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Health Net, Inc. Q1 2008 Earnings Call Transcript 1 comment

April 30, 2008 | about: HNT

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Health Net, Inc. (HNT)

Q1 2008 Earnings Call Transcript

April 30, 2008 11:00 am ET

Executives

Angie McCabe – VP, IR

Jay Gellert – President and CEO

Joe Capezza – CFO

Analysts

Matthew Borsch – Goldman Sachs

Bill Georges – JP Morgan

Josh Raskin – Lehman Brothers

Greg Nersessian – Credit Suisse

Christine Arnold – Morgan Stanley

Tom Carroll – Stifel Nicolaus

Justin Lake – UBS

Scott Fidel – Deutsche Bank

Charles Aborty [ph] – Citigroup

Presentation

Operator

Good day everyone and welcome to the Health Net Incorporated first quarter 2008 conference call. Today's call is being recorded.

At this time, I would like to turn the call over to Angie McCabe, Vice President of Investor Relations. Please go ahead ma'am.

Angie McCabe

Thank you, operator and good morning everyone. During this call, we will make forward-looking statements that are subject to certain risks and uncertainties. Risk factors that may impact those statements and could cause actual future results to differ materially from currently expected results are described in our filings with the SEC, as well as the cautionary statements in our press release issued in advance of this call.

In addition, today's press release makes and the comments on this call we'll make reference to certain measurements that are not calculated and presented in accordance with generally accepted accounting principles. I should note that today's press release, which is available on the company's Web site, includes a reconciliation of non-GAAP financial measures with operating results excluding legal and operations strategy related charges.

In addition, we included a supplemental schedule showing a breakout of reserves and health care costs per capitation, provider settlements, and the impact of Part D. These supplemental items provide the basis for discussion of operating metrics excluding the charges where appropriate and discussion of days claims payable, excluding the costs noted above.

Let me now turn the call over to our CEO, Jay Gellert.

Jay Gellert

Thank you, Angie. And before I begin, I would just like to point out we have a new voice reading the disclosure statement. We are in the transition from David Olson to Annie McCabe. David will stay with us and continue to work with us as we go forward. But, I do want to recognize all he has done for the company, how valuable he's been to all of us and all of you, and indicate how important a part he has been to our company. So thank you, David, and thank you for joining us this morning.

Today, I will review our first quarter '08 results and address our revised guidance for '08. After my remarks, Joe Capezza, our CFO, will take you through an in-depth discussion of the financials. As you know, we announced several weeks ago that we were going to engage in a comprehensive review of our results and prospects. Make certain that our 2008 earnings guidance reflected currently expected business conditions.

Since the middle of March, when we made that announcement, we have engaged in examining every aspect of our business. While we were completing this review, several issues emerged. These issues include adverse prior period development, primarily for the second half of '07, concentrated in Q4. We also saw higher utilization in both Medicare advantage and PDP for '08 and an unusually active flu season. Finally, in February of this year, we learned of the proposed rate decreases for our medical business.

The adverse prior period development was primarily the result of an unusually larger number of high cost cases and was exacerbated by a larger than normal build up in claims inventory during the holiday season. We do not expect this anomalous condition to recur.

Most of the issues I have described impacted our Q1 results. In fact, the adverse prior period development, flu and the Medicare and PDP issues impacted our first quarter results by approximately $95 million pretax or $0.53 per diluted share. As a result of both the proposed medical rate cuts and the residual impact from MA and PDP, the remaining three quarters of the year will be impacted by approximately $30 million to $35 million pretax or approximately $0.16 to $0.19 per share.

As a result of these items, combined with the charges that we took in Q1, we are lowering our '08 EPS guidance on a GAAP basis to between $2.47 and $2.65 per share. Excluding the impact of charges taken in the first quarter and the additional strategy-related charges we expect to take in the remaining three quarters of '08, our '08 earnings per diluted share guidance is $3.45 to $3.55.

Although the medical rate cuts will impact the second half of '08, we believe we can resume earnings growth in the second half of '08 compared to the second half of '07. Our revised guidance takes the 2007 development into account. As a result our, 2008 commercial healthcare cost guidance increases by 50 basis points. Therefore, commercial premium yields in cost trends are now expected to be approximately equal at 8%.

