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Aetna (NYSE:AET)

Q2 2012 Earnings Call

July 31, 2012 8:30 am ET

Executives

Thomas F. Cowhey - Vice President of Investor Relations

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

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

Analysts

Scott J. Fidel - Deutsche Bank AG, Research Division

Joshua R. Raskin - Barclays Capital, Research Division

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

Justin Lake - JP Morgan Chase & Co, Research Division

Christine Arnold - Cowen and Company, LLC, Research Division

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

Peter Heinz Costa - Wells Fargo Securities, LLC, Research Division

Melissa McGinnis - Morgan Stanley, Research Division

Carl R. McDonald - Citigroup Inc, Research Division

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Christian Rigg - Susquehanna Financial Group, LLLP, Research Division

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Operator

Good morning, my name is Jennifer, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Aetna Second Quarter 2012 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to turn the conference over to Mr. Tom Cowhey, Vice President of Investor Relations. Mr. Cowhey, please go ahead.

Thomas F. Cowhey

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

During this call, we will make forward-looking statements. Risk factors that may impact those statements and could cause actual future results to differ materially from currently projected results are described in this mornings press release and the reports we file with the SEC, including our 2011 Form 10-K, our first quarter 2012 Form 10-Q and our second quarter 2012 Form 10-Q, when filed. We have provided reconciliations of metrics related to the company's performance that are non-GAAP measures in our second quarter 2012 financial supplement and our 2012 guidance summary. These reconciliations are also available on the Investor Information section of aetna.com. Also, as you know, our ability to respond to certain inquiries from investors and analysts in non-public forums is limited, so we invite you to ask all questions of a material nature on this call.

One additional item to note. We would like to take this opportunity to invite you to our 2012 Investor Conference, which will be held at The Pierre in New York City on December 12.

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

Mark T. Bertolini

Good morning. Thank you, Tom, and thank you all for joining us today. This morning, we reported second quarter operating earnings per share of $1.31, a strong performance based on sustained execution on the fundamentals of our business.

Aetna's second quarter results built upon our performance in the first quarter and support the confidence we have heading into the second half of the year. Underlying these results, medical membership and revenues are growing as our value proposition is resonating in the marketplace. We are pricing with discipline.

Medical cost trends are developing consistent with our guidance. SG&A expenses are in line with our guidance as we continue to produce productivity gains and fund increased investments in growth initiatives, and capital deployment continues to be a strength. In short, we are very pleased with our second quarter and first half results. They are representative of the rigor with which we run our operations and our commitment to delivering value for our customers and shareholders.

In a few moments, Joe will review our detailed results and our updated guidance. But first, I'm going to discuss our second quarter 2012 highlights, our 2012 outlook and execution of Aetna's strategy.

Aetna's second quarter financial results exemplify our operating discipline. Aetna grew Health Care premiums by over 6% this quarter, demonstrating growth across all our lines of business. Aetna's continued pricing discipline, medical cost management and unit cost controls allowed us to deliver strong Commercial underwriting margins. This performance is evidenced by a commercial medical benefit ratio of 81.7% and the Medicare medical benefit ratio of 82.9%.

We continue to focus on striking the right balance between margin and growth with an emphasis on maintaining our high single-digit operating margin target. We ended the quarter with 18 million medical members, representing sequential growth of over 100,000 and are pleased with our membership traction across multiple business lines.

As we look forward to the remainder of 2012, we continue to expect strong operating performance. We are maintaining year-end medical membership guidance of 18.2 million members. This projected growth is produced by each of our major business lines and is driven by mid-year wins in Commercial ASC, expansion of Medicaid and projected growth in Commercial Insured and Medicare.

Based on our second quarter results and an updated outlook, we are also increasing our full year 2012 operating earnings per share guidance to a range of $5 to $5.10 per share. As we think longer term, we remain focused on our goal of making health care more accessible and affordable. The recent Supreme Court decision has not changed our strategy. We continue to believe that the private sector is the engine for innovation for our health care system as we focus on improving quality, lowering costs and improving access.

Our provider collaboration models reward quality and not just activity, eliminating unnecessary redundancy in the system and ensuring consumers get superior preventive and chronic health services. At the same time, we are lowering our operating expense ratio in part by reengineering our cost structure. Consumers want intuitive solutions that are affordable and easy to access, and we are committed to delivering on these expectations. At Aetna, we are not just preparing for change, we are leading through change.

Technically, Aetna's strategy to create shareholder value focuses on 3 primary initiatives: growing the core business, driving innovation in the changing health care marketplace and deploying capital effectively.

In our core business, we continue to add talent to our leadership team to accelerate growth. Specialty products, including our Pharmacy and Behavioral Health, dental and vision, Group Insurance and consumer financial solutions businesses are an important element of our growth strategy as we see opportunities to increase the cross-selling of these products to existing and new health-plan customers.

Karen Rohan, who recently joined Aetna as an Executive Vice President, will ultimately head all of the Aetna specialty product businesses. In our core government and commercial business, we are seeing positive momentum, and our focus on profitable and sustainable growth is gaining traction.

In government services, we are pleased with our momentum across both the Medicare and the Medicaid businesses. In our Medicare business, we recently announced that a longstanding customer, the Teacher Retirement System of Texas, had awarded Aetna a new fully insured group Medicare contract, effective January 2013. This contract win is early evidence of the potential revenue opportunity we have in converting Aetna's 1.2 million Medicare-eligible commercial members into a Medicare Advantage product.

At this time, we conservatively project this contract will yield incremental premiums of at least $800 million in 2013, based on the conversion of approximately 65,000 to 70,000 members. This contract, secured after a highly competitive procurement process, speaks to the strength of our group Medicare value proposition. Aetna's single integrated benefit simplifies administration and enhances benefits, while lowering costs for both plan sponsors and beneficiaries.

