3 and then the consumer would be next. And consumer and our general, what we call our other lines, the student health, other things like that would have followed that. So overall, we view it as a fairly well diversified performance, very consistent with our strategy and achieved consistent with our expectations in terms of the distribution.

Carl McDonald - Oppenheimer

Okay. And your comments relate to the consolidated enrollment or the risk enrollment?

Ronald A. Williams - Chairman and Chief Executive Officer

I was referring to the consolidated enrollment. And obviously other way to think about it is that most of the national account enrollment would have been self-insured business, ASC business, and in the middle market it would be split mostly toward the risk.

Carl McDonald - Oppenheimer

Okay. And any insight in terms of how the individual and student businesses are performing from an enrollment perspective?

Mark T. Bertolini - President

Carl, this is Mark Bertolini. In 2007 we had strong years, both in individual and in student. We expect that to continue forward in 2008.

Carl McDonald - Oppenheimer

Okay.And just a question would be on TriCare, any insight into the timing of the RFP there, and then related any update in terms of the regions that you expect to bid in?

Ronald A. Williams - Chairman and Chief Executive Officer

Well, we have been watching the website for the RFP. We've been expecting it for quite sometime. We are hopefully that it will be posted shortly, but we really don't have any significant insight. I think in terms of the regions, the first step for us will really be to thoroughly review the final RFP and then make decisions about how we would peruse it, and make decisions about whether we believe it continues to be a good use of capital. But we're optimistic. We think we have some great solutions for the government, and we think that military personnel could benefit substantially from this... our capabilities.

Carl McDonald - Oppenheimer

All right. Thanks.

Operator

We go next to Matthew Borsch, Goldman Sachs.

Matthew Borsch - Goldman Sachs

Yes. Just trying to understand your guidance. So it looks like you're bringing in substantially higher growth on enrollment for 2008 now. So, just to ask I guess the obvious question, what was the offset factor, in other words, why did you not raise guidance on the higher outlook at this point?

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

Now... this is Joe Zubretsky. The answer to that question is as you have seen, while we took up our first quarter guidance significantly, we pretty much tempered our membership guidance for the balance of the year, and in a slowing economy, we think that's the prudent thing to do. Second, a higher percentage of our membership growth during the year will be from service membership, rather than risk membership as we originally projected. And thirdly, in this low interest rate environment, our short-term investment portfolio will yield lower results. So, we felt in those mild headwinds it was prudent to stick with our $4 per share guidance which is still 15% growth year-over-year.

Matthew Borsch - Goldman Sachs

Okay. And if I could... if I could ask, maybe if you could give us a little bit more granularity on where you stand with your PBM, and you referred to the opportunity for greater penetration there. Is there... any statistics you can share with us in terms of where penetration is... has been and where it is now, and where you think it will be going forward?

Ronald A. Williams - Chairman and Chief Executive Officer

Yes. I'll ask Mark to respond to that.

Mark T. Bertolini - President

Sure Matt. We continue to have solid growth in the PBM, our largest opportunity as you might guess is in the large employer segment; in the self funded segment. And so we continue to make a headway there particularly with our integration value proposition. In the smaller segments, it's generally bundled. We also saw a strong growth in our PDP program for the first of the year. So, we are firing on all eight cylinders with the pharmacy program right now.

Matthew Borsch - Goldman Sachs

Okay, thank you.

Operator

We will go next to John Rex, Bear Stearns.

John Rex - Bear Stearns

Thanks. I am wondering if... I appreciate your comments on the investment portfolio but was wondering if you could update us also in terms of just some color commentary what you saw in January given the market volatility that occurred, so maybe from any kind of mark-to-market actions?

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

Well John, I think, the comments we gave with respect to our investment portfolio are pretty current. There have been no... certainly it's been a choppy market here in January but our comments hold for both the December balance sheet date and through today. We have a very well diversified strategy, we balance risk and return very carefully. We are durationally matched, we do not take interest rate bets and we invest in credit judiciously. So the investment portfolios behave very well through an extremely choppy market and we are really happy with the results.

John Rex - Bear Stearns

So, no material... I mean no material losses obviously is what you're saying even in January?