Given these developments, we know there is concern about commercial prices. We believe that our pricing discipline will produce better yields that might otherwise be expected through the balance of the year. We are confident with our pricing for '08 because more than 80% of the book has been priced. Therefore, we believe that the second half will bring improved margins. We expect to see an increase of more than $6 PMPM in commercial yields between the second and third quarters, and an additional $3 PMPM increase sequentially between Q3 and Q4, which is higher than we have experienced historically.

With this encouraging pricing picture, we believe that the second half of '08 will show a significant positive spread between commercial yields and costs with concurrent improvement in the commercial MCR year-over-year despite the increases in our cost expectations. We believe the positive spreads could be 100 basis points in Q3 and Q4. If we deliver on these expectations, which we think we will, we believe it will set a very positive tone for '09 performance.

Given our pricing activity and the generally difficult economic environment, we are reducing our commercial enrollment expectations. Instead of the 1% decline we targeted at our Investor Day, we now expect to see commercial enrollment decline of between 3% and 4% year-over-year.

Let me now turn to membership activity during the quarter. As expected, commercial risk membership of nearly $2.2 million at the end of the quarter was essentially flat compared to March 31, 2007 and declined by 45,000 members since December 31, 2007. Our commercial large group segment experienced lapses in both ASO and risk membership as we continue to prune unprofitable accounts and maintain our pricing discipline.

As many of you know, our strategy is to grow membership profitably in the segments where we know we can compete in terms of product and network cost competitiveness. The small group in individual segment grew year-over-year as we continue to focus on a wider array of products and on building relationships with our distribution channels. While this segment did experience a decrease in membership since December 31, most of the decline is attributable for lapses as we continue to maintain disciplined pricing. Going forward, we do expect to be somewhat less active in growing the individual segment.

We continue to experience strong growth in our Medicare lines of business. Our '08 guidance, which remains unchanged, is for 20% to 25% growth in MA, primarily in network model, HMO and PPO plans. We believe this is a more sustainable and stable business, especially with the changing political environment.

During the first quarter of '08, MA enrollment grew by 53,000 members, a 24% increase to 276,000 members. So, we are just about at the high end of our guidance range for MA enrollment. Enrollment in our private fee for service business grew by more than 14,000 members over the past 12 months to 22,500 members at March 31. Sequentially, private fee for service grew by more than 7000 members. PDP membership, which we continue to expect to grow by 40% to 45% in '08, stood at 522,000 members on March 31, growing by 143,000 members sequentially and 181,000 members from March 31, 07.

While we are very pleased with the enrollment news, our Q1 gross margins in both MA and Part D will be lower than expected. For the balance of the year, we have incorporated approximately $16 million of additional Medicare costs into our guidance. We will have the opportunity to rectify these issues in the pricing for our bid filing in June.

Our federal service division remains focused on delivering services that meets the needs of our military service members and their families. As an example, federal service is teaming with MHN, our behavioral health subsidiary, to introduce new programs and services such as the warrior care support program for those service men and women returning from military combat.

Also, as many of you are aware, the RFP for the new TRICARE contract was issued during the first quarter and our team is focused on developing and submitting a competitive proposal by the end of May. The expectation is that the new contracts will begin in April 2010. We expect that the current contracts will be extended.

Finally, a few closing remarks. While we are disappointed with our results, we are taking specific steps, including disciplined pricing, healthcare cost management, the implementation of our ops strategy to achieve our second half '08 expectations. We expect to resolve the PDP and MA issues in our '09 filing and expect that the cost for the flu and prior period developments will not recur in '09. We believe the worst is behind us and feel very confident going forward.

Now, I'd like to turn the call over to Joe Capezza, our CFO. Joe?

Joe Capezza

Thanks, Jay, and good morning everyone. As Jay had mentioned, I will review our revised guidance for 2008 and then discuss first quarter results. Let me start by saying that over the past several weeks, we've conducted an exhaustive analysis of all facets of our business. As a result of this analysis, we have good visibility as to our revenue outlook, healthcare cost trends and our ability to streamline G&A. With that in mind, we believe that we have a sound plan in place that will enable us to regain momentum in the second half of 2008 and lay the foundation for future periods.

