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Health Net, Inc. (NYSE:HNT)

Q3 2012 Earnings Call

November 5, 2012 11:30 a.m. ET

Executives

Angie McCabe – Vice President-Investor Relations

Jay Gellert – CEO

Joe Capezza – CFO

Analysts

Chris Rigg – Susquehanna Financial Group

Ana Gupte – Sanford Bernstein

Joshua Raski – Barclays

Sarah James – Wedbush Securities

Ralph Giacobbe – Credit Suisse

Carl McDonald – Citigroup

Justin Lake – JPMorgan

Matthew Borsch - Goldman Sachs

Christine Arnold – Cowen and Company

Kevin Fischbeck – BofA/Merrill Lynch

Peter Costa – Wells Fargo Securities

David Windley – Jefferies

Brian Wright – Monesse, Crispy & Hart

Operator

Good morning everyone and welcome to this Health Net Incorporated Third Quarter 2012 Conference Call. Today’s call is being recorded.

At this time, I would like to turn the call over to Angie McCabe, Vice President of Investor Relations. Please go ahead.

Angie McCabe

Thank you McKenzie, and thank you all for joining us for a discussion of Health Net’s third quarter 2012 results and agreement with the California Department of Healthcare Services covering our state sponsored health plans.

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

In today’s call, we will refer to adjusted day’s claims payable. This adjusted metric is not being presented in accordance with Generally Accepted Accounting Principles or GAAP. Please refer to today’s press release, which is available on the Company’s website for a reconciliation of this non-GAAP financial measure with the most directly comparable GAAP financial measure day’s claims payable.

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

Jay Gellert

Thank you Angie. On our second quarter call in August, we outlined a three-step process to get Health Net back on track. I’d like to update you on that and discuss our third quarter performance. First, in terms of our recovery process we highlighted three items in August.

One, we had to address pricing issues in certain commercial, full network, large group accounts totaling about a 100,000 members. Second, there had to be no additional negative prior period reserve development in 2013. And third, we had to stabilize our relationship with the State of California in our Medi-Cal plans including the SPDs.

We’ve made substantial progress on all three fronts since our last call. First, we acted on the issues in the large group accounts. These actions are effective January 1, 2013. Accounts totaling 60,000 members have renewed at an average rate increase of more than 13%. Accounts totaling 35,000 members will not renew on January 1. We do expect some additional in group attrition through 2013 due to our pricing discipline.

As a result of these steps alone, the commercial MCR should improve by 50 to 70 basis points in 2013. In addition, we continue to be disciplined with all other renewals in the commercial book and are willing to absorb additional reductions in unprofitable membership. Second, we had no adverse prior period development in the third quarter.

Our reserves are more than $150 million higher than 3Q ’11 and $20 million higher than Q2 ’12. Adjusted days claims payable is up sequentially and year-over-year. Third, while we are still working with the State on our 2012-2013 rates with the SPDs and initial rates for the dual eligibles, we have come to an agreement with the State on a comprehensive long-term arrangement regarding all of state health plan contracts. This arrangement addresses issues Medi-Cal including the SPDs, the new dual eligible demonstration pilot, and future Medi-Cal expansion.

At its heart this agreement removes a great deal of uncertainty regarding this program and stabilizes it for our current and future Medi-Cal beneficiaries. The agreement also includes provisions for the dismissal of all existing rate related litigation prior to 2011.

For Health Net, we believe we received two important benefits from this agreement. One, we received five-year extensions for each of our existing four Medi-Cal contracts. And two, in line with the State existing, actuarial targets for state-sponsored plans, we’ve developed a mechanism that promotes stability in our State health plan financial performance.

This is especially relevant in the early years of new programs. It also will enhance efficiency and allow for greater investment in new and expanded services for our beneficiaries.

Let’s look at these features in more detail. Health Net currently is managing healthcare services under four Medi-Cal contracts covering seven counties. In addition to dual eligible demonstration pilots in Los Angeles and San Diego counties currently are scheduled to begin in the middle of next year and Medi-Cal expansions are scheduled over the next 15 months.

Under this agreement, Los Angeles County is extended until the end of March 2019, Sacramento through the end of 2018, San Diego through June 2020 and our Central Valley contract covering four counties is extended through the end of 2022. We believe these extensions solidify our Medi-Cal operations, enable incremental investment and reinforce our commitment to the more than one million beneficiaries we presently serve.

Let me now turn to the new process that we believe will promote greater financial stability in the future. This mechanism will be in place for seven years with the State option to extend it under certain circumstances for three additional one year period.

Health Net and the State have agreed that our targeted annual pretax market on the totality of our state health business is 0.75%. In addition, to our current contracts that also includes the dual demonstration in any Medi-Cal expansion. The 0.75% within the state pretax margin targets for Medi-Cal plans in the state plan and equates to an approximate 2% after-tax margin.

Here is how it will work. If we achieve a tax margin in 2013, less than the targeted 0.75% the difference will be divided with the State picking up 75% and Health Net retaining 25%. For 2014, through 2016 any differences will be split 50-50. The State’s share will be booked on our balance sheet as a receivable. Any such receivable will be an asset that can be used to meet future capital needs in the regulated subsidiary.

