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Aetna (NYSE:AET)

Q3 2012 Earnings Call

October 25, 2012 7:30 am ET

Executives

Thomas F. Cowhey - Vice President of Investor Relations

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

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

Analysts

Joshua R. Raskin - Barclays Capital, Research Division

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

Carl R. McDonald - Citigroup Inc, Research Division

Justin Lake - JP Morgan Chase & Co, Research Division

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

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

Christine Arnold - Cowen and Company, LLC, Research Division

Melissa McGinnis - Morgan Stanley, Research Division

Ralph Giacobbe - Crédit Suisse AG, Research Division

Scott J. Fidel - Deutsche Bank AG, Research Division

Operator

Good morning. My name is Yolanda, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Aetna Third Quarter 2012 Earnings Conference Call. [Operator Instructions] After the speakers' remarks, there will be a question-and-answer period. As a reminder, this conference is being recorded. I would now like to turn the call over to Mr. Tom Cowhey, Vice President of Investor Relations. Mr. Cowhey, please go ahead.

Thomas F. Cowhey

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

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

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

Mark T. Bertolini

Good morning. Thank you, Tom, and thank you all for joining us today.

This morning, we reported third quarter operating earnings per share of $1.55, another strong performance. Aetna's third quarter result reinforces the value of our diversified business model, demonstrates our margin discipline and exemplifies the rigor with which we manage our operations. Underlying our third quarter results, Aetna grew Health Care premiums by 7% over the prior year quarter, with growth across multiple lines of business. We reported pretax operating margins of 10.2%, driven by excellent Commercial underwriting margins, and with the help of our midyear wins, we grew by almost 150,000 members in the quarter, achieving our full year guidance of 18.2 million medical members. We are pleased with our membership traction and continue to focus on striking a disciplined balance between margin and growth.

As we look to the fourth quarter of 2012, we continue to expect top line growth and strong operating performance. Based on our year-to-date results, we are raising our full year 2012 operating EPS guidance to approximately $5.10 per share from our previously stated range of $5 to $5.10. While we continue to project modest growth across certain businesses throughout the remainder of the year, we are maintaining our year-end guidance of 18.2 million medical members.

As we look to 2013, we remain focused on continuing to execute our strategy across multiple dimensions, including accelerating our efforts to transform the network model and engage consumers, preparing our enterprise for health care reform, including investing for exchanges in 2014 and appropriately pricing for the various health reform-related taxes and closing and successfully integrating our proposed acquisition of Coventry Health Care.

In a few moments, Joe will review our detailed results and outlook. But first, I am going to reemphasize the rationale behind our proposed acquisition of Coventry, provide some insight into our strategic initiatives and comment briefly on the political environment and its implications for our industry.

In August, we signed a definitive agreement to acquire Coventry Health Care. The acquisition will strengthen our core business, enhance our capabilities, promote greater operational efficiencies and create better value for our customers, provider partners and shareholders. This strategic acquisition is expected to add nearly 4 million medical members and 1.5 million prescription drug plan members at a growing Individual Medicare Advantage business, substantially increase our Medicaid footprint, improve our positioning in consumer baselines of business as we prepare for 2014 and beyond, and add a low-cost product set built on value-based provider networks. In addition to these many strategic benefits, the transaction is projected to be financially attractive for Aetna shareholders and generate excellent returns on capital. We have commenced the regulatory approval process for the transaction and have already launched our integration planning teams. We have filed all material applications required for regulatory approval of the transaction and are on target for a mid-2013 closing. Joe is the executive responsible for the integration and will speak more about that process in his remarks.

In regard to transforming the network model, we have been investing in the capabilities required to collaborate with providers. By sharing common platforms and goals, we believe that we can help providers shift from episodic acute care management to patient population management, which in turn converts volume-based reimbursement into value-based reimbursement. Provider groups, in collaboration with Aetna, can then drive unnecessary utilization out of the system, improving quality of care and lowering costs. We believe Aetna has a unique platform in the marketplace to enable providers to share and manage the risks associated with patient population management. Our solution combines Aetna's leading-technology stack, including Medicity, Active Health and iTriage, with Aetna's intellectual property, including our care management, underwriting and product expertise.

Our significant investments in technology as well as risk management systems and processes allow Aetna's collaborative agreements to transcend simple pay-per-performance measures and align incentives toward superior outcomes. These powerful tools and services are truly enabling a revolution among health care delivery systems. For Aetna, this transformation results in high-margin, unregulated fee revenues but, more importantly, results in an improved network medical cost position, which we then package into more competitively priced products. In our signed ACO contracts, we have achieved improved unit cost that at times have been 10% below our nearest competitor. It is on this basis that we have launched Individual and Small Group products with partners such as Banner or small and midsize employer products with Aurora.

Our technologies and relationships have also enabled growth in Medicare with partners such as Emory and Banner and then Medicaid with Carilion. These products drive member volume into our health plans but also drive patient volume to our provider partners. To date, Aetna has 11 signed Accountable Care Solutions partnerships, with 26 letters of intent and over 200 prospects in the pipeline. Further, our ACS capabilities have been instrumental in several significant wins, such as Teachers Retirement System of Texas and the state of Maine. We believe that our efforts can transform the network model and expect continued success in attracting and signing up new provider partners. We plan to provide additional detail on our membership projections associated with these relationships at our December Investor Conference.

