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Executives

Stephen J. Hemsley - Chief Executive Officer, President and Executive Director

Dan Schumacher

Jeff Alter - Chief Executive of UnitedHealthcare Employer & Individual Business

Gail Koziara Boudreaux - Executive Vice President and Chief Executive Officer of United Healthcare

Larry C. Renfro - Executive Vice President and Chief Executive officer of Optum

Dirk McMahon

Jack Larsen

John S. Penshorn - Senior Vice President

Analysts

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Joshua R. Raskin - Barclays Capital, Research Division

Justin Lake - JP Morgan Chase & Co, Research Division

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

Sarah James - Wedbush Securities Inc., Research Division

Ralph Giacobbe - Crédit Suisse AG, Research Division

Melissa McGinnis - Morgan Stanley, Research Division

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

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Scott J. Fidel - Deutsche Bank AG, Research Division

Jason Gurda - Leerink Swann LLC, Research Division

Christian Rigg - Susquehanna Financial Group, LLLP, Research Division

Christine Arnold - Cowen and Company, LLC, Research Division

Sheryl R. Skolnick - CRT Capital Group LLC, Research Division

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

Unitedhealth Group (UNH) Q3 2012 Earnings Call October 16, 2012 8:45 AM ET

Operator

Good morning. I will be your conference operator today. Welcome to the UnitedHealth Group Third Quarter 2012 Earnings Conference Call. [Operator Instructions] As a reminder, this call is being recorded.

Here is some important introductory information. This call contains forward-looking statements under U.S. federal securities laws. These statements are subject to risks and uncertainties that could cause actual results to differ materially from historical experience or present expectations. A description of some of the risks and uncertainties can be found in the reports that we file with the Securities and Exchange Commission, including the cautionary statements included in our current and periodic filings.

This call will also reference non-GAAP amounts. A reconciliation of the non-GAAP to GAAP amounts is available on our financial reports and SEC filings section of the company's Investors page at www.unitedhealthgroup.com. Information presented on this call is contained in the earnings release we issued this morning and in our Form 8-K dated October 16, 2012, which may be accessed from the Investors page of the company's website. [Operator Instructions]

I would now like to turn the conference over to the President and Chief Executive Officer of UnitedHealth Group, Stephen Hemsley.

Stephen J. Hemsley

Good morning, and thank you for joining us today to review our third quarter results. Third quarter revenues were $27.3 billion, increasing 8% year-over-year again this quarter. Earnings grew 28% to $1.50 per share, benefiting from strong revenue growth and improved operating margins.

Our third quarter 2012 operating margin of 9.6% reflects strong performance on clinical affordability and favorable reserve developments, resulting in the consolidated medical care ratio of 79%. Sharp margin improvement at Optum further contributed to the 140 basis point expansion in consolidated operating margin.

Operating costs grew seasonally to 15.7% of revenues. Execution across our enterprise continues to be strong and our financial flexibility remains distinctive.

Adjusted cash flows from operations of $2.4 billion in the third quarter brought year-to-date cash flow to $5.5 billion, a 9% year-over-year advance.

We ended the quarter at the ratio of debt to debt plus equity of 30% and have $1.6 billion in nonregulated cash on hand.

Last week, we announced our merger with Amil, the leading Brazilian health care company. We see expansive, early-stage market opportunities there, and we expect Amil will become a distinctive growth platform for both our Health Benefits and Health Services segments.

The rating agencies all reaffirmed our ratings subsequent to our announcement. Standard & Poor's had upgraded our corporate debt rating to A with a stable outlook in September; making UnitedHealth Group the highest-rated, publicly traded managed care organization they follow.

Our unique business diversity was key factor for S&P, along with strong cash flow generated from operations. And also during the quarter, we were honored to be added to the Dow Jones Industrial Average.

Let's review third quarter performance by business, beginning with UnitedHealthcare, which advanced third quarter revenues 8% year-over-year to $25.5 billion, and operating earnings 26% to $2.2 billion.

UnitedHealthcare has added 2 million people through the first 9 months of 2012. This includes net growth of 670,000 people this quarter alone, record organic growth for a third quarter. Major new clients this quarter included the initiation of health benefit services for state employees in Texas and Nebraska. We're honored to serve the employees of these states and their families.

UnitedHealthcare grew fee-based commercial benefits by 1.5 million people in the third quarter, bringing 9-month growth to 1.25 million people. Commercial risk-based business remained flat this quarter. The commercial environment continues to be characterized by persistently weak employment and new business formation.

The pricing intensity we see at local market levels remains unchanged from the last several quarters. Our offerings remain very competitive across the value spectrum due to our strong cost positions, effective care management, operating cost disciplines and innovative benefit designs and features. But we will remain disciplined on margins and continue to price to our forward view of underlying costs, including the insurer's fee. As we hold to these pricing disciplines, we expect to continue to lose moderate levels of risk-based membership in the near term, as we have for the last several quarters.

Our Medicare and Medicaid businesses contributed strongly to UnitedHealthcare's third quarter growth performance, together adding more than 165,000 people over the last 90 days. We grew by 35,000 seniors in Medicare Advantage and 70,000 Medicaid beneficiaries joined UnitedHealthcare plans. We made the decision, together with the state of Wisconsin, to end our contract serving 175,000 people in one product in the Milwaukee market as of November 1, while we continue to serve 125,000 people statewide.

UnitedHealthcare Community & State was awarded the opportunity to serve more than 20,000 dual eligible beneficiaries in Ohio beginning in April of 2013. This was part of the country's first Medicare and Medicaid eligible program award integrating all services, from comprehensive medical to long-term care to pharmacy benefits to behavioral health. We offer all of these services and are deeply experienced and skilled in integrating them to better respond to challenges for these beneficiaries.

UnitedHealthcare's 8.6% operating margins strengthened, ahead of both our expectations and last year's third quarter results. Our full year 2012 commercial medical cost trend benchmark is likely to come in around 5.5%, plus or minus 50 basis points.

Third quarter earnings benefited from reserve development, and we now project a full year 2012 consolidated medical care ratio in the range of 80.5%, based on the strong year-to-date results and the sharp seasonal increase in cost expected in the fourth quarter.