First, let me address our revised guidance. Jay provided the EPS numbers, $2.47 to $2.65 on a GAAP basis and $3.45 to $3.55 excluding charges. This translates into an approximately $130 million change in pre-tax income from prior expectations. $94million of this change relates to the first quarter. Of the $94 million, $50 million is from adverse prior period development primarily from the second half of 2007. Approximately $37 million of this amount relates to the fourth quarter of last year. This adverse development was primarily the result of an unusually large number of high cost claims.

80% flows out of the commercial book. This development ran against typical seasonal utilization patterns. These unusual cases drove both institutional and physician costs higher than expected. They rose from a number of diagnostic areas, including cardiovascular, neonatal, ICU and septicemia. We have not seen evidence of these types of cases driving higher utilization of what has developed in the first quarter.

Despite our belief that this is an unusual event, we've intensified our medical management efforts. We believe this will help ensure that we will keep health care costs in line with expectations. As it is, our plan assumes that commercial healthcare costs developed during the year along the lines of our historical patterns.

$20 million of the change relates to higher than expected utilization in the first quarter due to flu. Flu affected both the commercial and Medicare books. $24 million is due to higher than planned costs in Part D and Medicare Advantage in the first quarter that are not flu related. In Part D, we are seeing higher than expected utilization of brand drugs. So, for the next three quarters, that leaves a balance of between $31 million and $41 million pre-tax.

Approximately $15 million to $20 million of these results result from the medical rate cuts announced earlier this year. Since the new rates will start on July 1, this will impact the third and fourth quarters. Approximately $16 million to $21 million is attributable to Medicare Part D and Medicare Advantage costs running higher than planned as noted above.

It is now evident that our Part D bid was aggressive. We believe this impact will be more pronounced in the first half due to the Part D seasonality. In both Part D and Medicare Advantage, we have the opportunity to resolve these issues with our impending bids for 2009. That summarizes the reasons for our guidance revision.

Now let me talk to reported GAAP results if the first quarter. Pre charges amounting to $82.4 million pre-tax contributed to a loss of $0.33 per diluted share in the quarter. The components of the charges are as follows. $43.2 million to cover estimated liability for litigation and regulatory action; this includes liability related to the company's rescission practices in Arizona and California. It also includes additional liabilities booked in connection with the settlement agreements of three national lawsuits.

The total amount of these items was booked in health plan services expenses. $35.8 million of the charge relates to severance and other expenses including legal fees and that was booked in the G&A line of P&L. Lastly, an estimated $3.4 million relates to the pending sale of a small noncore subsidiary. This amount is booked in ASO and other income. $0.16 in operating earnings, as Jay mentioned, excludes the effects of these charges. There is a P&L reconciliation attached to our press release to show you how to get from the GAAP to the non-GAAP numbers for clearer operating picture.

Of all the factors affecting our quarter, most importantly there is good news on the pricing front. We recorded a 10.3% increase on the PMPM commercial yields in the first quarter. That's very close to our plan and we still expect to be on plan at 8% for the full year.

For the full year, we now expect commercial health care costs to be up approximately 8%, up 50 basis points from our previous guidance of approximately 7.5%. The change is all due to prior period development recorded in the first quarter.

An issue several of you have asked about previously is investment income. It was up nicely in the first quarter, $35 million against $31 million in last year's first quarter. Lower interest rates have actually helped more than hurt us. Less than 20% of our $1.5 billion portfolio is exposed to short-term rates. In addition, there's approximately $3 million of net unrealized gains in the rest of portfolio. We were able to realize $2 million of gains in the first quarter. We currently expect investment income to actually be up year over year and run slightly better than planned.

A different geographical mix with more taxable income coming from California than previously expected causes our effective tax rate on an operating basis to be approximately 39.5%. That compares with a 38.5% reported in previous periods. This impacts EPS for the year by approximately $0.06 per diluted share. Including the charges, the effective tax rate for the full year will be approximately 40%. So, better than expected investment income is offset by higher tax rates.

Interest expense did climb in the first quarter from a new financing facility that we entered into late last year. But, the higher interest expense is offset by other income related to this financing. You will continue to see this phenomenon throughout 2008.

For the first time or for some time, we have been telling investors that the extraordinary performance in our government contract segment could not persist. The first quarter pre-tax margin of 4% is lower than recent quarters as a result of lower risk sharing gains. We still expect the full year margin to be approximately 5%.