For external reporting, Health Net statement of operations will reflect the full benefit of the state share. If after-tax margin is greater than 0.75%, the difference will reduce any State share. The difference over 0.75% will be split 75-25 in 2013 and 50-50 from 2014 to 2016.

This will be calculated annually and recorded in an account setup for this purpose. Cash settlement will occur at the end of the agreement if there is a State share. The State liability is capped at $264 million. If Health Net is in a positive position at the end of the agreement, no money changes hands. There are a few more elements in this part of the agreement, but the most important point is this.

The early stages of new programs such as the SPDs, the duals, and Medi-Cal expansion can produce volatile and unpredictable financial results. We've seen these in many Medicaid programs around the country. What this agreement provides is a mechanism that will produce much more stable and predictable performance as new programs are introduced and eventually mature. That's good for all involved.

Let me close this part of the call by noting that we are in continuing discussions with the State on the issue of an improved process for resolving rate disputes. Both parties continue to look for ways to reduce the lengthy litigious process that has characterized past disputes. We will update you on the progress of these discussions as appropriate.

Let us now turn to a brief review of third quarter results. Our financial performance improved as expected. GAAP earnings per diluted share were $0.22 while earnings for our combined western region operation and government contract segment were $0.38 per diluted share.

Let me explain what happened with operating cash flow. We received only two monthly Medicare payments, such monthly payments are approximately $200 million, had we received all three monthly payments, our operating cash flow would have been greater, the net income plus depreciation and amortization.

As an initial positive sign in our 2013 goal, we recorded no adverse prior period development in the third quarter of ’12. Also in the third quarter, we were able to buy back stock repurchasing 1.5 million shares for $36.1 million. We expect cash apparent to be approximately $130 million on December 31, 2012 assuming no additional share repurchases.

Our tailored network products continue to garner a larger share of our commercial book, compared with a year ago. While initially targeted the small group segments, tailored network products are gaining ground in midmarket and among larger accounts.

To underscore this trend, we captured a larger share of enrollment in our largest account that utilizes a tailored network. Enrollment in this account climbed by 13% this year, affirmation of the growing popularity of our tailored network offerings. Despite this positive development overall sequential enrollment in the third quarter of ’12 was down, primarily due to pricing issues leading to the departure of one large account with 19,000 members.

Our way forward in our commercial business is now clear. We believe we’ve established a significant share in tailored network products that we can build on in the future. In addition, we must remain disciplined on pricing, making sure that each account meets our targets. If we do these two things, we believe we can produce substantial improvement in ’13, and build momentum as we enter the world of exchanges in ’14.

Let me now turn to commercial healthcare costs. The commercial MCR was as expected. If we put the appropriate portion of adverse prior period development back into the third quarter of ’11 costs the year-over-year commercial MCR would have shown improvement in the third quarter of ’12. This was because we saw low utilization for both physician and hospital services. And, in addition, we benefited from our new arrangement with CVS that produced low pharmacy trend. We expect these trends to continue in the fourth quarter. These facts provide further support for our positive commercial outlook going into ’13.

Let me comment, briefly on the slight sequential uptick in Medicaid MCR in the third quarter. On July 01, 2012 a premium tax assessed on all of our state programs ended. This had the effect of lowering our reported premiums and causing MCR to rise. Had the tax continued, the Medicaid MCR would’ve been lower by 120 basis points sequentially.

On the cost front, all the state programs including the SPDs performed as expected in the third quarter. Medicare did very well in the third quarter, enrollment climbed again. The third quarter MCR improved by 60 basis points compared with Q3 of ’11 consistent with our expectations for the full year.

Our government contract segment produced approximately $21 million in pre-tax income in the third quarter of ’12. This is consistent with our guidance approximately $27 million less than third quarter of ’11 reflecting the full implementation of the new TRICARE contract. We expect performance to be at this level in the fourth quarter and throughout 2013.

Our G&A ratio remained flat in the third quarter of 2012 compared with the third quarter of ’11. It was up slightly from Q2 ’12 as we’ve spent about $4 million in the quarter preparing for the duals. We expect to spend approximately $7 million in the fourth quarter this year as we continue to prepare for these pilots.

The tax rate in the third quarter was consistent with our guidance. We continue to expect a full-year ’12 tax rate for the combined western region and government contract segments of between 30% and 31%.

Let me conclude by summarizing where we are. We believe we have a clear line of sight on commercial improvement. Our strategy is sound and cost trends are moderate. Medicare is doing well. Medicaid with the state agreement and dual prospects are poised for growth with downside protection. Our government contract segment continues to produce steady performance. We know if we can execute on this strategy we can see significant improvements in ’13.

Thank you for your time and let’s now go to questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Chris Rigg from Susquehanna.