Another key part of Aetna's growth strategy is to profitably increase our participation in government programs. In particular, Medicare has been an important strategic growth area for Aetna, where we continue to demonstrate progress across all our product lines.

In Group Medicare Advantage, we continue to see traction in both securing new accounts but also converting the 1.2 million Medicare-eligible lives within our Commercial book to these products. The Teacher Retirement System of Texas award is but one example of this momentum, which alone is projected to generate over $800 million of incremental premiums in 2013.

In Individual Medicare Advantage, we have made great strides in realigning our products to capture our fair share of this growth opportunity. For 2013, Aetna will provide beneficiaries with consistent premiums and enriched benefits and services. To achieve these goals and maintain our target of financial returns, we have spent substantial time and effort adjusting our benefits and copayments, augmenting our medical management programs, improving our contracting and increasing the number of members who participate in one of our provider collaborations. Our goal is to have roughly half of our Individual Medicare Advantage membership in one of our Medicare provider collaborations or Accountable Care Solutions relationships by the end of 2013.

In Medicare Supplement, our Genworth acquisition continues to generate substantial growth. Since closing this acquisition in October of 2011, Medicare Supplement membership has increased by almost 40,000 members or over 20%.

In PDP, we are optimistic about our prospects for continued growth and are pleased to report that CMS recently reinstated our ability to receive auto-assigned membership. We expect to begin receiving auto-assigns as early as November of this year and project continued growth in the first quarter of 2013.

As we look across our balanced spectrum of products, Aetna's Medicare franchise has good momentum. We expect 2013 to be a much stronger year and are optimistic about our prospects for continued top line growth.

Finally, as we look to the elections in the coming weeks, we remain focused on our core business and on implementing the health care reform legislation enacted in 2010. We are preparing for competition on the exchanges in 2014, the impact of fees and taxes and the expansion of Medicaid eligibility. While the elections or deficit reduction actions may impact the Affordable Care Act between now and 2014, we believe that we can provide a market-based response to any change. We continue to believe that the private sector is the engine for innovation for our health care system as we focus on improving quality, increasing access and lowering costs.

In summary, I am pleased with our third quarter and year-to-date performance and expect continued strong performance in the final quarter of 2012. We are seeing good momentum in the following businesses: National Accounts, where we continue to improve our value proposition through targeted contracting efforts; Medicare, as we look to grow membership in the group and individual marketplaces; Medicaid, where we see growth in our existing markets and are gaining access to new markets; and Accountable Care Solutions, where we are driving innovative change and have a robust pipeline of opportunities. Further, I am confident in: our strategic direction and our ability to continue to execute on our business fundamentals, our ability to close and successfully integrate the proposed Coventry transaction, our ability to manage through the legislative and regulatory changes associated with health care reform, our 2012 medical cost trend outlook and our 2012 operating EPS projection of approximately $5.10.

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

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

Joseph M. Zubretsky

Thanks, Mark, and good morning, everyone. Earlier today, we reported operating earnings per share of $1.55 for the third quarter, highlighted by revenue growth of 6% balanced by volume growth and attractive yields; our Commercial medical benefit ratio, which was 79.6% in the quarter, as medical costs continue to develop consistent with our expectations; and pretax operating margins of 10.2% in the quarter, keeping us on track to achieve our targeted high-single-digit operating margin this year. We continue to price with discipline, actively manage medical cost for superior quality and cost outcomes and strive for administrative efficiencies to deliver profitable growth for our shareholders.

At the end of the third quarter, we had 18.2 million medical members, an increase of 149,000 members sequentially. Commercial ASC membership increased by 102,000 in the quarter, due primarily to continued strong growth in our network access products and the previously disclosed state of Maine account. Commercial Insured membership declined by 42,000 in the quarter, driven largely by a decline in Student Health membership, a low revenue per member product, partially offset by gains in International. Medicare membership increased by 24,000 in the quarter, with strong gains in our Medicare Supplement product. And Medicaid membership increased by 65,000 in the quarter as a result of the increased insured membership from our Missouri expansion.

Third quarter 2012 revenue generation was strong, increasing by 6% year-over-year to $8.9 billion, largely due to a 7% increase in Health Care premiums. The increase in Health Care premium included a net increase in Commercial premium of approximately 4% due to a 5% increase in premium yields, partially offset by a 1% decline in volume. The increase in premium yields was driven by a 4.5% increase from rates and 0.5% increase in mix. Health Care premium also reflected a 14.4% increase in Medicare premium as a result of the inclusion of Genworth's Medicare Supplement business and Medicare Advantage membership growth. We also posted a 23.4% increase in Medicaid premium due to our in-state expansion.

