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AETNA INC /PA/ - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A")(Edgar Glimpses Via Acquire Media NewsEdge) OVERVIEW We are one of the nation's leading diversified health care benefits companies, serving an estimated 45 million people with information and resources to help them in consultation with their health care professionals make better informed decisions about their health care. We offer a broad range of traditional, voluntary and consumer-directed health insurance products and related services, including medical, pharmacy, dental, behavioral health, group life and disability plans, medical management capabilities, Medicaid health care management services, Medicare Advantage and Medicare supplement plans, workers' compensation administrative services and health information technology products and services, such as Accountable Care Solutions ("ACS"). On May 7, 2013 (the "Acquisition Date"), we acquired Coventry Health Care, Inc. ("Coventry"). Our customers include employer groups, individuals, college students, part-time and hourly workers, health plans, health care providers ("providers"), governmental units, government-sponsored plans, labor groups and expatriates. Our operations are conducted in three business segments: Health Care, Group Insurance and Large Case Pensions. The following MD&A provides a review of our financial condition at June 30, 2014 and December 31, 2013 and operating results for the three and six months ended June 30, 2014 and 2013. The Coventry acquisition significantly impacts the comparability of our results for the three and six months ended June 30, 2014 to the corresponding periods in 2013 as only approximately two months of Coventry's results were included in the corresponding periods in 2013. This Overview should be read in conjunction with the entire MD&A, which contains detailed information that is important to understanding our operating results and financial condition, the consolidated financial statements and other data presented in this Quarterly Report on Form 10-Q as well as the MD&A contained in our 2013 Annual Report on Form 10-K (the "2013 Annual Report"). This Overview is qualified in its entirety by the full MD&A. Summarized Results for the Three and Six Months Ended June 30, 2014 and 2013: Three Months Ended Six Months Ended June 30, June 30, (Millions) 2014 2013 2014 2013 Revenue: Health Care $ 13,786.6 $ 10,847.5 $ 27,031.6 $ 19,670.4 Group Insurance 627.7 587.1 1,242.6 1,173.9 Large Case Pensions 95.1 102.8 230.0 232.0 Total revenue 14,509.4 11,537.4 28,504.2 21,076.3Net income attributable to Aetna 548.8 536.0 1,214.3 1,026.1 Operating earnings: (1) Health Care 584.3 592.1 1,303.3 1,105.3 Group Insurance 60.6 30.6 101.8 62.5 Large Case Pensions 5.4 3.8 10.2 10.0 Cash flows from operations 2,091.3 583.5 (1) Our discussion of operating results for our reportable business segments is based on operating earnings, which is a non-GAAP measure of net income attributable to Aetna (the term "GAAP" refers to U.S. generally accepted accounting principles). Non-GAAP financial measures we disclose, such as operating earnings, should not be considered a substitute for, or superior to, financial measures determined or calculated in accordance with GAAP. Refer to "Segment Results and Use of Non-GAAP Measures in this Document" beginning on page 39 for a discussion of non-GAAP measures. Refer to pages 41, 45 and 46 for a reconciliation of operating earnings to net income attributable to Aetna for Health Care, Group Insurance and Large Case Pensions, respectively. We analyze our operating results based on operating earnings, which excludes from net income attributable to Aetna net realized capital gains and losses and amortization of other acquired intangible assets as well as other items, if any, that neither relate to the ordinary course of our business nor reflect our underlying business performance. Our operating earnings increased for the three months ended June 30, 2014 compared to the corresponding period in Page 36 -------------------------------------------------------------------------------- 2013 primarily as a result of the May 2013 acquisition of Coventry, as well as higher underwriting margins (calculated as premiums less current and future benefits) in our Group Insurance segment partially offset by the year-over-year decrease in favorable development of prior period health care cost estimates in 2014. Our operating earnings increased for the six months ended June 30, 2014 compared to the corresponding period in 2013 primarily as a result of the May 2013 acquisition of Coventry, as well as higher underwriting margins (calculated as premiums less health care costs) in our Health Care businesses and higher underwriting margins in our Group Insurance segment. Total revenue increased during the three and six months ended June 30, 2014 compared to the corresponding periods in 2013 primarily due to higher Health Care premiums from the May 2013 acquisition of Coventry, as well as membership growth in our Health Care businesses and the effects of pricing actions designed to recover ACA mandated fees and taxes. At June 30, 2014, we served approximately 23.1 million medical members (consisting of approximately 40% Insured members and 60% administrative services contract ("ASC") members), 14.4 million dental members and 15.3 million pharmacy benefit management services members. At June 30, 2013, we served approximately 22.0 million medical members (consisting of approximately 38% Insured members and 62% ASC members), 14.3 million dental members and 13.8 million pharmacy benefit management services members. We continued to generate strong cash flows from operations in 2014 and 2013, generating $2.2 billion and $759 million of cash flows from operations in our Health Care and Group