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Health Net, Inc. (NYSE:HNT)

Q2 2012 Earnings Call

August 3, 2012 11:00 am ET

Executives

Angie McCabe – Vice President of Investor Relations

Jay M. Gellert – Chief Executive Officer, President and Director

Analysts

Joshua R. Raskin – Barclays Capital, Research Division

Sarah James – Wedbush Securities Inc.

Justin Lake – JPMorgan Securities LLC

Ana Gupte – Sanford C. Bernstein & Co. LLC

Scott Fidel – Deutsche Bank

Matthew Borsch – Goldman Sachs

Chris Rigg – Susquehanna Financial Group

Kevin Fischbeck - Bank of America Merrill Lynch

David Windley – Jefferies & Co.

Carl McDonald – Citigroup

Peter Costa – Wells Fargo Advisors LLC

Operator

Good morning, everyone, and welcome to this Health Net, Incorporated Second Quarter 2012 Conference Call. Today's call is being recorded. At this time, I would like to turn the call over to Angie McCabe, Vice President of Investor Relations. Please go ahead.

Angie McCabe

Thank you, Christie. And thank you all for joining us for a discussion of Health Net's second quarter 2012 results.

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

In today's call, we will refer to adjusted days claims payable. This adjusted metric is not being presented in accordance with generally accepted accounting principles or GAAP. Please refer to today's press release, which is available on the Company's website for a reconciliation of this non-GAAP financial measure with the most directly comparable GAAP financial measure; days claims payable.

I will now turn the call over to Jay Gellert, Health Net’s CEO.

Jay M. Gellert

Thank you, Angie, and good morning. I want to answer three basic questions this morning. One, how did this happen, two, how do you know we’ve gotten it all and three, can we give you confidence, we can fix this for 2013.

So first, how did this happen? Two factors had the greatest influence on second quarter results, commercial large group full network products and SPD experience particularly outside Los Angeles County. Let me talk first about commercial. Our lower than expected, second quarter was largely driven by factors arising from a select number of our largest groups, mostly multi-stage using our full network products.

In total, these accounts are running MCRs above a 100%. They include about a 100,000 members and were the primary factor driving a 150 basis point change in commercial spread guidance. The deterioration is largely driven by adverse risk selection. As we’ve noted in the past, price competition has been particularly intense in these large groups and the move to ASO continues to grow. ASO offerings tend to have lower benefits and/or higher out-of-pocket costs.

As a result, the traditional full network HMO products tends to retain a disproportionate number of high cost members, when offered by side-by-side with these ASO plans in Kaiser in slice accounts. This trend has exacerbated in recent years. The key in these specific groups is pricing to the risk profile without regard to retention. We will not sell or renew groups below cost in 2013.

We are taking other steps as well. We’ve modified provider network configurations and intensified medical management. We’re also offering our Tailored Network Products, as an alternative. These products have done remarkably well in small and mid market accounts and in the few large groups where they’ve been adopted. Because of these steps, we could lose up to 50,000 members among these largest groups next year. In the rest of our commercial book, mid markets and small groups as well as Tailored Network Products in large group, we believe we’re doing well.

Recent regulatory filings showed that our small group, MCRs are among the lowest in California, helped by the rapid growth of Tailored Network Products. To further support this, if we put prior period development back into the proper period, we see year-over-year improvement in the overall California commercial MCR for the first half of 2012 even with the large group headwinds. We believe our success with Tailored Network products and in small and mid markets continues to meet the customer needs for affordability, while producing solid margins and growth. The steps we’ve outlined will serve to strengthen our California commercial franchise.

Let’s next review California Medicaid. The Medicaid MCR was up by 460 basis points sequentially, primarily due to the SPD population. As we said in the past, we’ve been booking the SPD members at a high MCR. As we completed the enrollment process and the experience with the new book matured, it is now cleared that the MCR for these members was greater than a 100%.

The experience is centered in certain counties where institutional costs are well above projection. We also have had more high-risk patients than anticipated in areas such as end-stage renal disease. The patients recognized some of these issues and we are currently engaged in what we believe are productive discussions with the state. These discussion encompass a wide range of issues including past rate disputes, the adequacy of current and future rates and the structure of the SPD population.

We are hopeful that these discussions will result in rates that meet the state’s stated [2% to] 4% profit margin range for contracting plans. Let me add a few words about the dual eligibles. We’re making progress internally and continue to work with the state on many issues. We expect to hear about rates next month and still expect to begin enrolling Dual in the first half of next year. We will make sure that any dual activity is premised on adequate rate, keeping our SPG experience in mind.

We expect to spend somewhere between $20 million and $25 million in G&A expenses this year, preparing for duals. These expenses include consultants, IT, customer service modification, legal and regulatory costs and provider re-contracting. These incremental costs are included in our 2012 guidance.

Let me now turn to Medicare Managed. Our MA MCR for the fist half of 2012 was 89.9%, which compares with 90% for the first half of 2011. The first half tracked with our expectation that the full year 2012 MCR will improve, compared with 2011 and we continue to see opportunities, especially among the agents. We believe our Medicare book is back on track. It may be an underappreciated asset for Health Net, but our 2012 profitable growth clearly shows that we're a strong competitor in all our MA markets. Our government contract segment continues to produce solid and consistent results.

Pre-tax income was approximately $23 million in the second quarter of 2012. That is right in line with our annual expectations. We do expect to have a new contract in place later this year for our military and family life consultant contracts. Combined with the ongoing stability of the TRICARE contract, we expect that this segment can produce $90 million to $100 million of annual pre-tax income this year.

Let me now move to the second question. How can you be sure we’ve gotten it all? The third party review recommissioned after the first quarter claims issues with HIPAA 5010 is completed. The review confirmed that 5010 issues were a factor in our adverse prior period development in the first quarter.

