Coventry Health Care Management Discusses Q2 2012 Results - Earnings Call Transcript

Jul.27.12 | About: Aetna, Inc. (AET)

Coventry Health Care (CVH) Q2 2012 Earnings Call July 27, 2012 8:30 AM ET

Executives

Drew Asher - Senior Vice President of Corporate Finance

Allen F. Wise - Executive Chairman and Chief Executive Officer

Randy P. Giles - Chief Financial Officer, Executive Vice President and Treasurer

Analysts

Thomas A. Carroll - Stifel, Nicolaus & Co., Inc., Research Division

Joshua R. Raskin - Barclays Capital, Research Division

Carl R. McDonald - Citigroup Inc, Research Division

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Justin Lake - JP Morgan Chase & Co, Research Division

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

Operator

Good morning, and welcome to today's Coventry Health Care Second Quarter 2012 Earnings Conference Call. Today's call is being recorded. [Operator Instructions] Today's call will begin with opening remarks by Chairman and Chief Executive Officer of Coventry Health Care, Mr. Allen Wise, after a brief forward-looking statement read by Mr. Drew Asher.

Please go ahead, Drew.

Drew Asher

Ladies and gentlemen, during this call we will make forward-looking statements. Certain risks and uncertainties, including those referenced in our press release and described in the company's annual report on Form 10-K for the year ended December 31, 2011, the company's quarterly report on Form 10-Q for the quarter ended March 31, 2012, and all subsequent filings with the SEC, may materially impact those statements and could cause actual future results to differ materially from those anticipated and discussed. Allen?

Allen F. Wise

Good morning and thank you for your interest in Coventry Health Care. Earlier today, we reported earnings per share of $0.65 for the quarter bringing year-to-date earnings per share to $1.85. The quarter was marked by significant improvement in Medicaid performance, sequential growth in Medicare products, continued SG&A leverage and cash deployment for share repurchase. We are on track for our 2012 EPS forecast of $3.10 to $3.30 per share and therefore, are again reiterating full year 2012 guidance.

I'll cover some of our business highlights and perhaps, more importantly, where we feel we're headed for tomorrow. Let's start with government programs, which now represents about 1/2 of the company's revenue. You may recall from the first quarter that our Medicare Advantage business, spanning 15 states, had an excellent annual enrollment period with 13% sequential membership growth in the first quarter of 2012.

Since Q1, we've continued to add membership each month in our Medicare Advantage business, and were at 253,000 members at the end of the second quarter. We're well positioned in our Health Plan footprint from a cost structure, distribution and product standpoint and as such, expect to continue the growth and strong performance as we look multiple years ahead. During Q2, we filed our bids for 2013, and we're quite optimistic about the future serving the senior population.

The story is similar for Medicare Part D. We experienced significant growth in Q1, followed by continued growth in each month of the second quarter. In fact, Medicare Part D grew by 36,000 members in Q2, averaging growth of about 12,000 members per month. We expect to continue growing throughout 2012 based on our positioning of our Value Plus product and the attractive value proposition we've been able to create for the senior population. To round out Medicare, the margins on these products continue to be on track with their forecast and consistent with prior years.

In Medicaid, coming into 2012, we experienced substantial growth, effectively doubling our revenue to about $2.9 billion, led by the 2011 Kentucky win, the FHP acquisition and organic wins in both Nebraska and Pennsylvania. Our challenge is to manage that growth and demonstrate that we're able to improve and manage bottom line performance.

Continuing the bottom line performance thought, I'd like to continue the Medicaid discussion with a much more in-depth review of Kentucky. You may remember during Q1 conference call, when I advised you that after 5 months of data, it was obvious to us that we had severe earnings pressure and other challenges with regard to our 32-month contract with the Commonwealth of Kentucky with approximately 230,000 members. At that time, I identified some of our major problems in the areas of adverse risk selection, especially in Regions 7 and 8, lack of compensation from the Commonwealth for past due payments to hospitals due to errors or omissions in the data book and the challenge of managing the health and care of a very large population with limited preparation time. These problems are exacerbated by the fact that there's not been a managed care program in Kentucky previously and the fact that there wasn't permanent leadership in the cabinet for health and family services in the early days of the program. Our challenges were made even more difficult to litigation -- due to litigation from one of the largest provider groups in Region 8 to prevent us from exercising the 30-day notice of termination provision, even though our agreement clearly allowed us to do so, almost a perfect storm.

Well, enough history, and I'm pleased to report that we're making very significant progress in many, if not most of the areas, which created a very poor financial result during the first 5 months of the contract. First, there's now permanent leadership at the cabinet level for health and family services, which has resulted in the necessary and meaningful dialogue to develop a program that works for both Coventry and the Commonwealth of Kentucky.

Second, we have received a partial adjustment regarding risk-adjusted revenue, which we were contractually owed. And this revenue produced prospective relief beginning April 1, 2012.

Third, we received an adjustment of pass-through for hospital payments effective on May 1, 2012, that is retrospective back to November 1, 2011. Accordingly, it reimburses the Health Plan for these past-due costs for the entire contract period.

In the area of patient management, I advised you on the last conference call that we'd identified 50 initiatives to take better care of the members and we have made, and we'll continue to make, very significant progress in this area. The Commonwealth of Kentucky is a DRG state, and we've been able to reduce costly and very numerous one-day admissions, which in many cases, were replaced with observation periods, as is the practice in most hospitals throughout the country.