Fees and other revenue also increased by 1% year-over-year as lower volumes in our Commercial ASC business were offset by the inclusion of PayFlex and modest increases in yields. Note that the impact of the Prodigy acquisition is now included in the prior year quarter, lowering the reported growth rates in this line item.

Our third quarter total medical benefit ratio was 80.7%, including the impact of approximately $96 million before tax of favorable prior-period reserve development. We remain confident in the adequacy of our reserves as we experienced favorable reserve development in each of our businesses, primarily related to the second quarter, with the majority emerging from our Commercial business. Additionally, our days claims payable were 46.3 days at the end of the quarter, up 1.9 days sequentially, partially due to the timing of claim processing cycles.

We continue to invest in opportunities for profitable growth and to improve productivity. Our third quarter 2012 business segment operating expense ratio was 18.3% due to continued execution on our expense initiatives. Our operating expense ratio for our insured Health Care business was 11.3% in the quarter, a decrease of 100 basis points year-over-year due to our continued operating expense management.

Third quarter net investment income on our continuing business portfolio was $136 million as declining yields continued to create downward pressure on earnings. At September 30, the continuing business portfolio was in a net unrealized gain position of approximately $1.4 billion before tax and is well positioned from a risk perspective.

Our capital generation was strong in the quarter. We started the quarter with $400 million in liquidity at the parent. Net subsidiary dividends to the parent and commercial paper issuances resulted in $450 million of additional cash flow. Due to the pending Coventry transaction, we did not repurchase any shares during the quarter. After other net uses, including our shareholder dividend, working capital changes and retirement of certain long-term debt, we ended the quarter with $450 million in liquidity at the parent. Our basic share count was 334.5 million at September 30. Our financial position, capital structure and liquidity all continued to be very strong. We are on track to execute our financing plans for the Coventry transaction and expect to issue long-term debt in the fourth quarter of 2012.

Turning now to the proposed Coventry acquisition. We remain confident that the transaction will deliver substantial benefits to our shareholders. Shorter term, we continue to project that the transaction will be modestly accretive to our pre-transaction 2013 "operating earnings per share" baseline, excluding transaction and integration costs. Longer term, we project $0.45 of operating earnings per share accretion in 2014 and $0.90 in 2015, again excluding transaction and integration costs.

Our synergy value is projected to build over time and reach $400 million pretax in 2015, derived from the following sources: 1/3 is the elimination of duplicate corporate overhead; approximately another 1/3 comes from fixed cost operating expense leverage due to the increased medical membership; 20% is driven by streamlining our combined $1.5 billion of information technology spending; and finally, the remaining synergies are a result of provider network, medical management and pharmacy benefit management synergies.

The combined cash flows of the pro forma entity are also strong. With $2.3 billion of pro forma combined parent cash flows in 2012 plus synergy values, we project that we could repurchase approximately $1 billion of shares in each of the next 3 years while still meeting our deleveraging commitments.

As we prepare for the projected closing of the Coventry transaction, we have already assembled an integration team, for which I am the executive sponsor. We are pleased to announce that Karen Rohan, who recently joined Aetna as an Executive Vice President and a member of our Executive Committee, will lead the Coventry integration. Karen is an accomplished executive with deep health plan experience. We are committed to ensuring a smooth transition and achieving the financial projections and the attractive returns we previously articulated.

Moving to our 2012 outlook. We are increasing our operating earnings per share guidance to approximately $5.10 from our previous guidance range of $5 to $5.10. The net increase is a result of improved operating performance and higher underwriting margins. This improved operating performance is partially offset by expected seasonal medical expenses in the fourth quarter that are higher than previously projected, slightly higher projected investment spending in the fourth quarter on health care reform and ACO initiatives and a "higher than previously projected" share count due to the impact of the Coventry acquisition. Our implied operating earnings per share guidance for the fourth quarter of 2012 is approximately $0.92. This projection is consistent with Aetna's recent quarterly earnings progression.

Our projected Commercial medical benefit ratio and Medicare medical benefit ratio guidance remains unchanged. However, we now expect that Aetna's full year Commercial medical benefit ratio will fall in the lower half of our 81.5% plus or minus 50 basis point range. Aetna's 2012 Commercial MBR projections reflect underlying medical cost trend at 6.5% plus or minus 50 basis points, consistent with our prior guidance. The components of projected trend remain unchanged.

We now project that our full year 2012 business segment operating expense ratio will be approximately 19%. The implied fourth quarter operating expense ratio is approximately 20% and is driven by the normal seasonal pattern of our expenses, which tend to be higher toward the end of the year; the timing of certain programs and expenses shifting to the fourth quarter; and a higher projected level of investment.

For 2012, we now project net dividends from subsidiaries of approximately $1.9 billion and deployable capital of approximately $1,550,000,000 as a result of disciplined capital management. Our share count guidance range continues to be approximately 344 million to 347 million weighted average shares. Note that through the date of the Coventry stockholder vote, we will not be repurchasing our shares. Following that vote currently scheduled for November 21, we will be able to repurchase our shares, subject to customary considerations and restrictions.