Along with the emergence of an unanticipated flattening of the commercial trend in the fourth quarter of 2011, we believe that the 5010 issues will not impact reserve development going forward. The review also helped us identify the adverse selection issue in large group full network products that was the major cause of our second quarter adverse development, as well as specific SPD issues. Our second quarter reserve changes reflect these findings.

As a result of the commercial and SPD challenges, we are changing our 2012 GAAP guidance to between $1.45 and $1.55 of earnings per diluted share. Our guidance for the combined Western Region and Government contracts segment is now a $1 to $1.10 earnings per diluted share. This guidance includes the $79 million in adverse prior period development relating to 2011, which was recorded in the first and second quarters of 2012.

Let me now address the third question, how does all this affect our view of ‘13. For 2013, there are three items of paramount interests. We need to; one, drive 50 to 70 basis points of commercial MCR improvements, excluding prior period development through our corrective actions in large group. Two, we need to experience no adverse prior period development in 2013 as compared with the $79 million incurred in ’12. And three, we need to achieve 300 to 400 basis points of improvement in the Medicaid MCR.

Our ‘13 outlook is also supported by the expectation of additional Medicare Advantage enrollment growth next year. Our goal for ‘13 is a stable Medicare MCR. It also includes ongoing solid, predictable results from our government contract segments. Taken together these factors support our confidence that we can achieve meaningful earnings growth next year.

Let me close by saying that we believe our assets, a Medicaid book with significant future potential and improving Medicare book, our commercial with a solid presence in small and mid-market groups with tailored networks for all groups and the ongoing stability of TRICARE have real substantial underlying value for our shareholders.

It’s our job to make sure that we do what’s necessary to demonstrate this value to all of you. This is our focus. We are determined to show Health Net’s businesses are worthy of your support.

Thank you. And now let’s open it to Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Joshua Raskin, Barclays.

Joshua R. Raskin – Barclays Capital, Research Division

Hi, thanks. Good morning, Jay. Just want to I guess touch on where you left off in terms of 2013. So it sounds like you were putting together a path when you talked about meaningful growth in 2013. I guess, what exactly does that mean? Does that mean EPS growth off of, your combined Western $1 to $1.10 and then just so I understand, one of the key components is a 300 basis points to 400 basis point improvement in Medicaid MCRs excluding the negative development and that's coming despite the onset of California duals. Is that right?

Jay M. Gellert

Yes, let me go through the question. First of all, the three items I mentioned for 2013, will it be on top of the 2012 guidance, $1 to $1.10, the three items include as I said, about 50 to 70 basis points of commercial improvement that will result from the large group strategy I articulated and even build in some cushion for continued competitiveness in the market.

Second, as I indicated, we believe through this third party process that we've dealt with the prior period development issue, as you’ll note, our DCP is up and we’ve had a significant increase in reserves for claims in the balance sheet. And then third, what we articulated was that the state has in the rate setting methodology that it has established with CMS on targeted profit margins of 2% to 4% middle of the range, being 3%. The numbers we’ve articulated reflect that profit on a going forward basis. We’ve had discussions with the state and we believe that they are committed to implementing that methodology and rectifying issues related to the SPDs.

Joshua R. Raskin – Barclays Capital, Research Division

Okay, I mean, I apologize. I just didn’t have enough time to do the math, which is really rough back of the envelop, I mean you are talking about, is it something in the ballpark of a doubling of that dollar-to-dollar trend next year?

Jay M. Gellert

Those, when you do the math, you come to conclusions like that or maybe even a little more, but it’s roughly those numbers.

Joshua R. Raskin – Barclays Capital, Research Division

Okay, got that. Okay, that’s it. And then, just sort of taking a step back and thinking about the company, you guys have, as you mentioned, some valuable assets, tables [at] TRICARE business. You got a Medicaid contract in California et cetera. How do you think about sort of the future of Health Net? It seems like the commercial book has been tough. Is that a scale issue, I mean is that sort of long-term? Is that fixable in terms of longer-term improvement or is it just going to be one of these sort of ebbs and flows over time. How do you think about Heath Net and the grand scheme of things?

Jay M. Gellert

Fair question. I believe that the points you made about the government business are valid, strong TRICARE, strong Medicaid, new Medicaid opportunities, solid MA business and dual opportunities. I think that the California large group full network business won’t get that. So I think that does present scale issues. On the other hand when we look at the filings, our performance in small group and mid is really strong and as we said, are long been holding time to the individual business in anticipation of the exchange. We think there will be some opportunities there, but I do believe that the scale issue you raised, particularly in light of the other strong asset is something we really have to consider and particularly in light of what we anticipate to be continued competitive pressure in California in the commercial segment.

Joshua R. Raskin – Barclays Capital, Research Division

Does that signal a change in what you’re doing as a member of the Board in terms of the direction of Health Net, is there something are you saying right now that you’ve made that decision and those actions in place to think about that?

Jay M. Gellert

I think that it reflects a recognition of the increased competitive environment in terms of the California market and the need for the Board to look at it and make a determination of what makes sense. I think it’s a change in the evaluation of the market, not per se a specific comment related to the approach which we take, and we’re always looking at what we should do, but I do believe it articulates two things. One, I believe an increased recognition of the value of the government’s businesses and some ongoing concern about the California commercial markets that we have to incorporate in the strategic considerations, and in that regard scale is an issue.

Joshua R. Raskin – Barclays Capital, Research Division

Okay. So not a change, a change in the evaluation of the marketplace, but not a change in the way you guys think about the company?