Chris Rigg – Susquehanna Financial Group

Hi, good morning guys. I just wanted to follow up on the agreement with California. I mean it certainly has relative benefits, but I guess if you really believe that you were sort of in the right position over the long term, I guess I’m just wondering why now versus continue to drag it out and fight for a little bit more over time?

Jay Gellert

It’s our belief that litigation with customers don’t have long term positive results.

Chris Rigg – Susquehanna Financial Group

Okay. I guess the other question is, so your guidance right now assumes at the midpoint $0.38 for the fourth quarter, is that correct?

Jay Gellert

Yes.

Chris Rigg – Susquehanna Financial Group

Okay. And so, we expect that to continue to improve in fourth quarter, seasonally it’s usually a bit tougher. I guess is there any reason to believe why we couldn’t be looking at north of a $2 number next year or is it too early to tell?

Jay Gellert

I think we outlined the changes in our earlier call that we anticipated the three I mentioned. I think we reported on them. We’ll give more specific guidance later in the year.

Chris Rigg – Susquehanna Financial Group

Will you give the guidance in 2012 for ’13 like you did last year in December or what’s the plan at this point?

Joe Capezza

We’re trying to resolve that, but probably.

Chris Rigg – Susquehanna Financial Group

Okay, great. Thanks a lot.

Operator

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

Ana Gupte – Sanford Bernstein

Good morning Jay. For 2013 again just following upon the earlier line of questioning, the first is on headwinds-tailwinds. For commercial, is the 50 to 70 bps point improvement in the loss ratio additive to the $79 million of prior period negative development that won’t be recurring.

Jay Gellert

Yes.

Ana Gupte – Sanford Bernstein

So, that's about – that’s roughly about $1 or so I’m seeing. And then, on this Medicaid agreement with California, you had earlier talked about the 300 to 400 bps improvement in Medicaid loss ratio, so is that pretty much consistent now and so next year that 3.25% kind of pivot point is that what you would expect overall for the book in terms of what the loss ratio improvement could be?

Jay Gellert

I think there are some give and takes, but I think that we’re pretty comfortable with the 300 basis point improvement we talked about. We also believe that and this provides us some protection in the context of the implementation of the duals.

Ana Gupte – Sanford Bernstein

Okay. So, the duals are included – and so at worst, and I’m still trying to digest the terms that you talked about. So, at worst, you don’t go in negative territory, right, is that a fair assessment?

Jay Gellert

It would be very hard to go into negative territory under this agreement.

Ana Gupte – Sanford Bernstein

Right, got it. Okay, so that gives us kind of a $1 on commercial and $0.50 something cents on Medicaid, and then Medicare you’re expecting growth now that you’ve seen the selling season and the bids and so on?

Jay Gellert

We’re expecting some limited growth. We believe that we took reasonably conservative approach in our offerings, but we'll see growth, but it won't be of the level we’ve seen last year.

Ana Gupte – Sanford Bernstein

And then, finally on excise taxes, how is the California Department likely to think about this in terms of pricing any of that from 2014 into 2015 pricing?

Jay Gellert

Are you talking about the state?

Ana Gupte – Sanford Bernstein

The industry tax that, you know, some kind of the companies in your space and back loading it.

Jay Gellert

Yeah, yeah. I think that in the agreement there is provision for consideration of that in ’14 when it occurs, but there is no consideration for that in ’13 because we’re not actually paying it.

Ana Gupte – Sanford Bernstein

Okay, got it. Thanks so much.

Operator

Your next question comes from the line of Josh Raskin with Barclays.

Joshua Raski – Barclays

Hi, thanks. First, just a quick question on the California dual cost, I think you said it was $4 million and then another $7 million in the 4Q to the ’11, I think you said 20 to 25 previously. Is that just timing related getting pushed back to the timing, the duals coming back to June as opposed to March or was there sort of lower cost than you expected?

Jay Gellert

It’s partially timing and then it’s using some internal resources to reduce the cost.

Joshua Raski – Barclays

Okay, and was there any sort of puts and takes in the overall guidance for this year since those costs are lower or is that a sort of small breakage in other areas?

Joe Capezza

I think it’s a small break versus the other area.

Joshua Raski – Barclays

Okay. And then just on the California agreement as well, just wanted to make sure that I got this right. So, the State will reimburse you basically 75% of any shortfall below that 0.75% in the first quarter, but up to $264 million. So what are your expectations, I guess one, what is first year, first year calendar ’13 or is it from data first…

Jay Gellert

Calendar ’13, Josh.

Joshua Raski – Barclays

Okay. So that’s going to be a huge – that would be a huge, huge number, right. I guess in terms of revenue expectations, what do you have baked into ’13?

Joe Capezza

Revenues this year is about $1.9 billion and I could see it being another $300 million to $600 million.

Joshua Raski – Barclays

Another $300 million to $600 million on top of that.

Joe Capezza

In ’13, yeah.

Joshua Raski – Barclays

And that’s just basically the duals coming and starting in June.

Joe Capezza

That’s really the full year effect of the SPDs and – in the account and some increases in revenue, that’s not the duals.