You may also recall that we bid the business with a significant rate increase in year 2. In October of this year, we will see a rate increase between 5.3% and 7%. The difference between the 5.3% and the 7% is that while we don't have a final, final agreement, we should receive additional risk-adjusted revenue beginning October 1 in addition to the agreed-upon 5.3% rate increase.

And while we received a partial increase prospectively for this risk-adjusted revenue and resolved the hospital pass-through issue, we have not received reimbursement retrospectively for risk-adjusted revenue, which we strongly feel is due. We filed an appeal to address this issue and if that fails, we'll litigate the issue.

Kind of final thoughts on Kentucky, even though we were delayed by provider litigation, we will be able to move forward with terminating providers who do not meet our utilization and quality criteria, so that we continue to develop a more efficient delivery system as the year progresses. My personal belief is, in a worst case, that Kentucky will be breakeven in 2013. And I feel that the more likely outcome is that we will have a reasonable profit on this business for 2013.

In other Medicaid news, we're off to a great start in Nebraska where our expansion contract for a recent RFP win commenced on July 1 of this year, and we've enrolled more than half of the available membership, adding approximately 40,000 members, resulting in a #1 statewide market position. We've served Nebraskans in Medicaid since 2010. We've had a Health Plan presence in Nebraska since 1998.

We also look forward to 3 new Pennsylvania regions, which are being rolled out in a staggered fashion over the next 3 quarters, starting with the Southwest in Q3, followed by the New West and ending with the New East in Q1 of 2013. And we'll continue to pursue these new opportunities, where we believe we can bring our suit of capabilities to serve state and government program populations.

One final Medicaid topic, which is Kansas. Based on the state's proposed terms for the new 2013 Medicaid contract and our corresponding bid posture, we did not win the state of Kansas Medicaid contract effective January 1, 2013. You may recall that FHP, which we acquired in January of 2012, operated in both Missouri and Kansas. We won the Missouri rebid earlier in the year, which is where most of the performance and value of FHP resided. And accordingly, with the loss of the Kansas contract, we wrote off $7.7 million intangible in the quarter.

Effective July 1, we did extend the existing Kansas contract for the remainder of 2012 at what we believe is an appropriate rate increase. While suffice it is to say, we learned some lessons in Kentucky and although disappointed with the outcome in Kansas, we will not sacrifice operational or financial prudence in the service -- in the search for just growth. We feel good about the growth dynamics included in the federal poverty level expansion in Medicaid and the dual-eligible migration to managed care, and look forward to seizing our fair share, which should be significant opportunities over the next 3 to 5 years.

Moving onto a few comments on the Commercial business. We feel that we're well positioned for the future from a cost structure standpoint and our local Health Plan footprint, and we look forward to significant opportunities in 2014. For the past decade, we have certainly experienced some normal challenges and opportunity in the commercial book. But one thing has been constant, our cost structure, which has been sound, and the commercial business has always been profitable.

The earnings and cash flow from the commercial business has enabled us to invest in M&A, as well as organic opportunities in government programs. And while the commercial business represents about 40% of Coventry's revenue today, we are targeting a portfolio with a balanced spread across Medicare, Medicaid and Commercial with our Fee business being a complementary part of a diversified revenue earnings and cash flow stream. Don't really have any new news on the Commercial environment, which is a bit challenging, as there are many carriers seeking membership in what I feel is at best a stable pool of business and more likely today, a diminishing pool.

Despite the discussions and speculations about health care reform over the past year, we really never altered our focus in terms of preparing for the opportunities in 2014 and beyond. One of the efforts to position Coventry for 2014 is the high-performance network model of teaming up with leading health systems and physician groups and together, we expect to deliver a superior value proposition to Commercial and Medicare members in terms of care coordination, quality, access and cost. We expect the Commercial individual market to expand dramatically over the next few years. And we feel we'll be well positioned to seize that growth opportunity as well.

In the area of capital activity, we deployed $300 million of cash on share repurchase in the second quarter, which represents about 6.5% of the outstanding shares. And since Q2 is a quarter when we receive most of our regulated dividends, our deployable cash balance really didn't change significantly, as we ended the second quarter with approximately $850 million of deployable cash on hand.

So in summary, I'm very pleased with the positioning of our diversified business model as we look to the future. Given our exposure to and capabilities in government programs, we will continue to participate in growth opportunities in Medicaid expansion, Medicare and dual eligibles. We also expect our Health Plan cost structure in many markets to be a winner in the 2014 commercial exchange jump ball. As usual, we take nothing for granted. We work every day on cost structure and product positioning. We're committed to continuing the improvements in Kentucky. And we'll continue to use our strong balance sheet, when appropriate and attractive, for capital deployment.

On balance, we feel very positive about the diversity of our products and our balance sheet. We have never been stronger or better positioned to continue positive growth in Medicare Advantage and Part D. And I feel that we're positioned by resources, focus, commitment and experience to make substantial new Medicaid gains in the future.

With those general comments. I'd like for Randy Giles, our CFO, to provide some financial details. Randy?

Randy P. Giles

Thank you, Allen. This morning, we reported earnings per share of $0.65, which includes a $0.03 impairment charge, resulting from the non-renewal of our Medicaid contract with the state of Kansas. This result allows us to reaffirm our 2012 full year EPS guidance range of $3.10 to $3.30 per share. I'm pleased with the results we have reported today, which reflect improved performance in our Medicaid business, sequential growth in our Medicare products, continued SG&A efficiency and effective use of deployable capital.