Insurance businesses during the six months ended June 30, 2014 and 2013, respectively. During 2014, these cash flows funded our ordinary course operating activities, repurchases of shares of our common stock, the payment of cash dividends to shareholders and the acquisition of the InterGlobal group ("InterGlobal"). We paid dividends to our shareholders of approximately $162 million and $131 million during the six months ended June 30, 2014 and 2013, respectively. In addition, we repurchased approximately 10 million and 11 million shares of common stock under our share repurchase programs at a cost of approximately $720 million and $625 million during the six months ended June 30, 2014 and 2013, respectively. Refer to "Liquidity and Capital Resources" beginning on page 49 and Note 11 of Condensed Notes to Consolidated Financial Statements on page 26 for additional information. Acquisition of Coventry Health Care, Inc. On August 19, 2012, we entered into a definitive agreement to acquire Coventry. On the Acquisition Date, we acquired Coventry in a transaction valued at approximately $8.7 billion, including the $1.8 billion fair value of Coventry's outstanding long-term debt. We recorded goodwill related to this acquisition of approximately $4.0 billion, of which $267 million will be tax deductible. Acquisition of InterGlobal In April 2014, we acquired InterGlobal, a company that specializes in international private medical insurance for groups and individuals in the Middle East, Asia, Africa and Europe. The purchase price was not material. Health Care Reform The Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 (collectively, "Health Care Reform" or "ACA") has changed and will continue to make broad-based changes to the U.S. health care system which could significantly affect the U.S. economy and we expect will continue to significantly impact our business operations and financial results, including our pricing, our medical benefit ratios ("MBRs") and the geographies in which our products are available. Health Care Reform presents us with new business opportunities, but also with new financial and regulatory challenges. It is reasonably possible that Health Care Reform, in the aggregate, could have a material adverse effect on our business operations and financial results. On October 1, 2013, public health insurance exchanges ("Public Exchanges") became available for consumers to access and begin the enrollment process for coverage beginning January 1, 2014. Through June 30, 2014, our Public Exchange membership has continued to exceed our initial projections. Page 37 -------------------------------------------------------------------------------- In addition, because we included a portion of the 2014 Health Care Reform fees, assessments and taxes in the pricing for our 2013 contract renewals with member months in 2014, we experienced a temporary operating earnings benefit in 2013. We expect this benefit to be greatly diminished in 2014. The non tax-deductible health insurer fee is payable in September 2014 and is being recorded within operating expenses, and we project that our expense for this fee in the year 2014 will be approximately $600 million. In aggregate, we expect our portion of the total fees, taxes and assessments imposed by Health Care Reform to be approximately $1.0 billion in 2014. Federal budget negotiations, the technical problems with the federal health insurance exchange website, ongoing regulatory changes to Health Care Reform (such as the November 2013 action permitting renewal through 2014 of individual and small group insurance policies that do not comply with Health Care Reform and the March 2014 action permitting such renewal through 2017), pending efforts in the U.S. Congress to amend or restrict funding for various aspects of Health Care Reform and litigation challenging aspects of the law continue to create uncertainty about the ultimate impact of Health Care Reform. Examples of this uncertainty include the conflicting decisions issued by the United States Courts of Appeals for the District of Columbia Circuit and for the Fourth Circuit on July 22, 2014, concerning whether the Internal Revenue Service may make tax credits available as a form of subsidy to individuals who purchase health insurance through Public Exchanges established by the federal government ("Federal Exchanges"). The District of Columbia Circuit ruled that tax subsidies are only available through Public Exchanges established by the states. It is expected that one or both of these cases will be subject to further appeal or review, possibly including review by the United States Supreme Court. The District of Columbia Circuit has issued a stay of its ruling, and we will continue to enroll and insure members through the Federal Exchanges pending the resolution of these and other pending cases. If the payment of subsidies with respect to members who enroll through the Federal Exchanges ultimately is invalidated, it could result in a significant reduction in Aetna's Public Exchange membership because almost all of Aetna's Public Exchange membership is through Federal Exchanges, and most of those members benefit from a tax subsidy. We cannot predict whether pending or future federal or state legislation or court proceedings, including the proceedings relating to tax credits for Federal Exchange members described above, will change various aspects of Health Care Reform or state level health care reform, nor can we predict the impact those changes will have on our business operations and/or financial results, but the effects could be materially adverse. In May 2014, the Centers for Medicare & Medicaid Services ("CMS") published a final rule on Public Exchanges. The final rule provides that payments to health plans under the risk corridor program required by Health Care Reform will no longer