We believe our consumer education and engagement efforts and our clinical management and affordability programs are meaningfully impacting the cost curve for our businesses. With benefit design improvements and effective outreach and population health management, we're increasingly helping patients receive care from the best doctors and have better suited more cost-appropriate sites of services.

We have also grown our performance-based payment programs, which are approaching an annual run rate of $17 billion or 18% of our in-network medical spend and our ability to detect inaccuracies and erred in claim submission and, therefore, to pay more fairly and appropriately for services rendered. Together, these capabilities deliver fundamental value to clients by improving the overall affordability of the products they buy.

Looking ahead to 2013, UnitedHealthcare's business plan is built on record customer growth, led by TRICARE and National Accounts, and strong performance in the public and senior sector. We expect UnitedHealthcare's performance in the Public and Senior Markets will be highlighted by continued market competitive Medicare Advantage offerings, continued Medicaid expansions and the compelling new Medicare Part D product offering that fully leverages our PBM capabilities.

We expect commercial risk business to continue to be down moderately in a price-sensitive market, as we adjust our pricing to reflect our forward view of medical costs, trends and cost increases for the insurance fee provisions of the Affordable Care Act. We continue to expect generally lower gross margin percentage across UnitedHealthcare's risk-based businesses in 2013, as we said last quarter.

For the longer term, our view remains strongly positive. We believe UnitedHealthcare is building a distinctive health benefits franchise by aligning benefit design, consumer engagement, clinical program management and network usage. This alignment continues to deliver sustainable cost and performance advantages, growth, and deeper, richer relationships with consumers and physicians across all benefit categories.

Moving to Health Services. Optum continues to progress steadily, in line with the long-term expectations we set out nearly a year ago at our Investor Conference. Even in these initial stages as the enterprise becomes what we refer to as One Optum, the results foreshadow some of the acceleration and impact of expanded capacities that will become even more apparent as it matures in 2013 and 2014.

Optum's third quarter revenues were $7.2 billion, and operating earnings of $408 million grew 28% year-over-year. Importantly, all segments showed year-over-year and sequential quarterly operating margin gains, benefiting from growth and from the simplification and integration investments made in the first half of this year.

The initiatives and investments that underline the One Optum strategy continue and should benefit 2013 and '14. Third quarter revenue growth was led by OptumHealth, up 19% year-over-year; and OptumInsight, up 15% year-over-year. Optum Insight's revenue backlog continues to grow and now stands at $4.5 billion, up more than $700 million or 19% year-over-year. The depth and quality of our customer relationships are increasing as the market becomes more familiar with our Optum offerings. Some examples of new third quarter sales illustrate Optum's diverse and broad market reach.

For a specialty drug maker, we will measure over multiple years the in-market clinical performance of a high-profile product. For a major care delivery system, we will provide technology and services to enable the development of competencies in population health and risk management. For a variety of health plans, we will deliver medical care to members through our integrated care clinics. For employers and freestanding drug benefit programs, we'll manage pharmacy benefits, including their rebate programs. And many more examples could be offered.

Optum is making steady progress in strengthening its margins by addressing its overall cost structure, operating, processes and deeper product and business integration. We are committed to a higher performance, more responsive, more agile enterprise, consistent with results that have been realized over the years through similar approaches applied at UnitedHealthcare.

We expect these improvements will strengthen performance for customers and unlock the scale advantage that should accrue from Optum's strong, sustainable top line growth. We have added seasoned, talented executives and aligned the organization to support more comprehensive solutions and deeper customer partnerships. We are focusing product development on these larger, broader opportunities, while continue to execute on always important, individual product sales, day in and day out.

Our long-term view for Optum's potential remains exceptionally positive. This is a competency-based platform with leading assets that are applicable to serving a broad variety of channels. Serving customer relationships across the full expense of a health system that needs to evolve and improve performance. We operate in an emerging health services marketplace, characterized by fragmented suppliers who typically are offering narrow products instead of broader-based solutions. If we focus on our clients and the challenges they face and deliver strong execution around solutions, Optum has dramatic growth potential.

So in sum, 2012 continues to be a strong year for our enterprise at this point. Our results show growth and balance across virtually all our businesses. We have achieved revenue growth, further diversification and stronger margins, and we continue to develop and position our businesses and business leaders for the future. With Tom Paul taking an important new role as UnitedHealthcare's Chief Consumer Officer, and Jack Larsen and Steve Nelson, both strong veteran leaders, now running respectively Medicare & Retirement and Community & State for UnitedHealthcare, 2012 should finish out strongly.

The fourth quarter is challenging from a seasonality perspective and as you know, bears a heavy cost burden as we prepare for new January volumes and related benefit changes and as we work through the intense Medicare selling and enrollment season.

That said, excluding any potential impact from Amil, we expect the year 2012 to end in a revenue range approaching $110 billion and an earnings per share range of $5.20 to $5.25 per share, with strong operating cash flows of approximately $7 billion.

Quarter-by-quarter, across the UnitedHealth Group, UnitedHealthcare and Optum platforms, we have been improving our products and services, executing more consistently and more strongly, diversifying steadily and regularly advancing innovations to better serve the needs of our customers. Organic growth has been strong and distinctive in both 2011 and 2012. Medical and operating costs have been well managed, with more opportunities in front of us. And as a result, we've been consistently delivering more value to the wide, diverse and growing customer base be serve. We expect strong execution to continue in 2013.

But as we have said in previous calls, given the weak business climate and employment outlook in the United States, the mounting pressures in federal state budgets, to mention just a few some of the challenges, we continue to be cautious about 2013 earnings performance. We expect to grow revenues and earnings per share in 2013, but we view the current consensus level as the considerable challenge from this distance, given these market conditions.

We certainly expect to continue to grow broadly across our businesses in 2013, with the exception of commercial risk-based membership. We continue to expect pressure on margins across all benefit markets. We have TRICARE implementation and PBM in sourcing to add to the operating challenges, as well as the growth opportunities.