Joshua Raski – Barclays

But the duals would get included, I’m just trying to figure out what’s your first year revenue number would be?

Jay Gellert

I’d say in the range of $3 billion may be in total, $2.5 to $3 range.

Joshua Raski – Barclays

Okay. That would be your…

Jay Gellert

The ’13 revenue are covered under this agreement.

Joshua Raski – Barclays

Okay, right. So, the $264 million potential loss would be compared to that. And then, just so I understand, this is cumulative over the light of the agreement the 264?

Jay Gellert

Yes, sir.

Joshua Raski – Barclays

Okay. And then, when would be actual settlement be, what does end of agreement mean?

Joe Capezza

The end of the agreement is 7 years out with the state having an option under certain circumstances to increase it up to three additional years.

Joshua Raski – Barclays

Okay, okay. So, 2019 possibly?

Joe Capezza

To 2022, but as we indicated it would be accepted for regulatory capital in the interim. So, in terms of cash apparent in meeting, the requirements of the dual capital it would have the same effect.

Joshua Raski – Barclays

Right. And you’re going to focus from a GAAP perspective, net of this agreement, right?

Jay Gellert

Net of this agreement, we’re going to book it – we’re going to book from a GAAP with consideration of this agreement.

Joshua Raski – Barclays

Got you. And you’ll just have some sort of seven year receivable?

Jay Gellert

Yes.

Joshua Raski – Barclays

If there is loss, okay, all right, got it.

Jay Gellert

Yeah. If there is a loss versus a target.

Joshua Raski – Barclays

Thank you.

Operator

Your next question comes from the line of Sarah James with Wedbush.

Sarah James – Wedbush Securities

Thank you. I just want to make sure I understand the contract even further. So, any adjustments that you would have – you would show in your reported EPS?

Jay Gellert

Yes.

Sarah James – Wedbush Securities

Yes, okay. And then if I think about the number of years that are covered by the contract and the size of the dual revenue coming in, it’s about – I mean depending on what your assumptions are somewhere between 5% to 8% of revenue – of the annual revenue but you’re talking about that 264 being split over a period of six years. So, maybe like a 1% swing factor a year that this is allowing?

Jay Gellert

Basically, you’re saying that over the life of the agreement that when you take the total revenue and I don’t – we’ve not kind of assumed it entirely, but our basic view the way we look at it is that the first – it is really has to cover the first couple of years of transition. After that we need to – we’ve historically gotten to equilibrium within the State share format. So, we’re now looking at this in the context of seven years of coverage. We’re looking at this more as – you know, 2013, 2014 and 2015 where we don’t have good auctorial experience and the State doesn’t either. And then, historically, we've rectified it for those past years and going forward, but we won’t have the volatility we’ve historically had.

Sarah James – Wedbush Securities

Okay, that’s helpful. And then, are there any contract terms what refer to MLR or gross margin caps or is it strictly pre-tax?

Jay Gellert

Strictly what we’ve disclosed in terms of that.

Sarah James – Wedbush Securities

Okay. And last question here is on enrollment. There is a new entrant in the California tailored network market for 2013. So just curious on how your retention is looking on that product for 2013, versus 2012 and maybe the robustness of the pipeline?

Jay Gellert

Yeah, our experience has been that as people entered tailored network it probably increases the number of accounts that are looking at tailored network. So it tends to not change retention but expand the scope of opportunity.

Sarah James – Wedbush Securities

All right. Thank you.

Operator

Your next question comes from the line of Ralph Giacobbe with Credit Suisse.

Ralph Giacobbe – Credit Suisse

Thanks, good morning. I just wanted to go back to the cap, the 264 and maybe just didn’t follow it exactly. You said the 264 is for the life of the contract?

Jay Gellert

Yes.

Ralph Giacobbe – Credit Suisse

I’m sorry. And if it goes below that then, what exactly happens, what triggers?

Jay Gellert

No, no. There is up to 264 available for the – to cover deficits in the account. If it goes above 264, it’s cap there, so that’s the amount of cover we have. Alternatively, if it goes the other way, where it ends up at “we’re above 0.75%” we are not liable to pay the State. So it’s downside protection of up to $264 million along the lines that I described.

Ralph Giacobbe – Credit Suisse

Okay. That’s fair. And then…

Jay Gellert

Again, just so everyone is aware. It’s really aimed at the first couple or three years where you make investment, where you have – where you don’t have the ability necessarily to come to actuarially sound agreement based on history. It’s not in our view intended 17 or 18 if we have new – where we don’t have any new expansions, we don’t expect to operate under it.

Ralph Giacobbe – Credit Suisse

Okay. And then, maybe just your thoughts on kind of capital deployment to this change, how you think about conserving capital and sort of ahead of bringing on the new duals or is there really no change there?

Jay Gellert

I think the only thing it does is it gives us protection in terms of the capital requirements for the new duals. So, if we had negative early experience like we’ve had this year with the SPDs it wouldn’t affect the requirements significantly for us to meet the capital requirement. So, I think it basically puts us in a position where the capital demands for expanded business will be helped.