be limited to the aggregate amount of the risk corridor collections received by the U.S. Department of Health and Human Services ("HHS") over the duration of the program. For additional information on Health Care Reform, refer to "MD&A-Overview-Health Care Reform," "Regulatory Environment" and "Forward-Looking Information/Risk Factors" in our 2013 Annual Report. Medicare Update On April 7, 2014, CMS published final Medicare Advantage and prescription drug program ("PDP") premium rates for 2015. These rates reflect a reduction in 2015 premiums compared to 2014 for Medicare Advantage and PDP plans, and represent an aggregate high single digit funding decrease during 2014 and 2015 and a meaningful revenue and operating results challenge for us. This rate reduction is in addition to the challenge we face from the impact of the industry-wide health insurer fee that became effective January 1, 2014. In addition, in March 2014, the Protecting Access to Medicare Act of 2014 delayed for one year scheduled cuts in Medicare physician payments and delayed until October 1, 2015 the requirement that the health and related benefits industry upgrade to ICD-10, an updated and expanded set of standardized diagnosis and procedure codes used for describing health conditions. In the second quarter of 2014, CMS issued a final rule implementing the Health Care Reform requirements that Medicare Advantage and Part D plans report and refund to CMS overpayments that those plans receive from CMS. Page 38 -------------------------------------------------------------------------------- Board of Directors Update Olympia J. Snowe was appointed to our Board of Directors (our "Board") in July 2014, for a term that will run until our 2015 Annual Meeting of Shareholders. Ms. Snowe is a former United States Senator and currently is Chairman and Chief Executive Officer of Olympia Snowe, LLC, a policy and communications consulting firm. She also serves on our Board's Audit Committee and Medical Affairs Committee. With the addition of Ms. Snowe, our Board now consists of thirteen directors. Management Update In July 2014, Harold L. Paz, M.D., M.S., joined Aetna as Executive Vice President and Chief Medical Officer. Segment Results and Use of Non-GAAP Measures in this Document The following discussion of operating results is presented based on our reportable segments in accordance with the accounting guidance for segment reporting and consistent with our segment disclosure included in Note 14 of Condensed Notes to Consolidated Financial Statements beginning on page 31. Our operations are conducted in three business segments: Health Care, Group Insurance and Large Case Pensions. The acquired Coventry operations are reflected in our Health Care segment for 2014 and from the Acquisition Date through June 30, 2013 for the three and six months ended June 30, 2013. Our Corporate Financing segment is not a business segment; it is added to our business segments to reconcile our segment reporting to our consolidated results. The Corporate Financing segment includes interest expense on our outstanding debt and the financing components of our pension and other postretirement employee benefit plans ("OPEB") expense (the service cost and prior service cost components of this expense are allocated to our business segments). Our discussion of operating results is based on operating earnings. Operating earnings exclude from net income attributable to Aetna reported in accordance with GAAP, net realized capital gains or losses and amortization of other acquired intangible assets as well as other items, if any, that neither relate to the ordinary course of our business nor reflect our underlying business performance. Although the excluded items may recur, we believe excluding them from net income attributable to Aetna to arrive at operating earnings provides more meaningful information about our underlying business performance. Net realized capital gains and losses arise from various types of transactions, primarily in the course of managing a portfolio of assets that support the payment of liabilities, and amortization of other acquired intangible assets relates to our acquisition activities, including Coventry; however, these transactions and amortization do not directly relate to the underwriting or servicing of products for our customers and are not directly related to the core performance of our business operations. Operating earnings is the measure reported to our Chief Executive Officer for purposes of assessing financial performance and making operating decisions, such as the allocation of resources among our business segments. In each business segment discussion in this MD&A, we provide a table that reconciles operating earnings to net income attributable to Aetna. Each table details the net realized capital gains or losses, amortization of other acquired intangible assets and any other items excluded from net income attributable to Aetna, and the footnotes to each table describe the nature of each other item and why we believe it is appropriate to exclude that item from net income attributable to Aetna. Non-GAAP financial measures we disclose, such as operating earnings, should not be considered a substitute for, or superior to, financial measures determined or calculated in accordance with GAAP. Page 39--------------------------------------------------------------------------------HEALTH CARE Health Care consists of medical, pharmacy benefit management services, dental, behavioral health and vision plans offered on both an Insured basis and an ASC basis and emerging businesses products and services, such as ACS, that complement and enhance our medical products. Medical products include point-of-service ("POS"), preferred provider organization ("PPO"), health maintenance organization ("HMO") and indemnity benefit plans. Medical