Universal American Corporation Q1 2008 Earnings Call Transcript

Universal American Corporation (UHCO)

Q1 2008 Earnings Call

May 7, 2008 9:30 am ET

Executives

Richard Barasch, Chairman, and CEO

Robert A. Waegelein -Executive Vice President & Chief Financial Officer

Rob [Churl] - Director of Investor Relations.

Analysts

Joshua Raskin - Lehman Brothers

Steven Schwartz - Raymond James & Associates

Carl McDonald - Oppenheimer

Daryn Miller - Goldman Sachs

Kevin [Krondayone] - J.P. Morgan

Jukka Lipponen - KBW

Presentation

Operator

Good day everyone and welcome to the Universal American Corp First Quarter 2008 Earnings Conference Call (Operator Instructions) I will now turn the conference over to Richard Barasch, Chairman and CEO

Richard Barasch

Thank you and good morning everyone. Welcome to the Universal American 2008 First Quarter Conference Call. I’m here with Bob Waegelein, our CFO, and Rob [Churl] our Director of Investor Relations.

Before we begin I’d like to ask Rob to read our Safe Harbor Language.

Rob Churl

I’d like to remind you that some of the information discussed during this conference call will constitute forward-looking statements within the meaning of the Federal securities laws.

These forward-looking statements may include statements regarding our expectations of the performance of our Part D Med supp and Medicare Advantage businesses and other lines of business. Estimation of loss ratios and lapsation adequacy of reserves, our ability to institute future rate increases, expectations regarding our Part D and Medicare Advantage program, including our estimates of membership, costs, revenue and future operating results.

Identification of acquisition candidates, completion, integration, or accretion of any acquisition transactions, risks of the MemberHealth transactions and statements regarding the viability of any acquisition proposal.

Although we believe that the expectations reflected in these statements are based upon reasonable assumptions and estimates, we cannot give assurance that we will achieve the expected results.

We also suggest that you review the most recent risk factors that we periodically filed with the SEC.

Richard Barasch

2007 was an extraordinary year of growth for Universal American and we head into 2008 with a great deal of optimism about our prospects; however, the past several months have been quite challenging for us for several reasons and the result of this quarter will raise some further questions about our operating position.

All of these issues taken together have raised understandable questions about the company, which have been reflected in, among other ways, a significant reduction in our stock price.

This morning I’m going to spend some time talking about the quarter and of course you should speak to Bob Waegelein or Rob, with any specific questions.

I want to step back for a moment and talk about the company from the ground up.

I recognize that it will take some time and of course performance to regain the support that we’ve lost and I think the first step on that path is to go back to basics; first the plan.

Several years ago we chose to focus on the senior market, in large part, because of the demographics. This strategic direction was validated and enhanced by the passage of the Medicare Modernization Act in 2003. It implemented Part D and fueled growth in the Medicare Advantage business.

Nothing has changed to alter our view as to the attractiveness of this market. We recognize that the Medicare business is a complex business that has significant risks, not the least legislative and regulatory, but we believe strongly in the future of the market, broadly defined as providing valuable health insurance coverage to seniors.

The specifics may change and I’m sure they will, but the need for these coverage’s will grow and we have demonstrated our ability to innovate rapidly as the market and the environment changes. I believe it is one of our core strengths.

Through acquisition and internal growth, Universal American rapidly transformed itself from a small multi-line insurance company into one of the leaders in the senior business. We have three profitable, scalable businesses with important market positions and a lot of growth potential.

We operate the leading Medicare Advantage plan in Southeast Texas and have a far leading coordinated care structure that is starting to find traction in our expansion markets. We felt a large private fee-for-service for service membership, which while valuable in and of itself, also gives us the distribution and infrastructure upon which to move to the second phase, the PPO business.

We now have in our two programs the third largest Part D business in the country, servicing more than 1.8 million Medicare beneficiaries. All in, we now provide coverage to more than two million members who rely on us for all or part of their health insurance needs, which generates more than $4.5 billion of revenue to Universal American.

We’ve also built a vibrant, experienced distribution capability of [core] and independent that has helped us to get to the position that we are presently in, that will enable us to resume our growth. This too is one of our core strengths.

Another of our core strengths has been our ability to establish creative partnerships that permit us to leverage our own capabilities. Our alliances with primary care providers in Southeast Texas, with community pharmacists all over the country are two great examples of this philosophy. We are known as good partners and I’m sure that we will be able to do more creative partnering in the future.