Ralph Giacobbe – Credit Suisse

Okay, all right. Thank you.

Operator

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

Carl McDonald – Citigroup

Thanks. So, I’d be interested what you would view as the risks to this agreement with California, so I guess, one, given the $264 million cap, one risk would be you’ve an outlier event to lose 10% or 15% in a year over the first couple of years. I guess another would be you lose money on duals, you make money on Medi-Cal. If not so, you don’t get any deficit accrual, any other major things you’d point to?

Jay Gellert

Not that we see because it doesn’t – if we get into a situation where the business isn’t working after a year or two and we can’t remedy, we still have the option to get out of it. So, to me, it allows us to take on these new opportunities without being unduly concerned about the risk until we get data so that we can show the State what we’ve done. Like in the case of SPDs I think everybody realizes that we probably went too far with the State in terms of its savings, but the State has got a significant amount of saving. That's why we think this is all going to get rectified. So, it gives us a chance to have that kind of experience without having to have calls like we did in Q2.

Carl McDonald – Citigroup

And what’s the State’s incentive for signing this agreement, I mean I guess you get rid of some of the historical litigation, but why would they be interested in doing something like this?

Jay Gellert

Well, I think there’s – first of all there was a lot of risk to the State in the litigation. So I think that it had already in one year got into court and it had been resolved in our favor. So, it puts the state in a position where it had a significant amount of vulnerability into very near-term. So, the State I think has relieved itself of a lot of fiscal pressure, which I think was very wise, but the other thing is I think that California has the bottom three or four cost per beneficiary in Medicaid. The state in California is really – is kind of gone as low as it can go in terms of these costs. And, in the instances where things have kind of gotten disruptive because of a one-year situation, they’ve ended up paying substantially more having to clean it up. So, I think that the stability of relationship with all the financial pressures on the state is a very positive thing for them and I think it allows us to look at longer-term systemic change in terms of some of the stuff we're doing without having to – I guess haggle on a quarter-by-quarter basis.

Carl McDonald – Citigroup

Last question is the extension of the Medi-Cal contracts, I guess all of the arrangements, and does that mean that the planned rebids for Sacramento and Los Angeles are no longer happening or is that you keep your contract as long as you win those upcoming RFDs?

Jay Gellert

No, this is an extension of our existing arrangement. So, it will be extended, we won’t have to rebid.

Carl McDonald – Citigroup

Got it. Okay, thank you.

Operator

Your next question comes from the line of Justin Lake with JPMorgan.

Justin Lake – JPMorgan

Thanks. First question is a follow-up on some of the Medicaid. Can you remind me the state savings assumption on the SPDs? It was around 10% or am I off there?

Joe Capezza

It was greater than that and the sort of savings were – from what we understand in that case significantly above that number.

Justin Lake – JPMorgan

That was a call sort of 20?

Joe Capezza

It may have even been a little higher than that.

Justin Lake – JPMorgan

Okay. And how did they get to – like is that a number that you signed off on or is that just – you didn’t realize that that was the savings assumption?

Jay Gellert

No, no they had an outside actuarial firm to do the work and come up with a set of assumptions and one of the reasons for this screening is under our contract we have to accept it and then go through a dispute process. So we don’t have the option to – and we I think raised some issues based on our understanding of the process that have proven to be true. So the things here for – I think both the state and ourselves is that we can go through that kind of dispute without having immediate negative events that then get rectified later by virtue of the screening.

Justin Lake – JPMorgan

Okay. If we kind of think about how the dual implementation is going to go, as part of this agreement have they talked to you about rates and what they’re going to be looking out for savings yet?

Jay Gellert

Well, yeah and I’d like to differentiate the duals from the SPDs because I think there is a real understanding at the state and with the federal government that on the kind of – the kind of numbers that I’ve just articulated aren’t realistic in the context of the duals. So I think that there is a good understanding. If you look at the Massachusetts dual pilot, it’s based on 1% the first year 2%, the second 4%, the third. We’re still working through what the right numbers are, but they’re not the SPD numbers or in the range of the SPD numbers.

Justin Lake – JPMorgan

Okay. And then in terms of this deal that you – I know there is litigation there, but is there any reason to think that others wouldn’t be able to get a similar type of reinsurance arrangement from the state when they are extending their deals?

Jay Gellert

I think you have to talk to them in the State. We are not at all privy to any of the discussion states have with anyone else.

Justin Lake – JPMorgan

So, I guess what I was trying to ask Jay is just in terms of – I know you had this litigation, I can’t remember if others were part and parcel to it or not, but do you think that the arrangement that you caught here was a direct response from the state to this litigation or do you think that this is just a State looking at this population, and look we’ve blown up people in this SPD population. Let’s be more reasonable in terms of offering this reinsurance kind of like a risk quarter type of thing it sounds like, during the initial fees and over this dual population given how big this is going to be?