Optum should remain rock solid on its plan to continue to increase its contribution to our overall performance. And Amil is expected to be slightly accretive, but not really expected to be much of a factor in the earnings next year.

2012 had significant favorable performance attributes, starting with favorable medical cost trends, reserve development and rebate true-ups that we cannot assume will carry into 2013 with similar levels of impact. We will introduce our first view of 2013 to you at our Investor Conference in just over a month from now.

As 2012 closes, we continue to generate significant growth momentum. Our customers are responding to the distinctive competencies that underlie products and services access from both UnitedHealthcare and Optum. We will continue to focus on fundamental execution with the goal of creating value, both for those we serve and for shareholders.

In the meantime, our team is here to take your questions about market development and 2012 performance. Please, let's hold to one question per person. Thank you.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Matt Borsch with Goldman Sachs.

Matthew Borsch - Goldman Sachs Group Inc., Research Division

Yes, I just wanted to ask you about the commercial pricing and cost trend environment. I mean in particular, of course we noticed the lower outlook on trend now at 5.5%, down from your prior outlook. Can you just talk through the components of your view that changed during the quarter and also maybe just dovetail that with whether you've seen any change on the pricing side as well?

Stephen J. Hemsley

Sure, I think Dan might be the best to be begin that.

Dan Schumacher

Matt, this is Dan Schumacher. So on the cost trend side, stepping into 2012, we did have an expectation of higher utilization as compared to 2011. We are actually seeing that, although I will tell you it is more moderate than we thought. We saw a surge in the first quarter utilization, and then that moderated from the second quarter forward. And I think beyond the consumer behaviors underneath that, I think what we are seeing is some really strong contributions from our medical affordability agenda. We work across the health care landscape, whether it be inpatient management focused on the most appropriate site of service, most appropriate course of treatment, all the way through to payment integrity; fraud, waste and abuse; and strong delivery, frankly, from our contracting, aligning more around value and quality outcomes. So all of those things are making a difference for us. As you look at the components of it, I guess I would take you back to the Investor Conference guidance and update the components from there. First on inpatient, we are seeing a little better inpatient. Again, that's really our strong management on 1-day lengths of stay, observations, conversions and things like that. We are seeing a little bit more moderate pharmacy utilization, particularly in the space of Hep C. We're seeing relatively stable position, and outpatient is actually a little bit higher than our expectation. And we continue to have strong programs really focused on the site of service behind the outpatient setting. So all of that informs our revised view of 5.5% plus or minus 50 basis points. And then I think I'll turn to Jeff to talk a little bit about the pricing environment.

Jeff Alter

Matt, it's Jeff Alter. Yes, on a general basis, we have said this before, we expected and have been seeing a more competitive market environment around commercial pricing. I don't think it's changed. It's about the same as it has been since the first few quarters of this year. So not really a market change in the third quarter. But as you know, our approach hasn't changed for a very long time. Our approach and discipline remain intact. And as Steve mentioned, we believe the result of that will be some loss of commercial risk-based membership over the next, call it 6 months. And in relation to the discussion or the answer that Dan gave, we have a very disciplined process that takes a forward view of costs. And as medical trend changes and expectations change, and some of those results change, we look across those 350 intersections of MLR. And then look at a couple other factors and try to come up with the answer that will optimize our results in each one of those given markets. So that has remained unchanged. What has changed, I think internally, is we are able to get some of these changes into our pricing much quicker than we had in the past. So...

Operator

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

Joshua R. Raskin - Barclays Capital, Research Division

Just wanted to talk a little bit about the commentary you made on 2013 consensus. Steve, you mentioned that, that will be a challenge. I think the consensus first is the mid-point of your current -- of your updated 2012 is about 7% growth. So I guess a couple of things on that. We've heard from the company before that it's a double-digit earnings grower. Are we just -- in sort of last couple of years, we're just sort of not seeing necessarily all of that, if you take out some of these one timers? So are we thinking about the growth trajectory wrong? You guys seem comfortable that Optum is still on pace to double by '15. And then I guess you mentioned pricing for the industry fee. Is that having a bigger effect? Is there a net income impact next year? And maybe specifically, how you plan on accounting for that?

Stephen J. Hemsley

Well, Josh, I think that is like 6 questions rolled into 1. I really commend you for that. Our view in terms of the outlook of our business is unchanged. We have seen these kinds of challenges in the marketplace and I think we have been successful in navigating through them over the last couple of years. But that doesn't deter us from recognizing that we need to continue to operate and focus on that basis, that the economic environment has not changed, the employment outlook really has not changed. It doesn't appear to us to be -- the reimbursement environment relative to the federal and state budgets, arguably has gotten even more intense. The impact of the reform act, including the insurance fee, really begins to get in -- to come into play, as we set to begin the rate development process for 2013. So we are respectful of those elements and intend to engage them and to perform to our maximum potential through those, and are perhaps more cautious than those who set consensus of those factors at this distance as we look into 2013. If you actually take a look at our actual performance, I think it has been pretty strong over the last couple of years and we are certainly focused and actually think we are more capable and stronger than we have been in those past years. But we have to strike an appropriate balance there. And that's really all we are saying. We expect to grow revenue in earnings in 2013. We're really not intending to give you more specifics or color on 2013 guidance, other than to maintain a sober balance in terms of some of the headwinds that we see. And on a, from a growth perspective, we consider these to be kind of the headwinds of perhaps the next couple of years. But if you really take a look at the growth potential of this enterprise, the market expansions that are in front of it over the long term, Optum is performing well. It is maturing. It is gaining momentum. And we fully expect to be in line with our kind of the guidance, the longer-term guidance we set at last year's Investor Conference. So no discouragement along those lines, and I don't know what else to offer.

Joshua R. Raskin - Barclays Capital, Research Division

I understand, Steve, you're not going to give sort of specific guidance. But you talked about industry fees, so I'm just curious what the impact there is? Are you -- is there a specific percentage you're assuming that the fee will come in at as a percentage of premiums? And are you accruing for that in '13? Is that the idea?

Stephen J. Hemsley

Well, so it's coming into play in 2013 because it applies in that fashion. Maybe Dan Schumacher can address the insurance fee.