Jay M. Gellert

I think that we continue to on an ongoing basis, look at what’s best for the shareholders in the context of those data, so obviously they will have an impact. I’m not saying anything more definitive than that, but I would say that.

Joshua R. Raskin – Barclays Capital, Research Division

Okay, perfect. Thank you.

Operator

Your next question comes from the line of Daniel Patt of Wedbush.

Sarah James – Wedbush Securities Inc.

This is Sarah James. I just had a question. You mentioned that the cost issues was on a 100,000 members, but then later in the prepared remarks you said that you could lose up to about 50,000 of that because of the changes. So I was just wondering if you could explain a little bit more about what makes 50,000 the high end of that 100,000 books that you could be losing. And then does that assumptions also reflect the fact that there is an increase competitive pricing environment in California that could cause enrollment pressure even if you weren’t making changes in your network?

Jay M. Gellert

What I was speaking to is specially those 100,000 accounts. We will maintain price discipline throughout the book. We agree with your point about competitiveness and we could see as much as an additional 50,000 in commercial loss in that context. So, let me now go back to the assessment of the 50,000 in large group.

The estimate is premised on the experience we’ve already had with some groups shifting to narrow network products or shifting away from the vulnerable large group market, other groups making adjustments in contribution structuring and related so it makes it a viable product and still others accepting large enough increases that they give us confidence that the numbers work. So but it’s primarily groups that have been willing to adjust their benefit structure and/or their network structure to give us confidence that we can retain them economically, because they reflect structures that are more consistent with what the economic for us and they’ve heard some of them have already been sold.

So again, it’s not assuming business as usual. It’s assuming that if we maintain the discipline we talked about and the willingness to walk away from the full 100,000 that half will adapt and that’s what the evidence seems to be and half will lose.

Sarah James – Wedbush Securities Inc

Okay. And then a quick question on the California SPD, you gave a lot of detail in the prepared remarks about some negotiations going on with the state which is helpful, I was just wondering if there is any issues also going on that could relate to continuity of care issues or something that would run out and provide sort of a step up as it runs out?

Jay M. Gellert

That’s a valid point. One of the actual errors, I think we think were made was there was an assumption of utilization reduction and unit cost reduction in the context of continuity of care. We don’t have definitive data there but we would expect some improvements as continuity of care work waves off. We also are seeing that a large number of the SPD population, much larger than we thought, had access issues before. So they weren’t getting adequate and sufficient care.

And as we track those people now that they have access to primary care, particularly in certain suburban and rural counties that we’re seeing the cost begin to come down. So it’s a combination of the cost of continuity of care that weren’t effectively reflected in the rates. And I’m quite honestly surprised we’re foreseen that many of them have not had adequate care and the fee for the services that managed system is actually bringing them greater care in the short-term which will yield greater saving down the road and a better quality of care.

Sarah James – Wedbush Securities Inc

What was that date for the continuity of care runs out?

Jay M. Gellert

Well the continuity of care runs at least three to six months from the point of initiation. So the way the process is working on, we started bringing people in June of 2011. We completed most of the enrollment by May of 2012. So we are nearing the end of the continuity process

Operator

Thank you. Your next question comes from the line of Justin Lake of JP Morgan.

Justin Lake – JPMorgan Securities LLC

Thanks. Good morning. First question, just a follow-up on the Medicaid side, Jay. So as you’re having these discussions with the state and you look back and think about what the issue is really with these, the core issue really is in these, with these Medicaid rates. Was it the state looking for more savings than you could deliver or was it some issues in terms of the actual data on cost in terms of the state, which was mistaken in terms of what they thought the costs were that they based the rates upon?

Jay M. Gellert

I think it was a combination. The biggest issue was not taking adequate consideration into continuity of care, and I’m not recognizing that in certain areas where there were inadequate providers that we wouldn’t be able to get adequate provider [at] Medicaid rates. So I think it was transition issues, some over optimism on the utilization side. And then thirdly, and again, particularly in those counties where there weren’t a lot of disproportionate share providers or there wasn’t an adequate physician base, we needed higher than Medicaid rates in order to provide the quality and access that was required under the State program.

Justin Lake – JPMorgan Securities LLC

Got it. And so these MLRs outside, it sounded like the issues are outside LA county, is that right?

Jay M. Gellert

There are some in LA, but the more suburban or rural the county is, the greater the problems, because typically you don’t have adequate number of physician providers and you don't have the competitive institutional market.

Justin Lake – JPMorgan Securities LLC

What's the MLRs inside of LA County?

Jay M. Gellert

We are still working on all that. I think we'd like to just hold that county by county, but I think that the issues exist in LA, I think because of some of the first couple of issues, continuity of care issues and some of those issues, but the rate issues and some of the access issues are more profound in other counties.

Justin Lake – JPMorgan Securities LLC

Okay. What was the savings that the state was looking to get when they transitioned these numbers over?

Jay M. Gellert

I believe…

Justin Lake – JPMorgan Securities LLC

Were they looking for meaningful savings or what…

Jay M. Gellert

Yeah, the numbers that I recollect from the waiver, was $365 million, so they've got substantial savings in doing this and I think that we will produce savings that are significant, but they probably over anticipated it in year one.

Justin Lake – JPMorgan Securities LLC

Okay. So, last question then, kind of thinking if this all of these issues through to the dual implementation next year in terms of – if the state were to just say, let's put rates out there that had pretty modest savings targets for early on, but had all these continuity of care issues – so the state's only looking to save a few percent, but they're looking for continuity of care, and you’re thinking through all these…

Angie McCabe

Justin?

Jay M. Gellert

We're losing you Justin.

Angie McCabe

Justin?

Jay M. Gellert

Justin. We’re losing you Justin.