Jay Gellert

Again, in our – let me talk about our discussions because I really – I don’t want to give any impression I have any knowledge whatsoever of what is going on and is being discussed with the state and others, because I just I’m not privy and I want to make that clear. In our discussions, I think that the state has – California isn’t known to have really low costs in just about anything. This is a Medicaid program is I think third or fourth lowest in the country, maybe even lower. I think the State has been tough, they’ve been focused on making sure they get maximum value, and when you compare them to others I think they have done a great job. But I think they wanted to be sustainable because they don’t want disruption. So, I think that they are being thoughtful, sensitive, tough, but I just – I’m not trying to be evasive. I just think we’ve been – all have been very careful to make sure that our discussions with the State are totally independent of others and I truthfully don’t know what other people are talking to them about.

Justin Lake – JPMorgan

Okay, thanks. I appreciate it.

Operator

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

Matthew Borsch - Goldman Sachs

Yes, thank you. Maybe I could turn to a couple of other issues. Could you give us an update on how you see the pricing environment on the commercial side as you I would assume are getting through the bulk of finalizations on 2013 renewals, are you seeing any shift there?

Jay Gellert

I think we’re seeing aggressive actions in certain large group cases, I don’t think it’s changed from the last call, but I do believe that as we’ve been more selective and aware in where we’ve written that we’re thinking that pricing clearly can cover trend. I think that there probably are a select number of accounts where we’ve walked away and we can’t understand how they were priced, but in general the market is rationale in terms of covering trend.

Matthew Borsch - Goldman Sachs

Is there any generalization you can give us about where the pricing hasn’t made sense, is it that generally been more from not for profit or for-profit competitors?

Jay Gellert

That’s a good question, let me make a couple of comments. First of all, I think it’s generally been from competitors who have less government business as opposed to more government business. I think though that that the larger nationals like Well Point and United have been rationale in the market. And so, I guess that’s how I would explain it. I think in some cases when I went through those 35,000 members, we saw people bid substantially below what would be our trend which made – didn’t make a lot of sense to us. So there are instances where that’s going on and – but I don’t think it’s the Well Points or the United and I think it’s – in general cases people who have less government business.

Matthew Borsch - Goldman Sachs

Got it. And maybe just one more on the commercial side or actually maybe more broadly. But, as you look at how spending trends, utilization trends and now with nine months behind us, what do you – how would you characterize trends has developed for this year relative to last year and any thoughts you have on where it might be going for ’13?

Jay Gellert

Well, I think it’s less this year than last year. I think that – we said this before, which is that we don’t expect it to continue to go down but we don’t expect it to rebound substantially.

Matthew Borsch - Goldman Sachs

Yes.

Jay Gellert

And I think we’re seeing a combination of some cyclical stuff. But when a cycle lasts for four or five years, it becomes much more secular.

Matthew Borsch - Goldman Sachs

Yes.

Jay Gellert

That’s what we’re seeing. I think we’re seeing some of that going on and I think we’re seeing that in the commercial work force. I’d say I contrast and everyone knows this, while we’ve been successful with some of the SPD population there is less change there because those are more really chronic, sick people where you can make some adjustments but you can’t fundamentally change disease data and move them to an outpatient environment or something like that. But in the commercial side, I think that – we think it’s plateau, maybe see some – a little pickup next year, but the more fundamental change that we’re seeing we think is lasting.

Matthew Borsch - Goldman Sachs

All right. Thank you.

Operator

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

Christine Arnold – Cowen and Company

You referenced some Medi-Cal expenses over the next few quarters. Could you highlight what those are and how much membership – is that the kids that you are trying to move?

Jay Gellert

Well. There are three things that we would raise. One is the movement from healthy families to Medi-Cal. The second is 14 expansions, which will be much larger, I think the number is 2 million to 3 million in California, I don’t know the exact number. And then, third the discussions going on moving portions of the long-term care of the LTSS population to manage care over the course of the next 18 months, so all three of those that we referred to.

Christine Arnold – Cowen and Company

Okay. And how much is the healthy families or is that moving from one bucket to another, does that net [inaudible]?

Jay Gellert

That doesn’t mean – that’s less than moving one bucket to another.

Christine Arnold – Cowen and Company

Okay. In the portion in the long-term care, how much?

Jay Gellert

We’re still talking about. I think they’re still working on it. They’ve discussed it, but I don’t have the exact details yet. As we said that population some of them are dual-eligible’s and they’ll be part of the dual-demo. Some of them are Medi-Cal only and then some of them are different special populations, and I think we’re in discussions on all of that.

Christine Arnold – Cowen and Company

Okay. Looks probably too soon to know.

Jay Gellert

Yeah, exactly.

Christine Arnold – Cowen and Company

It looks like you’re running about 90% Medicaid MLR this year. Would that have triggered your arrangement?

Jay Gellert

I think it would have, but I can’t be specific as we haven’t run it yet, but it would have.

Christine Arnold – Cowen and Company

Okay. So, I just have a good sense for the SG&A load. So, when we think about the SPDs in the duals, how shall we be thinking about SG&A loads of that because that’s going to change your business mix?