Dan Schumacher

Sure. So with respect to the accounting, the insurance fee is assessed in 2014 based on 2013 premiums. So we will begin at -- accruing for it in 2014 as premiums are earned, and we will actually make the payment in January of 2014. So that's kind of mechanically how it works.

Joshua R. Raskin - Barclays Capital, Research Division

And you're accruing in '14?

Dan Schumacher

No, we're accruing in '14 for the fee. With respect to pricing in the commercial business, we have annual policies. So those policies that begin February forward in 2013, they have months that carry then into 2014. So we are increasingly reflecting the health insurance tax in those renewals, so that we capture the cost of that tax in '14, in our premiums in '13.

Operator

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

Justin Lake - JP Morgan Chase & Co, Research Division

I just want to follow up here on the commentary, specifically around the revenue growth. Yes, obviously a strong year here across just about all the businesses on the membership side. Is there anything you can talk to just in terms of anything we should be thinking about structurally in terms of the growth that you saw in 2011 or should I say, 2012 that may or may not continue into 2013, and whether that's the strong commercial ASO business? That Medicare Advantage results? Yes, I know you had a good Part D bidding season. Just curious if there's anything we should be thinking about in terms of nonrepetitive?

Stephen J. Hemsley

I think I'll let Gail and Larry comment with respect to their business platforms, but the item that we really highlighted is really no different than '12, and that is continued moderation in terms of commercial risk. But Gail, do you want to...

Gail Koziara Boudreaux

Thanks, Steve. From an overall perspective as you've seen from the benefits side of the business, we've had a very strong growth trajectory over the last several years, including this year in 2012. As we think about the positioning of each of our businesses, certainly, we're coming and still into the final pieces of our selling season for 2013, but feel we're well positioned in the commercially ASO side and think we will have another strong national account season. Again, that's part of the positioning around our consumer facing products, our value-based benefit design, the innovation that we're bringing to the market. So we feel positive about our positioning in the commercial ASO side. As Steve mentioned in his opening comments around commercial risk, it's a very competitive market we're seeing extremely disciplined around that pricing components of that and we'd expect to see membership decline. But again, feel good about the positioning of our products in each of our local markets. On the Medicare & Medicaid side, from our -- as you know, we're just starting into the AEP season. Again, we feel we have a very balanced offering in the marketplace, feel good about our Medicare positioning, and Medicare Advantage had a very strong Medicare Supplement business this year and we'd expect to continue to see strong performance there and feel we have a balanced offering in Part D as well. On Medicaid, we've continued to win procurements. And again, that is a market where we know that states are facing some significant budget challenges. We see opportunities. We're pleased with the win that we had in Ohio on the dual eligibles, as well as the state Medicaid and the procurements there, and continue to get very focused on affordability and providing I think strong offerings to our State partners, both across Medicaid and Medicare. So overall, from a growth perspective, getting back to your question, I think we feel well positioned, but recognize the competitive nature of the marketplace and are very respectful of that.

Justin Lake - JP Morgan Chase & Co, Research Division

Got it. So the kind of net answer here sounds like the business momentum feels just as strong going into 2013 as it was going in -- as it kind of has continued to be during 2012. And the commercial risk business is the area where you see pressure, and that's no different than what you're seeing this year in terms of the economy. Is that a fair way to look at it?

Gail Koziara Boudreaux

Well, I won't comment on '13 guidance, but I'll tell you that we do feel we're well positioned.

Stephen J. Hemsley

And you've only heard part of the story because Larry Renfro can speak to the Optum side.

Larry C. Renfro

I think everybody knows that we have a 3-year business plan that we're operating under. We call it Becoming One Optum. And if you look at that plan and you look at the execution that we've been achieving this year, there's really 4 areas that'll give you a little detail behind that. One being financial discipline/cost management; two being reengineering/organizational simplification; three being portfolio management; and four being growth. So I think in terms of your question, you were more geared towards the growth. So let me just give you a couple of comments. We do feel pretty well positioned. I think if you look this quarter, OptumHealth was up about 19%. OptumInsight up about 15%, with OptumInsight's backlog being up about 19%. But if you look at growth, where we see it coming from in the future as part of our plan, it'll be the PBM, it'll be care delivery, the retail/consumer and provider. So we feel pretty good about the overall plan. We feel pretty good about the execution in 2012 and looking forward to some results in the future.

Stephen J. Hemsley

So overall, I'd say pretty positive.

Operator

And we'll go next to Ana Gupte with Sanford Bernstein.

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

The question is about cost trend, both around utilization as well as unit cost. So can you give me some color first around the reserve development, which is very favorable compared to some of your peers in recent quarters by segment, Medicare/Medicaid, commercial and if utilization is equally weak and well-controlled in all segments? And then on the unit cost side, given that we've got now 40% of docs owned by hospitals, per the recent advisory board data, Sutter, Long Island Jewish, New York Montefiore and many others are beginning to apply for health plan licenses, are you seeing any pressure on your unit cost? And how do you see that evolving in the next 1 to 3 years?

Stephen J. Hemsley

Dan?

Dan Schumacher

Hi, Ana. This is Dan Schumacher. So let me take the pieces of that. First, with respect to the reserve development. I think it's important to share that our fundamental discipline has not changed. So we have a comprehensive reserve setting process. It's consistent. It's stable. And each month, each quarter, we are trying to sort out our best estimate of the ultimate claims expense. And as a result, we don't have an expectation of future favorable development. And as you look at it on a year-to-date basis, we'll get it in relation to prior year medical spend and so forth, it's about 1%, so in a relatively reasonable range. In terms of the things that are contributing to the development, I'd say first on the utilization side, as I mentioned, we saw a surge in utilization in the first quarter and some moderation in the second quarter forward. And that's true across Medicare, Medicaid and commercial. And that contributed to our development. We also continue to have improving processing speed, as well as processing quality. That's showing up in the form of reserve development. And then beyond that, our performance around our affordability agenda. So we take a prudent approach as we introduce programs. We wait to see that manifest in actual claims payment. And then that starts to impact our reserve results. And so you're seeing favorable development across kind of those 3 things. As you look at the composition of trend between cost and utilization, utilization is a little bit better than we expected, and I would likewise say that unit cost is a little bit better than expectation. On the commercial side specifically, it remains an area of intense pressure for us, and it represents more than 2/3 of our trend outcome each year, so it is a very meaningful part of our trend equation. But I will tell you that on the unit cost side, we are doing a little bit better than we thought. We think that's in part due to the reconfiguration of our payment, aligning it with performance and quality and value.