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

Yes, the rigor that you have to go through at a balance sheet reporting date in terms of looking at assets that are under water and would continue to be for a long period of time and all losses are reflected in our balance sheet at yearend.

John Rex - Bear Stearns

Okay. And then I was wondering if you could give some view as you guys look at the potential slowing economy, rising in employment, how do you guys think about the impact on utilization in your commercial benefits business. Also what do you think about... also any impact in your disability businesses and kind of how do you forecast that and bring that into your outlook?

Ronald A. Williams - Chairman and Chief Executive Officer

Yes, I will give you some color on how we think about on the commercial businesses and then ask Joe to speak to disability. When you think about the commercial business, there are multiple competing forces. The first issue is that as companies begin to think about their workforce, there's a reaction time from figuring out what they might want to do to actually taking that action and often that action simply means that they simply don't hire at the pace that they have historically hired. In some instances there may be reductions but sometime those people get deployed into individual and small group types of businesses where we have additional opportunity.

So there is the overall question of are they employed or not. From the utilization perspective there are different schools of thought; one group says, gee, my knee hurts, I should go out have it scoped and get it done, have the procedure. The other says, if the company is thinking about resource allocation decisions I want to be at my desk adding value each and every day. And so I think we are watching it carefully, we don't see any evidence of changes in utilization and our sense is that to the extent these manifest themselves, there are significant lags of time.

John Rex - Bear Stearns

And Ron, just thinking about your experience in the business, have you ever seen a correlation to utilization really and changes in employment, have you been able to perceive that over time?

Ronald A. Williams - Chairman and Chief Executive Officer

I would say that the actuarial data suggest that there is a more positive correlation with positive economic times and there's a two to three year lag. And I am going ask Joe to go to the... your next --

John Rex - Bear Stearns

Thank you, very much.

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

With respect to your question... same question related to disability, if you look at our benefit ratios year-over-year and quarter-over-quarter it had significant improvement in our group lines due to better pricing and underwriting selection. We are really happy with that progress and it is absolutely irrefutable that disability incidence is correlated... highly correlated with consumer confidence. We follow the Michigan study very closely and our view of the consumer confidence index for the balance of the year is fully reflected in our benefit ratio outlook for the group business for 2008.

John Rex - Bear Stearns

Thank you.

Operator

We will go next to Charles Boorady, Citi.

Charles Boorady - Citigroup

Thanks, good morning. The integrated offering approach seems to make a lot of sense intuitively and it's also gaining traction with your national employers which is great. I just had two question on it, number one, pharmacy continues to be carved out and I guess I don't want to see you firing on all eight the way Mark described on the pharmacy side as it continues to get carved out. I am just wondering, is there a point at which if your customers continue to prefer using the much larger Medco, Express, Caremarks of the world. Do you think some sort of strategic partnership or a tighter integration with those independent PBMs would wind up providing your customers with a better integrated offering since you are not choosing your PBM anyway?

Ronald A. Williams - Chairman and Chief Executive Officer

Charles, I would probably take the liberty of reframing your assumptions and questions here. I think we view our value proposition in the context of integration and very strongly we continue to have success with large customers obviously not with every customer, and would ask Mark to really more fully respond to your question.

Mark T. Bertolini - President

Charles our PBM continues to growth at a rate faster than our medical membership. And so that supports our value proposition that we are continuing to penetrate the book of business. Indeed not every client will want to have our pharmacy benefit, we continue to propose it to them, and we expect that overtime we will continue to penetrate that book of business. But we still need the ability to partner with and work with some of the larger PBMs to still provide as much of that integration value proposition as we can. So we do have relationships with PBMs that are system related, system locked that allow us to exchange data and provide full value to our clients.

Charles Boorady - Citigroup

On a recent very large win, integrated offering was mentioned by the customers, the main reason they chose you over the Blues, even though the Blues have more extensive networks which I think is testament to how effective your integrated offering is. One of the other things I mention though, which you didn't mention on the call was performance guarantees. And I'm wondering, can you characterize first what the performance guarantees look like and to what extent Aetna's at risk financially?