Our mix of business continues to shift towards more balanced levels across Commercial Risk, Medicare and Medicaid products with an important level of non-risk revenue provided by our fee-based businesses. We believe that a diversified portfolio of businesses provides a critical ability to both seize growth opportunities and provide the best positioning for continued growth and profitability.

Let's begin with our Government Programs businesses, where I'm pleased to report significant improvement in Medicaid during the second quarter. Medicaid MLR of 93.3% is a 670-basis-point sequential improvement was driven primarily by the significant improvement in Kentucky during the quarter. Excluding the impact of Kentucky, our consolidated Q2 Medicaid MLR was an outstanding result at 83.5% or a decrease of 340 basis points over the prior year period. Our Kentucky Medicaid business improved from the 120.9% MLR that we reported in Q1 to 110.8% for the second quarter, a sequential improvement of 1,010 basis points, which was driven by favorable trends for both revenue and expense during the quarter.

On the revenue front, during the quarter, we received more clarity from the Commonwealth regarding risk-adjustment payments owed to Coventry. While we'll continue to discuss the underlying methodology of the risk-adjustment calculation with the Commonwealth, Coventry began recognizing the positive revenue impact of a monthly risk-adjustment payment, with an 8% quarter during the second quarter.

As we disclosed in the investor conference during June, the supplemental payment issue has been resolved favorably, which had a positive impact on revenue in the second quarter and will continue throughout the remainder of the year. In addition, we'll be receiving a 5.3% contract rate increase on October 1, which will provide $4 million of incremental revenue per month, plus any amounts that result from continued discussions on risk adjustment, as Allen mentioned.

In terms of medical expense, we continue to make progress with our list of targeted cost initiatives and expect the fruits of our labor to resolve in continued cost improvement during the second half of 2012 and throughout the remainder of the contract. We're in continued discussions with the Commonwealth regarding various aspects of the Medicaid program that we will continue to update you on as they develop.

We remain on track to exit 2012 with the results such that Kentucky Medicaid will not have a material impact on our 2013 earnings performance. As you will recall from our last earnings call, I highlighted that we were awarded an expansion to our existing presence in the state of Nebraska, which just went live on July 1. The contract is off to a great start as we've added nearly 40,000 members according to the initial data, out of approximately 60,000 new eligibles. This brings us to approximately 90,000 members statewide with the #1 market share.

We also expanded in Virginia effective July 1, as the state expanded in the Southwest region where Coventry has been awarded 7,000 new members. And finally, in Florida we were recently re-awarded a contract to serve the state's Healthy Kids Medicaid program to 16 counties serving approximately 20,000 members, which is generally consistent with our presence today.

We participate in multiple programs in the Florida Medicaid market and view this rebid as an encouraging sign as we think about further expansion programs that the state is considering for 2013 and beyond. We were also successful in our rebid efforts in Missouri, which is Coventry's largest Medicaid state by membership and has been performing well throughout 2012. This contract was effective July 1 and initial open enrollment results yielded growth of an additional 25,000 members to solidify our #1 presence statewide. This outstanding momentum across our Medicaid businesses puts us on pace to exceed our 1 million member goal during the third quarter of the year.

With that being said, we were unsuccessful on one bid during the second quarter, as we will not be renewing our contract with the Kansas Medicaid program, which is scheduled to end on December 31 of this year. Contract terms offered by the state were very complex in nature and presented unique challenges for managed care organizations. We bid prudently based on the data that was available, most of which was our own experience, as well as the requirements that the state was putting forward for the new contract.

Although our contract terminated on June 30 of this year, we've been able to reach an agreement with the state to provide managed care services through the remainder of the year at an acceptable rate. Because this contract was held by recently acquired Family Health Partners subsidiary, we took an impairment charge in the second quarter of the $7.7 million or $0.03 per share to write down certain intangibles associated with the Kansas portion of FHP. Just to remind you, the Kansas Medicaid contract represented approximately $350 million annual revenue with a year-to-date MLR into the 90s, such that it was essentially a breakeven contract. While we are disappointed with the foregone opportunity, we remain quite optimistic about the growth trajectory for our Medicaid business in total and the growth initiatives that we have on the horizon.

Turning to our Medicare business, Medicare Advantage continues to see favorable membership trends, as we added 3,000 members during Q2. The second quarter MLR of 84.1% is in line with expectations and is consistent with our full year MLR guidance of low to mid-80s, excluding the impact of the RADV reserve release. As Allen mentioned, we have submitted our 2013 bids. I'm confident that we are well positioned, both operationally and financially, to serve the senior population in the future.

Our Medicare Part D business experienced very impressive sequential growth during the second quarter, as the 36,000 members that we added was the best growth in the entire industry. The year-to-date Medicare Part D MLR of 92.5% is consistent with our 2011 year-to-date MLR performance and keeps us on track for our full year MLR guidance of low to mid-80s. Similar to my commentary on Medicare and managed, I like our positioning in the 2013 Medicare Part D bids in light of these continued stable results.

Moving on to the Commercial business. This morning we reported MLR of 83% for the second quarter and 81.5% year-to-date. As you saw on the commentary in our earnings release, there's one specific item that is mathematically pushing up this result relative to 2011 but importantly, does not significantly impact the overall earnings profile of the Commercial Risk business. We have been able to implement broker capacity initiatives in the majority of our geographic areas across both large and small group business in 2012, which is an important strategy to create a more appropriate comparison to minimum MLR definitions. The effect of this process on the GAAP financials, though, is to mathematically reduce revenue for the broker commission component that otherwise would've been reported in our risk revenue total, which increases our MLR this year as compared to the prior year.