We supported our rapid growth with a solid financial structure that provides us a lot of flexibility. All of our major businesses are profitable, we have a comfortable amount of leverage, our subsidiaries are well-capitalized and generating cash, and we hold a significant amount of unregulated cash at the holding company; we’re at $170 million at the end of the last quarter.

In addition, our legacy businesses, with the possible exception of the small remaining long-term care block, our salable assets can generate additional capital and flexibility should we decide to go in that direction.

Never the less the past few months have been quite challenging for us. First, we are quite disappointed with the lack of membership growth in our private fee-for-service business, after our stunning success in 2007. There are several factors that caused this, but we’re determined to regain a growth pattern in 2009, in part with the introduction of PPO products in approximately 20 new markets.

Lack of membership growth in private fee-for-service has matched two important positive developments: first our margins of private fee-for-service in 2008 are expected to be higher than in 2007, especially if the negative reserve development is pushed back to 2007; next, for the second straight year, but for opposite reasons, our private fee-for-service experience has over shadowed the steady growth and very good profitability of our HMO businesses and in 2008 emerging success of our expansion HMO markets.

The issues surrounding the MemberHealth transactions were also disappointing on several fronts, but as promised when we announced those issues, we have immediately attacked them and feel we are on track towards solving them. We have accelerated the process of rationalizing costs and integrating the operation of our two part D businesses and will begin to see significant savings in the balance of this year, 2008. We also feel increasingly comfortable that we can reduce our benefit cost structure as well.

Some of you are giving us credit for the purchase gap adjustment and some of you are not. But, I think it’s important to understand its implications. Very simply, it had a technical mistake in risk scores not being made in the 2008 bid. Member house bid and revenue would have been higher, but still under the benchmark in most regions. More important for our 2008 results, is even more critical to the understanding of why we believe the issue is correctable for the 2009 bids.

Let me spend a few moments discussing our subprime portfolio.

With the benefit of hindsight, it was clearly as mistake to chase a little extra yield while purchasing securities that ultimately had more risk in them than we originally thought. Having said that, the level of write-downs that we have taken are at least some what to greatly in excess of what we see as the reasonable probabilities of actual loss, unless economic conditions materially worsen from here.

While we have taken the write-downs, we have neither the intention nor the need to sell these securities, in what appear to be artificially depressed prices and we will see what happens from here with both pricing and performance. To make matters somewhat more unsettling, it’s unclear what the appropriate tax treatment of these unrealized impairment losses should be and as a result we have concluded that we could not record a tax credit that’s related to these impairments, that we took in our first quarter.

There are other less visible, but important issues that have our attention in 2008. Managing explosive growth in this company has not been easy. We’ve made significant investments in our infrastructure with a view toward improving our service and lowering our operating costs, especially in our Medicare Advantage business, but we still have room for improvement. A key element of this effort has been the recent hiring of several qualified people at all levels of our company.

We also will focus attention on optimizing our capital structure and have several tools at our disposal. First we’ll continue to buy-back stock, especially at these levels. We have both the balance sheet strength and the liquidity to do this without strain. In addition, we’ll take a harder look at disposing our non-core assets. If we do so, we will get the benefit of additional capital by simultaneously reducing the distractions that are inherent in non-core businesses.

Now let me turn to the highlights of the first quarter:

Simply speaking, our Medicare Advantage HMOs, administrative services company, and traditional businesses performed well or ahead of expectations in the first quarter. I’d like to highlight that our Medicare Advantage HMOs experienced significant membership growth, 15% in the aggregate, over the same period in 2007.

Of note, we are finally getting traction into our expansion HMO markets and are increasingly confident that we are on the way to proving that the model that has worked so well in Southeast Texas, a real strategic and financial partnership between us and the providers, is attractive in other markets and can be exported.

As we have discussed previously, we are committed to building a Medicare Advantage PPO plan in many of the markets in which we already have a concentration of membership. While we continue to believe that private fee-for-service holds an important spot in the senior health care continuum, our guiding philosophy is to create lasting and meaningful relationships with providers. This has worked well for us in Southeast Texas and is largely responsible for the success of MemberHealth. Expanding into PPO products will allow us to continue to build on this principle.