Mark T. Bertolini - President

In general, our performance guarantees year-over-year are fairly stable. We have not seen any significant financial impact as a result of those performance guarantees. Anything that we have done is reflected in our financial statements. So we see a continued pressure, largely around service guarantees and sometimes claims guarantees. But, given our service record and the fact that we are leading the industry in service, we have not been paying a whole lot out on those guarantees at this time.

Charles Boorady - Citigroup

Are they on the medical expense line or somewhere else on the income statement? You have performance guarantees related to medical trend specifically.

Mark T. Bertolini - President

They are net against our fees.

Charles Boorady - Citigroup

Okay. So, we wouldn't see it in the net loss ratio. We would see it net against your ASO fees?

Mark T. Bertolini - President

Yes.

Charles Boorady - Citigroup

Great. Thank you.

Operator

We'll go next to Doug Simpson, Merrill Lynch.

Doug Simpson - Merrill Lynch

Hi. Good morning. You guys are obviously enjoying a strong enrollment season relative to the other players. And Joe I was wondering if you could just kind of look at over the next couple of years, some of your competitors are talking about 15% EPS growth is sustainable, others have pulled back to close to the 13%. And recognizing you have room to lever the balance sheet, if we sort of held that stable, what do you think is a sustainable bottom-line growth rate over the next couple of years in this environment?

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

We have... right now given the strong enrollment gains we've had early here in 2008, we have no reason to move off our basic total shareholder return model, which is long-term, 15% earnings per share growth. And the two components are really important, and that is double-digit revenue growth, which means double-digit operating earnings growth, and the balance of the earnings per share growth provided by capital management. So we continue to maintain that two-thirds of our earnings per share growth will come from operating earnings.

Doug Simpson - Merrill Lynch

Okay. And then just recognizing things ebb and flow, is there any... could you just give us a little more color on the competitive backdrop of what you are seeing specifically from the larger publicly traded players versus the smaller players in the market, any different competitive positions in the market right now?

Ronald A. Williams - Chairman and Chief Executive Officer

Yes. I'll give a few comments, and I'll ask Mark to comment as well. I think that the competitive environment, I would characterize as a consistent competitive, we do see again different geographies, it shows up in different customer market segments, and I'll ask Mark to give you some color on both, a little bit of geography as well as the segment activity here.

Mark T. Bertolini - President

I would frame in two ways, Doug. First from a pricing standpoint, I think the market's stable, while it's competitive, everybody is maintaining their pricing discipline, and we generally do not see on a national player basis any significant aggressive activity around pricing. And everybody is healthy in the national account segment. So from the national player standpoint, everybody finds that market competitive. What's happening as a result is that a lot of our competitors are moving down market and opening up other segments in the marketplace, like we have over the last three years.

The second dynamic as it relates to local players, and I think it's important to understand is the technology arms race around integration, around systems platforms, around patients safety and quality, and high performance networks, things that we have invested in over the last three or four years that our competitors to some degree have, but that's smaller players are finding more and more difficult to invest in, particularly in the relationship with their providers. So, we see that as competitive advantage going forward.

Ronald A. Williams - Chairman and Chief Executive Officer

Yes, I would just want to build on that. I think that what we really are seeing is the culmination of our integration strategy and a value proposition that is demonstrating to many of our customers the financial value of it in terms of the medical cost ratio and, increasingly, productivity as we look at integrated health and disability, as more and more customers are interested in that. And so, back to our fundamental strategy is not competing on price, but really competing on the value that we bring to our customers, which is based on very significant and long-term investments that we've made over a number of years. And so in a lot of ways, we are trying to redefine the basis of competition, and that disadvantages certain companies that haven't been able to make those investments, either financially or executionally.

Doug Simpson - Merrill Lynch

Okay. Thank you.

Operator

We'll go next to Scott Fidel, Deutsche Bank.

Scott Fidel - Deutsche Bank

Thanks. Good morning. First question is if you can maybe just walk through on the 2008 enrollment guidance. How you expect that to break out for the year between ASO and risk and maybe for the first quarter as well?

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

Sure Scott. Sort of embedded in our first quarter guidance of 550,000 to 600,000, the first thing to recognize is that there is a transition, a shift of 100,000 members from ASC to risk. Without that shift I think between 15% and 20% of the membership will be risk, and between 80% and 85% of it will be ASC. That would be for the first quarter.