There are, of course, many other moving parts in this nearly $6 billion block of business, but I thought it would be instructive to spike out this specific factor, which drives our slightly higher Commercial Risk MLR result, without a material impact to the overall earnings profile of the business. Given this item, our full year guidance is now 81.5% to 82.5%, which, at the midpoint, is an increase of 40 basis points from the prior year.

Staying in our Commercial book, once again our view of fundamental prospective trend remains unchanged in the range of 8%, plus or minus 50 basis points. We continue to see trends in the high 7s, looking in the rearview mirror, which have migrated higher from the very low levels seen during the second half of 2010. Unit cost trend, which continues to be the largest driver of overall trend, is stable. As we look at trend by component in the second quarter, we saw the trend for inpatient days per 1,000 remain slightly negative, and we're projecting inpatient utilization trends to be flat to slightly positive prospectively. Physician trends appear to have stabilized after showing some slight uptick over the last few quarters, while the utilization trends that we are seeing in the outpatient category, continue to tick upwards. These various trend dynamics have been gradual and importantly, have been anticipated in our pricing. You'll recall that we first mentioned seeing this migration in the third quarter of 2011.

Our Fee-based business has all performed in line with expectations in the quarter, and we have increased guidance slightly for this second consecutive quarter, reflecting a broadly improved view across all lines of our Fee-based businesses. We continue to be pleased with our Fee-based businesses, as they have consistently generated steady levels of valuable unregulated cash flow and earnings.

Turning now to SG&A. I'm very pleased with the second quarter result that we reported today and the lower full year expense level that we have included in the new guidance ranges. Just to put this into context, in 2011, we reported an SG&A rate of 16.5% of revenue, which was reduced to 15.4% of revenue in our initial guidance and has now been reduced to 14% -- 14.8% of revenue today. This is the second consecutive quarter where we have been able to increase our overall revenue range, while lowering our SG&A projection, a leveraging dynamic that we think is critical to succeed in today's environment, and even more so, as we look to the future. While we continue to leverage our efficient operating structure in the near term and enjoy the benefit on the SG&A line from our broker pass-through initiatives, we are also very mindful of the investments that we'll need to make for the future and are preparing accordingly.

I would now like to spend some time on our balance sheet and cash flow performance for the second quarter. Our investment portfolio continues to be in excellent shape and is in a net unrealized gain position of $108 million at June 30, an increase of $8 million from the prior quarter. Following through on our commitment to deploy capital towards share repurchase, we bought back 9.3 million shares during the second quarter for $300 million, which represents approximately 6.5% of our outstanding shares. Not only is this level of activity comparable to our total share repurchase activity for all of 2011, it also represents the highest share repurchase level in a single quarter in the company's history.

Also during the second quarter, our Board of Directors approved our second quarterly cash dividend, which was paid to shareholders on record on July 9. In addition to deploying cash to repurchase shares, we completed our dividend process during the second quarter, collecting $215 million from our regulated subsidiaries. We ended the second quarter with $850 million in deployable free cash at the parent, which even after $300 million of share repurchase, which combined with our undrawn $750 million credit facility, provides $1.6 billion in accessible capital capacity.

As of June 30, our debt-to-cap ratio stands at 26%, falling well within our typical leverage levels. So as I reflect on our results for the quarter and the progress that we have made across all of our businesses, I'm very satisfied with how the company is positioned and in fact feel that we're advantaged in many areas. Health Care Reform continues to move forward. And while this will surely create changes in the marketplace, it will also create significant opportunities for those that have a low-cost structure and can execute effectively. We believe that we have the capital and free cash flexibility to prepare, adapt quickly and support the growth prospects that we see for the future.

Thank you again for your interest in Coventry Health Care. Operator, this now concludes our prepared remarks, and we are ready to open the lines for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And we'll go to Tom Carroll with Stifel.

Thomas A. Carroll - Stifel, Nicolaus & Co., Inc., Research Division

So question on Kentucky, what was the Kentucky Medicaid premium in the quarter?

Allen F. Wise

Stand by, we'll get you the exact number.

Thomas A. Carroll - Stifel, Nicolaus & Co., Inc., Research Division

Great.

Allen F. Wise

Tom, it was $249 million.

Thomas A. Carroll - Stifel, Nicolaus & Co., Inc., Research Division

$249 million, great. And do you expect sequential MLR improvement to continue there? I mean, the data points you gave us suggest continued improvement, would you agree with that?

Allen F. Wise

We do.

Thomas A. Carroll - Stifel, Nicolaus & Co., Inc., Research Division

Any magnitude? I mean, another 10 percentage points of decrease, rather?

Allen F. Wise

I don't know. We've made very substantial and consistent progress. There's a lot of opportunities remaining on the revenue side. Ultimately, can't book it this point but -- and can't guarantee it. But ultimately, I believe we're entitled to retroactive risk-adjusted revenue. And we'll pursue that to the end, and we continue to make substantial progress in admissions and taking better care of the patients. We continue to weed out prescription drug abuse, pain center types of mills. We will make future progress in refining our delivery system, which was made more difficult by some litigation by the biggest provider group there. So we've made a lot of progress, and we have a lot of opportunity. And I can't -- it was a pretty bold statement for me to say worst case next year is breakeven and my view is we're going to make a reasonable profit. So it's kind of hard to predict month by month and quarter by quarter because we've seen one great quarter of improvement, and I see no reason why that trend won't continue. I wouldn't say it's going to be another 1,000 basis points in the next quarter.