products also include health savings accounts ("HSAs") and Aetna HealthFund®, consumer-directed health plans that combine traditional POS or PPO and/or dental coverage, subject to a deductible, with an accumulating benefit account (which may be funded by the plan sponsor and/or the member in the case of HSAs). We also offer Medicare and Medicaid products and services and other medical products, such as medical management and data analytics services, medical stop loss insurance, workers' compensation administrative services and products that provide access to our provider networks in select geographies. We separately track premiums and health care costs for Government businesses (which represents our combined Medicare and Medicaid products); all other medical, dental and other Health Care products are referred to as Commercial. We refer to insurance products (where we assume all or a majority of the risk for medical and dental care costs) as "Insured" and administrative services contract products (where the plan sponsor assumes all or a majority of the risk for medical and dental care costs) as "ASC." Operating Summary for the Three and Six Months Ended June 30, 2014 and 2013: Three Months Ended Six Months Ended June 30, June 30, (Millions) 2014 2013 2014 2013 Premiums: Commercial $ 7,195.5 $ 6,068.0 $ 14,010.1 $ 11,282.0 Government 5,220.6 3,633.3 10,317.7 6,205.1 Total premiums 12,416.1 9,701.3 24,327.8 17,487.1 Fees and other revenue 1,261.2 1,089.8 2,480.9 2,027.2 Net investment income 88.7 80.2 175.6 153.6 Net realized capital gains (losses) 20.6 (23.8 ) 47.3 2.5 Total revenue 13,786.6 10,847.5 27,031.6 19,670.4 Health care costs 10,314.8 8,006.9 19,891.1 14,386.4 Operating expenses: Selling expenses 384.5 305.9 758.8 575.9 General and administrative expenses 2,123.5 1,735.7 4,107.9 3,109.6 Total operating expenses 2,508.0 2,041.6 4,866.7 3,685.5 Amortization of other acquired intangible assets 61.9 50.7 123.0 82.0 Total benefits and expenses 12,884.7 10,099.2 24,880.8 18,153.9 Income before income taxes 901.9 748.3 2,150.8 1,516.5 Income taxes 381.9 285.0 907.1 558.9 Net income including non-controlling interests 520.0 463.3 1,243.7 957.6 Less: Net (loss) income attributable to non-controlling interests (1.1 ) (3.0 ) .9 (3.4 ) Net income attributable to Aetna $ 521.1 $ 466.3 $ 1,242.8 $ 961.0 Page 40-------------------------------------------------------------------------------- The table presented below reconciles net income attributable to Aetna to operating earnings (1) for the three and six months ended June 30, 2014 and 2013: Three Months Ended Six Months Ended June 30, June 30, (Millions) 2014 2013 2014 2013 Net income attributable to Aetna $ 521.1 $ 466.3 $ 1,242.8 $ 961.0 Transaction and integration-related costs, net of tax 36.3 77.2 78.2 92.0 Release of litigation-related reserve, net of tax - - (67.0 ) - Amortization of other acquired intangible assets, net of tax 40.3 32.9 80.0 53.3 Net realized capital (gains) losses, net of tax (13.4 ) 15.7 (30.7 ) (1.0 ) Operating earnings $ 584.3 $ 592.1 $ 1,303.3 $ 1,105.3 (1) In addition to net realized capital gains and amortization of other acquired intangible assets, the following items are excluded from operating earnings because we believe they neither relate to the ordinary course of our business nor reflect our underlying business performance: • During the three and six months ended June 30, 2014, we incurred transaction and integration-related costs related to the acquisitions of Coventry and InterGlobal of $36.3 million ($55.8 million pretax) and $78.2 million ($119.5 million pretax), respectively, all of which was recorded in our Health Care segment. During the three and six months ended June 30, 2013, we incurred transaction and integration-related costs related to the acquisition of Coventry of $81.4 million ($101.3 million pretax) and $106.0 million ($138.4 million pretax), respectively, of which $77.2 million ($94.9 million pretax) and $92.0 million ($116.9 million pretax), respectively, were recorded in our Health Care segment. Transaction costs include advisory, legal and other professional fees which are not deductible for tax purposes and are reflected in our GAAP Consolidated Statements of Income in general and administrative expenses. Transaction costs also include transaction-related payments as well as expenses related to the negative cost of carry associated with the permanent financing that we obtained in November 2012 for the Coventry acquisition. Prior to the Acquisition Date, the negative cost of carry associated with the permanent financing was excluded from operating earnings. The components of the negative cost of carry are reflected in our GAAP Consolidated Statements of Income in interest expense, net investment income, and general and administrative expenses. On and after the Acquisition Date, the interest expense and general and administrative expenses associated with the permanent financing are no longer excluded from operating earnings. These are other items because they neither relate to the ordinary course of our business nor reflect our underlying business performance. • In the fourth quarter of 2012, we recorded a charge of $78.0 million ($120.0 million pretax) related to the settlement of purported class action litigation regarding Aetna's payment practices related to out-of-network health care providers. That charge included the estimated cost of legal fees of plaintiffs' counsel and the costs of administering the settlement. In the first quarter of 2014, we exercised our right to terminate the settlement agreement. As a result, we released the reserve established in connection with the settlement agreement, net of amounts due to the settlement administrator, which reduced first quarter 2014 other general and administrative expenses by $67.0 million ($103.0 million pretax). Refer