Jay Gellert

Right, right. And I think we’re still working on it and when we give our guidance we’ll be specific to that. We really are in the process right now of separating the one time from the ongoing and all of those things. And, really looking at whether more or actual medical management on the SPD side would yield some benefits. So, we’ll have to come back with all of that when we give our guidance.

Christine Arnold – Cowen and Company

Okay. Thank you.

Operator

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

Kevin Fischbeck – BofA/Merrill Lynch

Great, thanks. I appreciate going to the contract terms that was helpful. I guess I understand – I think I understand what happens if there is a shortfall, but I guess if you do above the margin target, how does that work out? Are you actually paying the money back to the State in real-time or do you create a payable – accounts payable that you have to pay them back at the end of the term?

Jay Gellert

If we are above the number, it would offset the deficit. So, it will depend on what situation the account is in at that point in time.

Kevin Fischbeck – BofA/Merrill Lynch

Okay. If it was in that positive at that time, would you be paying money back in real-time or would you hold it safe?

Jay Gellert

We wouldn’t be paying money back at all, because the provision basically is downside protection. It’s an offset but wouldn’t lead at the end of the agreement to a positive payment on our part.

Kevin Fischbeck – BofA/Merrill Lynch

Okay. So on a GAAP basis, are you booking any offset if things go well or do you book it and then have a reversal at the end of the term?

Jay Gellert

I think we’re still looking exactly at that, but my sense is that there is more likely to be an offset.

Kevin Fischbeck – BofA/Merrill Lynch

Okay. And then as far as this agreement incorporating the duals, obviously the Medicaid portion of the dual spending, is the state kind of giving up total Medicare and Medicaid spend. I’m just attributing this shortfall to the Medicaid slice of that or are they trying to give you coverage for the full dual revenue?

Jay Gellert

It’s a full dual demo.

Kevin Fischbeck – BofA/Merrill Lynch

Okay. So, includes the Medicare spending as well as, what was Medicare spending as well as Medicaid spending.

Jay Gellert

Exactly right.

Kevin Fischbeck – BofA/Merrill Lynch

Okay. And then I guess going back to the tailored network, do you have a percentage of your business which is now a tailored network products you gave that in the past, I don’t remember hearing it at this time?

Jay Gellert

35 or 36.

Kevin Fischbeck – BofA/Merrill Lynch

Okay. And that 13% growth that you gave in the prepared comments is that – would that just in the larger group segment or is that overall?

Jay Gellert

I was speaking to our largest account. They had a 13% growth in third year actually of the arrangement. People went into the group initially and then they kept coming, which is we think is very encouraging, because it’s a sign that people found the product really work for them, not the opposite where they pick the lower cost and then later on decided to move out of it.

Kevin Fischbeck – BofA/Merrill Lynch

Okay, so this isn’t a slice product. You’re getting more share within that comp – within that customers?

Jay Gellert

Yes, it is, yes.

Kevin Fischbeck – BofA/Merrill Lynch

Okay, and then last question, is there any update – you reaffirm the cash flow guidance, is there an update for the cash apparent at yearend?

Jay Gellert

Yeah, I indicated that we anticipate $130 million assuming…

Kevin Fischbeck – BofA/Merrill Lynch

130, that’s basically just reflecting the repurchase to happen, okay.

Jay Gellert

Yes, yes, no change in the purchase.

Kevin Fischbeck – BofA/Merrill Lynch

All right. Okay great. Thanks.

Operator

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

Peter Costa – Wells Fargo Securities

Hi guys. Is there anything in there to – in the contract to cause the State to want to pay you money if they’re in a higher rate – if they’re in a deficit position at that point, or is it just a threat of you leaving once the deficit becomes too big, I’m just wondering if the State could look at it like cheap borrowing from you guys?

Jay Gellert

Well, yeah, I don’t think they’re looking at it as cheap borrowing because they’re still – the process for the determination of actuarial sound rates. So, this is in addition to the existing mechanism, and we are still trying to work with them to expedite that mechanism. So, they’re looking to make this an intelligent viable consistent arrangement, not something where they would cheap borrow.

Peter Costa – Wells Fargo Securities

Okay. And then I believe the disputed rates are from years prior to 2011, 2012.

Jay Gellert

That’s correct.

Peter Costa – Wells Fargo Securities

So, if there’s disputes in 2011-2012, do you still have those on the table at this point being discussed or what’s the status of that?

Jay Gellert

Yeah, yes. Those are not settled there as a result of this agreement.

Peter Costa – Wells Fargo Securities

Okay, so that could still be something that would come back to you.

Jay Gellert

If we could still have that, we’re still in those discussions. Again, we hope we could come up with an expedited process that would minimize the amount of state and our money spent in litigation.

Peter Costa – Wells Fargo Securities

Great. And then in terms of your Medicare business, just to get away from the dual contract for a minute, Medicaid contract, do you expect now that you’ve seen the various Medicare advantage rates in California that you compete with, do you think that you’ll get growth out of our program next year or not? How much growth?

Jay Gellert

Yeah, we anticipate growth. I said the overall growth we expect would be in the 3 to 5 range. I’d say it’s higher in California. I don’t have the exact numbers here, but 3 to 5 premises more in California.