Eligible retirees, who moved to Aetna's Group Medicare Advantage plan, will have lower premiums, a significantly lower deductible and added benefits. We are pleased to be able to demonstrate this value to TRS and its retirees. The unique feature of this contract is that Medicare Advantage provider collaboration agreements will comprise a substantial portion of the provider network. Aetna's unique capabilities in accountable care and provider collaboration were a key differentiator in the bidding and selection process.

Meanwhile, our Medicaid business is also demonstrating strong growth. The previously announced Missouri expansion added approximately 50,000 members on July 1. We now have approximately 100,000 full-risk Medicaid members in Missouri, as we continue to build on the value we have provided there over the past 14 years. We continue to be focused on the opportunity represented by moving high-acuity population to the managed care, despite a complicated regulatory and political environment. Care for high-acuity individuals is a complex task that requires a coordinated and holistic view of the patient, local community presence and most importantly, experience.

In this regard, our capabilities in serving these high-acuity populations are gaining recognition. A recent Avalere study of dual-eligible members of Mercy Care plan in Arizona, which has been managed by Aetna's Medicaid business for 10 years, highlighted our capabilities and expertise. The study showed that compared to Medicare fee-for-service to all [ph]eligibles, Mercy's dual-eligible beneficiaries had 43% fewer in-patient days, 21% fewer readmissions and 9% fewer emergency department visits.

We remain focused on Commercial membership growth and are encouraged by the recent market response to our products. Certain customers who left Aetna to pursue alternatives, primarily focused on discounts, are returning to our integrated solutions and strengthened discount position.

Based on known wins from a strong-selling season and projections of normal levels of attrition on out-to-bid accounts, we currently project that our National Accounts membership will demonstrate modest positive growth in the first quarter of 2013. As we gain further clarity on ongoing sales opportunities, we hope to update this projection. We are pleased with this baseline outlook, which speaks to the renewed strength of our total cost value proposition and the tireless efforts of our network team to enhance our discounts position.

Moving on to our emerging businesses. As we look across America today, it is clear to us that the health care system is not working well for members with respect to quality and cost. It is disconnected. The quality of care varies unacceptably, and it is expensive. To help address these growing issues, we are driving change in how we interact with providers and consumers through our Accountable Care Solutions business.

In June, we announced the joint venture with Inova Health system named Innovation Health Plans, which will begin offering a range of health plan products in Northern Virginia on January 1, 2013. We value our unique partnership with Inova, a pre-eminent health system serving over l million individuals and seeing mutually beneficial and substantial growth opportunity over the next several years. This accountable care implementation represents a fundamentally different and advanced model of provider-insurer collaboration. The collaboration leverages Inova's care delivery, clinical expertise and engagement with the local market, along with Aetna's medical management and health insurance infrastructure.

In May, we also announced an expanded relationship with Banner Health Network in Phoenix. In addition to our previously announced ACO relationship, Aetna is deploying technology in care management, providing tools that will enable Banner to better manage care for approximately 200,000 of its patients, irrespective of the health plan to which they belong. This fee-based, risk-sharing arrangement incorporates support for approximately 50,000 Medicare fee-for-service beneficiaries, including those under Banner's Medicare shared savings program with CMS.

Additionally, we recently signed accountable care partnerships with Hunterdon HealthCare Partners in New Jersey and Aurora Health Care in Wisconsin. We continue to execute on a strong pipeline of opportunities as we work to transform the network model and enhance patient care and outcomes. The third major component of our strategy to create shareholder value is deploying capital effectively, and we continue to be pleased with our progress on this front. Joe will provide an update on our capital actions and outlook shortly.

In summary, I am pleased with our second quarter and year-to-date performance and expect continued strong performance and execution in the second half of 2012. We remain committed to our operating model premised on financial discipline. We are seeing good momentum in National Accounts, where our value proposition is resonating; in government services, where our Medicaid business is growing and where our group Medicare business has already secured a large new contract for 2013; in Commercial Insured, where we continue to see prospects for growth; and in Accountable Care Solutions, where we are driving innovative change and have a robust pipeline, reflecting the value that providers see in our differentiated offerings.

Further, I am confident in our strategic direction, our ability to manage through the legislative and regulatory changes associated with health care reform, our ability to grow membership over the second half of 2012, our 2012 medical-cost trend outlook and our increased 2012 operating EPS projection of $5 to $5.10 a share.

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

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

Joseph M. Zubretsky

Thanks, Mark, and good morning, everyone. Earlier today, we reported operating earnings per share of $1.31 for the second quarter and $2.64 for the first 6 months of 2012. We continue to price with discipline, actively manage medical costs for superior quality and cost outcomes and strive for administrative efficiencies to deliver profitable growth for our shareholders.

We have maintained a consistent outlook for medical-cost trend as actual results continue to validate our full year projections. Premium yields are in line, resulting in a trend-yield spread consistent with our full year medical benefit ratio guidance, and we delivered a pre-tax operating margin of 9.1% in the first half, evidence of the rigor with which we manage the business and our commitment to operating excellence.

Specifically, Aetna's results were driven by solid execution on business fundamentals. We continued our revenue growth momentum this quarter, posting a 6% year-over-year increase. Our commercial medical benefit ratio was 81.7% for the quarter and 80.8% in the first half of 2012, both excellent results demonstrating our disciplined approach to underwriting margin management.

Our reserve position, which increased despite flat premiums, generated approximately $40 million before tax of favorable prior-period reserve development in the quarter, which demonstrates the strength of our balance sheet.