Let me take a moment to talk about reserves. The higher reserves clearly helped GAAP days claims payable. As we do every quarter, we include a table in the release that normalizes days claims payable. This quarter, the normalized number is down about 1.5 days sequentially. This is consistent with what we've seen seasonally in past years.

Finally, our debt was up $100 million as a consequence of our draw on the credit line. We are currently paying LIBOR plus 70 basis points on this debt, so it's a very attractive alternative for us. As a result of the GAAP loss in the quarter, active share repurchases and higher debt, our debt to total capital ratio climbed to 27.5% at the end of the first quarter. We are very comfortable with this level at the moment and we believe that we can keep it under 30% for the balance of the year.

Let me shift briefly to cash flow. We recorded negative cash flow of $117 million for the first quarter. We had told investors to expect the Q1 to be negative due to the payments associated with litigation settlements that have amounted to approximately $160 million in the first quarter.

Our full year expectation is that operating cash flow will equal approximately 60% of GAAP net income due to improved performance in the remaining quarters, offset by the effect of their litigation related payments. Excluding litigation payments, cash flow is expected to approximate 100% of net income.

On the share repurchase front, in the first quarter, we bought back 3.2 million shares, spending approximately $143 million. It is our intention to continue repurchasing shares. The range of full year earnings guidance excluding charges is directly tied to how many additional shares we buy. The more we buy, the more likely we are to reach the higher end of the range.

Let me make a few additional comments on guidance. Our current expectations for the second quarter is approximately $0.77 to $0.79 per diluted share, excluding charges related to our G&A cost reduction efforts. We expect these efforts to contribute to a ramp up in earnings in the third and fourth quarters to get to our revised EPS range for the full year.

Let me close by saying that we believe the balance of the year will show stronger performance. We see strong pricing in our commercial book being solidly right side up in the second half. This will help drive year over year earnings growth in the third and fourth quarters. We believe (inaudible) Medicare issues in the 2009 bids will reflect them. We look forward to seeing many of you in the coming weeks to discuss these issues in more detail.

With that, let's move on to Q&A and we turn it back over to Angie.

Angie McCabe

Thank you, Joe. Operator, we would like to now open the call for Q&A.

Question-and-Answer Session

Operator

Thank you, Ms. McCabe. (Operator instructions) Matthew Borsch with Goldman Sachs.

Matthew Borsch – Goldman Sachs

Yes. Good morning. Thank you. First question I have is, on your look back on 2007 commercial medical cost trend, what was it, if you could remind us, and what is it now in light of the trend development that you saw. And I guess the follow-up question is, I'm a little bit puzzled that you haven't seen, you haven't raised your outlook at all for the '08 trend, excluding the unfavorable reserve development just in light of what you saw late last year and also in light of perhaps what you have seen so far on the severe flu season, although I recognize it's early in the year? And that's it.

Jay Gellert

The effect of the prior period development that is up about 50 BPs for the year on the commercial side, it would make it so that we were originally about 30 – 20 to 30 BPs right side up, it basically turns it the other way around. We went through all those cases – one of the reasons we took so long was in fact to do that. We looked at Q1 and I think we feel strongly that the trends support the adjustment we made and there was no need to make a further adjustment. It's important to note that, as we did our '08 plan, we didn't anticipate continued positive improvement in terms of the commercial trends. So, we are comfortable with what we did and again one of the reasons we took so long was to really assure ourselves of that.

Matthew Borsch – Goldman Sachs

Just so I'm clear, can you give me what the absolute figure now is in terms of your – in other words, I'm trying to understand if you put the reserve development back where it belongs in 2007, what was trend for commercial and what is now the view of '08 trend excluding that reserve development, if you can share that?

Joe Capezza

Let me state it but then I'll also tell you that it is obscured by the fact of the guardian. So we have this problem where that effect changes the numbers. But I think if you try to make it apples to apples, our basic view is that the trend you look in '08 is pretty equivalent to the trend that we had in '07.

Matthew Borsch – Goldman Sachs

Okay, so trend is about flat.

Joe Capezza

Yes, when you make the adjustment, so that's why we're comfortable with where we are.