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

So its default being you're turning more to shed savings risk-based contracting, if I may just close that off?

Stephen J. Hemsley

Yes, we're working up the continuum, so starting in fee-for-service and then working towards shared savings and gain sharings, up through bundle in episode relatively sub-capitations and capitations and so forth, working to align the incentives across the continuum. And we rely heavily on our partners in Optum to help to provide those services and support tools for the delivery system to be able to meet us where we want a contract.

Operator

And we'll go next to Sarah James with Wedbush.

Sarah James - Wedbush Securities Inc., Research Division

Steve, I wanted to clarify a comment that you made in the prepared remarks. You said that you would expect commercial risk business to be down moderately next year, and I wanted to understand better if that was referring to top line or margin because it sounded like you thought the intensity of pricing and competition was continuing and cost would be up next year. So looking at those 2 pieces together, where do we end up from a margin perspective?

Stephen J. Hemsley

Sure, I think Gail can respond to this.

Gail Koziara Boudreaux

Sure. What Steve was referring to is that, as you know this year, we're down in enrollment over 25,000 lives on risk-based. And as Jeff said in his comments to the earlier question, we expect to continue to be a competitive environment, and we would expect enrollment to be down.

Sarah James - Wedbush Securities Inc., Research Division

Got it. So the comment was directed at enrollment, not at margins?

Stephen J. Hemsley

Yes.

Gail Koziara Boudreaux

It was at enrollment, yes.

Operator

We'll go next to Ralph Giacobbe with Crédit Suisse.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Just want to go back to cost trend. I know you took it down a bit. Maybe can you talk about what you expect on the inpatient and outpatient side of what you're seeing in terms of trend there? And then you mentioned sort of the shift to inpatient outpatient. How much of that is really driving the lower cost, what you're doing to help that push? And if at all, if you can frame sort of the savings in aggregate on a like-for-like basis.

Stephen J. Hemsley

Dan, you want to cover that again?

Dan Schumacher

Sure. So with respect to the categories, where we're seeing utilization up, we're seeing it up in the outpatient setting, and that is in part due to some of the management programs we have in place. So we focus on converting one day lengths of stay to a more efficient setting to observation status. So they flip from inpatient to outpatient, and that was what I was talking about with respect to our management programs. And then on the inpatient side, we are seeing continuously restrained utilization. Our bed days were actually flat to declining, and each of our benefits businesses and those things extend through from admissions, the length of stay, as well as focused on the readmission rates so that when you leave the hospital, you're able to stay home. And again, that's an example of a partnership with Optum, where their care management teams are working to transition people to the home setting and help them stay there. Those are some of the examples of the things that we're doing that are making a difference inside of our cost trends.

Ralph Giacobbe - Crédit Suisse AG, Research Division

And then just -- again, on the 5.5%, I guess I'm just trying to get a sense. Does that equate to inpatient being up 4% and outpatient being up 9% or can you help in that regard? Just trying to get a sense of the magnitude when you talk about inpatient and outpatient, given that you lowered the trend?

Dan Schumacher

Well, so you when you're talking about the trend, you got to take into account unit cost and utilization. On the utilization side, specifically, inpatient is actually down, outpatient is up. On the unit cost side, most of our unit cost increases come in the inpatient setting. That's where our increases are coming from. So when you blend that all together, as I mentioned before, balanced against our Investor Conference guidance, better in inpatient, better in pharmacy, relatively stable in physician and higher in outpatient.

Operator

And we'll go next to Melissa McGinnis with Morgan Stanley.

Melissa McGinnis - Morgan Stanley, Research Division

2012 is definitely a year of investment, not just around your Optum segment, but also in preparation for certain regulatory changes and reform implementation in 2014. Can you just help us think about any incremental investments you may still need to make as we head into 2013, and whether there's any sort of step function change, up or down, in your SG&A as we head into next year?

Stephen J. Hemsley

So let me see if I can understand the question. As we continue to prepare for adopting and embracing the healthcare reform changes and continue the activities in our business, such as in-sourcing our PBM, et cetera, I guess you're asking us where our cost -- you're looking for an increase in cost or something like that, is that...

Melissa McGinnis - Morgan Stanley, Research Division

Yes, sort of just how we think about your SG&A, especially around those types of investments as we move from '12 into '13.

Stephen J. Hemsley

I think '12 has actually had a reasonable burden with respect to those kinds of investments, and I think that much of it will carry through into 2013, and probably subside more in the latter stages of it, but I think an area that's most impacted by those kinds of activities is Optum. So maybe I'll ask Larry or John Rex to kind of comment.

Larry C. Renfro

Sure. If you -- and I think that most people know that we have spent the last couple of years designing the PBM operational platform, as well as the infrastructure to move the UHC business onto our platforms. So 2012 ended up being the strong year for us to invest. That investment should start to wind down at the end of this year, and there'll be some lag into 2013, but we feel pretty good about where we're at with that. It's perfectly on plan. So that's pretty much it. John, I don't know if there's anything else.

Dirk McMahon

Yes, so what I would add to that, Larry, is that you're absolutely right, this is Dirk McMahon. In 2012, we had probably our highest SG&A burden associated with investments in the insourcing, but in 2013 we'll also have some expenses associated with training our people as we bring them into deal with the membership that we will ratably bring in throughout 2013.

Dan Schumacher

Larry, just to follow-on here, I think in the first half of the year, we made comments in the first 2 quarters about the investments we're making across the broader business in addition to OptumRx. We expect to continue to make those investments, and I think from what you're seeing in this quarter as we're starting to realize some of the benefits that we would expect to continue to make with investments that we work out into 2013 also.

Stephen J. Hemsley

But nothing -- but basically continuation, nothing...