As we head into the end of the year, I would like to provide some color on the factors that impact our outlook for 2013. We continue to prepare for the upcoming changes from health care reform and expect to maintain increased spending on new capabilities particularly related to exchanges. Additionally, we will continue to advance our readiness plans to recover the health insurance fee and the reinsurance contribution in 2014.

In 2013, we should see some favorable earnings lift as a result of Government revenues. Aetna expects to grow revenues in both Medicare and Medicaid in 2013, including at least $800 million in projected incremental premiums from the TRS Medicare conversion.

Share repurchases. While more limited than it would have been absent the Coventry announcement, the full year impact of share repurchases in 2012 and 2013 will enhance operating earnings per share.

2011 acquisitions. In 2013, we project additional accretion from our 2011 acquisitions as synergies are realized and integration costs subside and positive fixed cost leverage as we continue to grow the revenue line.

As we look to 2013, there will also be some challenges to earnings growth, including experience-rated margin pressure. Aetna's 2012 operating margins are currently near the high end of our target range. The experience-rated nature of our large account businesses, including Group Medicare, will pressure our earnings growth in 2013 as favorable 2012 results are credited back to customers.

Commercial Insured growth. Commercial Insured membership growth opportunities may be limited by the lack of employment growth. We will not attempt to aggressively increase market share and put at risk the maintenance of our margin profile. When faced with the choice, Aetna will always choose margins over membership.

Net investment income. Net investment income will again decline due to the low-yield environment. We project that retained net investment income could decline by over $65 million pretax in 2013.

Commercial ASC growth. As the 2013 selling season draws to a close, our latest projections suggest that National Accounts membership will decline slightly in the first quarter of next year. When combined with the conversion of TRS members into a Medicare Advantage product, we project that total Commercial ASC membership will be lower in the first quarter of 2013. This projected result remains a substantial improvement over our 2011 and 2012 selling seasons. We remain confident about our prospects in this business due to our increasing sales momentum, the positive fee yields and enhanced cross-sells we achieved for 2013 and the large Medicare Advantage conversion opportunity.

The fundamentals of Aetna's business remain strong, and we are confident in our operating earnings per share projection of approximately $5.10. We believe we have the winning strategy in the marketplace. Our core business is performing, and we are well positioned for growth. Our emerging businesses continue to work to transform the network model, improve our cost structure and drive additional membership. The acquisition of Coventry will only serve to strengthen our current positions in Commercial, Medicare and Medicaid. And the projected accretion will add to earnings growth in the years to come. Finally, our capital generation remains strong and will be further strengthened by the Coventry transaction.

We look forward to discussing our long-term strategies in greater detail at our Investor Conference in December.

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

Question-and-Answer Session

Thomas F. Cowhey

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

Operator

We'll hear first from Josh Raskin with Barclays.

Joshua R. Raskin - Barclays Capital, Research Division

Just one quick clarification point on the cash flow this quarter, I guess just relative to net income, a little bit weaker. And I know year-to-date, it's actually below net income. So I'm just curious if there's been some timing issues and what the expectation around cash flow from ops in 4Q.

Mark T. Bertolini

Josh, the cash flows for this quarter were lower than net income due to the timing of CMS payments. Year-to-date, they are in excess of net income. And for the full year, we still project they'll be at approximately 120% of net income, all due to the timing of CMS payments, which had a very strange pattern this year.

Joshua R. Raskin - Barclays Capital, Research Division

Okay, that's helpful. And then I just want to see if I'm sort of reading into things too much, but you talked about headwinds and tailwinds for 2013, and it's difficult, I guess, without the quantification of those to understand which one is bigger. But you've said multiple times, and Mark's said it as well, around position for growth beyond 2012. Is it fair to say that when you said much improved that you would expect earnings, core operating earnings, to be up on a year-over-year basis before sort of changes in share count and below-the-line stuff?

Mark T. Bertolini

I missed the last part of that, Josh.

Joshua R. Raskin - Barclays Capital, Research Division

I guess it's not looking at the EPS line, per se, but just at operating earnings, maybe an EBIT number or a pretax number, would you expect earnings in '13 to be higher or lower or about the same?

Joseph M. Zubretsky

Josh, at this point in time, we're saying that our earnings per share will -- is projected to definitely increase for next year over 2012, but we're not commenting on operating earnings at this point in time. We will give you a full briefing on that at our Investor Day in December.

Joshua R. Raskin - Barclays Capital, Research Division

Okay, then, I'm sorry, maybe I could ask a different question, then. Just the Commercial risk lives in 2Q were up and then down in 3Q. Is it just sort of some pluses and minuses? Or was there anything to read in terms of change in the environment?

Mark T. Bertolini

Josh, it was actually a large student health group, with fairly low premium that came out. Otherwise, we had some growth in the quarter, but it was puts and takes. But it was largely driven by student health.

Operator

We'll take our next question from Ana Gupte with Sanford Bernstein.

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

Following up on your headwinds, tailwinds, you talked about risk membership potentially showing pressure, margin over membership. Can you tell us, given that you're talking about pricing in the excise tax load on a staged basis from February, what the blended underwriting spread is likely to be over the course of the full year, given 50% is renewed in January? And then have you an idea of what the load will be starting with the 2014? Given it's $8 billion for the industry, what is your share of that?