Pre-tax operating margins were 8.9% in the quarter towards the high-end of our targeted, high single-digit range, and net subsidiary dividends were nearly $1.2 billion in the first half, putting us on track to exceed our previous full year forecast.

At the end of the second quarter, we had 18 million medical members, an increase of 114,000 members sequentially. Commercial ASC membership increased by 58,000 in the quarter, due primarily to the addition of lower revenue network access membership.

Commercial Insured membership increased by 27,000 in the quarter, driven by growth in our large group commercial risk accounts and our international business. Medicare membership increased by 15,000 in the quarter, largely a result of adding approximately 12,000 new Medicare supplement members, and Medicaid membership increased by 14,000 in the quarter, reflecting additions in existing geographies, including Delaware and Texas.

Second quarter 2012 revenue generation was strong, increasing by 6% year-over-year to $8.8 billion, primarily due to higher health care premiums and higher fees and other revenues.

The increase in Health Care premium included a net increase in Commercial premium of 3.5%, due to a 5% increase in premium yields, partially offset by volume declining by about 1.5%. The 5% increase in yields results from a 6% increase in rates, partially offset by a 1% decrease due to mix. Health Care premium also reflected a 14% increase in Medicare premium, driven by membership growth in Medicare Advantage and the addition of Genworth's Medicare Supplement business.

We posted a 20% increase in Medicaid premium, as growth in our Illinois ABD program, as well as in Delaware and Pennsylvania, more than offset the impact of the 2011 year-end exit from Connecticut.

Fees and other revenue increased by 7.9% year-over-year, primarily as a result of our 2011 acquisitions. With respect to the core business, Commercial ASC fee yields substantially offset the 4% decline in core Commercial ASC volume. The impact of Prodigy will be incorporated into year-over-year comparisons starting in the third quarter of 2012 and will result in lower reported growth rates in the fees and other revenue line item.

Our second quarter total medical benefit ratio is 82.4%, including the impact of approximately $40 million before tax of favorable prior-period reserve development. The favorable reserve development largely reflects the current year's Medicare and Commercial performance and supports our outlook on emerging health care cost trends.

Our days claims payable were 44.4 days at the end of the quarter, up 0.4 days sequentially and up 0.8 days year-over-year. Our Health Care cost payable increased approximately 2% sequentially, while premiums were flat. We continue to invest in innovation to improve health care delivery for our customers, to capitalize on opportunities for profitable growth and to improve productivity.

Our second quarter 2012 business segment operating expense ratio was 18.7%, as expected, down 40 basis points year-over-year. This reflects the continued execution of our expense initiatives and favorable shifts in our membership mix, partially offset by the addition of fee-based businesses, which have operating expense ratios higher than the company average.

Our operating expense ratio for our insured Health Care business was 11.2% in the quarter, an improvement of 90 basis points year-over-year. The final area of financial performance I will comment on relates to our investment portfolio, management of capital and cash flow generation.

Second quarter net investment income on our continuing business portfolio was $146 million, as declining yields continued to create downward pressure on earnings. At June 30, the continuing business portfolio had a net unrealized gain position of approximately $1.2 billion before tax and is well positioned from a risk perspective.

Our capital generation was very strong in the quarter. We started the quarter with $100 million in liquidity at the parent. Net dividends from subsidiaries were $535 million. We issued $750 million in new debt securities at highly attractive coupon rates. We repurchased 13.8 million shares for $581 million. We paid down $150 million in commercial paper and after $260 million in other net uses, including our shareholder dividend, interest expense and other settlements with subsidiaries, we ended the quarter with $400 million of liquidity at the parent. Our basic share count was 334.2 million at June 30.

Our financial position, capital structure and liquidity, all continued to be very strong. At June 30, we had a debt-to-total capitalization ratio of 31.5%. We continue to target a risk-based capital ratio of approximately 300% of company-action level.

Operating cash flow generation was strong for the first 6 months. Health Care and Group Insurance operating cash flow was approximately 1.3x operating earnings for the first 6 months.

Moving to our 2012 outlook. We are now projecting operating earnings per share of $5 to $5.10. Our revised operating EPS guidance range reflects a lower projected share count, our solid performance in the first half and higher-projected investment spending in the back half of the year. Our guidance also implies that slightly greater than 50% of our operating earnings per share will have occurred in the first half of the year.

We continue to project year-end medical membership of 18.2 million members. This is driven by the 114,000 medical members we added in the second quarter, as well as projected third and fourth quarter additions to our Commercial ASC membership and a significant ramp in Medicaid membership.

In Commercial ASC, we project adding approximately 100,000 members. This includes the state of Maine account, which added over 30,000 members on July 1. In Medicaid, we expect to add approximately 75,000 members through the end of the year. This includes our new Missouri contract, which added approximately 50,000 members on July 1.

We also continue to project growth in our Commercial Insured and Medicare businesses by the end of the year. Our projected commercial medical benefit ratio and Medicare medical benefit ratio guidance remains unchanged. Aetna's 2012 Commercial MBR projections reflect underlying medical-cost trends that we expect to be 6.5%, plus or minus 50 basis points, and is unchanged from the guidance we gave at our Investor Conference in December.

Higher utilization remains the primary driver of the projected 2012 trend increase. The projected components of our 2012 trend guidance also remains unchanged. In the outpatient category, we continue to see upward pressure year-over-year, and we currently project outpatient trends for 2012 will be at the upper end of our guidance range. However, this increase in outpatient trend has been largely offset by inpatient medical costs, which represent a higher percentage of medical spend and are trending at the low end of our projected range.