Dan Schumacher

In continuation, that kind of levels it out...

Stephen J. Hemsley

And how about on the UnitedHealthcare side?

Gail Koziara Boudreaux

It's Gail Boudreaux. In the UnitedHealthcare side, you'll continue to see there's some investments, stable investments in Reform, so you think about ongoing investments in ICD-10. In addition, we made investments this year in 2012 in helping to standup the TRICARE contract, and we will continue to make those as we prepare to serve that membership in March of 2013, and those investments will -- getting that contract ready to stand up will also flow into 2013.

Operator

And we'll go next to Peter Costa with Wells Fargo.

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

You guys talked about Optum growing and margins continuing to improve, and then SG&A being perhaps higher in '12 than maybe in '13 or at least similar, but not growing, and talk about building the insurance fee into the commercial risk business. I'm trying to gauge why the pressure on EPS growth making earnings growth -- the consensus numbers challenging for 2013. It comes sort of down to the Medicare business and we look at that, and you clearly have some very good margin in the Medicare business or certainly lower medical loss ratio. Are you sort of expecting a much weaker margin in Medicare for next year sort of getting ready for the MLR minimums in 2014? Is that the way to think about this?

Stephen J. Hemsley

Yes, no, maybe I could reset. I think if you go back to a commentary we have made really over the last couple of years, really it is -- we're responding to an environment that is broadly challenging, and where we have been successful navigating those challenges. Those challenges remain, and the economic environment remains, and the pressure on budgets remain. And the pressure on making sure that we execute flawlessly with respect to -- we just mentioned the TRICARE contract or the PBM in-sourcing, staying on the One Optum plan, those kinds of elements, which we have a lot of respect for the work that goes into executing across those and basically, we remind the market each quarter about those challenges, and we approach things perhaps more cautiously than the marketplace, and I think that's what we are suggesting. We are really not -- you are perhaps overanalyzing if you're trying to focus down on a single product line. We're actually pretty positive about the breadth of our business, very positive about our Medicare and Medicaid outlook and potential. Actually, very positive with respect to commercial. If you take a look at the commercial market broadly, it has been, at best, treading water, or if not, contracting from that perspective. So we're just reminding the marketplace of those challenges in light of very, very strong results. So that really is the goal here, not -- there is no lack of confidence with respect to our competitiveness in the marketplace, our ability to prosper under all the product lines we have right now.

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

And just getting back to the minimum MLRs in Medicare, can you address that a little bit in terms of how well you think you are prepared? I know we don't even know how that's going to be calculated at this point, but in terms of your expectation for how that's going to work going forward, what kind of pressure do see on margins in the Medicare business in 2014, if not sooner?

Stephen J. Hemsley

Actually, we feel pretty good about that. Gail?

Gail Koziara Boudreaux

Yes, I think -- this is Gail Boudreaux again. I think you said at first, we don't have the exact calculation yet for how the minimum MLR will be applied in Medicare, but it is obviously one of those factors that as we get into 2013 and prepare our bids for 2014, we'll take that into consideration along with a number of other factors but to be more specific, would you expect to be able to manage within it.

Stephen J. Hemsley

And if I would add, one other element to the thinking is the '12 has had a lot of favorable elements to it, and as I said in the prepared remarks, you cannot necessarily assume that those will play into '13 as strongly as they did in '12. We will continue to operate in endeavor to achieve that, but that's an element of caution that we also give. So I wouldn't over read our caution. I would just think that we have to regularly remind ourselves and remind the marketplace of the issues.

Operator

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

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

I just want to go back to the industry fee pricing commentary. So you guys are starting to price for the industry fee starting next year, but there's no actual fee until 2014. So shouldn't that be a tailwind to 2013 MLRs?

Stephen J. Hemsley

Dan, review that again.

Dan Schumacher

You're right, Kevin, that will provide a little bit of help in 2013 as we collected our premiums, the cost of that tax in 2014 in the commercial space.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Okay, good. Maybe I was misreading it, but it sounded to me like you were saying it gives you a feel there's some sort of headwind that had to be dealt with. It's actually just more on the commercial membership side that you're talking about? And if you believe that it is in some ways a headwind on the commercial membership, does that mean that some of your competitors, I guess, most of the non-profits because the for-profits have kind of indicated a similar pricing dynamic to use. Does it mean that some of the non-profits are not following that strategy?

Dan Schumacher

We really can't comment. We don't really know the strategies others are following. This is an element that is part of our rate development. The headwinds we talk about are a fact of the market coming to grips with this element of pricing as it goes into our rate development process. So really, that's what we are talking about. You're right about it being a tailwind in terms of that element, and we really aren't going to comment about how others are going to approach this. Any further things to add?

Stephen J. Hemsley

Yes, I just think, Kevin, that the pressure that we're talking about is really the increase in pressure on -- pressure on already strained employer, consumers, federal and state governments. It's really the pressure it adds to the system, as it adds another cost in the environment. And I think just in terms of how this is recovered in 2013, I do want to clarify that it is ratable. So if you're a February 1 effective date, we would be looking to recover the month of January in 2014. So 1/12, 2/12, 3/12 and so forth.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Yes, as the year goes on, that would increasingly be a benefit, but then as you roll into 2014, it's now a net mutual aspect. But I guess as you thought about that, I think it's accounted for that you expected margin compression in your business lines. Is that because the thing with development is not going to re-accrue into net even though you're going to have a pickup and a tailwind at 2013, the fact that you don't assume favorable development, they wash? Or how do we think about that?

Stephen J. Hemsley

Well, the only thing I'll leave there is that we do not assume development going forward. We believe our reserves are set appropriately, and so we don't really have a view of reserve development going forward.

Operator

And we'll go next to Scott Fidel with Deutsche Bank.

Scott J. Fidel - Deutsche Bank AG, Research Division

Just wanted to stick on the industry tax subject, and maybe if you can just talk about what some of the latest feedback that you're getting from CMS and from the states. Is -- if you're guiding anything in terms of how they're planning to build in the tax into the rates for Medicaid and for the Medicare products?

