Good morning. I will be your conference facilitator today. Welcome to the UnitedHealth Group second quarter 2012 earnings conference call. A question and answer session will follow UnitedHealth Group's prepared remarks. The question and answer queue will not open until the conclusion of the prepared remarks. As a reminder, this call is being recorded. Here is some important introductory information. This call contains forward-looking statements under U.S. federal securities laws. These statements are subject to risks and uncertainties that could cause actual results to differ materially from historical experience or present expectations. A description of some of the risks and uncertainties can be found in the reports that we file with the Securities and Exchange Commission, including the cautionary statements included in our current and periodic filings. This call will also reference non-GAAP amounts.
A reconciliation of the non-GAAP to GAAP amounts is available on the Financial Reports and SEC Filings section of the company's investors page at www.unitedhealthgroup.com. Information presented on this call is contained in the earnings release we issued this morning in our Form 8-K, dated July 19, 2012, which may be accessed from the Investors page of the company's website. I would now like to turn the conference over to the President and Chief Executive Officer of UnitedHealth Group, Stephen Hemsley.
Good morning. Thank you for joining us. Today, we will review our second quarter and first half 2012 results and discuss the near-term outlook for our businesses. In the second quarter, UnitedHealth Group earned $1.27 per share, an advance of 9% year-over-year on revenues of more than $27 billion, which increased by 8% year-over-year. Our consolidated medical care ratio of 81.3% reflects strong performance on medical cost results that were slightly better than expected, primarily due to favorable reserve development. The operating cost ratio of 15% reflects continuing growth in services at both UnitedHealthcare and Optum, and the investments we are making to advance our Optum businesses, particularly pharmacy services. Efficiencies from our multi-year operational improvement efforts partially offset this cost growth. Adjusted cash flows of $2 billion brought first half 2012 adjusted cash flows to $3 billion, up $615 million year-over-year. Our financial flexibility continues to be distinctive.
In the first half of this year, we grew our dividend payment rate by 31%, extended our share repurchase activities, closed three acquisitions in Medicare, and still maintained a debt-to-total capital ratio of 30% and $1 billion in available cash. Annualized return on equity through the first half of 2012 was 19%. Let's review our business results, starting with UnitedHealthcare, which continues to sharpen its innovative focus toward greater simplicity, quality, affordability, and consumer value. UnitedHealthcare provided medical benefits to nearly 36 million people at June 30, an expansion of 1.7 million year-over-year and an increase of 305,000 in the quarter. Second quarter revenues increased 8% to $25.5 billion, and the outlook for new business remains strong. Looking forward, recent successes include affirmation by the government of our mid-2013 TRICARE award for military benefits to serve nearly 3 million military personnel and family members.
The Kansas and Ohio awards for Medicaid benefits and the selection of UnitedHealthcare by Texas and Nebraska to provide health benefits to their employees. These awards and less-publicized engagements we're winning day in and day out reflect our commitment to serve, to execute, and to innovate. Breaking down second quarter results, UnitedHealthcare Employer and Individual year-to-date growth stands at 550,000 consumers served, which reflects a decrease of 25,000 people in the second quarter as we expected. Favorable cost trends and overall client satisfaction remain key positives. Our service reputation remains strong. Customer retention is high, and response in our newer, more innovative products and technologies continues to grow. The value of our networks deliver in care quality and cost containment is high. We are seeing an ongoing shift in market priorities.
Large, sophisticated buyers are placing their business based upon well-aligned consumer and care provider engagement, aligned to effective clinical management capabilities. Collectively, these elements have positioned us to continue to add value and grow our self-funded business into 2013. For the risk-based market segment, the competitive climate continues to be aggressive but rational. This remains consistent with what we have been seeing for more than a year. Some pricing we see in select regional markets seems to reflect the assumption of ongoing lower medical trends, while some pricing strategies seem to be simply based on the avoidance of any rebates under minimum MLR provisions. We expect this market to continue to be highly competitive into 2013. We will hold fast to our disciplines and accordingly expect continued pressure on our risk-based product membership.
We believe customers and our company are better served by consistent and predictable pricing supported by a realistic view of forward cost trends. In Medicaid, UnitedHealthcare Community and State continues to grow steadily, adding 210,000 people served this quarter and a total of 275,000 people year-to-date. New implementations and new awards in 2012 include Louisiana, Texas, Washington State, and Kansas. In Ohio, we received awards for both the traditional Medicaid population and for dually eligible residents. We now serve Medicaid programs in about half the states in the U.S. This includes services such as behavioral health care and pharmacy benefits, which state customers increasingly seek to integrate into their Medicaid offerings. Service to the dually eligible and integrated benefit offerings both play to UnitedHealthcare's historical experience and strength.
As with our commercial benefits, UnitedHealthcare Community and State remains disciplined in ensuring we achieve an appropriate return on the capital we've invested. We continue to take a prudent, market sustainable posture for both new bids and maintenance of existing relationships. We remain committed to partnering with states that are committed to the long-term viability of their programs. While we will withdraw from programs within states or change the nature of our service to those programs as needed in instances where we see that commitment to viability weaken. UnitedHealthcare Medicare and Retirement completed two acquisitions in Florida and also had the strongest organic growth this quarter among all participants in the Medicare Advantage market based on CMS data.