Our Part D business also performed well, basically in line with our reset expectations for MemberHealth. This gives us the confidence that we will have the right metrics upon which to correct the 2008 bid issues as we bid the 2009 business.

Another highlight of the quarter, especially for those of you who have been following the company for awhile, is the Medicare Supplement [rasation] has moderated, again proving the correlation between private fee-for-service and Med Sup.

A negative for the quarter was the performance of private fee-for-service, which was burdened by $10 million of net adverse 2007 reserve development and write offs of commissions on business that lapsed prior to the end of a full year in force. Excluding this development, the private fee-for-service first quarter benefit ratio is consistent with our plan and with our prior full-year guidance. As with Part D, this is important for the basis for the bids that we are currently working on and will submit for 2009.

The other notable positive for the quarter, which also relates to 2007, is the reversal of the accrual set up for 2007 bonuses resulting in around $6 million in gain. After the events surrounding the MemberHealth acquisition, our board decided that it was inappropriate to pay the bonuses that had been otherwise earned by some members of senior management in 2007.

Let me finish my prepared remarks by talking a little bit about the guidance for the balance of the year:

The results for the first quarter were slightly weaker than our own expectations, largely as a result of the 2007 issues: the negative that came from private fee-for-service which was partially offset by the reversal of the unpaid 2007 bonuses. In addition, we will experience a significant reduction in net investment income for the balance of the year as a result of recent reductions in short-term rates. On the positive side, as previously noted, our Part D business should perform better as we have begun to benefit from some of the changes that we have made in member health. In addition, we will have a lower share count as a result of staff repurchases completed through the end of the first quarter.

All in, we are reiterating our full-year guidance for between $1.56 and $1.74 per share.

Thank you for your time this morning. I’m sure that there are several questions out there and Bob and I will be happy to answer them.

………..

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Josh Raskin of Lehman Brothers.

Joshua Raskin - Lehman Brothers

First question revolves around the private fee-for-[service business. First is just the negative prior period reserve development that you saw. Was that related more towards the fourth quarter, was that possibly the start of the flu or anything like that, maybe which geographies and which segments of the cost trends were really a little bit higher? Then tied to that, how do you have comfort in 2008 that your loss ratios are going to be in line in spite of higher costs in ’07.

Robert Waegelein

You know Josh. When we looked at 2007 in hindsight, the reserve adjustment that we posted is primarily related to the fourth quarter and all the reserve sets that we had for the prior quarter seemed to be spot on.

That being said then, our loss ratios, for some reason, it increased in the fourth quarter higher than expected. We’re trying to see if it is crew related. We don’t have any indication if it’s any specific region, company, or medical condition that caused that.

With that being said, we looked at our first quarter results and we’re more in line with what we had bid for and we’re still within the pricing on a look-back basis as well for ’07, which we built our bids for ’08 on; so, we’re comfortable that ’08 is not going to be affected by what we saw in the fourth quarter.

Joshua Raskin - Lehman Brothers

I guess, Bob, maybe you could flush out completion factors, how much data you’ve actually seen for the first quarter, what the benefit design goes, why maybe fourth year would be so much worse than the first three quarters of last year?

Robert Waegelein

Again, I think we had different issues in reconciling membership with the government and things like that. It’s hard to say about completion factors, they’re still being evaluated for how complete they should be given this point in time. We have new business sets coming through that could complicate some of the enrollment and as we considered the rapid growth that Richard talked about in 2007, it was a new business.

Again, when we look at each quarter individually in 2007, no period was developing any differently from September and prior, it’s very much located in the fourth quarter and we feel comfortable with the reserve adjustment we posted for the first quarter for last year.

Joshua Raskin - Lehman Brothers

Switching topics a little bit, Richard had mentioned that MMA PPOs in the introduction, 20 different, 2009, what’s a good result in terms of PPO growth next year and how much of that is expected to be private fee?

Richard Barasch

Let me see if I can answer the second question first. We’re not looking to move private fee-for-services members to the PPOs. What we’re looking to do, in March, is where we have strength, in the HMO markets is to offer a product set that is broader than we currently have, to be able to appeal to lots of different buyers of these products.

It’s very early to predict a size of membership, particularly until we see what our competition looks like in each one of the markets.

Joshua Raskin - Lehman Brothers

Okay, so maybe we’ll get a little more clarity towards the end.

Richard Barasch

I think so, I think sort of by the end of the summer we should have a much better view of where we stand in each market place.