Angie McCabe

Justin, we’re losing you.

Justin Lake – JPMorgan Securities LLC

Hello. Can you hear me?

Angie McCabe

No.

Jay M. Gellert

Hello. Try it again here.

Angie McCabe

Christie?

Jay M. Gellert

Maybe I can try and answer and see if Justin needs to come back.

Angie McCabe

Okay, okay.

Jay M. Gellert

First of all, we don’t have near the provider rate issues in Medicare that do in Medicaid. California in particular has Medicaid rates significantly lower than Medicare, so some of the unit cost issues that are articulated would not apply to the dual. Secondly, the expectations are much reduced compared to the numbers that were included in the SPD program. And third, the federal government is just paying a considerably larger amount relative to the risk status of people than the failures for similar population.

Nonetheless, I think the key advantage we have now that we have gone through the SPD affirmative, we actually have real data. So in the past I think it’s been we’ve argued points, but we’ve had no – not the depth of data. Now we have more experience in dealing with this [population] then just about anyone else and can actually show both on the delivery, cost, quality and access side what’s necessary to run a program like this in California. We think that there is some great opportunities particularly as I said, because of the relative payment experience of the two programs.

Operator

Your next question comes from the line of Christine Arnold of Cowen.

Christine Arnold – Cowen & Co. LLC

Hi.

Jay M. Gellert

Hey.

Christine Arnold – Cowen & Co. LLC

A Couple of questions. One, large group, are your rates already out for large group and have you finalized any of your rate action or are we early enough to catch the whole commercial book?

Jay M. Gellert

We’re early enough to catch the whole commercial book. So the rate that we’ve signed to this point in time fit the framework I’ve articulated. The way it’s happened is we started out with understanding of what we had. We probably would anticipate some negotiations historically and we’re just not having negotiations now, so the rates we’ve set out are full and complete in the context of the findings we made as a result of the independent review.

Christine Arnold – Cowen & Co. LLC

And you said you’re going to negotiate historical rates, you mean some of it that you’ve locked in, you’re going to try and reopen?

Jay M. Gellert

No, in the past sometimes we’ve had people come back and say well you can keep this account if you drop it by X percent because we have another competitive bid. And in these cases what we’ve said is take it to the other person, we’ll see you next year.

Christine Arnold – Cowen & Co. LLC

And then on the SPDs you have about 80,000, you’re making about 500 bucks per member per month, about $480 million in revenue. What’s the MLR on that?

Jay M. Gellert

The…

Christine Arnold – Cowen & Co. LLC

And the math like…

Jay M. Gellert

Go ahead, Christine. I’m sorry.

Christine Arnold – Cowen & Co. LLC

And I just wanted to confirm that my math is right on the $480 million in revenue?

Jay M. Gellert

I think that the annualized revenue is going to be a little higher because we’ve got more members I would say, more in the low probably high-5s maybe for the full-year, close to 6 actually, and the MLR is in the high is between 105 and 110.

Christine Arnold – Cowen & Co. LLC

Okay. Can you exit these people because it feels like they were just kind of dumped on you? There was no negotiation. If you are serving Medicaid, you keep them. So if you try and exit, you’d have to exit Medicaid or [you have the dual]. How does that work?

Jay M. Gellert

Yeah, I think that the state has basically an established rate setting process. The problem is that, there was some preexisting experience with this population in managed care. Our view is that the state recognizes some of these issues and we believe we’ll be able to come up with an approach that works. We’ll look at other alternatives, if those productive discussions don’t reach positive culmination, but at this point, I think that there’s an understanding of the issue at the state level.

Christine Arnold – Cowen & Co. LLC

Do they need to find dollars to offset this? I’m just not familiar with the California state budget situation.

Jay M. Gellert

I think that California has a rate setting methodology. I believe there’s some alternative in terms of structure and some other ideas that have been discussed that can make this work in a budgets [on] way. So I think those discussions are presently going on and I think we’ll be back in a reasonable period of time and we’re encouraged by the level of discussion to this point in time.

Christine Arnold – Cowen & Co. LLC

Okay, thanks.

Operator

Our next question comes from the line of Ana Gupte of Sanford Bernstein.

Ana Gupte – Sanford C. Bernstein & Co. LLC

Hi, thanks. Good morning. So it sounds like you’ve isolated the problem pretty much to large group, but just looking at the broader competitive commercial pricing environment, in terms of pricing it sounds to me like you’re saying pricing will continue to remain weak, well and hard and is this a regulatory issue in terms of rate review, is it MLR floors or is it competition? It sounds like Aetna has been saying insurance rate reviews are so challenging in California where you can get publicly flogged, if you will, and so why is it that it sounds to me you are saying it’s not going to improve, why wouldn’t pricing harden? Why wouldn’t all of you try to do something here?

Unidentified Company Representative

Well, I think that other than in the large group market, we think probably pricing is rationally competitive and we’re actually doing well and where you have enough volumes that you could develop competitive products, we are finding that the market is working.

California is a state with complex regulatory and it takes a lot of hard work, but I think at the end of the day that the mid and small market is pretty rationale. With regard to the large group market, what we are seeing is a couple of sliders, who really don't have a lot of government business trying to retain and compete for certain large group accounts at levels that look to us in the high 90s, the low 100s.

So we are basically just saying, I’ll be with you, we’ll do the business we’re doing and particularly in light of this kind of some of the adverse selection, I think we’ve just taken a pretty conservative attitude, but in the terms of small group you have to reprise your whole book, you can’t selectively re-price. In terms of the midmarket there is a much greater appetite for narrow networks and for focused networks in certain geographies. So the net effect of it is that those markets in our view allow product innovation. When you look at a large group full network product, you’re really in a commodity product and there is really not the ability to get competitive advantage. So I’d say again, small group mid-market rational, but competitive; large group kind of erratic.