Our growth demonstrates the value for consumers of our Medicare Advantage plans, which includes our focus on benefits popular with seniors and their positive experience receiving well-coordinated care from a strong network of local physicians. In total, we increased our Medicare Advantage participation by 85,000 seniors this quarter and are serving 340,000 more seniors through the first half of 2012. Our filed 2013 benefits again offer market competitive plans and focus on the benefits that seniors tell us they value most. We anticipate continued steady growth next year as well because of the ongoing entrance into Medicare of millions of seniors, our expanding market presence, and the consistently high consumer value our programs offer. Overall, we expect UnitedHealthcare will serve between 1.8 million and 2 million more consumers this year, making 2012 among the strongest and most diversified membership growth years UnitedHealthcare has ever experienced.
Turning to margins and medical costs, UnitedHealthcare's second quarter operating margin of 7.5% remained in line year-over-year. We expect our consolidated medical care ratio in 2012 to be in the range of 81.5% ± 50 basis points. This is an improvement to our outlook from last November and is based on results from the past six months, including reserve development realized to date. We forecast our commercial medical care ratio for 2012 to come in toward the lower end of the range we most recently provided, which was 82% ± 50 basis points. We continue to forecast commercial medical cost trends this year at about 6% ± 50 basis points. Unit cost increases remain the primary driver. Utilization continues to increase modestly. Outpatient usage continues to rise with increases across all markets, commercial, Medicare, and Medicaid, all consistent with our last quarter.
This is more reflective of an increased number of patient visits and procedures than the more intensive services on a per visit basis. Some of this increased volume results from our efforts to encourage more appropriate use of health system resources with patients receiving service on an outpatient basis rather than via full inpatient admissions. Use of physician services is generally stable and inpatient activity remains restrained. UnitedHealthcare's pharmacy costs are again showing the benefits of our intensive management. We will improve upon these approaches still further as we engage OptumRx to administer our commercial offerings and pharmacy programs. While we're executing well, we remain cautious because pressures on the benefits market remain significant and continue to build. The commercial sector is competitive. Job creation and new business formation are weak, which impacts growth.
Rate pressures in government programs are intensifying and rates in some Medicaid venues are even slightly negative. Unlike prior years, these current Medicaid rate reductions are generally not been mitigated by corresponding benefit reductions or provider fee schedule reductions. We have discussed the funding challenges faced by state programs a number of times and are now more clearly seeing the predicted effects of those pressures in the marketplace. In the senior market, Medicare Advantage rate increases have been minimal for three years or more. Changes to quality star definitions that were made after the measurement period was completed will adversely impact rates for many Medicare Advantage market participants in 2013. This backdrop suggests year-over-year gross margin pressure in the back half of 2012 and into 2013 in healthcare benefits.
In this environment, UnitedHealthcare will focus on using new product offerings aligned to more modern consumer engagement techniques that effectively engage our focused clinical programs and high performance networks to achieve growth with fair margins and capital returns. We are also intensely focused on reducing operating costs, becoming leaner, more streamlined, and ever closer to the customer. Turning to health services, Optum produced revenues of $7.3 billion in the second quarter, an increase of 4% over last year. The OptumHealth and OptumInsight businesses posted 21% and 16% top-line gains respectively, with the latter adjusted for divested businesses in 2011. Growth drivers included expansion in integrated care delivery and continued growth in compliance services in clinical and operational performance tools. Our technology and related services offerings continue to show strong market acceptance, with the Optum revenue backlogs again growing more than 20% over last year.
This growth was led by strength in data and information infrastructure solutions for government customers, compliance services for hospitals, and performance tools for payers. Future revenues will also benefit from the integration of services in the new Medicaid award in Kansas. In pharmacy services, we are implementing some recent large customer awards, which will modestly benefit second half 2012 revenues, and we continue to steadily grow specialty drug and mail services. These impacts are more than offset by the decline in Part D volumes that began in January of this year. Optum's mission is to make the healthcare system work better for everyone. We leverage enterprise-level capabilities to drive more effective outcomes, reduce costs, and simplify and improve the healthcare experience for all participants across the system. We size our addressable market at $500 billion and steadily growing.
As a business, we're continuing to create what we call One Optum, evolving Optum into a more integrated enterprise, intensely focused on customer needs across the eight distinct markets we serve. The businesses are aligning to deliver the more comprehensive and sophisticated, and sustaining solutions customers require in an increasingly complex and changing healthcare environment. Solutions that bring greater and more consistent quality, speed, efficiency, and lower cost. Our One Optum efforts are creating a progressively flatter, more integrated organization that is simpler and leaner, more understandable and more responsive to customers. Our Optum cost structure is also becoming leaner, and we're better leveraging the scale of the enterprise. We are strengthening and more tightly aligning shared services and operational support and administration and removing redundancies that are the historical result of organizing smaller businesses around specific products.
When combined with this flatter, simpler organizational approach, tighter alignment enables in an evolution from a product-oriented enterprise to one focused on more integrated customer solutions. This opens up opportunities to serve larger, more comprehensive, and longer-term relationships established with customers at more senior executive levels. Optum's second quarter operating earnings of $320 million were in line with our expectation and improved $68 million sequentially. We accelerated certain investments this quarter to move faster on integration and better position Optum for future growth. With our first half performance, Optum is on track to deliver full-year operating earnings consistent with our projections. Second half earnings will benefit from improved leverage from our One Optum efforts and seasonably favorable revenue trends in a number of our businesses that are driven by year-end business dynamics. We continue to see operating earnings of between $1.3 billion to $1.4 billion, which is modestly above 2011.