For the full year I think what we are looking at right now with the early read, I think, you can look at it as though the mix will be consistent with our average mix which is one-third risk and two-thirds ASC and then we will update you as we know more as the year moves forward.

Scott Fidel - Deutsche Bank

Okay. And then second question, if you could walk through the expected sources and uses of cash for 2008 and how much share buyback is built into the guidance right now?

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

Right now we plan to buyback approximately well... we have resources available to buyback $1.5 billion of shares and we built that into the EPS guidance. But keep in mind we have a very active M&A pipeline and could deploy that capital in a different way. But if we were to repurchase shares depending on your view of the average share price during the year and how many options get exercised it could be around $1.5 billion and I think our share count... diluted weighted average share count guidance for the year of $505 million is a good number.

Scott Fidel - Deutsche Bank

Okay and if I could just slip in just on the specialty businesses as you did touch on pharmacy and just think about some of the other specialty lines like behavioral and dental, how should we think about growth rates in that business or I guess net adds? Is there any type of sort of penetration rate relative to the 800,000 to 850,000 that we should be thinking about?

Mark T. Bertolini - President

I am, Scott, Mark Bertolini. We have seen very strong growth in our behavioral health business particularly our EAP business and so we continue to see that outpace our enrollment growth. And the dental side in the large employer market, there is a lot of competition around dental, we have seen some reasonably good growth, middle market is all tougher, on the insurance side as employers are considering not offering that coverage, let alone having a competitive environment where some of our competitors may be taking some of that business. So dental's mixed, I would say, better on the high end of the market and more difficult in the middle market.

Scott Fidel - Deutsche Bank

Okay, thank you.

Operator

And we will go next to Peter Costa, FTN Midwest Securities.

Peter Costa - FTN Midwest Securities

Hi. Can you talk a little bit about your success with the Medicare group product, why you are having it relative to some others out there and can you talk about the timing of that account, what that's going to do to your MLRs going forward and then other MLR guarantees on that account?

Ronald A. Williams - Chairman and Chief Executive Officer

Yes. The... overall, the strategic relationship that we were able to establish with the HR policy association has been very helpful to us in demonstrating our value proposition and solving what many of our large customer see as a very important problem. I will ask Mark to give you some background on it and in terms of how it's playing out and how we see it and then Joe will speak to the MCR question.

Mark T. Bertolini - President

There are two large pieces that we see, Peter. First is the HRPA relationship where we've had lot of activity with our large national account employers looking at the opportunity provide pre-retiree and retiree benefits and had reasonably good success there and look forward to more success in 2008.

Secondly, is around the government business and what is occurring with GASB, the Government Accounting Standards Board, where they have required local and state municipalities to start to record the liability associated with the retiree benefits. As a result of looking at that projected liability and looking at ways of capping that, we have found a lot of interest in our private fee-for-service offerings as a way for them to assign more certainty to their forward liabilities around that benefit. So a lot of activity in that market as well. Longer lead times, because we are working with governmental agencies but on a lot interest.

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

With respect to the financial performance, Peter, the bids we have been seeing in the marketplace, clearly the group private fee-for-service product is expected to have a higher MBR than the average Medicare advantage product that has been fully contemplated in the forward guidance we've given you on our MBR. But there is still very attractive markets in... margins in this product.

With respect to MBR guarantees, I would characterize them more as price points and bands and corridors of performance and we are fully aware of that and are managing that very closely.

Peter Costa - FTN Midwest Securities

And do you want to disclose what those are?

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

No, we are not going to disclose those.

Peter Costa - FTN Midwest Securities

Okay, thank you.

Operator

We go next to Justin Lake, UBS.

Justin Lake - UBS

Thanks, good morning. Just a couple of questions, one on G&A. The... when I think about how your back half of the year run-rate, it looked like you increased your spent pretty significantly. I know some of that was acquisition based, can you just break out for us a little bit, what the incremental spend or remind us incremental spent on Schaller as well the fourth quarter spend ramping up the platform for HRPA and AARP that might not occur again in 2008?