Mark T. Bertolini

So Ana, I think you're correct in stating that we are always going to price with margin over membership, particularly in a down economy. Our ability to maintain the high-single-digit margins that people have always asked whether or not we'd be able to maintain in this economy are important, particularly as we turn the economy, hopefully, with the fix-the-debt campaign here soon rolling into that new economy. I think our pricing model will include capturing some -- will include capturing our health insurance fees and taxes. And we already have 70% of our book priced and into the marketplace already. I'll let Joe talk about some of the details associated with that. Joe?

Joseph M. Zubretsky

Ana consistent with what some of our competitors have already spoken about publicly, we are pricing in 2013 the reinsurance contribution in the health insurance fee. Our -- as we stated many times, our strategy is to collect a portion of those taxes in every member month that earned in 2014, which means you have to start that process in accounts that renew in February of '13. On balance, it's different by books of business, but similar to what other industry players are speaking about, the reinsurance contribution is approximately $6 per member per month. And the health insurance fee on a full annualized basis is approximately 2.5% of premium.

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

And other publics are talking about pricing or loading this in. What is the posture that you're seeing from your not-for-profit blue [ph] competitors in this regard?

Joseph M. Zubretsky

The rate filings that we've pulled from various states suggest that most industry participants, including the non-for-profits, are attempting to price for the fees in 2013 in advance of '14.

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

And finally, just related to that, again, the 6.5% plus or minus 50 that you had as your medical cost trend outlook, you did not lower it for full year. One of your competitors, United, did. As you're looking forward into 2013, are you baking in an uptick in your expectation and pricing accordingly?

Mark T. Bertolini

A couple of things, Ana. We're sticking with 6.5% plus or minus 50 basis points. Two, because we saw lower buydowns this year, we are seeing people buy through their deductibles and co-pays. So we'll see more consumer-directed health plan and high-deductible plan utilization beyond deductibles in the fourth quarter. So we've anticipated that in our fourth quarter. And as we look into 2014, we're not giving any guidance yet, but we see utilization going up in 2013 by 50 basis points. But that's not total trend.

Operator

Our next question comes from Carl McDonald with Citi.

Carl R. McDonald - Citigroup Inc, Research Division

Just another point of clarification on the last question, I want to make clear, so you are assuming that cost trends will be up? So basically what you're saying is there will be a cushion in your pricing for 2013 relative to the cost trend you're seeing today?

Joseph M. Zubretsky

Well, we wouldn't call it a cushion. We are actually expecting utilization trend to increase by 50 basis points in '13 over '12 as compared to '12 over '11. If it doesn't happen, it obviously would be a spread that would emerge in our P&L. But right now, that is our full expectation that utilization, even though it's higher this year than it was last, is still at all-time-low levels.

Mark T. Bertolini

But what we haven't included, Carl, in that are the buydowns and all the nets that come out of coming to a net trend number year-over-year. And we won't do that until we get to our Investor Conference in 2012. We're finalizing our plan as we speak.

Carl R. McDonald - Citigroup Inc, Research Division

Got it. In terms of the utilization, anything specific that you're pointing to in 2013? Or is this sort of the historical view of, "It's low. We don't think it's going to stay that way. So we're just assuming it's going to be higher"?

Joseph M. Zubretsky

It's the latter. It's the reversion to the mean, back to pre-distressed economy levels.

Operator

We'll go next to Justin Lake, JPMorgan.

Justin Lake - JP Morgan Chase & Co, Research Division

First question just again on the cost trend side. So you had strong development in the second quarter, indicating that your trends were below with your expectation there. And then the third quarter, you saw your days claims payable, or at least we saw your days claims payable, up a couple of days, which indicates you didn't project that cost trend improvement in the second quarter continuing. I'm just wondering what did you see in the second quarter there and the concerted view into the third quarter. Can you give us a little bit of color around how the second quarter compared to what your expectations were and what you saw would be better there?

Mark T. Bertolini

Most of the prior period development that we reported was second quarter 2012 prior-period development, Justin.

Joseph M. Zubretsky

And with respect to reserve positions, obviously, the days claims payable is an important metric. It's up mostly due to the timing of claim processing cycles. We would point to you the 2 statistics that we look at, and that is the comparison of how the increase in reserves compares to premium. Reserves were up this quarter sequentially by 2%, while premiums were up 1%. And quarter-over-quarter to prior year, reserves were up 17% compared to a 7% increase in premium. So we're very confident in the strength of our reserve position.

Justin Lake - JP Morgan Chase & Co, Research Division

All right. What did you see in the second quarter that was -- that resulted in all that prior-period development? Was it lower utilization? And why don't you think it's going to continue?

Joseph M. Zubretsky

Generally speaking, because our cost trends are locked in, we have very good visibility into unit cost. Any variation from our expectation is utilization. And so obviously, utilization was a little lower than we expected.