This despite absorbing incremental development expenses of more than $150 million in 2012. We expect to further build on that performance into 2013 and remain on path to doubling Optum's 2011 earnings by 2015, driven through organic growth, operational efficiencies, and PBM insourcing. To sum up, in a challenging environment, UnitedHealth Group's strong second quarter and first half performance were characterized by broad-based growth, strong service and execution for clients, continued innovation in products and services, solid margins and positive earnings and cash flows. We want to thank our 100,000 employees for their compassion and their commitment to the people we serve. Every day, they're working intensively to deliver dependable, consistent service, innovating and building the capabilities of the future. Their capacities to adapt quickly to changing markets remains critical to our future. As always, we have concerns about today's challenging environment in the health benefits market.
These are not new. There continues to be more downward than upward pressure across the healthcare landscape. We expect this environment to prevail for some time due to the employment malaise and imminent regulatory changes. State budgets are clearly constrained for Medicaid. Medicare funding is similarly pressured. Deficits leave policymakers with little room to address long-standing funding issues. Long before expansion markets such as exchanges and dual eligibles and broader state Medicaid expansions are fully established and productive, industry regulations and taxes will be imposed and realized. Our diversified position is a strength as we work to address these headwinds, but we have respect for the challenges ahead and believe market expectations should remain in check and aligned to these realities. Based on our results so far, we have increased our 2012 outlook for revenues to $110 billion and earnings to a range of $4.90 to $5 per share.
First half earnings benefited from reserve development as well as the first quarter rebate adjustments, while second half results will include TRICARE startup costs. While we always endeavor to perform to our full potential, we expect earnings per share in the second half to be slightly lower than the first. Longer term, we expect significant market expansion and see opportunities for market share growth. Consumers and benefit sponsors want more for less. At the most basic level, they want higher quality care at a more affordable cost. Consumers have demanded and received more for less in virtually every other segment of our economy. Healthcare will not be immune. Government, as a benefit sponsor, has been increasingly relying on private sector solutions. The private sector provides a more flexible and open, better managed, higher quality healthcare experience than traditional passive indemnity programs built solely on leveraging fee for service.
The commercial market has been consolidating for some time. That trend will continue. To capitalize on the opportunities of the future on a national or even multi-market basis, it will be essential to invest in and create leading innovative capabilities and competitive operating cost structures. These have been underlying themes in our businesses for some time. On the Optum side, the market for health services is just beginning to ripen. Optum is an early stage enterprise relative to the scale of what we believe will ultimately develop in this sector. We look forward to providing you with a full view of our 2013 aspirations and expectations at our annual investor conference, which will be held in New York City on Tuesday, November 27th. I will now turn this call back to our moderator for questions. Again, thank you for joining us today.
At this time, we will proceed with the question and answer period. The operator will clear the queue and register your questions now. We ask those with questions to limit to one question per person so we can get to as many participants as possible. In order to ask a question, please press star followed by the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. We request that you do not utilize a speakerphone or headset when asking a question. Your first question comes on the line of Ana Gupte with Sanford C. Bernstein.
Hi, good morning. Thank you. I was looking, Steve, to get a perspective from you on the consolidation that's ongoing in the government segments, particularly the large transaction that WellPoint and Amerigroup conducted recently. Can you tell us what your thoughts are on strategic alliances versus consolidating more regional players than more of a national sort of broader based M&A play?
Sure. Ana, obviously we won't comment on specific transactions, I think I kind of hit it in the end of my formal comments, that is the demands in the marketplace broadly, whether they're in the commercial side or the government side, are just continuing to increase, become more sophisticated, more complex, the responses to them, we think, deserve a very focused response and need to be scaled. We've kind of taken those philosophies in our own business for many years have focused our responses to those kinds of markets with dedicated business units have sought to expand them and grow them and build their capabilities. It is not surprising to see that kind of activity. We have said that will be coming, it really has been happening for probably 15 years or more.
As I said in my final comments, we expect that to continue. Now, in some respects, we accomplish those things both through relationships in the marketplaces alliances, in some instances, we have chosen to invest. I think you're going to see both those kinds of responses in the marketplace, I think both of them can work depending upon the specific markets that you're dealing in.
a follow-up on that. The excess cash flow that you have, if you could provide some perspective on the priorities on health benefits relative to health services and on the benefit side, commercial versus government, then on buybacks and potentially future increases in dividends.
Again, our financial position remains strong. Our cash generation capacities remain strong. That's really no change from the past. Our approach with respect to capital allocation hasn't changed. As it relates to expansion activities, we are interested continuing to build across our business broadly. We look at it not just in market segments also, but in the cultivation of capabilities. Basically all the above is my, I'm sure, unsatisfactory answer to you, because we're really interested in building and see opportunities to build in virtually every one of our business areas.
Thank you. Appreciate the question.
Your next question.
Next question, please. Your next question comes from the line of Tom Carroll with Stifel.
Hey, good morning. A question on Medicare Advantage. Steve, I think you mentioned steady growth expectations as we've seen in prior years, but that continuing to 2013. You followed that up with a comment about, we've seen rate increases at a minimum for the last few years, and that perhaps is going to lead to some margin pressure, second half this year, maybe in the first half of next year. Just maybe pull those two comments together. Does that suggest perhaps a more aggressive strategy to grow market share? Maybe spending a bit of margin here now to perhaps accelerate Medicare Advantage growth over the next, call it two to three years?