Ana Gupte – Sanford C. Bernstein & Co. LLC

And is there any difference between Southern California and Northern California and is this largely a Kaiser, Blue Shield driven thing or is it more even the publicly traded guys doing it?

Jay M. Gellert

Well, first of all, I think the difference it depends on the competitiveness of the market. Southern California, particularly Los Angeles County is a much more competitive environment, so there are many better opportunities in relationships with providers. Where you’re having more consolidated markets, you have less of an opportunity to do things, to offer better options to customers. So it is a north-south issue. I think that there are issues with not-for-profits and until recently even there have been certain instances with some of the – for profits but that’s abated some and I think now that’s the right focus going forward.

Ana Gupte – Sanford C. Bernstein & Co. LLC

Now in small group, Jay, you said that you have the lowest loss ratio in California. If you look at it from a pricing perspective and then some of your – I think basically all of your competition is saying outpatient is increasing. Can you just give some color on the outlook for spread here as it relates to pricing now specifically in small group and middle and then what specific cost categories in outpatients are seeing higher acuity and/or volumes, any color there?

Jay M. Gellert

First of all, we said a month, we didn’t say they’re lowest, but that’s just an amendment, but secondly in the context of the small group market one of the key things for us is the tailored network products, because in those products we’ve built in some incentives to containing outpatients. In the fuller network products we’re seeing what our competitors are talking about. So to us we’re actually seeing MLR improvement in those segments particularly in the tailored network products where they are the incentive to appropriately use outpatient and particularly to use outpatient services with valid units costs. There is separately some ER. Then there are some very significant, in our view, in the full network product, unit cost issues and some discretionary utilization issues. So, I think as we look at it, one of the good things about some of these Tailored Network Products is that they have schedules that both discourage excess outpatient utilization and encourage appropriate unit cost in those areas.

Ana Gupte – Sanford C. Bernstein & Co. LLC

Got it. Thanks Jay.

Operator

Your next question comes from the line of Scott Fidel with Deutsche Bank.

Scott Fidel – Deutsche Bank

Thank. First question. Jay, can you give us a sense of what type of rate increases you’re going to be looking to push through on those large risk group accounts where you’re seeing the very high MLRs?

Jay M. Gellert

Well, I think that that we will see rate increases that if you’re looking at a group overall at 100% we would be targeting to bring them down at least into the low 90%. So, it would be trend plus the differential in the rates. I truly believe that when you risk adjust it, the rate increases are less and if we can move people to narrower networks, the rate increases will be significantly less. So our anticipation is that in many of those instances and that’s recently talked about, the 50,000. If people don’t want to move to these other structures, they may be able to find better opportunities out there.

Scott Fidel – Deutsche Bank

Got it. So when we think in that context, that implies sort of mid-to-high teens type rate increases?

Jay M. Gellert

Well, in this political environment, I think it’s very difficult to start talking about those kind of numbers. I would rather talk about the fact that we’re offering alternatives, plus we’re willing to look at risk adjustment methodology, so that we don’t necessitate those significant pricing increases.

Scott Fidel – Deutsche Bank

Then second question, just, can you give us an updated parent cash number at the end of the second quarter?

Jay M. Gellert

$100 million to $125 million. End of the quarter.

Scott Fidel – Deutsche Bank

Okay.

Jay M. Gellert

I’m sorry. I’ve got some advice. $50 million is the end of the quarter. Our guidance in Q1 for end of the year was $250 million to $260 million because of these adjustments that without, those numbers will assume no share repurchase. There’ll be some share repurchase, but it’s about $75 million less than what we guided to at the end of Q2.

Scott Fidel – Deutsche Bank

Okay. Then just saw that you trimmed your, cut your tax rate guidance by around 700 bps to 800 bps. Can you just talk about the factors that drove the change in the tax rate guidance?

Joseph C. Capezza

Hey, Scott, this is Joe. What drove the tax rate guidance is, the final tax terminations as part of the sale of the PDP business and the utilization of the non-operating was carried forward to have been held, they get applied on a GAAP basis to continuing [purposes as a] discontinuing operation.

Scott Fidel – Deutsche Bank

I see. So that was a GAAP change in the tax. Is there any sense of what type of tax are you building in on the operations view for that dollar to adopt the 10?

Joseph C. Capezza

I’m sorry, you lost me, because the $1.10 has a tax rate that we have put in the schedule. If you talk about on a run rate basis, we would expect that next year we would revert back to a normal tax rate – historical tax rate.

Scott Fidel – Deutsche Bank

Okay, I see. And then just one last question, just on the MA business, Jay, you talked about in sort of framing the first half, just in the second quarter when considering that 92% MA MLR, was the Medicare Advantage business profitable in the second quarter?

Jay M. Gellert

Yes it was and the reason we looked at it on a first half basis is we had some positive adjustments in the first quarter related to risk adjusters and some negative adjustments related to some provider payments in the second quarter. So that appropriate look would be at the full half, but it was profitable.

Scott Fidel – Deutsche Bank

Okay, thank you.

Operator

Your next question comes from the line of Matt Borsch of Goldman Sachs.

Matthew Borsch – Goldman Sachs

Yes, hi. Question on the SPD rate, on the SPD rate and the impact, how is that affecting your capitated providers? Are you as widely capitated on that side of the population as you are under your regular Medi-Cal? I guess I would have thought that would blunt the impact more than it has?

Jay M. Gellert

Well, the big issues are as I said in the counties other then LA.

Matthew Borsch – Goldman Sachs

Yeah, okay.

Jay M. Gellert

Those places were fee for service.