to Note 13 beginning on page 28 for additional information on the termination of the settlement agreement. Operating earnings for the three months ended June 30, 2014 were relatively flat primarily as a result of the year-over-year decrease in favorable development of prior-period health care cost estimates in 2014 substantially offset by the May 2013 acquisition of Coventry. Operating earnings increased for the six months ended June 30, 2014 primarily as a result of the May 2013 acquisition of Coventry, as well as higher underwriting margins in both our Government and Commercial businesses. We calculate our medical benefit ratio ("MBR") by dividing health care costs by health care premiums. For the three and six months ended June 30, 2014 and 2013, our MBRs by product were as follows: Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 Commercial 80.6 % 79.1 % 78.9 % 79.0 % Government 86.5 % 88.3 % 85.6 % 88.2 % Total 83.1 % 82.5 % 81.8 % 82.3 % Refer to our discussion of Commercial and Government results below for an explanation of the changes in our premiums and MBRs. Page 41 -------------------------------------------------------------------------------- Commercial operating results for the three and six months ended June 30, 2014, reflect the full period impact of the May 2013 acquisition of Coventry and improved underwriting margins. Commercial premiums increased approximately $1.1 billion and $2.7 billion for the three and six months ended June 30, 2014, respectively, compared to the corresponding periods in 2013, as a result of the May 2013 acquisition of Coventry, as well as higher membership in our Commercial Insured business, the effects of pricing actions designed to recover ACA mandated fees and taxes and higher premium rates. For the three and six months ended June 30, 2014, based on our 2014 Public Exchange experience, there was no adjustment to commercial premiums to account for the risk adjustment and risk corridor provisions of Health Care Reform. Refer to Note 2 beginning on page 6 for additional information. Our Commercial MBR was 80.6% and 78.9% for the three and six months ended June 30, 2014, respectively, compared to 79.1% and 79.0% for the corresponding periods in 2013. The increase in our Commercial MBR during the three months ended June 30, 2014 is primarily a result of the year-over-year decrease in favorable development of prior-period health care cost estimates during 2014, costs associated with new hepatitis C treatments, and our 2014 public exchange membership, partially offset by higher premiums driven in part by pricing actions designed to recover ACA mandated fees and taxes. Our Commercial MBR was relatively flat during the six months ended June 30, 2014 compared to the corresponding period in 2013, as pricing actions designed to recover ACA mandated fees and taxes were substantially offset by the year-over-year decrease in favorable development of prior-years' health care cost estimates during 2014. Refer to "Critical Accounting Estimates - Health Care Costs Payable" in our 2013 Annual Report for a discussion of Health Care Costs Payable at December 31, 2013. Government results for the three and six months ended June 30, 2014, primarily reflect the full period impact of the acquisition of Coventry and improved underwriting margins. Government premiums increased approximately $1.6 billion and $4.1 billion for the three and six months ended June 30, 2014, respectively, compared to the corresponding periods in 2013 as a result of the May 2013 acquisition of Coventry, as well as membership growth in both our Medicare and Medicaid Insured products. Our Government MBR was 86.5% and 85.6% for the three and six months ended June 30, 2014, respectively, compared to 88.3% and 88.2% for the corresponding periods in 2013. The improvement in our Government MBR for both periods is primarily due to actions impacting revenue and medical costs designed to solve for the gap between Medicare premiums and medical costs and other expenses, including the health insurer fee. Fees and Other Revenue Health Care fees and other revenue increased approximately $171 million and $454 million for the three and six months ended June 30, 2014, respectively, compared to the corresponding periods in 2013 as a result of the inclusion of Coventry's service businesses, as well as growth in our ASC membership. General and Administrative Expenses General and administrative expenses increased approximately $388 million and $1.0 billion for the three and six months ended June 30, 2014, respectively, compared with the corresponding periods of 2013. The increase for the three months ended June 30, 2014 is due primarily to the inclusion of ACA mandated fees in 2014 as well as the inclusion of Coventry's general and administrative expenses, partially offset by continued execution of our expense initiatives, including execution on our Coventry-related cost synergies. The increase in general and administrative expenses for the six months ended June 30, 2014 is due primarily to the inclusion of Coventry's general and administrative expenses, as well as the inclusion of ACA mandated fees in 2014, partially offset by continued execution of our expense initiatives, including execution on our Coventry-related cost synergies, and the favorable impact of releasing a litigation-related reserve during the first quarter of 2014, which reduced general and administrative expenses by $103 million. Refer to Note 13 beginning on page 28 for additional information on the release of the litigation-related reserve. Page 42-------------------------------------------------------------------------------- Income Taxes Our effective tax rate for both the three and six months ended June 30, 2014 was 42 percent, compared to 38 percent and 37 percent for the three and six months ended June 30, 2013, respectively. The