I'll comment broadly and then let Gail and maybe Tom respond. I would say one is that environment really isn't any different than the one we've been having for the last three years, probably at least. We really align to philosophies around steadiness of managing our benefits, and being consistent in the marketplace. We have historically tried to lean towards the benefits that seniors in specific marketplaces seem to respond to most effectively. I don't think things like that broadly are changing. We're really just outlining an environment that has prevailed and looks like it is not going to change anytime soon. Go ahead.
Good morning, it's Gail Boudreaux. A few comments just to build on Steve's. We have, as you know, been dealing with the rate environment in Medicare for a number of years, and our focus is on the sustainability of the benefits and the program for consumers. We work hard around affordability, how we work with physicians and hospitals to ensure that we've got the right programs underneath that, as well as improving our overall quality. From that perspective, we've had that strategy for the last few years, and we're going to continue to stay focused on that. We think that's really important to the Medicare program overall and think we provide good value. The second issue on growth, we're pleased with our growth.
We've had, as you heard in Steve's opening comments, very strong growth in the SEP part of enrollment, as well as a strong opening to the year in AEP. Pleased with the value that we're bringing to the marketplace and in the markets that we're growing. As you saw this quarter, we also added several acquisitions, which we think help strengthen our position in markets as well as capabilities.
Next question, please.
Our next question comes from the line of Michael Baker with Raymond James.
Yes, thanks a lot. Just a follow-up on the Medicaid comments that you made. Do you think we're close to the point where we'll start to see again some Medicaid managed care participants begin to pull out of the market in order to rebalance the relationship between state governments and the private sector?
I'll start this and let Gail and Jack mop this up. That response obviously varies market by market, and the posture that states take on vary market by market. The answer to that is yes, that if we see situations that we believe the state isn't prepared to sustain in a particular market, we will withdraw or, as I said in my formal comments, withdraw or reposition the programs. I think that that discipline has to prevail, just like it prevails in other parts of our business. Jack?
Thanks, Steve. Hi, Mike. Just to maybe echo a part of Steve's comments. A successful program between the private sector and any particular state really rests on two things. It really rests on a partnership going both ways, and I use partnership in the fullest sense of the word, then really mutually satisfactory economics. If one or both of those aren't missing, then I think we're not doing a service to a state, and they're certainly not being well-served by us, if we continue to sort of slog along in a relationships that isn't really working ultimately for the Medicaid beneficiary.
Thank you. Next question.
Our next question comes from the line of Sheryl Skolnick with CRT Capital Group.
Good morning. First of all, I just want to clarify something. Nothing in your comments should suggest with respect to Medicaid or any of your other businesses that you're willing to break price discipline, even if your margin might be a bit lower year-over-year. Is that correct?
We are not breaking pricing disciplines across any of our business platforms at all.
Yeah, because there-
On the health benefits side or on the Optum side?
Thank you. I just wanted to hear you say that because there was an element to that question which almost made it sound like that was the question.
Actually, I think we answered that one, that we will take the steps necessary if the economics aren't sustainable.
Yes, you did. My real question is this. I'm fascinated by the notion of One Optum. It appeals on so many different levels, from the good business sense to the market opportunity. I'm curious about what trends or factors you might have seen in the market that tell you that now is the appropriate time to respond in that way and/or to lead the customer, whether there's been perhaps a growth in the sophistication at a pace that maybe is a little bit more accelerated than it might have been a year ago, whether there are fundamental changes going on in the market. I guess I'm sorry for the lack of specificity around the question because it's What I'm trying to get at here is there's an issue of United leading too quickly where the market can't go. This is a major change.
It's a different approach. I think it's the right approach, and I'm curious as to why you think that now is the right time to do this, and what types of things you might be able to accomplish by having a more integrated product, in transforming some of these relationships and ultimately the way we pay for and deliver care.
Sheryl, I think it's an excellent observation and question. I think I'll have Larry respond, but I would offer a few themes in the onset. As we formulated Optum, brought it in under a single brand, aligned the businesses, rebased buying them last year. This was basically that market need we saw at that time. We are really just continuing to execute along those same themes, and the One Optum is a good title, in essence, that is code across our enterprise for the acceleration of those integration themes across our business.
These have been well laid out, and Larry can really run with those.
Sure, it's Larry. I think, with Steve's comments as well as Steve's earlier comments when he opened up, I think you kind of know where we're headed in terms of One Optum. Let me back up for one second. We decided, based on goals that we set, that we were trying to go to this 15% ROIC and 6% margin by 2015, which is basically doubling our 2011 earnings, that we needed to put together a very strong and focused business plan, three-year plan. In putting together that three-year plan, we are seeing the amount of attention, traction, however you want to look at it, that we're receiving from our eight markets that we're focused on. As a result of that, we're looking at how we're going to hit those numbers from a performance standpoint.
As we've been getting into this with our potential customers and so forth, we believe that about 50% of that will come from growth, and 50% will come from what I'll call cost management, integration, alignment, and the PBM insourcing. If you take a look at where we're at today, in 2012, we're feeling pretty good that we're in line with expectations. When we get to what I think one of the questions you were asking is about the markets and growth and so forth, we're seeing that we're in large markets that are getting larger, and then we believe that we're starting to really be able to learn a lot, and we're going to be expanding as we go forward.
I think the market is postured for longer term relationships, that they're pursuing a broader set of aligned services, and seeing the need for that. They're building capabilities, and we are building ourselves into them as part of that, and they are clearly buying. Their buying behaviors are moving towards longer term, more sustainable, integrated. The point I was making before is that probably existed a year and a half, so we are urgent about getting this One Optum agenda moving forward because we think the market's already there.