Justin Lake - JP Morgan Chase & Co, Research Division

Then why don't you expect that to continue? Is there anything you see in the third quarter that leads you to believe that you needed those -- that conservatism on reserves and to leave your cost trend where it is?

Mark T. Bertolini

In the -- as I mentioned earlier, in the fourth quarter, we expect to see more people spending through their deductibles and their funds and coming into backwards [ph] on our nickel, more or less. And so we're seeing that trend more than we saw last year, where utilization was unusually low. And also, there were not as many benefit buydowns this year. So the spend-through is not as significant -- it's not as significant to spend through and get into -- get back into our paying 80% or more of the -- or the bill.

Operator

Our next question will come from Kevin Fischbeck, Bank of America Merrill Lynch.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

I want to go into the SG&A commentary around Q4. I think this year, you'd indicated that SG&A was going to start off a little bit higher and then remain stable during the year as the normal seasonality in cost was going to be offset by the cost save that you had put in place. Now it sounds like Q4 is going to be higher or maybe more normal, seasonally-wise. I guess, can you talk a little bit about why that is? And then you mentioned some shifting of cost. I'm not sure what that was referring to. And then I know that you mentioned as far as 2013 goes that you're going to be investing for exchanges, but I wasn't sure whether that was going to net be a headwind to earnings in 2013 or whether that's just kind of going to be a neutral or a positive? Can you talk about that?

Joseph M. Zubretsky

Certainly. There were 2 factors that affected the progression of our SG&A ratios this year. One is an absolute increase as we do plan to ramp up investment spending in advance of '13 and '14, particularly related to our Accountable Care Solutions business and certain health care reform activities. From a seasonality perspective, there was also a "third to fourth quarter" swing as certain expenditures that were anticipated to be made in the third quarter related to things like our implementation of our CVS Caremark relationship are going to shift to the fourth quarter. So there's a little bit of shift and an absolute increase that are putting pressure on that ratio, but all with the outlook of creating future growth.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Okay. So that makes sense. So that explains part of the reason why this quarter was very good and -- but you're not raising the guidance by as much as the beat this quarter. There is some shift on the G&A side into Q4, but -- okay. But then I guess as far as the Accountable Care Solutions investment, should that -- I mean, how do we think about those? You talked about in the context of growth. I kind of think about an investment SG&A and ACS would be leading to better medical costs next year. Is that not the way to think about it? Or is the way to think about membership, I guess?

Mark T. Bertolini

I mean, it's both. So we are seeing growth in the ACS networks themselves from the standpoint of membership, both for us and for the provider, because it's not necessarily all Aetna membership. And we're also seeing impact on medical costs, some of which we're using in the market for pricing.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

Okay. And just last question on the -- to wrap up this topic. The net, if you're spending a little bit more now and in front of 2013, 2014, do you think that the investments next year are going to be a headwind or that you now ramped it up so that it's not going to create a year-over-year drag into earnings next year?

Joseph M. Zubretsky

There most likely will be higher spending on our ACS initiative next year compared to this year as we're ramping up significantly.

Kevin M. Fischbeck - BofA Merrill Lynch, Research Division

And the exchanges, I assume, as well?

Joseph M. Zubretsky

That is correct.

Operator

We'll hear next from Peter Costa with Wells Fargo Securities.

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

Just help me to quantify a little bit more about the cost shift from Q3 into Q4 on SG&A. Also just what incremental spending, if you can quantify the incremental spend in SG&A in Q4 that you didn't plan on before? And then lastly, in terms of the seasonal medical shift, it's still a little vague on why you would lower your view of utilization in the second quarter so you have the prior-period development that you booked this quarter and then not see that carrying into the fourth quarter. What exactly did you see in terms of utilization that drives you to expect that to go higher in the fourth quarter?

Joseph M. Zubretsky

Peter, let me answer the last question first. The fourth quarter is the most difficult quarter to forecast your medical cost. For each of the last 2 years, we had increasing deductibles and increasing level of penetration to our consumer-driven health plans. As Mark stated before, you got the deductible leverage effect and the benefit buydown effect. And so that's our best estimate at this time, but the fourth quarter is very, very difficult to forecast.

Mark T. Bertolini

Peter, just one more point on that. It's not utilization. It's just higher cost on our nickel, because people are now spent through their deductibles and out-of-pockets, and we're now paying. So it's not an increase in underlying utilization. It's an increase of what we are responsible for versus the member.

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

Yes, though you'd think that if utilization was lower already, there would fewer people spending through at this point, not more spending through. I'm a little confused by that. Are we more conservative on the fourth quarter?

Mark T. Bertolini

We have lower -- we had lower buydowns this year, and so deductibles didn't raise. So we had some trend leverage in those. And so we believe it's prudent to project that it's going into the fourth quarter of the year.

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

Okay. And then can you quantify the SG&A component a little bit more for us so we can understand how much of the fourth quarter issue is in the G&A side versus in the medical side?