increase in our effective tax rate reflects the impact of the non-deductibility of the ACA mandated health insurer fee. Membership Health Care's membership at June 30, 2014 and 2013 was as follows: 2014 2013 (Thousands) Insured ASC Total Insured ASC Total Medical: Commercial 6,421 13,082 19,503 5,937 12,697 18,634 Medicare Advantage 1,113 - 1,113 948 - 948 Medicare Supplement 434 - 434 341 - 341 Medicaid 1,315 739 2,054 1,169 876 2,045 Total Medical Membership 9,283 13,821 23,104 8,395 13,573 21,968 Consumer-Directed Health Plans (1) 3,566 3,253 Dental: Total Dental Membership 5,883 8,556 14,439 5,466 8,788 14,254 Pharmacy: Commercial 10,840 10,062 Medicare PDP (stand-alone) 1,609 2,084 Medicare Advantage PDP 735 572 Medicaid 2,105 1,128 Total Pharmacy Benefit Management Services 15,289 13,846 (1) Represents members in consumer-directed health plans who also are included in Commercial medical membership above. Total medical membership at June 30, 2014 increased compared to June 30, 2013, reflecting growth in our Commercial, Medicare and Insured Medicaid products which was partially offset by a reduction in our Medicaid ASC products. Total dental membership at June 30, 2014 increased compared to June 30, 2013 primarily reflecting growth in our Insured dental products partially offset by a reduction in our ASC dental products. Total pharmacy benefit management services membership increased at June 30, 2014 compared to June 30, 2013 primarily reflecting growth in our Medicaid products and Commercial business which was partially offset by a decline in our Medicare products. Page 43--------------------------------------------------------------------------------Health Care Costs Payable The following table shows the components of the change in health care costs payable during the six months ended June 30, 2014, 2013 and 2012: (Millions) 2014 2013 2012 Health care costs payable, beginning of period $ 4,547.4 $ 2,992.5 $ 2,675.5 Less: reinsurance recoverables 8.5 3.8 3.3 Health care costs payable, beginning of period, net 4,538.9 2,988.7 2,672.2 Acquisition of businesses 29.2 1,440.1 - Add: Components of incurred health care costs: Current year 20,423.1 14,756.0 11,929.3 Prior years (531.9 ) (369.6 ) (163.5 ) Total incurred health care costs 19,891.2 14,386.4 11,765.8 Less: Claims paid Current year 15,365.0 11,800.9 9,326.1 Prior years 3,730.4 2,437.0 2,231.5 Total claims paid 19,095.4 14,237.9 11,557.6 Disposition of business - (42.3 ) - Health care costs payable, end of period, net 5,363.9 4,535.0 2,880.4 Add: reinsurance recoverables 8.0 5.5 3.1 Health care costs payable, end of period $ 5,371.9 $ 4,540.5 $ 2,883.5 Our estimates of prior years' health care costs payable decreased by approximately $532 million and $370 million in the six months ended June 30, 2014 and 2013, respectively, resulting from claims being settled for amounts less than originally estimated, primarily due to lower health care cost trends than we assumed in establishing our health care costs payable in the prior years. The May 7, 2013 acquisition of Coventry significantly impacts the year-over-year comparability of these decreases. This development does not directly correspond to an increase in our current year operating results as these reductions were offset by estimated current period health care costs when we established our estimate of current year health care costs payable. GROUP INSURANCE Group Insurance primarily includes group life insurance and group disability products. Group life insurance products are offered on an Insured basis and include basic and supplemental group term life, group universal life, supplemental or voluntary programs and accidental death and dismemberment coverage. Group disability products primarily consist of short-term and long-term disability products (and products which combine both), which are offered to employers on both an Insured and an ASC basis, and absence management services offered to employers, which include short-term and long-term disability administration and leave management. Group Insurance also includes long-term care products that were offered primarily on an Insured basis, which provide benefits covering the cost of care in private home settings, adult day care, assisted living or nursing facilities. We no longer solicit or accept new long-term care customers. Page 44-------------------------------------------------------------------------------- Operating Summary for the Three and Six Months Ended June 30, 2014 and 2013: Three Months Ended Six Months Ended June 30, June 30, (Millions) 2014 2013 2014 2013 Premiums: Life $ 315.4 $ 290.0 $ 619.5 $ 577.0 Disability 203.5 185.2 406.1 365.4 Long-term care 11.2 11.2 22.2 22.6 Total premiums 530.1 486.4 1,047.8 965.0 Fees and other revenue 25.9 34.4 52.6 61.1 Net investment income 70.4 68.8 138.0 144.8 Net realized capital gains (losses) 1.3 (2.5 ) 4.2 3.0 Total revenue 627.7 587.1 1,242.6 1,173.9 Current and future benefits 440.2 440.0 892.0 876.3 Operating expenses: Selling expenses 28.5 26.3 57.0 53.5 General and administrative expenses 81.1 75.0 160.7 149.1 Reversal of allowance on reinsurance recoverable - (42.2 ) - (42.2 ) Total operating expenses 109.6 59.1 217.7 160.4 Amortization of other acquired intangible assets - 1.1 1.1 2.2 Total benefits and expenses 549.8 500.2 1,110.8 1,038.9 Income before income taxes 77.9 86.9 131.8 135.0 Income taxes 16.5 26.4 28.0 38.5 Net income including non-controlling interests 61.4 60.5 103.8 96.5 Less: Net income attributable to non-controlling interests - .2 - 1.4 Net income attributable to Aetna $ 61.4 $ 60.3 $ 103.8 $ 95.1 The table presented below reconciles net income attributable to Aetna to operating earnings for the three and six months ended June 30, 2014 and 2013: Three Months Ended Six Months Ended June 30, June 30, (Millions) 2014 2013 2014 2013 Net income