Matthew Borsch – Goldman Sachs

And last, just last one, on the individual segment, what are you guys seeing there that's causing you to back off a little bit?

Joe Capezza

Well, I think that the pretty volatile California regulatory environment is encouraging us to be conservative in that segment until we see it play out.

Matthew Borsch – Goldman Sachs

Okay. Thank you.

Operator

Thank you. We'll take our next question from Bill Georges with JP Morgan.

Bill Georges – JP Morgan

Thanks. Good morning. Jay, I was a little bit confused by your discussion of pricing your book for the balance of the year. And if you could just provide a little more detail, if your view of cost is essentially unchanged when you normalize for the prior period development, why was your pricing sufficient to cover this new view? In other words, in other words, I would have expected you to have price at a somewhat lower level in '08. But yet you said that your pricing should be sufficient to right size the price cost spread, and then you also mentioned that you have 80% of the book locked in. So can you sort of explain that to me because I was confused? I was thinking your pricing would be insufficient given the change in view.

Joe Capezza

Yes, it's a good question. When we entered '08, we entered it with the assumption that some of the favorable trends we saw in '07 wouldn't continue. So, we priced up both for margins and to give us some cover. If you look at for example our small group filings in California, you'll see that we did price up to reflect that. So what we are saying is that if you look at our cost trends, and you look at your pricing, 80% of which we already know that it adequately covers them.

Bill Georges – JP Morgan

Could you give a little more detail also just exactly how developed at this point in time is your view of the first quarter? What I'm getting at there is whether or not you have seen the claims mature sufficiently to know that you are kind of out of the woods with respect to the doctor and hospital utilization spike you saw in the fourth quarter.

Joe Capezza

I think we have studied it and really taken the time and that's why again as I said, we waited to give the guidance at this time. And I think the key difference is that the backlog we had last year at the end of the year, which kind of I would say obscured some of our line of sight has now been paid down and it's back to being consistent with our usual experience.

Bill Georges – JP Morgan

Okay. Can you give us a sense for just exactly what your backlog inventory looks like over say the last three quarters?

Joe Capezza

Yes, why don't – David and Angie can maybe walk you through that. I don't have that right in front of me, but we can get it for you, for sure.

Bill Georges – JP Morgan

Okay. Thanks very much.

Operator

We'll take our next question from Josh Raskin with Lehman Brothers.

Josh Raskin – Lehman Brothers

Thanks, good morning. And I will echo your comments, Jay, about Dave as being helpful for us as well. Just want to talk a little about the guidance I think specifically the second half. If I look at last year's second half, that was sort of $2.09 reported. If I exclude the development, if I sort of take the first quarter development and put that back into the second half, I get a number close to $1.81. Now, the '08 guidance is suggesting something in the range of $2.51 or $2.61, which is growth of over 40% and I haven't each included the California impact at that point. So, I'm just curious, maybe you could talk – Jay, you had mentioned you had taken specific actions, maybe you could size some of the incremental improvements, maybe dollar wise how much is going to come from the improvement in the spread and how much is SG&A, et cetera?

Jay Gellert

Let me kind of highlight a few points. First of all, we have higher pricing in the second half of the year than we had in the previous periods. And in fact, the higher pricing numbers we gave you pretty much balance out the prior period when you look at it. So those I think play each other off pretty well. We'll see improvements in G&A that make up much of the remaining difference. And so I think those are the two real effects that you'll see that can get you pretty easily from the second half of '07 to the second half of '08. And Angie and David can go into the specifics with you, but those are the key points and they can walk you through them.

Josh Raskin – Lehman Brothers

Okay, that's perfect. The second question is as you think about the '09 Medicare environment, you had said I think Joe had mentioned the bids for '08 were slightly competitive or slightly aggressive was the word he used. I'm just curious, as you think about '09 for the Medicare book, I'm assuming you are pricing to sort of fix those margins. But what are your thoughts in terms of the overall size of the book? Obviously you had tremendous growth this year. I'm just curious as you think about the Medicare side of the business.