Randy P. Giles

And then, Tom, obviously, the bigger step-down would come with a rate increase effective 10/1.

Thomas A. Carroll - Stifel, Nicolaus & Co., Inc., Research Division

Great. And just as a follow-up on your Commercial cost trend side, it sounds like you're not seeing anything outside of what you were expecting, so nothing like the Blues being more competitive than you thought or utilization rising more so than you thought. Just trying to reconcile the slight increase in your consolidated MLR number for the year. Would you suggest that's just -- that's all related to the broker pass-through mechanism?

Allen F. Wise

Our view of the commercial environment is consistent with really what we've talked about for the last 5 or 6 quarters, which is it's very competitive. It's beyond competitive in Western Pa., but it doesn't -- isn't dramatically different than we've experienced in 15 years in the business, which is there's always a couple marketplaces where it borders on irrational. And so we will lose membership until that settles down. I believe it's probably a diminishing pool of business. There isn't any job growth, and I think that for the most part in the data that I -- I would suggest that we lose membership within existing groups, meaning that employees can't afford the coverage and drop it. But it basically – there's not been any substantial change this quarter over the last quarter. It's competitive and not a growing pool of business but because of our cost structure and our experience in -- long term in the marketplaces we are, we don't really see any deterioration for the rest of the year.

Randy P. Giles

On your question about MLR, last year we recorded an MLR of 81.6%. Our guidance today increased to 82%. All of that 40-basis-point year-over-year increase is explained by increased broker pass-through activity in 2012.

Operator

And we'll go next to Josh Raskin with Barclays.

Joshua R. Raskin - Barclays Capital, Research Division

Just a first question just on the broker commission. Just so I understand, you guys are basically increasing that ratio by taking out. You said there's no impact, but you guys get $15 million in rebates for the last year. So is there no impact on your expected rebates either? Or ultimately, will there be a little bit of a benefit in terms of the P&L?

Randy P. Giles

The strategy is actually -- I think the broker pass-through affects all markets. Our rebates on health care reform rebates, minimum MLR are really concentrated in a handful of markets. So the fact is, we basically have taken this broker commission pass-through strategy in all our markets. And so it's pretty broad based. So it doesn't really line up one for one. You're right. There could be, theoretically, be a benefit in those markets where there are rebates, there is one. But it's not concentrated in those markets.

Joshua R. Raskin - Barclays Capital, Research Division

Okay. And is there a reason you guys chose now to accelerate that strategy?

Randy P. Giles

It really -- I think the strategy was deployed last year, but it really involves working with each broker and each group to try and get that set up. So it really deploys as those cases renew. And so now that we've gone through a year, most of the groups have gone through that renewal cycle and are moving over to broker pass-through.

Joshua R. Raskin - Barclays Capital, Research Division

Got it. And then just second question on Kentucky, were there any -- I guess, 2 parts, were there any what you would consider out-of-period payments that came? It sounded like you had some stuff retroactive back to April or even last November. So I'm just curious if there was sort of like a one-time event that hit the MLR in 2Q that you could spike out. And then, what's the estimate on sort of the full year loss in Kentucky for 2012?

Allen F. Wise

There weren't any out-of-period payments in the revenue dates, for the dates that I gave you in my presentation...

Randy P. Giles

The supplemental payments did go back to November. That's a couple million dollars. The risk adjuster was all with -- the payments we received were all, at this point within the same Q2 period. We haven't received any retro-risk payments. We're -- that's what we're asking for.

Joshua R. Raskin - Barclays Capital, Research Division

Okay. So the sup payments going back, might have been a couple million but not a huge deal. The risk adjusters were all for Q2. And then the full year loss?

Randy P. Giles

What's your -- can you restate your question again?

Joshua R. Raskin - Barclays Capital, Research Division

Yes, just curious what your expectation in terms of a full year sort of pre-tax loss in Kentucky is going to look like this year.

Randy P. Giles

Well, we really don't spike out individual contract performance like that. I mean, you can kind of back into it. But with the losses that we've incurred in the first quarter and the MLRs that we've had year-to-date, the contracts -- we reported MLR year-to-date of 115.6%. That gives you -- and we're projecting that, that'll decrease over time with -- we'd expect the most significant MLR improvement at this point based on information that we have, visibility on it being in the fourth quarter. So we expect that to phase down toward a breakeven as we go in through the rest of the year and again enter 2013 with no material pressure.

Joshua R. Raskin - Barclays Capital, Research Division

Okay. When you say breakeven, do you mean 100% MLR? Or do you mean breakeven profit, including the G&A?

Allen F. Wise

No, we mean breakeven after we pay our SG&A expenses. 100% is not breakeven.

Joshua R. Raskin - Barclays Capital, Research Division

Right, right. I didn't know if we were talking gross margins or operating margins.

Allen F. Wise

And I think it's difficult, not to be -- to go much deeper and not to be misleading. We feel we have retroactive risk-adjustment amounts due. We filed an appeal on that front. We feel like that's supported contractually. If that appeal's not successful, we'll litigate the issue. How we ultimately resolve all of that, it can't get any worse. If we resolve that successfully, it's going to affect the year. But we made a lot of progress on the revenue side and a lot of progress on the cost side in Q2. And we think that'll continue in Q3. And even a 5.3% increase on a $0.25 billion in revenue puts us in a substantially better shot. We think that the worst days are behind us in Kentucky, and we've done many of the things and will do many of the things it takes to -- for this to be successful. It's been a humbling and valuable lesson, but we will prevail.