As we have previously noted, physician and pharmacy trends are both up year-over-year, driven primarily by higher physician visits and specialty pharmaceutical spending, respectively. Both the physician and pharmacy trend categories are well within our guidance ranges.

While guidance for our 2012 business segment operating expense ratio remains 18.5% to 19%, we believe we are likely to be at the higher end of the range on a full year basis, reflecting incremental investments and growth opportunities. These investments include: enhanced infrastructure spending to service newly won 2013 contracts, including TRS; expenditures to benefit our Medicare businesses, including investments to enhance our star ratings; and accelerated spending in our Accountable Care Solutions business, as we continue to focus on transforming the network model.

Despite this incremental spending, our 2011 voluntary early retirement program and other expense initiatives are projected to help reduce the impact of seasonal expense increases in the third and fourth quarters of 2012. We continue to expect our business segment operating expense ratio to be sequentially higher in each of the third and fourth quarters relative to our second quarter result.

For 2012, we are now projecting net dividends from subsidiaries of approximately $1.8 billion and deployable capital of approximately $1.45 billion. This increase of $100 million from our previous guidance is due to continued strong capital management.

Considering our repurchases in the first 6 months in capital guidance, we have updated our share count guidance to a range of approximately 344 million to 347 million weighted-average shares.

As we look to the remainder of the year, we would expect that sequential operating earnings per share will be higher in the third quarter. Further, we project that operating EPS in the fourth quarter of 2012 will be lower than our third quarter result. This is a function of the quarterly progression of our business, where medical costs tend to be the highest in the second and fourth quarters and where administrative spending will increase to support open enrollment toward the end of the year.

For the full year 2012, we are confident in our projection of a pre-tax operating margin of 8.5% to 9%, approximately $1.75 billion of operating earnings and operating earnings per share of $5 to $5.10.

The fundamentals of Aetna's business remain strong, and we are committed to maintaining our operational vigilance. Looking beyond 2012, we believe we have the winning strategy in the marketplace. We will continue to focus on adapting to the dynamic forces that are reshaping our industry, driving transformation of the network model to our Accountable Care Solutions business, enhancing and growing our government services businesses and striving for operational excellence and cost containment.

As we execute on our vision, we believe that growth in our core business, supplemented by our emerging businesses and effective capital deployment, will enable us to generate low, double-digit operating earnings per share growth on average over time.

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

Thomas F. Cowhey

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

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Scott Fidel with Deutsche Bank.

Scott J. Fidel - Deutsche Bank AG, Research Division

First question, just wanted to get an update on your views on the commercial pricing environment. Clearly, it's been a pretty volatile earnings season for MCOs. And maybe just talk about -- is your view that the commercial pricing environment remains relatively similar to what we've been seeing the last couple of quarters? Or have you seen more intensified price competition as we think about July renewals and then heading into 2013?

Mark T. Bertolini

Thanks, Scott. Mark here. A couple of points. I think the market remains rational and competitive. That's what we're seeing in the marketplace. But as we get to the bottom of the trend deceleration, start to see trend move up, I think the trends are so low and the pricing is so close that it's really hard to move clients. And so I would expect that you would see across the industry, except for people that our repricing the books of business, that their retention levels are going to be fairly high. So the ability to move business on the basis of pricing is very limited. So therefore, I would say from that standpoint, it's harder in the marketplace to move business.

Scott J. Fidel - Deutsche Bank AG, Research Division

Okay. And then I just wanted to ask a follow-up and ask a question on your views on strategic M&A relative to Medicare and Medicaid. Clearly, now we've seen CIGNA acquire HealthSpring and WellPoint acquire Amerigroup. And just want to get your sense on how you feel your Medicare and Medicaid platforms are positioned at this point. And clearly, I did notice that you repurchased shares pretty aggressively in the second quarter. So maybe how does that contemplate your thoughts on strategic M&A as well?

Mark T. Bertolini

Well, strategic M&A continues to be very important for us. As we look, going forward in the marketplace, we think it's appropriate to consider organic growth in membership in the 2% to 2.5% range. And as we look to other segments of the business that might be interesting to us, we always consider whether or not there are opportunities. I will be very clear on this call, again, as I am in most analyst meetings. We are not interested in bulking up the Medicaid, particularly at the current PEs and the current prices of those assets.

Joseph M. Zubretsky

And Scott, with respect to the share repurchases, I would just say that we really accelerated our annual allocation to share repurchases on the weakness in the stock price after the first quarter report. It was nothing more than that.

Operator

We'll go next to Josh Raskin with Barclays.

Joshua R. Raskin - Barclays Capital, Research Division

Question just relates to investment spending. I think, Joe, you had mentioned that your guidance includes a higher level of investment spending. So I'm just curious if there was a way to quantify that. And maybe within that bucket, how much is part of the ACS strategy?

Joseph M. Zubretsky

Josh, we're going to give you a fuller accounting of our emerging business and ACS strategy at our Investor Day. But for now, I would say that the spending on implementing the TRS account and one other very large installation, enhancements to our star ratings program and accelerated spending in ACS, approximated $50 million of additional pre-tax spending in our forecast. But we'll give you a fuller accounting of the breakout of that, particularly with respect to ACS in December.

Joshua R. Raskin - Barclays Capital, Research Division

Okay. And the $50 million, you're saying that's incremental relative to your guidance from 3 months ago.

Joseph M. Zubretsky

That is correct.

Joshua R. Raskin - Barclays Capital, Research Division

Okay. And then just -- could you give us the PPRD by segment, that $40 million, how much was Commercial? And I think you said it was Commercial and Medicare, how much was in each bucket?

Joseph M. Zubretsky

We haven't broken that out, Josh. So we're just saying the $40 million was across both Medicare and Commercial.