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

Well I think we might not parse it in that way. But clearly if you look at the G&A numbers, sequentially we spent about... on a pre-tax basis about $85 million more than we did in the third quarter. Much of that was due to the significant ramp up for our group private fee for service platforms, continued investing in AARP, HRPA and the other platforms and I think if we are going to continue to be successful with these large one-one installations I think you will see that as a recurring pattern.

Justin Lake - UBS

Okay. So there's no... there's not any one time... what about Schaller?

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

Schaller actually accounted for about 20 basis points in the quarter-over-quarter swing. So the ratio would have actually been better hadn't we included Schaller in the fourth quarter.

Justin Lake - UBS

Got it. And then just as we think about the margins for next year. I know you mentioned lower than 2007 and you talked about the MLR being less than 80%. I guess just focusing on the MLR for a second and the commercial business, what that... you came out of the year at about 79.5%. Is there any... can you kind of just parse us through, I guess, I would think about three pieces, your existing book, what's going to happen with that... with the newer membership and the individual and small group and the durational effect there that will have an upward lifting effect and then the continued mix shift towards those lower MLR businesses. Can you maybe parse us through that and talk about how you got from 80% to 79.5% this year, the initial guidance versus this year and what you are kind of expecting to see in 2008?

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

Yes, I think, the fact you just mentioned are certainly contemplated in our forecasting we are not going to give any tighter ranges than the 80% approximate guidance we have given; yes new business does have a durational impact but you are talking about nearly 17 million medical members and the exiting book of business is certainly the anchor of that. So it's not having... durational impact is not having a material movement on the MBR year-over-year. When we guided up on the total, it is literally related to Medicare mix our Medicare business was roughly 10% of consolidated revenues this year and with the success we've had, could be anywhere from 13 to 15% of total revenue next year and of course that carries the higher MBR, so the higher MBR guidance is strictly due to mix.

Justin Lake - UBS

Okay. Thank you very much.

Operator

We will go next to Josh Raskin, Lehman Brothers.

Joshua Raskin - Lehman Brothers

Hi, thanks. Good morning. And I apologize if I missed a minute or two, but just a quick question back on the investment portfolio. Joe I heard you mention that you are assuming, I guess, lower rate. Is that lower rate what you are assuming when you gave the guidance last quarter or are you assuming lower rate throughout this year, I just wanted to sort of follow-up on that.

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

Now Josh, generally when we give guidance we spot rate the portfolio and yes short-term rates are down at least 200 basis points from when we last gave guidance. So on our $1.8 billion of short-term investments, we are clearly looking to lower yields on that throughout the year. If we're surprise with some rate tick up later in the year, we'll guide up.

Joshua Raskin - Lehman Brothers

Got you. So... but you don't have further... it sounds like you are using today's rate, you don't have further cuts in the model then?

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

No.

Joshua Raskin - Lehman Brothers

Okay. And just one more clarification, you don't include investment gains, realized gains in that investment income number, do you?

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

No, it's separate, and there were only 6.1 million after-tax realized capital losses for the quarter.

Joshua Raskin - Lehman Brothers

Right, and you guys always exclude that from operation?

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

Correct.

Joshua Raskin - Lehman Brothers

And then just a second question, just... in terms of the Medicare Advantage, I'm... I know virtually, I guess a large, large percentage was coming in the group business. So I think there's different sort of potential risk to that from a regulatory standpoint if things do change. But I'm curious what the sort of tolerance for Medicare growth is? Do you have a target in mind of sort of where that should be in terms of your overall book of business?

Ronald A. Williams - Chairman and Chief Executive Officer

No, I would say that we don't have a specific target. Clearly it is a relatively small percentage of our membership, a growing percentage of our premium. We currently view it as unattractive market segment and we have... we think is reasonable visibility into the future and are actively engaged in all the dialogue and political process and we think that working with the group market is... gives us kind of an extra layer of capability and flexibility.

Joshua Raskin - Lehman Brothers

Okay, thanks.

Operator

And we'll go next to Bill Georges, JP Morgan.