Interesting. Great. Thank you very much.
Thank you. Next question.
Our next question comes from the line of Kevin Fischbeck with Bank of America.
Okay, thanks. I just wanted to follow up on some of your comments about pricing into next year. You broadly indicated that the environment was, I think, aggressive but rational. The comments around pricing, your competitors appear to be assuming a continuation of low utilization, maybe runs counter to how we think about what's rational, and certainly my impression of what we were seeing the last few years. Obviously, your comments about expecting to lose membership implies that you don't see your competitors as entirely rational. Maybe you can just flesh out some of what you're seeing there, and then also provide some color on markets in particular where you feel like things are maybe more competitive.
Sure. Really this is around the definition of rational, right?
Yeah.
Gail, do you want to take a shot?
Sure. Consistent with the comments we've made over the last several quarters, we expected the market to get more competitive, and that's what we're seeing. I would say we're not seeing any change in that. We talk about rational. Our competitors are making decisions based on their rebate positions, their view of minimum medical loss ratios, their view of future trend. Yes, as we said, I think in the last couple of calls, there are certain pockets where they're making those decisions. Overall, we do see it as rational. When we gave you our guidance last year and what we said in the last several quarters is that, consistent with that competitive environment, we are seeing some pressure on our enrollment. You saw that this quarter and you've seen it this year. I think that's how it ties to it.
We've been very consistent and disciplined in our pricing, and that's creating some of that pressure, but we're going to stay the course on that, and we're looking at pricing to our future view of trending costs.
Maybe just to follow up on that into a different product. You mentioned that you expected some rate pressure on the Medicaid side. Obviously, you've seen a lot of RFPs. Certainly some of your competitors have seen some disruption in states. How much of that disruption is a function of what states are asking for because of their budget pressures or because of the competitive environment as far as the bidding process goes from among your peers, has gotten more competitive and kind of forced people to go to a spectrum they shouldn't be?
I'll let Jack answer that, but I think the budget issues are the prevailing.
Yeah, I would agree. Hi, Kevin, Jack Larsen. You open your comments referring to some of the disruptions that some of our competitors had. Really, it's tough for us to comment on those particular disruptions. We don't actually participate in those programs that have gotten some of the more recent focus. I would say overall, price rates are being pressured, probably more so by state budget positions this year and then going into next year. We certainly expect a fair amount of competitive give and take on new states. I think we've priced very thoughtfully on our new wins in Kansas, most recently in Ohio. I would say overall, it is just the continuing pressure on states trying to make more go farther than they have before.
Great. Thanks.
You can really see it aligned to the budget status of the state.
Yep.
That's where you're going to have your problem.
Okay. Thank you.
Your next question comes from the line of Justin Lake with J.P. Morgan.
Thanks. Good morning. Just a couple of follow-ups. First, on the commercial pricing environment and your kind of outlook for that segment. Was hoping maybe you could just give us a perspective on this market on the pricing side, just in terms of the pricing environment today, this rationally aggressive. That's a term we've heard a lot over the years. Can you maybe compare it to what we think of as the last pricing cycle that we saw, let's call it 2006 or 2008. Maybe you can just give us some perspective there on how that looked. Then on the commercial cost trends, can you talk us through your cost trends by the four segments?
Given you lowered your commercial or at least took your commercial MLR target to the lower end of guidance, does that mean that cost trends also coming in toward the lower end there, especially given pricing doesn't seem to be all that great?
Yeah, I think with the opening qualifier that the market circumstances and situation of a time is unique to its time, so you really can't say, "Oh, this is 2000X or 19 something or other." I think putting that aside, I think we can offer some comments on that. Gail?
Sure. Justin, your question comparing it to prior cycles, I would look at that the environment is fundamentally different. We're at a different regulatory environment with minimum medical loss ratios. We didn't have that the last few years. Quite frankly, the utilization we're coming out of. I don't see it necessarily as comparable to those cycles. As Steve said in his opening comments, we remained, I think, very respectful of the underlying pressures around unit costs and increasing utilization over time, and then the impact of reform provisions as we go through 2013 and 2014. From that perspective, we see people making decisions based on their view of minimum MLR rate regulation, et cetera. That's why we're characterizing this and see it as a rational market, a competitive one, but rational. I guess I'll ask Dan to comment on your questions around utilization.
On a market by market. When you really analyze each market, the activities are understandable, right?
Right. Each market has different pressures facing it based on the dynamics of the competitors that are in that market and the products that they have. We also manage our business very much on a market-to-market basis, looking at both national trends, but also putting products in those markets that make sense where we can be competitive.
Sure. Justin, Daniel Schumacher. To follow up on your question on cost trends across all three of our businesses. We've been talking obviously through the balance of 2011 and into 2012 that we were seeing increases in our medical trend, largely due to increases in utilization, and that's coming true and playing out. We're seeing it across the platform. You had also asked about, I think, the relationship of the loss ratio to trend. With respect to our loss ratio on the commercial side, we do expect it to be at the low end of the range, that 82% ± 50 basis points. Our reported loss ratio has a host of factors influencing it.
When you look at the trend on more of a core basis, our trend is coming in exactly where we expected, and that's at that 6% ± 50 basis points, I would not update that to say anything other than in the midpoint of that range.