Joseph M. Zubretsky

Well, I think it's safe to say. I'll quantify the bridge from -- the annual guidance bridge. I think that's the easiest way to think about -- I actually just think that there was a phasing issue with consensus. We beat our internal forecast in the third quarter, but by not by as much as we beat consensus. So I think there is just an artifact in the way the street had the third and fourth quarter phased. But with respect to the full annual guidance, if you take the midpoint of the $5.05 range, $0.18 operating performance, including the prior-period development, offset by $0.08 of the higher seasonal medical expense and increased operating expenses, offset by another $0.05 of the lack of share repurchases due to the Coventry transaction, all of which gets you from the midpoint of $5.05 to $5.10. That's the way we think about the way we projected the full year. And as I said with respect to the third and fourth quarter, I think it was just a question of consensus versus our own internal forecasting.

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

Okay, that's very helpful. And then just going back to the trend for next year, you talked about utilization being -- utilization trend being higher by 50 basis points from this year's trend. This year, you talked about unit price being no more than it was the prior year, sort of 4.5% to 5%, where last year, I think it was at 5%. Can you talk about your view on unit price this year? Did you get to the 4.5%? Or were you more still at the 5%?

Joseph M. Zubretsky

We haven't parsed that range for you, but we're still saying that it's 4.5% to 5%. And because we're only projecting utilization increase next year, the implication is that we're holding firm with the 4.5% to 5% into '13 trend as well. So we're still operating within that range.

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

And are you more at the low end of that or more at the higher end?

Joseph M. Zubretsky

I mean, we haven't given that specific guidance.

Operator

We'll take our next question from Christine Arnold with Cowen.

Christine Arnold - Cowen and Company, LLC, Research Division

A couple of follow-ups. One, I'm trying to understand your Medicare guidance. It sounds like you're saying you have consistent premiums and enriched benefits for Medicare Advantage in 2013, but then you expect half of your arrangements to be in the collaborative ACOs by the end of 2013. As we think about the Medicare Advantage kind of loss ratio, is that a wash in that we've got pretty consistent loss ratio there, recognizing that the Texas Teachers is probably going to be a higher loss ratio. What's your message there on the Medicare Advantage?

Mark T. Bertolini

We're making no message about 2013 on the margins on Medicare Advantage, Christine. I think we've got more work to do. We'll lay that out in our 2012 Investor Conference. Our commentary is directly related to we believe that the Medicare margins are sustainable in this business and that we are preparing and pulling all levers to make sure that we continue to sustain those margins.

Christine Arnold - Cowen and Company, LLC, Research Division

Okay, that's helpful. And then on the ACO enrollment, my sense was that you were expecting to grown National Account membership, and there is the optics of the Texas Teachers transitioning from ASC or ASO to risk. Is that all that's happening there? Or are you changing your National Account enrollment expectations?

Mark T. Bertolini

Our enrollment expectations are slightly down. We are not done with open enrollment yet. So we have to go through that, so a final accounting of that, we'll have a better idea of that as we get near the end of the year.

Christine Arnold - Cowen and Company, LLC, Research Division

Okay. And then finally, given start-up costs for the Ohio dual [ph] and preparation performance [ph] in 2014 exchanges and investment spending, you said that you expect your ASP investment spending to increase '13 versus '12. It's probably reasonable to think also that you're reform and dual spending would increase. Are you willing to put any parameters around that?

Joseph M. Zubretsky

Not at this early stage. Again, we'll update you on our outlook for 2013 at the Investor Day.

Mark T. Bertolini

We do continue to work on expenses, and we're down 100 basis points this year. So that's still -- we see a lot of operating leverage in our fixed costs, and so we continue to work on that.

Christine Arnold - Cowen and Company, LLC, Research Division

Okay. But no kind of net expectations on that.

Mark T. Bertolini

Not at this point in time.

Operator

We'll hear next from Melissa McGinnis with Morgan Stanley.

Melissa McGinnis - Morgan Stanley, Research Division

Maybe just another question on unit cost effort or thinking about your unit cost trajectory going forward. Can you provide any color? As you've been rolling out more of these provider partnerships, what percentage of your medical expenses today sort of sits in more of the value base or pay-for-performance type contract arrangements? And what that could maybe track to over time?

Mark T. Bertolini

Melissa, we're going to give you a full accounting of that and how to think about it going forward at our Investor Conference, where we'll talk about the amount of membership we have in these arrangements, the level of impact they're having on medical costs and how to think about it going forward. We're just not prepared to do that yet.

Melissa McGinnis - Morgan Stanley, Research Division

Okay. And then maybe one more thing, on the provider partnership arrangements. I was interested on your commentary to get half of your Medicare membership into these provider partnership arrangements by year-end '13. Relative to a traditional HMO, how much more limited is the network for one of these partnership products? And based on your experience, do you believe seniors are really willing to transition to a tighter network overall in order to get these richer benefits?

Mark T. Bertolini

Melissa, it's not about transitioning Medicare members. It's about putting the Medicare members you have into different arrangements. And so our whole relationship with providers around Medicare in these partnerships is built on the fact that we get risk-adjusted revenue for sicker patients and they don't in their DRGs. And then if we work together, the people they do currently have on their programs, we have an opportunity to get more of their Medicare patients that come to their institution, get them on a capitated like arrangement that's associated with that risk-adjusted revenue and have them participate in doing good things in improving quality and reducing costs. So it's not about displacement at all. It's about converting what they have in fee for service today.