Operator

We'll go next to Carl McDonald with Citi.

Carl R. McDonald - Citigroup Inc, Research Division

So first question, WellPoint, earlier in the week, positioned the Commercial business as a change relative to what they'd been thinking about earlier in terms of both -- it sounded like both pricing and cost trends -- it seems like you and United have a sort of a more consistent view. So I'd just be interested, when you hear WellPoint say they think things are changing and things are getting more aggressive, did that give you pause? Or would you attribute that all just to a difference in expectations coming into the year?

Allen F. Wise

Well, I think we always spend a lot of time worrying about what we don't know. But I think if you would review our comments on the commercial environment and trends back for 6 quarters that we were probably one of the first companies that said the diminishing utilization wasn't going to continue forever. We don't know what caused it and what was going to change it. I think that we have been consistent in saying there was some pressure on outpatient costs. And not unlike Kentucky, I think we're the first people doing business in Kentucky that said, "We've got problems here." And disclosed that the minute that we knew it and went to work on it. So I think our view on Commercial, if you'd examine our comments for the prior quarters, have said it's a little tougher environment. We don't see any dramatic change. So it always gives you pause to say -- to once again think about what's occurred and where the future goes. But we -- our practice here is to think about the worst all the time and we have, I don't know, 50 initiatives on the unit cost side where we think we've gotten a little bit behind. And that's kind of how we view the business here, which is always with a little bit of fear and a little bit of suspicion and a lot of reality. So I don't understand – we aren't in most of the markets or many of the markets or most of the markets with WellPoint, the way we would be with United and some of the other Blues. So I don't know what would have suddenly happened. These things evolve over long periods of time, and I don't understand things that suddenly occur. So I can't be helpful there. But we don't see anything different than we've reported the last several quarters and we've reported today.

Carl R. McDonald - Citigroup Inc, Research Division

And then on Kentucky, to get to breakeven, the 111% has to go to, say, 93% or 94%. Is there any way of giving us a sense of how much of that 1,700-, 1,800-basis-point improvement is things that you've already achieved? So say the rate increase -- some of the provider renegotiations or cancellations versus how much is stuff that still needs to be accomplished like the, say, the retroactive risk adjustment.

Allen F. Wise

No. I think it's probably a little bit of both. It's always a little bit difficult to be able to measure precisely what you've achieved. The things that we have done 2 months ago will show up 2 months from now. When the numbers are in, the claims are paid. And now it's a sense of -- I think it's a continuous process, and I think that some of the things that developed in this quarter were really work that we did the quarter before. So I think that we have made progress. I think there's a lot more opportunities, a lot more opportunities in refining our delivery system, a lot more opportunities in continuing to take better care of the patients. If you'll think -- if you follow the media, at least 4 times or 3 times last quarter, Kentucky leads the -- is always highlighted as, the Commonwealth is one of the places where prescription drug abuse is the worst. So we have 50 initiatives and some of those are continuous. You're really never finished. I just think that in areas like reduced admissions and getting observation days, which is the practice in most hospitals. And I think it's guidelines that CMS issued and continues to refine. We just made a lot of progress, and I think the revenue increase in Q4 is huge. But I think on the patient management side and issue, those will go on for a long time. We've been in business -- Medicaid business in Missouri since 1994 and life changes. For a long time, our trend was 8%. The state gave us an 8% increase and life was good. And 2008, the revenue got tougher and so we continually evaluate our cost structure and how we deliver the care. And so we've done a lot of work in Missouri, which is a huge state for us, too, in terms of our contracts. We had a contract forever with the Washington University Physicians group that was 180% of Medicaid, which worked in the old days when revenue was easier to come by and you could have a very broad delivery system and make a reasonable profit. That contracts was canceled last quarter. So don't want to get off the subject Kentucky. It really never stops and with a decent amount of experience, and we think that we're getting closer to a partnership in Kentucky. We have better dialogue with them. This has to work for the Commonwealth, has to work for us. And we think that we've made progress, and we'll continue to make progress. And I can't do much better than to – I've stuck my neck out quite a ways saying I thought we were going to make a profit next year.

Randy P. Giles

Just to add to Allen's comment. We think we can make break even at -- with 4% admin and the 96% loss ratio in Kentucky. So the hurdle's not quite as large as you thought. In addition, one other point, I think that we've kind of already got visibility on is that we are putting in co-payments -- additional co-payments in Kentucky. We're going to open enrollment in the fourth quarter. So we're going to see economic benefit from that and that's already structured. The provider – high-cost provider adjustments will also happen in the fourth quarter, and we're already -- those are already – we're already committed to those. So there's a couple of these things that are both on cost side and on the revenue side that we have pretty good line of sight on. But there's, obviously, a lot more on the cost initiatives, the revenue side that we have to do to get all the way to breakeven.

Operator

And we'll go next to Kevin Fischbeck with Bank of America.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

As you mentioned, you're not the only company experiencing issues in Kentucky, and one of your competitors talked about changing the methodology for retro assignments. Have you guys factored that into your thought process? And what do you think the impact to you guys might be?