Matthew Borsch – Goldman Sachs

Got it.

Jay M. Gellert

Still there’s some issues with the capitated providers that need to be rectified too in the rate process going forward.

Matthew Borsch – Goldman Sachs

Okay. That makes sense. And coming back to the scale question that you addressed earlier, does your thinking about the investments that you need to make to properly manage the dual-eligible population influence you’re thinking about scale, as well as you ponder that with the Board?

Jay M. Gellert

I think that the scale issue is much more related to the ongoing efficiency of running the business. I think that we have the wherewithal to make those investments and because of our history with SPDs and the Medicaid program and all of that, I think that’s less an issue, but I definitely feel in terms of particularly looking in a commercial scale that, that’s an issue we have to heed.

Matthew Borsch – Goldman Sachs & Co.

Okay. And when do you think you have a fairly well formed view, not completely, obviously but a fairly well formed view of how the 2013 pricing environment is shaping up? I know the fruits in the pudding, so that would obviously be in next year, but…

Jay M. Gellert

Yeah. The concern that we would have – and this again, goes back to the scale issue. There was intense pressure to retain those large groups, and I would say that we would be concerned about the pricing environment. In light of the fact, that in the rest of the book, we’ve seen positive improvements and we see people becoming more rational and we see people also less aggressive particularly in the small group book, because it doesn’t insulate as much from the exchange, so when you package all that together, I think that we’ll get good visibility by the third quarter call on a lot of this. But at this point in time, we think that the 50 to 70 bps guidance we gave, which would be the result of take large group business efforts and then even (inaudible) for the competitiveness is a realistic view.

Matthew Borsch – Goldman Sachs

Okay. And last question, on the employers, the ASO conversions, are you seeing that in the middle market to some degree as well and how are you or is that being blunted by some of the regulatory push against the attachment points, just curious how you’re handling that?

Jay M. Gellert

In reality, what we’re seeing is the benefit of capitation for our outlays, the effect of going to ASO and you really can’t go capitate it in California at an ASO level. Where we’re getting our most pressure is from multistage employers, who are constructing national ASO plays in order to affect their mix. So that’s where they are affecting us. Even state wide employers that have taken the efficient network strategy, there is significant competitive advantage for them.

Matthew Borsch – Goldman Sachs

Okay. Okay, thank you.

Operator

Your next question comes from the line of Chris Rigg of Susquehanna.

Chris Rigg – Susquehanna Financial Group

Thanks good morning. Just wanted to come back to some of the problematic large group members that you think you can sort of move into, you can either get the rate increase, you can move to a tailored network. If you move those people into a tailored network, will they still see a rate increase or do you think that they’d see a rate decline because I think normally the selling point there that you can save them fair amount of money. I’m just trying to understand the economics for that type of movement with that client base?

Joseph C. Capezza

It’s different in different cases, but they’ll definitely see some stabilization of their rates. Also though in some of these cases, it depends on their benefit structure and some of those kind of things, but clearly our experiences with the efficient network products, the tailored network products that they can get depending on the debt, 10% to 30% savings versus the full network.

Chris Rigg – Susquehanna Financial Group

Okay. And then, coming back to the duals, I guess, when do you think the rates will sort of start to become visible enough that you are sort of comfortable moving forward and what is, I mean, the way the state sort of set it up is that they have locked themselves in at this point with two guys in each region. I mean, what would be the process to back out or can you even back out given that would sort of, with that [tar] your overall relationship with California?

Jay M. Gellert

I think that nobody will take this on with insufficient rates because it’s, and I think the State realizes that. So I think that all of the plans will want to be assured that they’re viable from the start, and the federal government, I think has a similar concern and I think State has that realization too. So I feel like even if it [tars] the people’s relationships, nobody should go forward with this program with insufficient rates because it will have a much greater detrimental effect than all of the participants.

Chris Rigg – Susquehanna Financial Group

Okay. and then last question, and sorry if I missed this. What is the rate cycle for your SPDs? When do we get the next increase?

Jay M. Gellert

The next increase is in October and there are discussions going on regarding some of the even issues related to ‘11 and ‘12 at present.

Chris Rigg – Susquehanna Financial Group

And what’s assumed in your guidance?

Jay M. Gellert

Assumed in our guidance is that we get back to the 2% to 4% range that's included in the [state] trading methodology.

Chris Rigg – Susquehanna Financial Group

Okay, great. Thanks.

Operator

Your next question comes from the line of Kevin Fischbeck of Bank of America Merrill Lynch.

Kevin Fischbeck - Bank of America Merrill Lynch

Okay great. Thank you. A couple questions on the commercial side. It sounds like with the 50,000 large group loss and I think you mentioned earlier another 50,000 loss elsewhere in the book. It is 100,000 commercial members of loss. That's basically the same membership losses you had this year, this actually maybe a little bit lower, but you already know the 50,000 losses you're trying to re-price that’s your large book business a little bit. The growth in your tailored networks is slowing. How do you feel comfortable with the general positioning into next year on the commercial book?

Jay M. Gellert

First of all, we said that we could lose up to 50,000 in terms of large group and the possibility of the additional 50,000 if we find significant ongoing pricing pressure. I think that when we look at the book, it performs really well, absent those areas and it's highly competitive in the places it needs to be. So, I think we feel good about the book. There's the scale issue that I was just surprise, but in terms of the core MCR experience and the competitiveness of the book outside of the large group area and outside of the occasional competitive irrationality we feel fine.

Kevin Fischbeck – Bank of America Merrill Lynch

Okay. And then I guess maybe just to go back to that scale issue that you mentioned. I mean, does that mean that you think that maybe not buying back stock is a good idea, maybe buying something in commercial to get that scale or are you saying that maybe as investors we shouldn't be surprised, a couple years from now we should be thinking of you as like Humana, which is mostly a government company, but has some small commercial book, but it's kind of the tail rather than the dog.