Joshua R. Raskin - Barclays Capital, Research Division

Was there one that was slightly more than the other?

Joseph M. Zubretsky

Yes, Medicare was slightly more than Commercial.

Operator

We'll go next to Ana Gupte with Sanford Bernstein.

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

So again following up on the Commercial loss ratio, you've gone from 77.9 to 81.7. But it's about a 380-bp deterioration year-over-year. Computing you have about 330 bps from reserve releases being lower, I think it was like $165 million or something like that last year. Is the rest of it just that your spread is now coming in negative? Or is there something around broker commissions being passed through net of MLR rebates. And then just to take that a step further, if it is negative, is there any intent to bring it back in line or even more positive going forward in your renewals for 2013?

Joseph M. Zubretsky

Ana, a couple of points. If you go back to the bridge we provided at our Investor Day last December, you will note that we bridged you from the 77.9 Commercial MBR result for 2011 in the following way: 80 basis points was the significant positive development that occurred in 2011; 30 basis points changes to the commission structure, as we decoupled commissions from the premium structure; and a 250-basis-point increase was the reversion to the mean. As the experience-rated book of business renews and you've over performed, you can still hold to your target margins and credit some of that favorable experience back to customers. What you're seeing in our actual results is the manifestation of that strategy.

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

So it's all about the experience rated you're seeing. So to offset that, though, going forward is your intent to keep it negative so you'll see continuously deteriorating Commercial margins sequentially...

Mark T. Bertolini

Ana, our intention is to price to a medical cost -- is to price to a margin of high single digits across our book of business. And so we have maintained that. We have a high single-digit margin. Part of the pullback was the experience rated. But we will continue to price to that high single-digit margin.

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

And just to finalize then, I think when you talked to Scott, Mark, you said that it's hard to move business. So is -- I mean, I'm trying to understand, does that mean there is no point in softening pricing? So it's basically staying the same? Or not?

Mark T. Bertolini

I lost the end of your question there, Ana.

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

I'm trying to understand what the -- I don't think I got what you said when you said that the pricing story is it's very hard to move business in this weak trend environment. Does that mean there's no point in pricing down? Is that what you're saying?

Mark T. Bertolini

There's never any point in pricing down. From our perspective, we always are on the side of margin over membership. So as we said last quarter, when we were describing why we were so careful on reserves is that we are finding bottom. We wanted to have a soft landing on top of trend going through this year and into 2013, and we think we've accomplished that and demonstrated that with the return of prior-period development in the second quarter. So there is, in our opinion, never any opportunity to underprice in the market to gather membership for 2 reasons. One, it's very hard to get that back in trend. Over time, you have to price up to do that. It's almost impossible now with rate review and 10% limits on some of those rate reviews to get that through some of the insurance commissioners, if you're really catching up on trend. So I think it's -- it would not be wise to price down.

Operator

We'll go next to Justin Lake with JPMorgan.

Justin Lake - JP Morgan Chase & Co, Research Division

First question. Just in terms of -- Joe, you've mentioned the high single-digit target margin. It looks likes your guidance embeds something in the neighborhood of 8.9%, 9% for this year. Any reason to think that number isn't kind of right in that sweet spot of high single-digits and therefore, should be sustainable -- what you're doing this year should be sustainable into 2013, given what we know?

Joseph M. Zubretsky

We believe so. And I'll point to the first half and the full year metrics. If you can settle at a Commercial MBR in the low 80s, produce high single-digit margins at current mix, grow again as we started to do in the second quarter, which takes pressure off the SG&A ratio, I think that high single-digit margins at current product mix is sustainable for the foreseeable future.

Justin Lake - JP Morgan Chase & Co, Research Division

Got it. And then just switching over, thinking about -- looking at 2013 and pricing. Given the cost trends have clearly appeared to uptick within what most people have priced for, not everybody, but most people, do you expect yourselves and the market, and more specifically yourselves, to price the cost trend again, likely being higher in 2013 than it was in 2012? And should we think about a similar order of magnitude as the 2012 was up from 2011?

Joseph M. Zubretsky

Well, Justin, we have not given a medical trend forecast for 2013. We probably will start talking about that on our third quarter earnings call because then -- by then, we'll be into the renewal season when that information becomes more relevant.

Justin Lake - JP Morgan Chase & Co, Research Division

Okay. Is there any view in terms of what you're seeing early on? I know you're very big in the large group space, for instance, where those renewals take place during the summer. Anything you're seeing in terms of '13 renewals that gives you any confidence that people or the market's pricing with any level of conservatism or at least not pricing more aggressively for '13 than what you saw in the same period last year?

Mark T. Bertolini

We still see the market is rational. But again, I'll make the comment. Because we're at the low point of trend across a number of products and trend is rising, it is tight to be able to get clients to move. So I think what I would describe the market as is still competitive and rational but harder to move business.

Operator

We'll go next to Christine Arnold with Cowen.

Christine Arnold - Cowen and Company, LLC, Research Division

A couple of things. One, we had thought that acquisitions based on your return hurdles would be $0.20 to $0.25 accretive in 2013 relative to 2012. Are we still on track for that?

Joseph M. Zubretsky

I think -- Christine, this is Joe. The last time we updated you on our acquisitions and their impact on 2012, we said they would be 9 -- you're talking about '13, they'd be $0.09 accretive this year. And we also provided some guidance at that time that said that once the integration costs burn off and once the synergies begin to be realized, they will be significantly more accretive in the future. So we haven't given a specific number for 2013. But we will, as we get into that 2014 forecast period later this year. But you're thinking about it the right way. Integration costs will burn off. Synergies will be realized. But I will tell you this, every single one of those acquisitions we executed last year is performing according to plan.