Jay Gellert

A couple of comments. First of all, regarding PDP, we have taken a pretty good look at the overall bidding versus the benchmark, and I think that gives us some comfort we can rectify the PDP bid. And we have also I guess seen from both public and nonpublic companies some of the same kind of issues we have articulated. So, I think we have a view that the PDP issue is going to work out. With regard to MA, I believe that in some of our more competitive markets, we are doing satisfactorily, so we won't need to pick up as much margins. The margin needs are in some what I would call less competitive markets. And so, I think we are fairly comfortable we can kind of make that up in the bid process. And I also think that, with some of the new members, we really have some questions about some of the risks or two which we are looking at. I think given all that, I think the key issue is we feel good about the ability to solve the PDP problem and that the MA problem is more kind of fine tuning in some markets.

Josh Raskin – Lehman Brothers

Okay. And then just last question, the de-emphasis on the individual market, can you talk about the specifics there?

Joe Capezza

Yes, it is directly related to the present issues that exist in the California regulatory environment, the whole issue of rescission and the like. And I think until we see that settle, we want to be conservative in terms of our sales in that market.

Josh Raskin – Lehman Brothers

So, it wasn't loss ratios or competitors or anything like that?

Joe Capezza

No, I think it is really directly the result of all the issues in the California market.

Josh Raskin – Lehman Brothers

Okay. Thank you.

Operator

We'll take our next question from Greg Nersessian with Credit Suisse.

Greg Nersessian – Credit Suisse

Hi, good morning. My first question was just hopefully a little bit more color on the higher physician and inpatient utilization in the fourth quarter. Could you just maybe give us a little bit of sense where that came from geographically? It sounds like maybe the east more than the west. Also, were there any specific product types, where you saw that? Some of your competitors have talked about high deductible plans impacting the seasonality of the cost there. Was that a factor?

Joe Capezza

I think we saw the effect mainly outside of California and Oregon. And I think in the Arizona, it was more of high deductible products and some of those products. And in the northeast, it was just some specific cases like multiple births and the like, which are kind of insurance risks.

Greg Nersessian – Credit Suisse

Okay, but you feel comfortable that you are pricing in Arizona on those high deductible health plans would have captured the higher utilization even though you didn't actually see them until the beginning of the first quarter.

Jay Gellert

Yes, I think that our view is that the pricing was adequate, but couldn't absorb some of these unique cases. So I think we feel comfortable that it's adequate and our first quarter experience gives us that comfort.

Greg Nersessian – Credit Suisse

Okay. And then, along those lines, the lower commercial risk membership guidance again geographically, where would you expect to see more of that come from?

Jay Gellert

Well, first of all, as I said, the individual market is California and maybe a little of Arizona. The rest is probably pretty much all over the country and is just – we have kind of become a little more conservative in the mid market in terms of making sure that we retain margin and discipline, because we fundamentally believe that if we hit this revenue number, it both revolves '08 issue and positions us well for '09. So, it's those two issues. It is specifically individual issues in California and a little bit in Arizona which is kind of less of pricing and more just kind of a prudent issue. And then, the other one is, the conscious decision to not follow the occasional furtive enter in the mid market.

Greg Nersessian – Credit Suisse

Okay, great. One last on the medical outlook, I guess that emergency budget passed in January when you reported the fourth quarter, it sounded like maybe didn't think it was going to be as big a deal because of our capitative [ph] provider arrangements. I guess that view has changed a little bit. What specifically has changed your budget view there? And then any update on your long-term view on the medical program? Do you view this as something – a systemic fault within the program or do you think this is just a temporary budget issue and you get back on your feet or something?

Jay Gellert

Yes, I would say the biggest issue that's kind of affected our view is it seems like each week the California budget deficit increases by $1 billion. So, I think it was more kind of a better kind of view of kind of the realities of this situation. I do believe it's kind of interim financial problem not a long-term one but I don't know how long it will last, so we have incorporated it into our thinking and our guidance for the foreseeable future till something changes. But, it is still a very viable business, it's still a business that clearly operates and with a good return for us, and so we want to stay in.

Greg Nersessian – Credit Suisse

Okay great. Thank you.

Operator

Next we'll go to Christine Arnold with Morgan Stanley.

Christine Arnold – Morgan Stanley

I would just like to clarify some of your expectations here. So, what you are saying is that you saw a spike in catastrophic claims related to last year and that that spike has returned to normalized levels in your view?

Joe Capezza

Yes.