attributable to Aetna $ 61.4 $ 60.3 $ 103.8 $ 95.1 Reversal of allowance and gain on sale of reinsurance recoverable, net of tax (1) - (32.1 ) - (32.1 ) Amortization of other acquired intangible assets, net of tax - .7 .7 1.4 Net realized capital (gains) losses, net of tax (.8 ) 1.7 (2.7 ) (1.9 ) Operating earnings $ 60.6 $ 30.6 $ 101.8 $ 62.5 (1) In 2008, as a result of the liquidation proceedings of Lehman Re Ltd. ("Lehman Re"), a subsidiary of Lehman Brothers Holdings Inc., we recorded an allowance against our reinsurance recoverable from Lehman Re of $27.4 million ($42.2 million pretax). This reinsurance was placed in 1999 and was on a closed book of paid-up group whole life insurance business. In the second quarter of 2013, we sold our claim against Lehman Re to an unrelated third party (including the reinsurance recoverable) and terminated the reinsurance arrangement. Upon the sale of the claim and termination of the arrangement, we released the related allowance thereby reducing other general and administrative expenses by $27.4 million ($42.2 million pretax) and recognized a $4.7 million ($7.2 million pretax) gain on the sale in fees and other revenue. These are other items in the second quarter of 2013 because they neither relate to the ordinary course of our business nor reflect underlying 2013 business performance. Operating earnings for the three and six months ended June 30, 2014 increased when compared to the corresponding periods in 2013, due to higher underwriting margins, reflecting improved experience in our disability and life products. The life underwriting margin during the three months ended June 30, 2014 is more consistent with historical experience than the three months ended June 30, 2013. Page 45 -------------------------------------------------------------------------------- The group benefit ratio, which represents current and future benefits divided by premiums, was 83.0% and 85.1% for the three and six months ended June 30, 2014, respectively, and 90.5% and 90.8% for the three and six months ended June 30, 2013, respectively. The improvement in our group benefit ratio in 2014 reflects higher underwriting margins in our disability and life products. LARGE CASE PENSIONS Large Case Pensions manages a variety of retirement products (including pension and annuity products) primarily for tax-qualified pension plans. These products provide a variety of funding and benefit payment distribution options and other services. The Large Case Pensions segment includes certain discontinued products. Operating Summary for the Three and Six Months Ended June 30, 2014 and 2013: Three Months Ended Six Months Ended June 30, June 30, (Millions) 2014 2013 2014 2013 Premiums $ 21.6 $ 27.9 $ 65.5 $ 70.6 Net investment income 69.2 76.0 158.9 161.7 Other revenue 2.4 2.4 4.8 4.7 Net realized capital gains (losses) 1.9 (3.5 ) .8 (5.0 ) Total revenue 95.1 102.8 230.0 232.0 Current and future benefits 85.4 99.1 212.3 222.1 General and administrative expenses 3.0 3.2 6.0 6.4 Reduction of reserve for anticipated future losses on discontinued products - (86.0 ) - (86.0 ) Total benefits and expenses 88.4 16.3 218.3 142.5 Income before income taxes (benefits) 6.7 86.5 11.7 89.5 Income taxes (benefits) .6 29.0 (.4 ) 26.8 Net income including non-controlling interests 6.1 57.5 12.1 62.7 Less: Net (loss) income attributable to non-controlling interests (.5 ) - 1.4 - Net income attributable to Aetna $ 6.6 $ 57.5 $ 10.7 $ 62.7 The table presented below reconciles net income attributable to Aetna to operating earnings for the three and six months ended June 30, 2014 and 2013: Three Months Ended Six Months Ended June 30, June 30, (Millions) 2014 2013 2014 2013 Net income attributable to Aetna $ 6.6 $ 57.5 $ 10.7 $ 62.7 Reduction of reserve for anticipated future losses on discontinued products, net of tax (1) - (55.9 ) - (55.9 ) Net realized capital (gains) losses, net of tax (1.2 ) 2.2 (.5 ) 3.2 Operating earnings $ 5.4 $ 3.8 $ 10.2 $ 10.0 (1) In 1993, we discontinued the sale of our fully guaranteed large case pension products and established a reserve for anticipated future losses on these products, which we review quarterly. Changes in this reserve are recognized when deemed appropriate. In the second quarter of 2013, we reduced the reserve for anticipated future losses on discontinued products by $55.9 million ($86.0 million pretax). We believe excluding any changes in the reserve for anticipated future losses on discontinued products from operating earnings provides more useful information as to our continuing products and is consistent with the treatment of the operating results of these discontinued products, which are credited or charged to the reserve and do not affect our operating results. Discontinued Products Prior to 1993, we sold single-premium annuities ("SPAs") and guaranteed investment contracts ("GICs"), primarily to employer sponsored pension plans. In 1993, we discontinued selling these products to Large Case Pensions customers, and now we refer to these products as discontinued products. Page 46 -------------------------------------------------------------------------------- We discontinued selling these products because they were generating losses for us, and we projected that they would continue to generate losses over their life (which is currently greater than 30 years for SPAs); so we established a reserve for anticipated future losses at the time of discontinuance. At both June 30, 2014 and December 31, 2013, our remaining GIC liability was not material. We provide additional information on the reserve for anticipated future losses, including key assumptions and other important information, in Note 16 of Condensed Notes to Consolidated Financial Statements beginning on page 33. The operating summary for Large Case Pensions above includes revenues and expenses