Randy P. Giles

Yes. I think in terms of -- there's really a couple of big changes happening there in terms of retro assignment and the way that's going to work. It's not just retro assignment. The Commonwealth is committed to changing the auto assignment process in general, and we think there are some high-cost categories for us like dual eligibles and some of the other categories that -- where we have a disproportionate share. So we think that shift will benefit us from some of the other categories. And we think, in general, that shifting might end up being neutral, just in general. The -- overall, we think that's a positive for all the MCOs because on average, it means the average revenue that the Commonwealth is paying is going to increase. Because currently, a majority of the selection criteria is based on who has the lowest premium in a given rate cell. And so we think that's going to end to -- lead to marginally higher PMPM revenue in the contract.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Okay, that's interesting. And then just to clarify a couple of things you guys had said earlier. If you think about the core Kentucky MLR, I guess, the pass-throughs and the retro portion was maybe a couple million dollars, that might have been 100 basis points to MLR, is that the right way to think about it? And then, in relation to Tom's question, you said there's sequential improvement in MLR. Is that -- even -- do you expect that even with not having that 100-basis-point tailwind? Or should we be thinking about that as kind of offsetting that tailwind sequentially?

Randy P. Giles

In terms of the pass-through payments, that's obviously an ongoing thing. There is an increase in the third quarter in the supplemental payments -- payment level that we expect to see that will hit in the third quarter. But again, that's just a pass-through. So we'll be getting more supplemental payment revenue, and then we'll be passing more of it through an equal amount. So we see that supplemental payment as you just kind of smoothing out. You're going forward and just being in sync. We don't see that flipping it one way or another. Second quarter and first quarter, obviously, had some shifting between -- supplemental cost between -- payments between first and second quarter, but I will see that as a huge issue. It's not – it's a couple million dollars.

Allen F. Wise

I think there's -- if you'll go back just one quarter, when we didn't make any comments about Kentucky other than saying we had big problems, we had a lot of progress. I think there'll be a lot more clarity about the next 12 months in another quarter. And in terms -- we know what the revenue projection's going to be. We'll have further insights into the value of the initiatives that we've been working on for really 6 months. So I think we've made really huge, huge gains in the financials and huge gains in our insights about where we are. And I think one more quarter will give us a lot better insights to more accurately be able to project what the next 12 months looks like.

Randy P. Giles

Another point I would make is, we have ongoing significant discussions with the Commonwealth and their leadership, and we're working hard with them to try and make this program financially viable for the long term. And that's in their best interest as well, and so they're engaged in productive discussions with us in that regard.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Okay. And then just, I understand what you're saying about the broker commission change impacting MLR and I guess, your SG&A guidance as well. But what's not clear to me is why wasn't this in your original guidance around those 2 line items?

Randy P. Giles

It was more of an execution thing. We weren't clear on the timing of when that would actually start flowing through the payments as these things came through. It's -- I would say broker pass-through this year is up like 400% over last year's run rate. So we've just actually seen it actually coming through. We didn't want to reflect it until we saw what the number was actually going to shake out as.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Was that a state, like, approval process? Or was that just the way the contracts kind of turned over?

Randy P. Giles

Yes. In certain states, you can't do it. So it is a state approval process, also relates to how the contracts turn over and also whether the broker's wanting to bill that directly to the customer or they wanted us to bill it for them.

Operator

And we'll go next to Justin Lake with JPMorgan.

Justin Lake - JP Morgan Chase & Co, Research Division

I just wanted to drill down on this commission issue one last time for everyone who's -- obviously, there's some concerns going on in the commercial market with the MLR trajectory and what's going on with price cost. So on a year-over-year basis, your MLR is up 230 basis points in the second quarter, it looks like. Can you spike out for us how much of that specifically was due to commissions? Or maybe give us the number of -- dollar amount of premiums, so we can do the math ourselves, that came out in the second quarter year-over-year?

Randy P. Giles

Yes. If you look at full year 2012 and you compare that to 2011, there's -- year-to-date, you have a 120-basis-point increase, about 35 to 40 basis points of that is driven by higher level of broker pass-through in 2012, then -- compared to 2011. 80 basis points is driven by really higher seasonality in 2012 for the same time period than we saw in 2011. And actually, the seasonality for the last half of the year that we're projecting for 2012 is actually more favorable than seasonality patterns for 2011 for the same time period.

Justin Lake - JP Morgan Chase & Co, Research Division

So you're saying that 80 basis points of seasonality should reverse itself in the back half of the year.

Allen F. Wise

That's what we're expecting, yes.

Justin Lake - JP Morgan Chase & Co, Research Division

Okay. And what's driven all that seasonality?

Allen F. Wise

It's actually the calendar, the number of days and the type of days kind of drives our seasonality models in our IBNR. And so, Justin, the slope is a little less steep through this year than last year, if you just look at the calendar and also as importantly, the type of days and the historical claims activity based on the day of the week.

Justin Lake - JP Morgan Chase & Co, Research Division

Got it. And then just drilling down a little bit on cost trend. It sounds like you were still in that high-7% range, so a little bit below the 8% midpoint. Can you talk to us about how that looked through the quarter and whether the outpatient utilization that you noted there is -- do you see that continuing to grow through the year? Do you expect to be north of that, towards the high end of that 8% by the end of the -- coming out of 2012?