Okay, great. Just my other follow-up was on the government segments. You're talking about, I think you've taken a more conservative tone on the margins going forward. I was just hoping you could give us some color in terms of how those businesses are performing in the second quarter, in Medicare Advantage and Medicaid. Maybe talking either year-over-year or sequentially, just in terms of are you seeing any pressure on those businesses yet, or are they coming in better or worse than expected? Just an at the moment comment would be great. Thanks.
You bet. This is Dan again. On the second quarter, as you look at it as compared to the performance in the same quarter last year, our government programs in aggregate are performing better. They're contributing more earnings, and they have a lower loss ratio in aggregate. As you start to break it into the pieces, our Medicare is actually performing a little better. Our Medicaid is performing a little bit worse. The largest contributor, too, is a little bit more favorable development in the Medicare space.
Thank you. Next question, please.
Your next question comes from the line of Carl McDonald with Citigroup.
Thanks. I was hoping you could elaborate on the comment that you made about the change to the Medicare star ratings after the bids were submitted and the pressure that would put on rates and margins in Medicare Advantage in 2013.
Sure. Actually, I think Tom can respond to that most effectively.
Sure. As you know, the Medicare program now has a Star Rating Program that includes a pay for performance. A lot of the performance that we're doing is more futuristic. We are working today for results in that bonus program that will actually be achieved in 2015. When you have that kind of gap in timeframe of performance to actual payment, there can be changes in definitions in the meantime that may change that focus of your performance. Going into 2013, there was a change in definitions around some of the thresholds or some of the performance measures around the Star Ratings, which in many situations caused plans across the industry to have a lower performance or Star Rating than would've been achieved under the previous definition.
Okay, you're essentially saying that the CMS made the requirements harder or higher to achieve, and that's resulting in lower Star Ratings?
Yeah. It could have been a change in the level of requirement. It could have been a change in priority for CMS.
Meaning a new metric that hadn't been looked at previously?
A change in the metrics or a change in weighting, right?
Yeah. It likely would be a change in the weighting or an increase in prioritization of a particular metric over another.
Got it. Thank you.
Thank you. Next question.
Your next question comes from the line of Melissa McGinnis with Morgan Stanley.
Good morning. Thanks for the question. I believe UNH expected to incur something like $245 million in total investments related to.
I'm sorry. Could you get closer? We can't hear you.
Yeah, I'm sorry about that. I believe United expected to incur $245 million in investments for the Optum Rx repatriation, Optum broadly and TRICARE, something like another $215 million in compliance costs. Given this year, given the commentary around some of that being accelerated into the first half, can you provide any additional color, maybe just how much of that we've seen in first half versus how much is left to go in second half? Also beyond that, how much of that we can truly count on rolling off into 2013, potentially providing a tailwind to offset some of the gross margin pressures we've been talking about across the benefits business?
I think if that had been as meaningful as your question might suggest, we would have responded to it specifically in the formal comments. I think there has been some pull-through into the first, but I can't also tell you that we won't continue to try to accelerate because we're trying to go as fast as we can, particularly across Optum. Dave, you want to comment?
I think, Melissa, you may be talking specifically a little bit about the cost of compliance that we outlined at the investor conference, and then also some of the commentary we made in the first quarter and how that's shaken out. Let me see if I can address this succinctly and then maybe give you a little bit more color. With respect to the ACA, the law implementation, actually, we see those costs accelerating towards the last half of the year, primarily as we prepare for the exchanges, and the payment of rebates and things of that nature. You can expect an acceleration there. Same holds true for the PBM, as you might suspect, as we get to the last innings, if you will, in the preparation for that. We're hiring people.
We're moving members onto our systems and incurring a lot of the operating costs in those final steps. You'll see that more towards the back half of the year. 5010, we're done. We finished that in Q1. We finished clean. It was a huge success for us, and I think we set the bar for the industry there. ICD-10 is pretty steady. Net-net, as you think about these costs of compliance, actually we'll see more of those in the second half of the year than we see in the first. Plus, in the first quarter, I think we outlined a couple of things, and these are all really good news. They may sound like bad news in terms of initial costs incurred, but they're all related to the superior growth that UnitedHealthcare's been able to put in place.
For TRICARE, you're going to see a significant amount of operating costs in the back half of the year associated with getting ready for that program. Those will carry over into the beginning part of 2013 until we start earning revenue on that case. Medicaid for Ohio and Kansas, obviously those wins are great, but we have to prep and install them. Same thing with commercial on Nebraska and Texas. All those things really are costs to implement. It's all good news. It may show up as a little bit of a deviation on the operating cost side, but that's good.
The last thing I would just remind you, on the last half of the year, we're seasonally high in our operating costs, primarily as we get prepared for January and the more intensive medical utilization seasons, as well as we get ready for AEPs with staffing and whatnot. Expect overall on the operating cost side, you'll see that operating cost ratio elevate over the back half of the year.
Okay, great. Just to clarify, as we head into 2013, we talked a little bit about some of that investment coming out and some ongoing. Is there any way that we can size maybe how to think about SG&A and those investments as a headwind or tailwind into 2013?
I think what you're referring to is principally around OptumRx, and that is the bulk of those will be incurred in 2012. There'll be some that will go into 2013, but on a comparative basis, OptumRx should step up next year. Derek?
Yeah. What I would say is that as you pace into our migration is scheduled to begin on the first of 2013, and it paces throughout 2013. We will have sort of operating and training costs ramped up consistent with that migration schedule. I'd say there'll be a little bit of operating costs, but if you look, the majority of the development costs have occurred in 2012.