Christine Arnold - Cowen and Company, LLC, Research Division

Okay. And then, I know you're not giving 2013 guidance. But you're saying you expect an increase of low double digit in operating earnings over time. Is there any reason that wouldn't be the case for 2013?

Joseph M. Zubretsky

They're low double-digit operating earnings per share over time.

Christine Arnold - Cowen and Company, LLC, Research Division

Right. Is there any reason that wouldn't be the case in 2013?

Joseph M. Zubretsky

That's our long-term goal, on average per year, on average over time.

Christine Arnold - Cowen and Company, LLC, Research Division

Okay. And the crediting [ph] back to the customers, it looks like trend upticked in '12. So is it reasonable to think the credit back to the customers would be less than 250?

Mark T. Bertolini

There was an uptick in trend from 2012 because we said it was less than 5.5 last year, and we're now at 6.5, plus or minus 50 basis points. But when you're pricing into the market, you're pricing ahead of that trend change with that trend in mind. So we gave them back and what's reflected in our MBRs is what we put into pricing.

Christine Arnold - Cowen and Company, LLC, Research Division

Okay. So it's probably a wash.

Mark T. Bertolini

We're performing to that.

Operator

We'll go next to Dave Windley with Jefferies.

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

I just -- in looking at some of the moving parts on guidance for this year, it looks like the additional share repurchase is worth about $0.09. Conversely, the $50 million in spend is also worth about $0.09. I wanted to get your agreement or disagreement on that. And then you had some favorable development in 2Q, which would seem to at least account for the change in your EPS guidance for the full year. Have I gotten those things right? And am I missing a major point that you would add?

Joseph M. Zubretsky

No. You're pretty close. I would look at it this way. Our previous guidance is $5 per share. The lower share count is approximately $0.10 earnings per share for the year. Our first half performance, all in, under -- particularly underwriting margin, I would add $0.05 to $0.10, and the higher investment spending will cost us $0.10 to $0.15. And if you just all -- add up the bottom and high end of all of those ranges, you'll get to $5 to $5.10.

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

Got it, okay. And then on the investment spending, in particular, how should we think about the leverage that you can get from that over time? I know in -- to one of the earlier questions, Joe, you talked about returning to membership growth, getting leverage on the SG&A. But in the case of this year, as you get that membership growth you're now making investment spending to support that. And so I wanted to understand, at what point do you get membership growth that you don't have to invest to support?

Joseph M. Zubretsky

That's a great question. It really is about growing the core membership, more Commercial HMO, PPO, Medicare, Medicaid business that leverages our core infrastructure. And I'll point you to one statistic that's quite stark. Back in 2008, '09, when we were at close to 19 million members, our SG&A ratio was 17.6%. And you could pretty much map out the -- per-million members, how many basis points of improvement or degradation that results in. So we're pretty comfortable that if we can begin growing the core Commercial Medicare and Medicaid books once again, that we will return to the positive fixed-cost leverage that we enjoyed during that period of time.

Operator

We'll go to Peter Costa with Wells Fargo Securities.

Peter Heinz Costa - Wells Fargo Securities, LLC, Research Division

If we assume your pricing has been maybe more stable relative to cost than others and others were perhaps pricing maybe too aggressively and that caused some of your membership declines over the past year and maybe is causing their earnings missteps this year, would you say that, that means that pricing is likely to firm next year, given what -- that others are experiencing problems and maybe you're sticking to sort of more relatively stable pricing?

Mark T. Bertolini

I think the way we would look at it, Peter, is that for 2010, specifically, and most of 2011, our pricing provided an umbrella for the industry because we were priced up. And that created some movement of membership and that is where some of the perceived organic growth -- and we would classify that as almost inorganic when people shed membership and it comes over to you. But that perceived organic growth came from in the industry. And so we believe that the baseline for the industry on organic growth is 2% to 2.5%. And so therefore, we would see, depending on how people react to the underperformance on their pricing in the next year and what they're able to get in price increases through the regulatory framework will determine how -- whether or not pricing firms up.

Peter Heinz Costa - Wells Fargo Securities, LLC, Research Division

Have you started to see any signs of firming pricing in the small group area, which reprices [ph] more regularly throughout the year rather than the national accounts?

Mark T. Bertolini

We see it in some markets and not in others. And I think that is something that you'll have to see over time, as this performance works its way through people's pricing models. Remember, even in small group you're pricing well ahead of the quarter. In a lot of markets, you're almost 90 days in front of your pricing impact once you figure out you've got a problem. So even in small group it takes some time to put those prices in the market. Not always can you get all of the pricing that you need in the marketplace. So I think we have more time to see this mature and will -- it depends on how our competitors respond.

Peter Heinz Costa - Wells Fargo Securities, LLC, Research Division

Okay. And then last question. You've done a number of acquisitions over the past few years, sort of filling gaps in sort of your product offering. Are we going to start to see some accretion more visible from these acquisitions over the next couple of years helping your earnings? And how do we go about looking at that?

Mark T. Bertolini

I think you'll start to see it as a result of some of the modeling we will give you at the Investor Conference in December around how we see the ACS opportunity influencing not only that business but more importantly, the core business. We're already seeing membership growth come out of those models. We'll give you better visibility on that membership and what we see for next year and how to model it and follow us as we go forward. So the December conference, you'll start to see a lot more visibility on that. We needed to see some of this strategy work its way through the market in reality so that we could model it more effectively, so that we could give you insights that you could rely on.

Peter Heinz Costa - Wells Fargo Securities, LLC, Research Division

In December, will we actually see earnings accretion? Or will it be more about spending and sort of advancing these initiatives further?