Peter Costa – Wells Fargo Securities

Okay. And then just the last thing, can you sort of lay out for us what you’re thinking at this point in time, your dual revenues would look like – the way the members would flow on to you relative to the people you subcontract with?

Jay Gellert

Well, I think we’re – it’s too early because I don’t think the state even completed the MOU process and how the transition is going to occur. We’ll end up subcontracting with a lot of people who – and exactly how that will all be split up in terms of the – we’ll have lot of provider groups and then – and so, I don’t know exactly where that will all go.

Peter Costa – Wells Fargo Securities

Do you think at this point you’ll use revenue shares with the subcontractors or will there be cost to you, exactly how will the subcontracting arrangements work?

Jay Gellert

Well, I think there will be the Medicare side and then the long-term care side. I think there is a robust infrastructure where we are in terms of the Medicare side, I think we are working with a bunch of providers on the other side and I think it’s too early to be exact on how we’re going to do it.

Peter Costa – Wells Fargo Securities

Okay, thank you.

Operator

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

David Windley – Jefferies

Hi, thanks for taking the question. So, Jay, on the last call, you talked a little bit about your assessment of whether you had critical mass in commercial. On this call, you didn’t reference critical mass and your tailored networks. I'm wondering what you think about the rest of the commercial book and when you – as a follow on to that, when you talk about the potential for further attrition in your full network product, is that just up to the $100,000 that you've identified or is it beyond that $100,000? Thanks.

Jay Gellert

First of all, as we indicated in our earlier call, we still have to address that question. We said before that we were going to work on resolving these three issues and I think we’ve made a substantial amount of progress. We indicated, we had to work on the duals and some of the other issues that have also been raised in the context of this call, we’re working on. We’re also dealing with the scale issue and as I said before, it’s a G&A issue, not a provider issue. So, we have to confront that and we’ve indicated that.

In terms of membership attrition, we’ve said overall a 100, could it be plus or minus, I don't know, but our basic commitment has been that we believe it’s really important going into 2014 that you're not cost shifting within the book. In other words, it’s really important that you’re not in a situation where some of your accounts are losing and others are disproportionately carrying the book. So, we are focused on that because we think that that‘s a nightmare scenario if you enter ’14 with a lot of cross subsidization. Since we have another volume coming online, we don’t have the necessity to do that. So we are focused on making that change.

Unfortunately for us, we are not – the narrow network prices are if anything doing really well. So that’s – they are not the products that are being hit by this issue, but we do have as we said, some instances where that’s going on and then we also have certain cases where people are being in our view more aggressive than the case merits and in those cases, we don’t want to enter ’14 with those kind of cases on our books.

David Windley – Jefferies

Okay, thank you for that. And then to follow up on the agreement, sorry one more question there. How does the state – so given – you have said and reaffirmed that it is a pre-tax margin targeted agreement, how does the state scrutinize your G&A spending and I am thinking for example, your dual demo spending $4 million this quarter, $7 million next quarter, would spending like that be included in the calculation of your pre-tax margin?

Jay Gellert

Yeah. I think in our discussions with the state, if anything, they want to be assured we adequately spend on the duals to make for a very positive transition. I think David this agreement if anything will give CMS and beneficiary groups and all that, the fact – the comfort that we will do what’s necessary to make this really work. So to me, I think that in this case, the way the 75% or if it costs say $20 million more to make it right, that’s what they want us to do. So they will look at it to make sure that we’re acting responsively, but I think their view is that they want to make this really work well, difficult population and that this agreement encourages the necessary investment to make it work.

David Windley – Jefferies

Okay. Thank you.

Operator

Your next question comes from the line of Brian Wright with Monesse, Crispy & Hart.

Brian Wright – Monesse, Crispy & Hart

Thanks. Real quick on the settlement, are there any accrual reverses or any benefit that impact the fourth quarter as a result of the settlement?

Jay Gellert

No. There is no impact related to the settlement until 2013.

Brian Wright – Monesse, Crispy & Hart

And then, just lastly on the commercial lives where you’re describing some increased, while with just continued pricing pressure, can you – do you know what kind of product offering you’re losing those lives to?

Jay Gellert

In general, we’re losing it to pretty much the same offering. So, it’s – generally these are cases that the going full network to full network. And, that’s why we’re highlighting that in some cases I think that we’re – we think that there are some instances where there are spasms of aggression.

Occasionally, they got self funded by – in most cases they seem to be going full network risk to full network risk and they are not any more widespread than they’ve been in the past. Just I think we’re confident with the way that narrow networks are going, we’re confident with our small group performance, we’re confident in a lot of other areas, so we’re more comfortable kind of not having to follow those.

Brian Wright – Monesse, Crispy & Hart

Okay. Thank you.

Operator

There are no further questions at this time. I would now like to turn the call over to Angie McCabe for any closing remarks.

Angie McCabe

Thank you for joining us.

Operator

This concludes today’s conference call. You may now disconnect.

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