Jay M. Gellert

I don't think the solution to the scale issue rests with something that would not have us buying back stock. So, I don’t think that’s – I wouldn’t reach that conclusion. And I think that we have to consider all options to the benefit of our shareholders, there is – this really strong government franchise, which is really the area of future growth, future opportunity in a state where there is a commitment to managed care and that there is going to be a substantial growth in the number of eligible peoples. So I think that we need to make sure that the scale issues on the commercial side don’t in anyway compromise the strength of the Medicaid, Medicare, dual, the TRICARE franchises that have long histories that are now in the right place for the future.

So I think net of all that, forgetting tails and dogs for right now, I think that that our goal is to make an intelligent assessment of this commercial issue, which has been raised a number of times on the call and to do what’s necessary to maximize the value of what we believe to be a very attractive government franchise and a very attractive small and mid-group tailored network franchise and the opportunity to expand out through what’s probably going to be the largest exchange in the country.

Kevin Fischbeck – Bank of America Merrill Lynch

Okay and then just to follow-up on the government side of the business, and it sounds like if you are relatively good about where MA beginning, but I guess Q2 was a more difficult quarter and it sounds like you caught some cost there I mean how comfortable are you that all of that is reflected in the 2013 bids that’s you have…

Jay M. Gellert

We’re highly comfortable, because we made the bid based on the half – the first half assumption. We knew there was some positives in the first quarter or some negatives in the second quarter that we’re fully aware of them, so the bid was prominent on the 90%, I get 89.9% anticipated experience, and if anything we’re seeing a little, potentially even a little better experience as we go into the second half.

Kevin Fischbeck – Bank of America Merrill Lynch

Okay good. Can you just talk about what the development was in any of them more specifically we’ve had Humana talk about a rising cost? So there’s a big difference. So I just want to understand?

Jay M. Gellert

No, it didn’t have to do with period cost. It had to do with some positive risk adjuster true-ups and provider true-ups and some shifts in PPIA between accounts.

Kevin Fischbeck – Bank of America Merrill Lynch

Okay. All right, thanks.

Operator

Your next question comes from the line of David Windley of Jefferies.

David Windley – Jefferies & Co.

Hi, thanks for taking my questions. I have a read a number for California duals budget savings in the $660 million range. I wondered if that is still kind of in the discussion or applicable, and what that would imply for savings rate?

Jay M. Gellert

I think that that there was a number put in the budget that was an estimate. Until all the rates come in, I believe that everyone would agree that that’s just an estimate and it will be adjusted to reflect that reasonable actuarial assumption. So I don’t think we can come to a conclusion on anything at this point in time in terms of the duals. But I can honestly say that I’ve not gone back and really recreated the number of members and the savings assumptions and all that inherent in it, but I think the state is anticipating reasonable numbers that are significantly less than the SPD assumptions.

David Windley – Jefferies & Co.

And your comments in regard to the State’s view or policy around the Medicaid side of 2% to 4% margin target range. So in your discussions with the state on your Medicaid business in getting those rates squared away, that’s what you’re hoping to see then move through. Is that same framework applicable in the duals discussions?

Jay M. Gellert

I think that there remains to be discussions, but I think that that’s the target that everyone’s seeking.

David Windley – Jefferies & Co.

Okay. And then, on the commercial side, just trying to do some rough math on the contribution to overall MLR from this 100,000 member portion. It looks like maybe they add in the neighborhood of 100 basis points to the overall MLR, which would then leave this year’s, even excluding that portion of the book would have this year’s MLR a couple of hundred basis points above last year. Is that increase versus last year solely attributable to the issues that we talked about last quarter, the HIPAA 5010 and that sort of thing or is there some erosion in the MLR in the book apart from this 100,000 loss?

Jay M. Gellert

No. When you take the PPIA experience we’ve had and put it back in ‘11, we’re not allowed to talk about, which is run rate. Then you would conclude that there’s actually a reduction in the MLR even including the large group and then minus the large group is even better. So the way that we’ve done it is again, take the number that we’ve quoted, put that back in ‘11 and then run the numbers, and I think you come to that conclusion.

David Windley – Jefferies & Co.

Okay. Thank you.

Operator

Your next question comes from the line of Carl McDonald of Citigroup.

Carl McDonald – Citigroup

Thanks. I wanted [to go] back to an earlier question, which is on the Medicaid expectation of 300 to 400 basis points of improvement. Is that based on the existing book or does that also factor in duals in 2013, when I run some quick numbers?

Jay M. Gellert

Existing book only.

Carl McDonald – Citigroup

Sorry, say that again.

Jay M. Gellert

Existing book only.

Carl McDonald – Citigroup

Existing book only. Okay.

Jay M. Gellert

And it reflects kind of the historical MLR and the MLR of the (inaudible) population.

Carl McDonald – Citigroup

Okay. And then another question on the run rate, you had – looks like it was $12 million investment gain in the first quarter, it looks like that may have been closer to $15 million in the second quarter, is that about right?

Jay M. Gellert

No, I think it’s $12 million in both.

Carl McDonald – Citigroup

$12 million in both. Okay. Thank you.

Jay M. Gellert

I am sorry, our anticipation for the year is consistent with our earlier guidance of about another $12 million.

Carl McDonald – Citigroup

Okay, so another $12 million over the second half of the year.

Jay M. Gellert

Yes.

Carl McDonald – Citigroup

Okay. Thank you.

Jay M. Gellert

Okay.