Randy P. Giles

No. I think the big thing we're watching for is when does inpatient utilization go to positive. It's slightly negative. It's approaching 0. The question is, is that going to move in to positive territory? At that point, I think that puts us -- that reconciles our rearview 7% to our forward view of 8%. And so that's kind of the difference between the 2, as we think about it. In general, just in terms of utilization, our inpatient commercial bed days were down low single digits from Q2 2011. Medicare Advantage bed days were flat. Medicaid bed days were down low to mid-single digits from Q2 of 2011. Commercial admits were down low single digits. Medicare Advantage admits were down mid-single digits from Q2 2011. In terms of the foreview, expect inpatient to be -- trend to be driven into the high single digits, almost entirely unit cost driven; outpatient, low double digits, mostly unit cost driven; physician, mid-single digits, tilted toward unit cost; and pharmacy, mid- to high single digits, split evenly. That's our kind of the detail on our rearview and foreview.

Justin Lake - JP Morgan Chase & Co, Research Division

Got it. The last question would just be, as you're thinking out to 2013 and we're going to, probably in the next couple of months, have to start getting an idea where pricing shakes out. And obviously, that's going to depend on your forward view or trend. Is it fair to think that looking out in the -- given your concerns on the potential or at least conservatism around the potential for upward pressure that you would probably price with some cushion, again, going into 2013, just like you did in 2012 or some uptick there versus your kind of current 8% view?

Randy P. Giles

Well, in terms of absolute pricing level, our pricing level in '12 is, on an absolute basis, higher than 2011 on Commercial. As we think about the future in '13 and beyond, I think our pricing remains pretty consistently in the same kind of posture. Once we get in '13, there's going to be health care reform impacts that we'll need to begin pricing for and so -- as we start getting closer to '14. So as we map all that out and start reflecting some of that in our pricing, that's going to put some upward pressure on pricing, we think, in the industry in general.

Operator

Our final question for today will come from Ana Gupte with Sanford Bernstein.

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

Just wanted to follow up on the previous question again. So 230 bps on the commercial loss ratio quarter-over-quarter -- I mean, year-over-year, for the same quarter. So you're saying it's 120 bps for half year in 2011 relative to 2012? And what I'm trying to get to is, you must have seen a reduction in medical loss ratio rebates as well, right, to offset this broker commission issue. So is this 35 to 40 bps net of the reduced rebates? And then secondly, you had $99 million in reserves last year, what is the favorable reserve development that you saw this year? And how much of that was commercial or not?

Randy P. Giles

Let me start with your second question on prior period development. We're going to disclose the full details on our Q filing in a few weeks, but as a means of preview, we have seen restatement levels during the first 6 months of 2012, which are consistent with or slightly better than the prior year. So we don't see much impact on the run rate on MLR from just prior period development being significantly different year-over-year. For the quarter, as it relates to medical reserves, we did increase our DCP by 1/3 of a day sequentially from the prior quarter. So combined with the prior period development year-to-date, we feel like we're -- we have good current reserve levels. So I just wanted to kind of hit that reserve piece. As far as rebate levels, we did in the -- have a rebate reserve for health care reform of $52 million at the end of the year, and we have filed and through -- made modifications to that accrual this year related to that, based on changes and clarifications in the guidance around the 4-prong test and other issues related to the calculations and final waivers that were received the books were closed for year-end for individual product. So we're able to pull that down to $14 million. That was the final number for 2011.

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

So you came down from $53 million to $14 million. So again, just trying to walk through this, is the 120 bps on a half-year basis. And if you just had to do it on a quarter-over-quarter basis, the 230, you're seeing rebates -- I mean, sorry, reserves that was no difference. There's a piece of it on rebates. I'm just trying to understand how do you net out any change in spread on pricing cost. Are you seeing anything worsening year-over-year on just the spread between underwriting, pricing and cost, net of rebates, net of reserves, net of broker commissions, what's kind of a clean way to look at this?

Randy P. Giles

If you take out the reduction in the minimum MLR rebate reserve from 2011, that's about a 125-basis-point benefit for the first half year run rate, compared to the run rate from last year. If we did -- that was really offset. We saw some -- an increase in some catastrophic claims above and beyond what we anticipated that offset that benefit in a limited number of markets.

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

And then going forward, as you're looking at -- you have 8% trend. You're seeing high 7s. So you're probably somewhere in the 25 spread range as you're pricing your business for the back half of the year on renewals. And then going into 2013, are you seeing your competition showing any hardening of pricing? Or is it getting softer or about the same?

Randy P. Giles

I think it's about the same, the pricing environment that we've been in for a while now for a number of quarters. I think my anticipation would be is that they would begin to harden their pricing just based on their financial results, it would seem to make sense. But I can't predict what they're going to do.

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

And would you that at all?

Allen F. Wise

The other thing I would add to that is, there's a little bit more breathing room rather than just the 25 bps. Because in the base measurement period, you also had the introduction of the September 2010 reform elements that pushed cost up. And so as that kind of falls away and rips through both the numerator and the denominator, that should give us some relief on our fundamental trend as well.

Randy P. Giles

I think the other thing is we've signed some contracts, major contracts with some medical providers for us that we've talked about on previous earnings calls, that improved our cost structure in those areas and improves it over, beyond just 2012.

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

So net-net, you have a positive spread of probably, maybe 50 bps and you're seeing potential for hardening beyond that in the marketplace.

Randy P. Giles

Yes. And actually, our actual pricing trend is higher than 8% as well. Before we build in those 2 things, our medical trend and pricing trend aren't exactly the same number.

Allen F. Wise

Thank you for joining us today. Concludes our comments.

Operator

Ladies and gentlemen, again, that does conclude today's conference. We thank you all for joining.

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