Joshua Raskin - Lehman Brothers

After the bids. I’m sorry could you just define what you consider to be non-core assets that you’re looking at: is that traditional including that?

Richard Barasch

I would say that MedStop feels like a core asset to us. On the other side of the coin the businesses that are at least in line with exactly what we’re doing now would be disability income, sort of in the middle is the life business, because a lot of our agents to pre-sell a fair amount of our life products. The tension for us is between being sort of a mono-line health insurer and a broader provider of products, particularly to our core distribution so; some of these issues are a little bit more complex.

We solved this to some degree by entering into arrangements with third party manufacturers of products we sell into our core agency system with our support as well. We try to find the right balance between what we should manufacture and what we should facilitate to sell within our core group.

Operator

Your next question comes from Steven Schwartz of Raymond James & Associates.

Steven Schwartz - Raymond James & Associates

Back to the adverse resource developments, I’m just wondering, when the new guidance came out following the surfacing of the issues with MemberHealth, were you aware of the adverse development?

Robert Waegelein

Not at that time.

Steven Schwartz - Raymond James & Associates

Can you give a sense of given the first quarters disclosure, of maybe what kind of loss we should expect for the PPO effort for the year?

Richard Barasch

I think it’s too early again, Steven, to give you a number for that, but obviously there’s some development issues where we’re still in the process of deciding, you know this is real prime, which markets to go into based on the size of the networks that we have developed. It’s a little bit premature to give a budget for that, attempt to give a precise budget for that.

Steven Schwartz - Raymond James & Associates

So, assume some type of development costs, yes?

Richard Barasch

Yes.

Steven Schwartz - Raymond James & Associates

If we can look at the subprime assets, what principle are you operating on in terms of recognizing OTTI, are you using a bright-line test or some other methodology for determining OTTI?

Robert Waegelein

Unfortunately we’re using the IDC pricing as the barometer of the measurement of the value of these securities, even though they’ve been marketed as vibrant and as liquid as one would like to use a pricing service like that; nonetheless, as we see the IDC pricing on certain securities drop at different levels from month-to-month, or quarter-over-quarter, that seems to be the trigger. We do an analysis as expected. Cash flows discount them back.

That’s why Richard made the comment that we feel comfortable that our recovery on these are going to be significantly in excess of what we wrote them down to, but nonetheless we’re currently guiding to using the IDC as a market value indicator.

Steven Schwartz - Raymond James & Associates

Just on that second topic, assuming you’re correct and these things do come back, can you recognize the gains? How does that flow through either the income or the balance sheet?

Robert Waegelein

Once we see a sustainable increase in the value, we can start amortizing that discount back into our balance sheet by accreting assets through net investment income, so it’s the amortization of the discount over the expected life of that security.

Once again, once the market price recovers and it sustains at that level, you start accreting back up to that level.

Operator

Your next question comes from Carl McDonald of Oppenheimer.

Carl McDonald - Oppenheimer

I have another completion factor question for you, which is, how much visibility do you think you have now into the 2007 private fee-for-service results?

Robert Waegelein

Well it’s pretty visible, Carl. As you know, the nature of this business completes a little bit slower than Med South and as we talked about the growth that we had in ’07, it gets a little more difficult as a result of that. That’s why we’re feeling pretty good about September and priors. It’s now seven months later. We feel good about what we did for the fourth quarter, but obviously a couple more months will give us more certainty as to the ’07 result.

That being said, again, when we look back at the loss ratio for 2007, it’s within the guidance that we had provided for that year and we’re comfortable with that range.

Carl McDonald - Oppenheimer

Do you have a sense yet of how you’re thinking about product design for Medicare in 2009, sort of a trade off between trying to grow the business a little faster than it did this year, versus continuing to see the margins improve?

Richard Barasch

Carl if you can get Humana, WellPoint, and tell us your answer to the same question, I’ll be happy to give you my answer.

I don’t mean to be facetious, but we’re in the process of doing that design work right now, putting together our bids based on more balance between being aggressive for new business and the obvious desire and need for us to make an adequate return.

Carl McDonald - Oppenheimer

Last question, there’s been some fairly material changes made to the PDP for 2009 in terms of taxation of benchmarks. I’d just be interested in your perspective on how you think that will impact the business?

Richard Barasch

There’s more rating being given to the LIS than I think previously was expected, or the ratings on the LIS. Our books contain a lot of LIS folks, so we think our bid is going to have a lot of weighting, to use their word, in this process.