Great. Thanks.
Next question, please.
Our next question comes on the line of David Windley with Jefferies.
Hi. Thanks for taking the question. I wanted to ask one around kind of principally XLHealth and the integration progress you're making there on two fronts. First of all, I understand that you're using some of their approaches in the more, say, chronic or comorbid portion of your MA book. I wondered when the benefits to scoring might manifest from that activity. Secondly, in the context of Excel Plus and Spirit and Evercare, what progress have you made in kind of pulling those together into an integrated solution as relates to presentations or pitches in dual-eligible opportunities?
I think it's a great question. I would include our Medicaid capabilities in that as well. Tom, you want to start?
Sure. Hi, David. This is Tom. With the integration of XLHealth, we're looking at it from two approaches. The one that you didn't mention was really around the health plan side of XLHealth, so the Care Improvement Plus plans and how we're looking to leverage their focus and their capability and their market presence in 2013, which we definitely took advantage of in our bid offerings for 2013. On the side you did mention, we are expanding the capabilities around house calls and their integrated clinical care model to a broader Medicare Advantage population with a legacy Medicare and retirement population. We are showing good progress in that. The results of that, the work we do in 2012 will be realized in 2013, as well as the clinical advantages that we get today in identifying early gaps in care from a medical management perspective.
We realize those now in 2012.
Okay, super. From a duals perspective?
Yeah, those same capabilities. Again, I think we originally saw the Excel Plus capability as more geared toward the chronically ill, but I think we are now looking at that differently, and we're rolling it out more broadly in the Medicare space, whether you're a dual eligible, whether you're in a more traditional Medicare Advantage program where you can also benefit from that same house call visit. We are incorporating that into our dual-eligible offerings as well.
Wherever the needs really are challenging.
That's right.
The care paths can be most effectively applied.
If I could follow up quickly on that, is it possible to call out which states or perhaps even just quantify the number of states where you think the approach by the state will provide you with the opportunity to really show off your skill sets as opposed to, say, the California situation that's just going to existing vendors?
Sure. Although I would say that when you really look at the compelling notion of how these capabilities ultimately align and integrate and the needs of the populations that to be managed, I think all the states will eventually come around. I really think it's a matter of pacing. Whatever factors get complicated, the pacing factor, whether they're political or otherwise, I really think that at the end of the day, the states confronted with the challenges they have are going to have to embrace these kinds of capabilities, as they're better for their populations, and they're much better for their programs.
Great. Thank you. Thanks for taking the question.
All of that. We're done. Next question, please.
Your next question comes on the line of Matthew Borsch with Goldman Sachs.
Yes. Could I just ask on the Medicaid rate pressures, how does that intersect, in your view, with the federal statute for actuarially justified rates? Is that a backstop that you can turn to some extent? If you can give us any geographic detail on the rate pressures, we'd appreciate it.
Right. I don't think we're going to offer geographic detail because I think we long-term believe that the states will be interested in sustaining these programs. The actuarial issue, Jack, do you want to respond?
Sure. As you point out, the actuarial soundness principle is always the backstop each year as states develop and release rates. I guess I would just make a couple of observations around actuarial soundness. One, they do provide ranges, and I think we have seen in our UnitedHealthcare Community & State business over the years, sort of a movement inside those ranges, if you will, from high to low. I will tell you that we are trending towards the lower side of the ranges most times. The second thing is around rate pressures. There's a range as to what you assume for managed care savings long term, and there is a significant amount of judgment applied to that. Most notably in new states.
where states are doing their very best to anticipate what managed care savings might be. Those two things are certainly big variables in actuarial soundness. We're seeing sort of points all in between.
All right. That makes a lot of sense. If I could just ask just one follow-up or clarification, really. As you talked about the cost trend at 6% plus or minus 50 basis points, I got a little confused in where you said you're coming in at that on a reported basis, but at the lower end on some other basis. Dan, maybe you could just clarify what you had meant about that.
Sure. Sorry, Matt. Let me try it again. On the loss ratio on the commercial side, we expect it to be on the lower end of our guidance, so 80-
Yeah
% plus or minus 50 on the lower end. With respect to our trend outlook, full year commercial trend outlook, we're not making any revisions to that. We expect it to be at 6% plus or minus 50 basis points.
Wouldn't you expect both of those to go together? Sorry, maybe I'm splitting hairs too much.
There's the other issues that affect it.
Yeah. What I was trying to get at is there are differences between those things that show up in our reported loss ratios versus how we look at core trends. I'm saying they're not moving exactly the same. I'm saying loss ratio is lower than the guidance.
Yeah. Got it.
Our trend, we expect to be at the 6% ±50.
Okay. I'm clear.
This is Dan Penshorn. Just for one, for instance, the rebate adjustment in the first quarter-
Yes
would have affected the loss ratio, but not the core medical trend.
I see. Okay, fantastic. Thank you.
Thanks. We have time for a couple more questions, but that's probably all. The next, please.
Your next question comes from the line of Christine Arnold with Cowen.
Hey there. If I missed this, just let me know because I had some phone challenges. Payables versus premiums, I know that they can fluctuate a little bit. Were there any timing issues in the quarter on the payables that you'd like to highlight? Because it looks like adjusting for PDP and prior period development, payables didn't quite keep up with premiums. Then Steve, at your Investor Day, you made some interesting observations about 2014 and how reinsurance and risk adjustment could help to keep small employers from dumping. Can you update us on your 2014 broad thoughts, recognizing that we're not in a position to make any specific projections?