Operator

We'll hear next from Ralph Giacobbe from Crédit Suisse.

Ralph Giacobbe - Crédit Suisse AG, Research Division

There's been a lot of talk about the push or shift from inpatient to outpatient. I guess is that disproportionate driver of lower cost trend? And then maybe if you can break out that trend, inpatient, outpatient, from what you're -- what you've seen. Maybe how much more is left there. And then your commentary of increased utilization into next year, is that more on the inpatient side?

Mark T. Bertolini

Ralph, inpatient utilization has been going down for at least the last decade, and we continue to see it happening. So I think that is just better technology, the ability to do more outpatient. And so our trends relative to inpatient are as expected. I think where we've seen the different changes is in just across the broader outpatient and position arena, not as high as we thought they were going to be. Joe, any other comments?

Joseph M. Zubretsky

Ralph, our guidance for all the medical cost categories remains unchanged, but we do track very carefully the impact of our care management programs, what we call site of service. And the fact that we can drive services from an inpatient to an outpatient setting, an ambulatory setting, and from an ambulatory setting to a physician's office might put pressure on the utilization statistics. But from an overall net effective cost perspective, it's a win for the customers and the shareholders. So we track that very carefully and we're pleased to say that we've been very successful at driving cost to lower-cost settings, and that pervades the statistics that you see.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Okay. And then on a separate topic, can you give us what percentage of your hospital contracts are negotiated for 2014 and maybe the conversation you're having with providers in terms of your pricing on exchanges? Will that just be a separate, carved-out negotiation in price or rolled into a product that's already been negotiated?

Joseph M. Zubretsky

Did you say 2014 or 2013?

Ralph Giacobbe - Crédit Suisse AG, Research Division

No -- yes, 2014.

Joseph M. Zubretsky

Very few, if any.

Mark T. Bertolini

Well, we have rolling contracts that are 3 years, but we have like 2% left this year and 29% left for next year. So think of it in that kind of rolling effect. So I would say the ones that open up in 2014, none of them, but that's not all the contracts, because we have multi-year contracts.

Ralph Giacobbe - Crédit Suisse AG, Research Division

But in terms of your conversations with providers, I mean, when exchanges sort of come up, is that just something that's going to be, in your opinion, sort of something that's carved out? Or priced into a current product that you already have?

Joseph M. Zubretsky

We are contemplating running a separate network for the on-exchange business. That is correct. And that is currently -- our network management program is currently deploying that.

Ralph Giacobbe - Crédit Suisse AG, Research Division

Okay, that's helpful. And just my last one. There's been sort of a recent sort of, I guess, re-emergence or interest in private exchanges. I guess just your overall view strategy here, opinion on uptake of this approach by more employers.

Mark T. Bertolini

Private exchanges, we will definitely participate in private exchanges, Ralph. We do see some employers that are interested in it. It's not a groundswell, but we think it's something that will emerge over time. It is our intention to be involved in that as well as the public exchanges.

Operator

And our final question this morning will come from Scott Fidel with Deutsche Bank.

Scott J. Fidel - Deutsche Bank AG, Research Division

First, I just wanted to follow up on the industry tax, and you gave some good detail on how your pricing that in for Commercial. Maybe can you talk about how you're approaching this for the government lines. And specifically for Medicare, do you think CMS will be looking to build that into the rates? Or do you think this will be more of where the industry will need to adjust pricing and benefits to reflect the tax in 2014?

Joseph M. Zubretsky

Scott, at this point in time, we are anticipating having to pull the levers one needs to pull to maintain an appropriate margin in that business in order to offset the impact of the tax. We're not anticipating that CMS will allow it to be built into raise. Should that be the case, obviously, it will be something that would be easier to deal with. But right now, we're anticipating adjusting benefits and premiums to offset its impact.

Scott J. Fidel - Deutsche Bank AG, Research Division

Okay. And then just last question, just on the Group Insurance results. It looked like those were down pretty significantly year-over-year. If you can talk about the key factors that drove that. And was there any reserve strengthening in there? Or do you expect that this is sort of the new run rate for Group Insurance margins?

Joseph M. Zubretsky

No, it is not the new run rate. We actually had 1 month during the quarter with unusually high claim activity, jumbo claim activity, in the group life business. We think that was a statistical anomaly and the business is going to hit its plan for the year.

Thomas F. Cowhey

Thanks, Scott. A transcript of the prepared portion of this call will be posted shortly on the Investor Information section at aetna.com, where you can also find a copy of our updated guide and summary containing details of our guidance metrics, including those that were unchanged and not discussed on this call. If you have any questions about matters discussed this morning, please feel free to call me or one of my colleagues in the Investor Relations office. Thank you for joining us this morning. And we look forward to seeing you on December 12, in New York at our Investor Conference.

Operator

That will conclude today's conference. Thank you all for your participation. You may now disconnect.

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