Joseph M. Zubretsky

We will show you how these assets will generate earnings for us.

Operator

And we'll go next to Melissa McGinnis, MS.

Melissa McGinnis - Morgan Stanley, Research Division

Going back to an earlier question on the Commercial MLR bridge. If we kind of think about the adjustments last year for development reported in Q2 and then even Q2 development reported in Q3, it would seem like the underlying MLR Q2 '11 jumping off point was more like a 78.6%, meaning we saw about 310 basis points of year-over-year. The duration in the underlying MLR, what adjustment are you maybe not making? Or in fact, are we seeing that 280 deterioration that's coming in a little bit higher and more towards the 300 or 310 level?

Joseph M. Zubretsky

Well, Melissa, I couldn't follow all your specific numbers quite frankly. But I think the bridge I gave before is absolutely emblematic of the result we've produced, that the development in any quarter of last year was significantly in excess of development this year. So when we gave you the development bridge, we gave it to you net. We have the changes to the commission structure. And the biggest piece, bears repeating, is literally the reversion to the mean and crediting favorable experience in 2011 back to experience-rated customers. That's what you're seeing in our reported MBRs. And with the result we just posted, the 81.7%, which is 80.8% for the first half, and we've guided to 81.5% for the full year, we think that's a very, very prudent forecast and a result that we fully anticipated.

Melissa McGinnis - Morgan Stanley, Research Division

Okay. So just to be clear, because you guys provided a slide at Investor Day Conferences that you're kind of at 290 versus at 280 in Q1. But now you feel like you're kind of falling out more around your 280, that you had expected. Looking at the 30 from commissions and the 250 from the experience rated.

Joseph M. Zubretsky

Yes, I think that's accurate.

Melissa McGinnis - Morgan Stanley, Research Division

Okay. And then I guess more a strategic question that goes to maybe some of your peers pricing commentary as well. Aetna has actually been doing a lot of these provider partnerships and various markets allowing you to enter some markets with some new unique product offering, thinking about like the Carilion offering in Virginia. Can you provide us just any color or even quantification of how much some of those provider partnerships can help a cost structure and then how much that might pull through into a pricing advantage relative to like the average price point of products in a marketplace?

Mark T. Bertolini

So it's way early. We only have a few of these out in the marketplace, and we're working through the performance of those. But generally, it gives us a 10% to 15% premium advantage in the marketplace.

Operator

We'll go next to Carl McDonald with Citi.

Carl R. McDonald - Citigroup Inc, Research Division

It looks like an anomaly in your first half results relative to other companies in the sense that you guys have maintained stable pricing but been able to keep the risk enrollment relatively steady, whereas pretty much across the board, every other competitor, whether they've said they've priced stable or priced a little bit more aggressively, has lost several hundred thousand lives in the risk business. So I'd be interested in your perspective, is it really just the international segment where you're seeing some growth and that's offsetting risk losses? Or is there some other dynamic going on there?

Joseph M. Zubretsky

Carl, there is some growth in our middle market segment. The middle market segment is one of the engines that drives the value of this business, and we had decent growth in the middle market segment in addition to international.

Mark T. Bertolini

In the middle market segment, Carl, is where you would find the experience-rated pricing impacts. So people are seeing some opportunity in that because the pricing, you have to get back some of that experience from the prior years. So that middle market segment would be a place for their pricing will be different than they what they would see otherwise in the market.

Carl R. McDonald - Citigroup Inc, Research Division

And then a follow-on question. Just if you can reset us in terms of where cost trends were and what you're seeing. So if you were less than 5.5% for the full year last year, where did you end the year? And where have you run in the first half of the year versus that 6.5% guidance? Basically, we're just trying to get a sense of -- are you seeing cost trends accelerate as we go through the year? Did you see cost trends step up on January 1 and then they're stable? Any color there?

Joseph M. Zubretsky

Well, Carl, we give in -- full year annual guidance on medical cost trend, which remains 6.5%, plus or minus 50 basis points. We do not parse that by quarter because you get all kinds of artifacts and days intensity and leap years and all types of things. But I think it's fair to say, is all of the major medical cost categories are performing within guidance ranges. And we feel very good about our full year forecast.

Mark T. Bertolini

And the 2012 number came in where we expected it to be. Our baseline is where we expected it.

Operator

We'll go to Kevin Fischbeck with Bank of America Merrill Lynch.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

You guys talked about growing the National Accounts modestly next year, that's clearly a positive. I think the last quarter, the commentary seemed a little bit more bullish. I think you talked about the business opportunity twice what it was and only had minimal account losses. Are -- is this a little bit of a change in tone? Or am I reading into that? Or does it go back to your comment about how hard it is to move business in this environment?

Mark T. Bertolini

I don't think there's any change in tone. Remember, we lost over 500,000 members in the first quarter of last year. So modest positive growth is quite a change based on what we saw in the prior year related to attrition and growth. So, no I don't think there's any indication. It's still early. I think National Accounts are still clearing late like they did the prior year. So for the last couple of years, we're seeing decisions made much later in the year than we otherwise would have.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Okay. And could you just talk a little bit more about the investment spending in the second half. I think in the prepared comments you mentioned spending thick on your contracts, MSR [ph] and then accelerating Accountable Care Solutions but then later on it sounded like it was mostly Accountable Care Solutions is the biggest driver to the ride. Can you talk -- is that the right way to think about it? And if so, what really caused your move to accelerate those investments? And how should we think about returns on that investment into 2013?