I'll do the best I can on that. Dave, maybe you want to comment on the payable.
Christine, I've not really seen anything on the payables versus premiums front that's unusual in the quarter other than the fact that we acquired Medica and Preferred Care and had to put those into our financial statements.
Okay.
Could you remind me about what specifically you wanted to probe on 2014? Did I comment enough?
Well, you'd made some comments about small employers probably not being incentivized to dump onto the exchange given risk adjustment and reinsurance, and also tax advantages. You had some broad thoughts about how you thought that the structure of the exchanges would protect small groups from dumping and help to protect some profitability there. I'm just wondering now that we have a little bit more data, not much, but a little bit more, and you've spent some more time studying it.
Probably don't have any more information. Quite honestly, I would say the implementation landscape has probably become more complicated because it's clear that there will be some pacing in terms of how this will be implemented as states seem to have more flexibility and the administration seems to be more flexible in terms of how these will go in. If there is going to be any sector that is going to pursue the exchanges, it's going to be on the very much smaller end. When you then take a look at that, I think that the pacing of that, if you're a prudent business person, you're not going to necessarily go right to that if you have benefits.
It might be those who have not had benefits in the past that will pursue the exchange, and that if you are an established business, you might be more prudent in terms of watching how that plays itself out. You do get tax deductibility on benefits. Your employees are paying 20%, 25% of the total cost of these benefits. The company is subsidizing 75%. When you begin to go to the exchanges, there clearly will have to be a releveling on wages. I think employers will look at that and believe that they perhaps have more control over their benefits than they might have if they lose those benefits and have to make compensation adjustments for healthcare that they no longer control.
I think those, when you really get into the heads of the business operators, that they'll be measured in terms of how the response is for those that have benefits and have been committed to benefits in the past. That's why I think that things perhaps will move at a more measured pace. I think the implementation now is clearly challenging given the time frames that we have left. If there's an update, that's all I'd offer. Gail, do you have anything?
I think Steve hit the key points. The first one, there's a lot of unknowns still around the exchanges. Two, as you think about the ranges that many experts have given on dumping from 30% to low single digits, we do think it's going to be at the lower end of that range for the reasons Steve talked about, the tax advantage that employers have, the impact of what employees pay right now, and the penalty. That will mute, we think, many of the people moving to the exchanges quickly in the beginning. Thank you.
They may firm up over time, but it'll take time. Next question, please.
Our next question comes from the line of Josh Raskin with Barclays.
Hi. Thanks. Good morning. Can you guys hear me okay?
Yes.
Okay, great. Sorry. Two quick ones. One, just looking at medical services CPI, there was a pretty big uptick in June. It was driven a lot by the hospital inpatient component. Seems kind of strange that you get kind of a one-month move like that. I'm just curious, are you seeing anything on the hospital pricing side that's different?
Hospital pricing side?
In terms of our negotiations with hospitals, I think we've shared this with you before. We're coming in in line with the expectations we set. There's clearly pressure. There's been pressure on the unit cost side. We're moving much more of our payment to pay for performance along a broad continuum. Always pressure in the system, but I wouldn't say anything has dramatically changed, and we're doing well against the expectations we set, as well as trying to move much more of our pay to pay for performance.
Okay. Then just on the 2013 national account front, I didn't hear much. I'm just curious if you guys have a-- I know it's still a little early, but you guys are probably moving through the process. Any updates on how the pipeline looks and any sort of initial expectations for January one?
Jeff Alter.
Hi, Josh. It's Jeff Alter. What we've seen over the last few years is that the clients in this marketplace are really looking for a long-term partner who can deliver practical innovations like our myHealthcare Cost Estimator and our mobility platform, coupled with distinctive service and new models of outreach to help their employees navigate the healthcare system in an easier way. They're really looking for that long-term partner who can manage their benefits and their medical trend, even more important during this time of enormous change. We performed really well over the last couple of years with this backdrop. We continue to perform well. Although I know your question was 2013, we still have over 500,000 members in this space to bring up between now and 1/1/2013.
It is early, we're in the middle of the selling season for 2013, all indications are that our past success will continue into the 1/1 season.
You guys were up somewhere in the ballpark of 800,000 in the first quarter. Is that sort of your baseline run rate target, or is there anything that indicates next year would be better or worse than what we saw this year?
Josh, we are not offering 2013 guidance today, I would just say I think our service to that market continues to be strong, we'll comment on 2013 when we get to the investor conference.
Perfect. Thank you.
Okay. Thank you. I think we should close now. I would hope that you would take away a few key points. First, that UnitedHealth Group continued to deliver strong performance in the second quarter and for the first half of 2012, but we remain focused and realistic considering the challenging economic and market environment we face today. Second, we continue to focus on providing consistent value, innovation, and dependable execution on behalf of customers and consumers in everything we do. We remain committed to improving quality and access while helping to contain the rising cost of care so that healthcare experience is simpler and more affordable. Lastly, looking to the future, we see markets expanding steadily for health benefits and exponentially for health services.
While we acknowledge the increasing competitive and regulatory pressures ahead, we believe our adaptable, diversified businesses are well-positioned to grow in the market, and that we'll continue to grow and to prosper over the long term. We thank you very much for your attention today, and we'll see you next quarter.
Thank you, ladies and gentlemen. This does conclude today's conference call. You may now