Carl McDonald - Oppenheimer

Do you think that’ll have a positive, negative impact on the benchmark rates?

Richard Barasch

It would be inappropriate for me to comment on that at this point.

Operator

Your next question comes from Daryn Miller of Goldman Sachs.

Daryn Miller - Goldman Sachs

Bob, how much was the accelerated write-off for commissions relating to private fee-for-service in the quarter?

Robert Waegelein

The accelerated write-off for commissions, about $2 million.

Daryn Miller - Goldman Sachs

Than Richard, if you were to attribute some of the slower growth in private fee-for-service, either benefit design or maybe your commission structure, how would we talk to that?

Richard Barasch

I think those would be two of the issues. Commissions in the marketplace did increase this year. We were slower to respond than perhaps, in retrospect, we could have been. We started increasing our commissions a bit as yearly item and you could see it in our sets, so commissions were a big factor.

Product design, in a fissure state thinking that the bridge from a seven through eight, we bid our ’08 business based on models of ’07, even though we really only were a couple of months into the year. In several places we raised our prices and I think that hurt us in the marketplace, particularly on the lapsation side.

I think those would be two of the bigger factors. We gave people excuses to move.

Daryn Miller - Goldman Sachs

Did you provide the Med Sup MCR for the quarter?

Robert Waegelein

Med Sup, which one?

Daryn Miller - Goldman Sachs

The Medigap MCR for the quarter?

Robert Waegelein

We probably did not disclose it anywhere, but I will report that the first quarter loss ratio was 76.2% compared to about 78% last year.

Operator

Your next question comes from Bill Georges of J.P. Morgan.

Kevin [Krondayone] – J.P. Morgan

This is actually Kevin [Krondayone] for Bill. I have a question for you on your Part D book of business. It looks like the PDMS earnings were up significantly for the quarter. What was driving that?

Robert Waegelein

The relationship with our partner PharmaCare on how the pricing of the drug spreads and things like that, so we will get some benefit there. The plan incurs some additional costs, so on a net basis it’s kind of embedded together on the Part D results in the aggregate.

Kevin [Krondayone] – J.P. Morgan

What changed it, I guess, relative to previous quarters? It looks like it was possibly about 2x what run-rate earnings have been?

Robert Waegelein

I don’t think it was as drastic as that. Clearly as the Caremark CVS merger happened, how they priced their businesses changed over the course of the year and now we’re on the Caremark pricing.

Kevin [Krondayone] – J.P. Morgan

Than just more color if you wouldn’t mind, on your build out on the networks and you’re talking about building in 20 new markets. Is there any percentage you could just kind of back of the napkin you could apply, I guess to how much you’ll be able to canvas where your existing private fee-for-service membership is?

Richard Barasch

It’s about another week or so before we put the final touches on that. But, the guiding principle for our expansion in the PPO, are markets in which we currently have a significant presence. [Inaudible] HMO markets include markets in which we have a big concentration of MemberHealth policyholders, so it’s not just a private fee-for-service conversation.

Operator

Your last question comes from Jukka Lipponen of KBW.

Jukka Lipponen - KBW

First of all, in terms of the private fee-for-service membership, was the answer to one of the previous questions basically the pricing issue is why the membership dropped in this quarter sequentially?

Richard Barasch

I think it was a combination of things. I also mentioned commissions as another reason.

Jukka Lipponen – KBW

It was those factors that you were talking about?

Richard Barasch

I think those are the primary factors.

Jukka Lipponen - KBW

Besides the lower net sup lost ratio, were there other factors within the traditional insurance products that drove the better results there?

Richard Barasch

I think, again, businesses are small and the variations are well within reasonable variations you could, this happened to be a good quarter, they put mortality with good results in DI, and we’ve had other quarters where it’s not quite as good. There’s no great explanation to it, except for Med Stop.

Robert Waegelein

It’s definitely a rough quarter over prior year quarter. Our lapsation has been less this year than last year, so the amortization of our debt was better than we expected and better on a comparable period for last year as well.

Richard Barasch

Thank you everyone for attending this morning’s conference call. Please feel free to call us for any color on any of the issues that we’ve discussed this morning. Thanks very much.

Operator

Ladies and gentlemen, this concludes our conference for today. Thank you all for participating and have a nice day.

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