Joseph M. Zubretsky

Well, I think -- the first thing I would say is we did accelerate the spending on our Accountable Care Solutions business. And the reason is the early-stage pipeline is a lot deeper than we ever anticipated. The level of excitement and enthusiasm on our fully integrated technology stack is quite extraordinary. So we did accelerate that. But no, I would say that with respect to compliant spending, ICD-10, exchanges, Health Care Reform, et cetera, I'll remind you that we previously guided that from a GAAP expense point of view, that will cost us over $100 million this year and $200 million in cash, which is the -- includes the capitalized value of some of those investments. So we continue to spend on reform, ICD-10 and a lot of these compliance initiatives. But the headline increase from a growth investment point of view is clearly Accountable Care Solutions. And it's the size of the pipeline that we're responding to that drove it.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Okay. And then I guess, Mark, your comments earlier made it sound like you don't think there's a significant amount of risk to margin contraction in 2013 based upon what you're seeing in the pricing environment. I mean, clearly, the markets -- has been concerned about that risk the last couple of weeks. So can you just give a little bit more color around what gives you confidence to talk about that the way you did?

Mark T. Bertolini

Well, I think, it -- again, as I said, it depends on how our competitors respond and the underpricing that they've seen in the market, whether or not that creates firming in the marketplace around pricing. And so I -- we will continue to be disciplined with our pricing. We'll price to our high single-digit target margins as we go into 2013. I think another thing sitting out there that I think a lot of people need to think about is 2014. And the big impacts that we'll see around rating changes, around the taxes that go into the system and the rate check that, that's going to create in the marketplace. Get too far behind, you're going to have a hard time catching up in 2014 as well.

Operator

We'll go next to Chris Rigg with Susquehanna.

Christian Rigg - Susquehanna Financial Group, LLLP, Research Division

Just a question on the Medicare Advantage. Can you remind us of the split there in terms of group versus retail? And then, when you look out to next year and how you just bid [ph], is the focus really to stay on the group side? Or are you looking to more meaningfully grow on the retail side of the business?

Joseph M. Zubretsky

Well, 70% of our Medicare Advantage book of business is group. We like that business because it leverages our distribution capability, both the National Accounts and government and labor. We tend to have good visibility into the medical-cost trends because we've managed those populations on an ASC basis for a number of years, and we like sort of the group underwriting aspects of that business. It's a very stable, well-performing business. We continue to be bullish on the individual Medicare Advantage business that represents 30% of the book of business, and we're doing well there this year as well.

Mark T. Bertolini

I would also note that our individual Medicare business is built off of an HMO platform. So that's why we don't -- we grow it where we believe we have good network controls and cost controls.

Christian Rigg - Susquehanna Financial Group, LLLP, Research Division

Okay. And then last question, just to follow up on a number of earlier questions. But Mark, you said you definitely believe trend is rising. And I guess, I know you don't want to give any guidance on 2013. But if you look at the 6% to 7% trend for this year, is there any reason to believe why that wouldn't be higher next year?

Mark T. Bertolini

I think it's too early to tell, although we have some pricing into the marketplace and we put trend into pricing going forward. But there are a lot of things that can happen with the fiscal cliff and a number of things around the economy come next year that we're watching very carefully. Because major economic disruptions can create major inflection points in trend, depending on employment and a whole host of other things. So I think we're watching all of that carefully, and we are being careful with our pricing as we go into 2013.

Operator

We'll take our final question from Matt Borsch with Goldman Sachs.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Let me just continue on the theme that others have asked on pricing and a high-level question, if I could, which is, if trend has bottomed and we're now in a somewhat rising trend environment, and as you say 2013 it isn't clear where things will go. But how do you think about the risk at this point, given the precedent that, correct me if I'm wrong, but every other instance of trend bottoming and rising has resulted in some pretty severe margin compression across the industry, if I think back, going back 30 years, I guess?

Mark T. Bertolini

Well, Matt, I think it depends. This environment is much different than it has been in the past, again, with the specter of Health Care Reform in front of us. And so I think people have generally been careful because if you don't get your rate increases, pricing up the way we used to in the past is almost impossible. And there are certain states, for example, like California, where getting a rate increase through is a battle almost every quarter, and with a lot of publicity. So I think people understand that and they're being very careful about their pricing. And it would be prudent not to get aggressive on pricing, particularly going into 2014.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Yes, no. That all makes sense. I guess, a different but maybe related question. On your experience-rated books, do you think that competitors see your -- or somehow see your rate adjustments there and perceive that you're pricing aggressively in some cases, when in fact, what you're doing is reflecting your annual adjustment with those experience-rated accounts?

Mark T. Bertolini

I don't think they'd see it because it's on renewal, Matt. So it's not in our new business pricing. It's on our renewal pricing. And that's a conversation between us and each client. Now they may be trying to figure out why they have to price so low to try to get the client to move, but that's more of hunting and pecking in the dark than anything else.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Okay. And last on the M&A front. I heard what you said on some of the sort of bulk-up on Medicaid. What are you -- what's coming to the fore in -- or you think will come to the fore in terms of consolidation opportunities in managed care? Are you talking to a lot of small plans? Are they more or less interested -- or are people in -- are people paralyzed ahead of the elections in November?

Mark T. Bertolini

No, I don't people are paralyzed. I think everybody's dance card has been pretty full for dinners and lunches throughout the marketplace, and there's been a lot of conversation going on. I think we're running up against a very real temporal barrier with mid-year next year. Unless you can get something done by mid-year or third quarter next year, you start running into the jeopardy of trying to integrate something while you're pricing into a whole new environment. So I think you're going to see a lot of pencils down near the end of this year, because it's going to be too -- a little too crazy to be integrating way into that process. So you've got to get something closed and done in the second quarter or earlier.

Thomas F. Cowhey

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

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