William Georges - JP Morgan

Thanks, good morning. A follow-up question on your Medicare Advantage membership guidance. I think initially you had guided to roughly 70,000 adds in the year, and I'm wondering if you are not being conservative with your expectations because of a... correct me if I am wrong, but I think your out of the box this year with over 110,000 already from your group win, yet you are guiding just for a 140,000 adds. So can you sort of highlight some of the puts and takes there?

Ronald A. Williams - Chairman and Chief Executive Officer

Well I think it's a function of the group private fee-for-service strategy. These tend to be large accounts, sophisticated accounts that take long time to make decision. These are very sophisticated solutions. So the guidance you are getting really is our one-one outlook and that outlook is for 140,000 including the 100,000 member conversion that we spoke of earlier. So perhaps we are being cautious, we have a very active pipeline, a group private fee-for-service opportunities, but they are just much too difficult to anticipate exactly when they will hit and how much.

William Georges - JP Morgan

Okay. And then could you just update us on your views regarding Medicaid and I am curious weather you are expecting to meaningfully build out your Medicaid risk book, and over what time period.

Mark T. Bertolini - President

Yes, Bill, Mark Bertolini. We will continue first and foremost with the integration of Schaller Anderson into our model. We will continue to build out the markets we are in. We are not anticipating large enrollments in 2008 but we will begin to open new market and new opportunities for Medicaid going forward.

William Georges - JP Morgan

Okay. And last quick question. Can you just update us on your yields on business won so far for '08?

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

Our yields are in line with our MBR guidance for the first quarter and the year. We continue to have an incredible ability to forecast medical trend, help our clients manage it and price through it with a great deal of discipline and I think our results are going to bear that out.

William Georges - JP Morgan

Okay, great. Thanks.

Operator

And we will take our final question from Greg Nersessian, Credit Suisse.

Gregory Nersessian - Credit Suisse

Hi, good morning. The first question is just on the reserve roll-forward... the... I guess the prior year redundancy related to 06 was $177 million, if I go back to the second quarter that was $204 million. Could you speak to the discrepancy there.

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

I think the way to look at our reserve position for the year-over-year is that reserve development in 2007 was not material to our financial results. There was intra-quarter development that I think we reported to you in the third quarter related to our Medicare book. We continue to hold prudent reserves, our reserve base is growing at a rate of 13% which is entirely consistent with the increase in our book of business. And the days claims payable although was down two days was influenced by the Schaller Anderson acquisition and a very noticeable speedup in both electronic claims submission and auto adjudication. So the reserve position's strong and perhaps you can go offline with Jeff and parse through the roll-forward schedule if you have more detailed questions.

Gregory Nersessian - Credit Suisse

Okay, that's fair. I guess then my follow up question was, when we calculate the commercial yields for the year, they are coming in right around 4%, a little less than that for the quarter. Could just speak to the various elements that get from your quoted yields down to the actual realized yields. What percentage is from benefit buy downs or product mix change or geographical mix change, how do those pieces come together?

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

Sure. I think the way to look at it is consistent with the rest of the industry, the gross trends in the industry tend to be around 11% to 12% and then after our customers make the decisions they need to make on benefit design and buy down, it gets you to the 7.5% trend that we typically quote to you as being our core commercial trend. Then if you adjust for the mix of customer segment, product and geography then you will get to the 4% yield that we reflect in our financial statements. That's the math on bridging from the 11% to 12% growth... gross trend to the 4% trend you are observing in the financials.

Gregory Nersessian - Credit Suisse

Okay, great. And then just one last one if I can sneak in. The Goodhealth membership, is that included in the other ASC, is that where we find that in terms of the regional breakdown of the enrollment?

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

The Goodhealth membership is ASC membership.

Gregory Nersessian - Credit Suisse

Okay, and that's in the other segment... okay, that's great. Thank you.

Operator

And this does conclude today's question and answer session. I would like to turn the call back over to management for any additional or closing remarks.

Jeff Chaffkin, CFA - Vice President and Head of Investor Relations

Thank you. A transcript of the prepared portion of this call will be posted shortly on the investor information section of the Aetna website at aetna.com. If you have any question about matters discussed this morning, please feel free to call me or one of my colleagues in Investor Relations office. Thank you again for joining us this morning.

Operator

And this does conclude today's conference. Thank you for your participation.

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