Operator

Your next question comes from the line of Peter Costa of Wells Fargo Securities.

Peter Costa – Wells Fargo Advisors LLC

Good morning. I want to make sure that you are not doing – covering yourself from the damage, but offering your narrow network products alongside your full network products, so you are not causing your own adverse selection, is that correct?

Jay M. Gellert

That’s right, it’s ASO based in multistate accounts.

Peter Costa – Wells Fargo Advisors LLC

So none of these 100,000 lives are in accounts where you also are offering your narrow network products?

Jay M. Gellert

Only in those instances when we look at the aggregate MLR, it’s consistent with expectation and not included in these numbers.

Peter Costa – Wells Fargo Advisors LLC

Okay. And then how confident are you that it’s adverse selection and just not overall cost trend going up? And then why are you confident of that?

Jay M. Gellert

Fair question. I think that we would anticipate seeing cost trend across the book not concentrated in the select number of accounts. One of the processes we have gone through over the last quarter is as a result of this analysis we did is really focusing on what the real issue is, and one of the reasons we lost it early on was it’s as clear as day if you isolate those accounts. It’s much less clearer if you try and do trend analyses based on the aggregate book. So the reason that we believe it’s adverse selection is that we can isolate it. And then secondarily, we went back and studied the benefit comparisons and those circumstances, what the other offerings were. So when you package all that together, you get the clarity of why it was concentrated in those circumstances.

Peter Costa – Wells Fargo Advisors LLC

Was there a specific competitor in those accounts that was cherry picking if you will?

Jay M. Gellert

No. I think it was not. There are some specific consultants maybe. But I do believe that there are some instances where we’re seeing a few competitors that have been mentioned by others that I won’t mention bidding for some of those accounts aggressively now in the same states that we’re walking away from them. So in the normal market if we were concerned about retention that would be a risk, but since we’ve put our foot down that’s not really an issue and so we’re not really tracking where it’s going.

Peter Costa – Wells Fargo Advisors LLC

And then what about in the other accounts, if there’s still heavy competitive pressure, what are you more worried that there is going to be competitive pressure in your other accounts where you currently are okay and somebody comes in and steals it away from you?

Jay M. Gellert

It’s a fair question, but there is really two key reasons. One is again this is as much a phenomena of adverse risk selection, which in the small and mid-group market is much harder to do. And secondly, in those markets where we have a Tailored Network Product, we do have the competitive differentiation. In some other parts of the state, others have competitive differentiation. The place where you’re at, risk is where you’re at commodity player, which is the full network large group product and a commodity player in an environment where people are trying to move the higher risk employees to a full network products without paying for them.

Peter Costa – Wells Fargo Advisors LLC

Okay. Was there anything consistent about those 100,000 lives in terms of the accounts that they’re in? Is there a geography that they’re more tied to? Is there a type of account, financial services or anything like that?

Jay M. Gellert

They’re tied more, as I said, to areas where there is concentration of members in less competitive markets, parts of Northern California and parts of Orange County and the Inland Empire so that because some employers in those cases oftentimes can’t get competitive advantage from narrow network products and other related products because of the consolidation of the markets. So there are accounts generally where there’s the membership concentration in those areas and there are accounts that are typically multi-state so there’s not the commitment to try and separately workout the California capitated model and unfortunately really there are not more financial services. It seems like some other people are more financially astute in terms of this issue.

Peter Costa – Wells Fargo Advisors LLC

Okay. All right thank you.

Operator

Your next question is a follow up from the line of Daniel Patt of Wedbush.

Sarah James – Wedbush Securities Inc

Hey thanks and thanks everybody, hop back on here. I just wanted to circle back to an answer that you gave about the large group pricing environment where it looks like some competitors maybe pricing to high 90s or 100 MLR, which is interesting because peers had commented that this competitive pricing had seemed to be correlated to trend, how to rebate position this year, which I typically don’t think that large group is being an area where there is rebate. So I was just wondering if you could speak to whether or not the competitive pricing that you are seeing in large group is correlated to, and you can have a rebate position or if this is something beyond rebate, because people just being more competitive?

Jay M. Gellert

I think it’s unrelated to rebate. If you look at the California numbers, the rebate numbers are very, very low. Rebate in California, I think the Commissioner put out something where in total they are $38 million or something. So the rebate number, when you compare California to Texas or states is de minimis and it’s more kind of a core circumstance that I think it is any general factor. So we have not seen aggressive pricing for rebate reasons. We’ve seen it more for accounts seeking scale that are primary commercial accounts and we don’t have alternative government business. So I think it’s more about that and more about people who are deep and individual and the low-end of small group, which they foresee going into the exchange, then is it anything to do with rebates.

Sarah James – Wedbush Securities Inc.

Got it. And last question, your tailored network product has been one of your fastest growing commercial products over the last couple of years and WellPoint announced on their call this quarter that they are launching a high efficiency product in California. So I was just wondering if you could talk about how competitive is the market now? Are there only a few people offering this narrow network, tailored network products, and how do you think the impact of the new entrant like WellPoint would have on the growth opportunity for that product?

Jay M. Gellert

Well, first of all, there is something about some serious form of flattery, but I think that the reality is for us and we said this all along. We think the business is all going to be high deductible and efficient network, and we think that phenomena is going to continue with all of the people and so I think we are encouraged by the fact that people are moving away from open access PPO where we’re not competitive for this kind of product where we’re more competitive. I think that that will be a good thing because it will move accounts in that direction and we’ll all have relative competitive advantage in different places. So I’m encouraged by that.

Sarah James – Wedbush Securities Inc.

Thank you.

Operator

This brings us to the end of today’s conference call. We thank you for your participation. You may now disconnect.

Angie McCabe

Thank you.

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