Christine Arnold – Morgan Stanley

When did you see the spike in catastrophic claims primarily related to fourth quarter? When did you spend – was that your March kind of don't-ask-don't-tell press release, is that when you started to see it?

Jay Gellert

It was – we saw it as we began the review process that we indicated in March. So, yes.

Christine Arnold – Morgan Stanley

So, if you didn't say in the middle of the fourth quarter was November and you didn't see those claims until March, how do you – I know you had a claims backlog. How do we have conviction that we have seen the end of them and that they have really died down?

Jay Gellert

Well, I think the reason that we took the don't ask don't tell strategy was to be able to go back and look at the sources and compare it with some of the things in terms of our early indicators and fix that process up and make sure that we had successfully gone back. We even went to the point where some of the places, the sources we have gone back and done inquiries into those facilities, checked them against our early warning indicators, our op system and the like. So, I think that was the process we went through to give us some comfort that we had adequately set cost expectations in line with our experience.

Christine Arnold – Morgan Stanley

Okay. And I understand the second quarter's going to benefit from sizable rate – I mean second half is going to benefit from sizable rate increases. Is second quarter going to benefit from sizable rate increases given kind of the timing of when you saw this?

Jay Gellert

Well, primarily second quarter won't benefit, but it's as much because of lack of turnover in that second quarter as it is because of the line of sight, so the combination did it.

Christine Arnold – Morgan Stanley

So here's what I'm struggling with. The second quarter is not going to benefit from a big increase in premiums. Ex flu, ex charges, ex prior period negative development, first quarter looks about a $0.52 quarter. If you have a dime swing in PDP just because the loss reverses, that gets you to $0.62. That is still quite a bit from $0.77 to $0.79.

Joe Capezza

Let me, maybe I could – let me, I guess David and Angie can work that through with you. But I just would call your attention to the fact that as I said, the effect of the kind of one-time things was $0.53 in Q1. So I think when you go from there, plus include some additional G&A savings, which will begin to run into the plan, you can get to the number that we have suggested and they can walk you through it.

Christine Arnold – Morgan Stanley

Okay, thanks.

Operator

Next we'll go to Tom Carroll with Stifel.

Tom Carroll – Stifel Nicolaus

Good morning. Question for you on, just in general, what percent of your total claims roughly are for out of network providers?

Jay Gellert

We'll have to get you that number. It would be a single digit number, but we'll get you the exact number.

Tom Carroll – Stifel Nicolaus

So relatively low, which is I suppose in line with my expectations. I guess a follow-up to that is, how should we think about – in understanding that's a low number, how should we think about potential operational implications of the McCoy litigation? I mean I'm not asking to you comment on litigation. But I guess would this drive higher medical costs for out of network claims, which you eventually just pass on to customers, which eventually a portion of it turns up as bad debt with providers again?

Jay Gellert

I think that it will lead to clearer disclosure and it will lead to decisions on the part of the employer of what level of benefits they want to buy. I think the core of the case to my view is it will demand that we be more explicit on what we mean by the term usual and customary charges. So I think your point is well-taken that if the net result is people expect to see a higher coverage level, yes, it will lead to higher premium. And so that is the issue with the case.

Tom Carroll – Stifel Nicolaus

Okay. Thank you.

Operator

Next question we'll go to Justin Lake with UBS.

Justin Lake – UBS

Thanks. I guess just first on hospital pricing, had a couple of your peers mention some difficulty in hospital negotiations on the coasts, given that's where you live as well. Can you give us an update on what you are seeing there and has there been any increase in the tension of negotiations on hospital pricing?

Jay Gellert

I think that we had our tension a couple of years ago, so it's kind of built into our baseline. So, we are not seeing a level of heightened tension.

Justin Lake – UBS

Does that mean you are just having negotiators doing any large contracts right now?

Jay Gellert

No, we've done it. I think that – and I don't know who the competitors are, but there is – what we see is that there's some evidence in some markets that some of the companies which had advantages are being challenged with those advantages. We went through that process a couple of years ago. So I think we have seen more orderly renewals.

Justin Lake – UBS

Got it. And just in regard to one of those competitors that might have had some advantages in California specifically, and you have a fair amount of overlap with the (inaudible) out there and given what they have seen as far as issues around cost trend and shadow pricing discussions in California and things of that nature, I'm just curious if you could comment, have you seen any changes in pricing in your either West Coast or East Coast markets that might show – drive some indicators of relief over the next couple of – over the next few quarters as far as what pricing competition looks like?