Dan Schumacher

So, Scott, good morning. With respect to Medicaid. Again, this will be an element of the cost structure that will go into our rate development. And this, along with all the other factors that go into rate development, will be part of our dialogue with our state partners over the course of 2013, as they start to set rates that flow into 2014. So I would say that conversation is on the horizon in earnest. And then on the Medicare side, it is going to be one of the factors that we consider in our -- developing our bid strategy and bid approach for 2014. So as you think about the first 6 months of next year, we'll be taking into consideration the health insurance tax, as well as all the other changes, and then trying to ultimately preserve the value of the benefits that seniors really enjoy.

Scott J. Fidel - Deutsche Bank AG, Research Division

So Dan, is it fair to think about for Medicare that we won't actually be seeing when CMS gives us preliminary and final rates for '14, and there won't be an adjustment in the rate? It's more that the industry will need to adjust the benefits and the pricing to accommodate the tax?

Dan Schumacher

I won't comment on CMS rate setting. I think our expectation is that as we formulate our bid approach, we'll need to consider this as another element in that approach.

Stephen J. Hemsley

CMS will have to consider it as well in terms of how they survey the private sector market for Medicare. So these conversations are really just beginning. This is really, just will be getting introduced at this point in time across basically all the elements for rate development, whether it's commercial or whether it's in the government programs.

Operator

And we'll go next to Jason Gurda with Leerink Swann.

Jason Gurda - Leerink Swann LLC, Research Division

One of your peers recently commented on their expectations for margins in the small group and individual product in 2014 on the exchanges. Can you provide may be a little bit of commentary or perspective on what you're expecting or how you expect the margins or how you expect the changes to impact your margins and maybe your perspective on what your competitor had stated?

Stephen J. Hemsley

Sure, Gail, you want to touch on this?

Gail Koziara Boudreaux

Sure. Yes, well, why I don't Jeff and I give you a little perspective. I'm not going to make some comments on our competitors’ perspective on the marketplace, but I think we want to put this a bit in context. The small-business market has always been a very competitive and a very transparent market. That's the market we've done very well in. We see it as a robust market, and quite frankly, the focus has always been about on affordable price point, strong consumer engagement, and making sure that you have a cost structure that underlies that strong positioning. So as we think about exchanges going forward, there's a wide range of expectations around the migration to exchanges, and we expect that to be measured as we head into 2014. Part of that is due just to the ability of getting these exchanges up and running. The second one is that employers, as they think about the tax advantage they currently have and then the need to have to make that up in compensation or other things, that's one of the reasons we do think it's going to be measured. But with that, we do expect that there will be pressure in margins over the long term, and again that goes back to underscoring the importance of having affordable plan design, strong network composition, making sure that your cost structure is aligned. But we do also see opportunities for growth, given that opportunity, given the positioning of ourselves in the small-business market, and maybe I'll ask Jeff to comment a little bit about that as well.

Jeff Alter

It's Jeff Alter. I agree with Gail's comments about the existing small group market. I'll also just remind that we have been involved in exchanges for quite a long time, certain states, certain industry associations. So some of the lessons learned there, I think are applicable as well for product design, choice around network construct. So there's still a lot to know about the exchanges. Things are being developed right now. We don't have all the rules. But I think as the exchanges become more firm, we will engage with the -- those constructs and apply some of the lessons that we've learned over the years in our small group business and in the participation and the number of exchanges to that marketplace. We don't -- we see it as just as another distribution in another marketplace, and we'll react to that marketplace like we have the deal with all the marketplace.

Stephen J. Hemsley

And the only thing I'd add is that there's really nothing new there. That basically reflects our thinking and our posture probably for the last 2 years or more. So there really isn't anything new. Those pressures have been there, and we expect them to remain.

Operator

And we'll go next to Chris Rigg with Susquehanna.

Christian Rigg - Susquehanna Financial Group, LLLP, Research Division

Just wanted to come back to the cost trend real quickly here. Relative to the initial trend guidance, is it fair to say that the new level is down entirely because the utilization, a component of trend is lower than relative to original expectations? And then I guess more importantly going forward, is -- even at when you started this year at up about 1.25% or so, is that sort of the new normal that we should think about is the right level prospectively? Or would you guys assume that, that eventually does reaccelerate?

Dan Schumacher

Chris, this is Dan. On the cost trends, the improvement in our guidance, that 50 basis point improvement at the mid-point, that is a blend of improvement both in utilization and a little bit better unit cost. So both are making a contribution to our 2012 cost trend view. As we think about our cost trend into 2013 in the commercial business, we expect the trend to be relatively stable.

Operator

We'll go next to Christine Arnold with Cowen.

Christine Arnold - Cowen and Company, LLC, Research Division

A couple quick questions. Are you assuming in kind of your cautious outlook the potential for the fiscal cliff and other situations not to be resolved favorably enough to have potentially a similar situation to what we saw in '08 with medical trends? And can you highlight your low-income PDP bidding strategy in terms of kind of what you were thinking there?

Stephen J. Hemsley

So to -- I'll have Dirk kind of talk to or the -- who wants to do the Part D, okay? And then are the elements of our fiscal cliff and so forth specific? No, I think they're part of the landscape and what we talk about when we talk about the pressures that are on government and so forth. I don't know how one would actually feather in that in a specific way, but it is clearly a factor in our caution list as we think about 2013. So clearly, we recognize it. Clearly, we're focusing on its impact in terms of potential impact on government programs and so forth, but nothing that we can actually specifically do, but a good reason why we stay more cautious than perhaps the marketplace. And with respect to Part D?

Jack Larsen

Jack Larsen. So on the Part D saver plan, I guess as market leader we had a point of view that we need to be serving the broader market. So we set out really to design a plan that appeal to those consumers who are really more, I guess economy minded, more sensitive to the fixed premium rather than some of the other planned features when you compare that to the third plan that we offer today which is, in comparison, relatively more comprehensive. I guess having designed that product for that consumer segment, I guess we're just happy that the plan actually have stayed below the benchmark status, and we get a chance to serve low-income population for calendar 2013.