Jay Gellert

Of course I don't know the competitor to whom you refer.

Justin Lake – UBS

Sure.

Jay Gellert

But I do believe that we've always viewed them as sound and prudent pricers and we have every reason to believe they will continue to be that.

Justin Lake – UBS

Are you actually seeing anything in the market that tells you there is a change in their stance?

Jay Gellert

Honestly, I think that we are comfortable they're acting intelligently and I'll leave it at that.

Justin Lake – UBS

Fair enough. Just one more question. Given the number of charges that have been at least somewhat surprising, over the last couple of quarters, in regards to litigation issues and settlements, can you just update us, is there anything else out there that you think could result in further one-time events over the next 12 to 18 months?

Jay Gellert

Justin, I think the best way to approach is that they are fully disclosed in the Q and we are prepared to respond to questions on it. But, I think that is the appropriate way to do it, so there is no – so I do it consistent with kind of what's the appropriate legal steps.

Justin Lake – UBS

Okay. So, I guess, my question is just that, if everything is disclosed in the Q and I know you do a good job of that, just normally if you have these kinds of issues out there, is it that you didn't set up a reserve for them? Or is it that the reserve that you set up for the potential liability wasn't large enough? And can you comment on how the reserves look for, what's still existing?

Joe Capezza

I think that is in these couple of instances, we were aware of the case but had no ability to kind of assess the magnitude or likelihood of them. So, these are situations where they are kind of – circumstances where they don't fit within the accounting standards in terms of exactly determining how you book it.

Justin Lake – UBS

That is helpful. Thanks a lot.

Operator

(Operator instructions) Next we'll got to Gregg Genova with Deutsche Bank.

Scott Fidel – Deutsche Bank

Hi, actually it is Scott Fidel. First question just back to Medical and talk about what type of MLR now you are expecting once the rate cuts kick in the back half of the year, and then also do you have a percentage of the rate cuts that you are expecting to offset through med cost and admin cuts or savings with providers and within the own business?

Jay Gellert

Let me try ask answer. The 15/20 is a net. We'll have to get you the exact number because I want to state it correctly. So we'll get that to you. We will still remain kind of in the – kind of low to mid-80s MCR, so it's a good business.

Scott Fidel – Deutsche Bank

And then in terms of any estimated on how much on the cut you think you can offset in terms of with provider, obviously I know you are capitated, so it is a little bit difficult but…

Jay Gellert

Let us get you the exact right number and we'll get back to you.

Scott Fidel – Deutsche Bank

Okay. Fair enough. Follow-up question, just I know it's early here for '09. But, just given that you guys have got a lot of different sort of numbers out there around earnings right now, just interested as we think about modeling '09, what would you recommend us use as sort of the baseline EPS number? Would you think the 345 to 355? Or more in the 380-ish range if we back out the '07 adverse reserve development? Which one of those you think is more of a good baseline? And then do you think you'll be able to grow earnings from that in '09?

Jay Gellert

Let me try and instead of giving you exact baseline number – let me talk through the thinking and then you can work off it. I don't think we anticipate PPI or flu recurring. I do believe we think that we can fix the PDP pricing issue. I think that we need to do more work on the MA pricing issue, so I wouldn't – but I think we think there is some opportunity there. Our anticipation that we could grow earnings from there. We still have not renegotiated the TRICARE agreement, so those are the kind of issues that we'd have to face going into '09. But we see growth opportunities and I think, as we look at '09, those are – that would be the kind of framework we'd be thinking, okay.

Scott Fidel – Deutsche Bank

And then just thinking about the cost components and I know it's a bit difficult with the negative reserve development, but any view on sort of the individual cost components and where you see those on an underlying secular basis here in first quarter?

Jay Gellert

Yes, I think if you maybe look all the it based on the 8% and I think where we'd go with that is physician in the mid single, pharmacy in the mid to high singles, and hospital in the 10 to low double-digit range.

Scott Fidel – Deutsche Bank

Okay. Thank you.

Operator

Our next question from John Rex with Bear Stearns.