Christine Arnold - Cowen and Company, LLC, Research Division

And your assumption is that the medical trend's stable in 2013, if I hear you correctly, versus '12 not the upticks in commercial?

John S. Penshorn

It's John Penshorn. I think Dan was referring to a stable rate of increase as opposed to 0% year-over-year.

Christine Arnold - Cowen and Company, LLC, Research Division

Got it.

Stephen J. Hemsley

Anything further?

Gail Koziara Boudreaux

No, the only thing I'd add, Christine, to Jack's comments around Part D is part of the -- I think the value is looking at the marketplace, as he said in assessing it, and then also our partnership with OptumRx, our ability to manage formulary effectively, our retail network, as well as our overall program. We think that adds unique value to us in our ability to play in that marketplace and broadly serve both the low-income, as well as the retail market.

Operator

We will go next to Sheryl Skolnick with CRT Capital Group.

Sheryl R. Skolnick - CRT Capital Group LLC, Research Division

First of all, it is a very hard work to do everything that has been accomplished at United and everyone there should be congratulated on the execution in a challenging environment and I want to thank you, Steve, for the appropriateness of the reminder of how challenging it is, and also for the fact that the tone is more cautious, not nearly assessing the stake as it was last year, and so the stock is not having heart failure. But my question is this, we've talked a lot on this call about what happens as reform is implemented? But there is a nontrivial risk at this point that we could have the 3 Rs on the hill and then the White House. And if we've got Romney, Ryan and we've got republicans running the senate, or at least, a split senate, so 51 going to republican and the republican house. Is it possible that reform may change materially, if not go away completely in some way, shape or form. So my question to you is what happens to United in the event that reform doesn't happen? How are you positioned to succeed?

Stephen J. Hemsley

Well, Sheryl, regardless of what legislation went in place, some of the underlying elements in the marketplace that led to policy initiatives around making the health care system more effective and efficient, modernizing that system, expanding and addressing areas where coverage was not sufficient, access needed to be better channeled, needed to be established, making -- being able to deliver more consistent quality, getting at the underlying cost. All of those elements contributed to kind of this national conversation around health care, and the results are a first policy initiative, which was largely around the expansion of coverage. And I think everybody recognizes there will continue to be work to be done to improve the health care system both from a policy point of view and from an operational point of view. That's what we do. That's really where kind of the mission of this enterprise is. So regardless of what comes forward in terms of policy and what generations follow it, we will respond and operate and work within the system to maximize the potential of this enterprise as commercial enterprise, and to maximize our impact on the health care system in total. So if there is a change in direction with respect to health care, we will maneuver and evolve and adapt to that change. We've talked about our adaptability for years. We don't think the underlying issue has changed. Fact of the matter is, coverage needs to be better considered. Costs need to be addressed more effectively. The system needs to operate more efficiently. Resources need to be accessed in a fair way and gone further, and the consistency of the processes and so forth need to advance. All those elements are things that basically work to our competencies and the strength of our businesses. So we will just adapt, if you will, to those kinds of changes. And I think as an organizational capability, we have very, very strong adaptability skills. So that would be the response. We really -- we'll never comment in terms of the political persuasion one way or another. We will respond with what the market -- how the market begins to evolve, and we'll adapt to serve it.

Sheryl R. Skolnick - CRT Capital Group LLC, Research Division

And just to follow-up. So in terms of the contingency plan, is it fair to say the entire company strategy is the contingency plan?

Stephen J. Hemsley

Yes, I think the whole nature of this organization has been to adapt to that and to adapt to it, the market challenges. So the whole construct, modular development of the business built around competencies, the fact that we deploy and redeploy kind of almost on a nonstop basis is really how we approach serving the marketplace. And if there are changes, we obviously have thought through the kind of changes that could occur. We think we can respond to them very effectively.

Operator

And we'll take our last question from David Windley with Jefferies.

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

So, Steve, as I think about adjusting my outlook, our outlook relative to the cautionary comments that you've made on the call, I'm interested in kind of thinking about whether that is pulling back a little bit on Optum and UnitedHealthcare, or if it's more heavily weighted toward one side or the other. And thinking about Optum, you've got the UHC business coming in, preparatory costs winding off, margins in all 3 segments there seem to be progressing pretty nicely, and so it would certainly seem to point toward lower expectations on the UHC side of the business. I think most of your comments point toward that on the call. I just want to make sure I confirm and understand that being the case and in particular, that it would be in the commercial risk business that you would point to as being the -- maybe the area of greatest weakness, for a lack of a better word.

Stephen J. Hemsley

Actually, our goal is really not to provide that kind of specific guidance for you today. Really, it is really more of messaging that we take perhaps a more respectful and cautious view of the market in total. We also recognize 2012 has been a strong year and has benefited from a number of positive things which we hope we'll continue, but we can't be sure of. We're certainly confident in our Optum business, but we're also very confident in our United health care business and businesses. The commentary around the commercial marketplace is almost identical to last year. I mean, we were saying the same things last year about moderation in terms of growth in the commercial risk segment, and we're saying it again this year. We are down about 200,000 in commercial risk, and we consider that to be a moderate level. So we are not trying to signal alarm in any particular area. We are really just suggesting that 2012 has been a very strong year. We expect 2013 to grow in both revenue and earnings. But as we sit in October of 2012 and assess the challenges ahead, we hope to continue the strength of this performance. We're actually in a good or better position than we were at this time last year, but we think we are being cautious and we think the market should be cautious as well, and that's all I can offer you until we discuss this at the Investor Conference in more detail, which is just a little bit more than a month.

So as we wind it up, I think UnitedHealth Group continues to deliver a solid performance in the third quarter. We remain cautious about the challenges ahead, and we certainly have discussed that well. Perhaps most critical, though, in terms of the challenges we're continuing to work to really improve the quality of the health care system to control the rising cost of care, and to really work to serve the people that we serve across the enterprise. So as we said today, we're very optimistic that we have the people of this company. We'll rise to the challenges across-the-board, and we look forward to seeing you at the Investor Conference in just a little over a month. So thank you very much for joining us this morning.

Operator

This does conclude today's teleconference. You may now disconnect and have a wonderful day.

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