related to our discontinued products, with the exception of net realized capital gains and losses which are recorded as part of current and future benefits. Since we established a reserve for anticipated future losses on discontinued products, as long as our expected future losses remain consistent with prior projections, the results of our discontinued products are applied against the reserve and do not impact net income attributable to Aetna for Large Case Pensions. If actual or expected future losses are greater than we currently estimate, we may increase the reserve, which could adversely impact net income attributable to Aetna. If actual or expected future losses are less than we currently estimate, we may decrease the reserve, which could favorably impact net income attributable to Aetna. In those cases, we disclose such adjustment separately in the operating summary. Management reviews the adequacy of the discontinued products reserve quarterly. As a result of this review, $55.9 million ($86.0 million pretax) of the reserve was released in the three and six months ended June 30, 2013. This reserve release was primarily due to favorable investment performance as well as favorable retirement experience compared to assumptions we previously made in estimating the reserve. The current reserve reflects management's best estimate of anticipated future losses, and is included in future policy benefits on our balance sheet. Refer to Note 16 of the Condensed Notes to Consolidated Financial Statements beginning on page 33 for additional information on the activity in the reserve for anticipated future losses on discontinued products for the six months ended June 30, 2014 and 2013. INVESTMENTS At June 30, 2014 and December 31, 2013 our investment portfolio consisted of the following: June 30, December 31, (Millions) 2014 2013 Debt and equity securities available for sale $ 20,778.1 $ 19,730.4 Mortgage loans 1,605.1 1,549.6 Other investments 1,771.5 1,718.8 Total investments $ 24,154.7 $ 22,998.8 Investment risks associated with our experience-rated and discontinued products generally do not impact our operating results. Our investment portfolio supported the following products at June 30, 2014 and December 31, 2013: June 30, December 31, (Millions) 2014 2013 Experience-rated products $ 1,503.4 $ 1,458.1 Discontinued products 3,537.7 3,443.5 Remaining products 19,113.6 18,097.2 Total investments $ 24,154.7 $ 22,998.8 Page 47-------------------------------------------------------------------------------- The risks associated with investments supporting experience-rated pension and annuity products in our Large Case Pensions business are assumed by the contract holders and not by us (subject to, among other things, certain minimum guarantees). Assets supporting experience-rated products may be subject to contract holder or participant withdrawals. Experience-rated contract holder and participant-directed withdrawals for the three and six months ended June 30, 2014 and 2013 were as follows: Three Months Ended Six Months Ended June 30, June 30, (Millions) 2014 2013 2014 2013 Scheduled contract maturities and benefit payments (1) $ 46.7 $ 59.4 $ 105.0 $ 118.5 Contract holder withdrawals other than scheduled contract maturities and benefit payments 1.8 1.8 3.0 3.9 Participant-directed withdrawals 1.1 .6 2.2 1.5 (1) Includes payments made upon contract maturity and other amounts distributed in accordance with contract schedules. Debt and Equity Securities The debt securities in our investment portfolio had an average credit quality rating of A at both June 30, 2014 and December 31, 2013, with approximately $4.7 billion and $4.5 billion rated AAA at June 30, 2014 and December 31, 2013, respectively. The debt securities that were rated below investment grade (that is, having a credit quality rating below BBB-/Baa3) were $1.4 billion and $1.2 billion at June 30, 2014 and December 31, 2013, respectively (of which 18% and 17% at June 30, 2014 and December 31, 2013, respectively, supported our experience-rated and discontinued products). At June 30, 2014 and December 31, 2013, we held approximately $770 million and $747 million, respectively, of municipal debt securities that were guaranteed by third parties, representing approximately 3% of our total investments at each date. These securities had an average credit quality rating of AA- and A at June 30, 2014 and December 31, 2013, respectively, with the guarantee. These securities had an average credit quality rating of A at both June 30, 2014 and December 31, 2013 without the guarantee. We do not have any significant concentration of investments with third party guarantors (either direct or indirect). At both June 30, 2014 and December 31, 2013, less than 1% of our investment portfolio was comprised of investments that were either European sovereign, agency, or local government debt or European corporate issuers of countries which, in our judgment based on an analysis of market-yields, are experiencing economic, fiscal or political strains such that the likelihood of default may be higher than if those factors did not exist. We classify our debt and equity securities as available for sale, and carry them at fair value on our balance sheet. Approximately 1% of our debt and equity securities at both June 30, 2014 and December 31, 2013 were valued using inputs that reflect our own assumptions (categorized as Level 3 inputs in accordance with GAAP). Refer to Note 8 of Condensed Notes to Consolidated Financial Statements beginning on page 18 for additional information on the methodologies and key assumptions we use to determine the fair value of investments. At June 30, 2014 and December 31, 2013, our debt and equity securities had net unrealized capital gains of $1.4 billion and $756 million, respectively, of which $397 million and $231 million, respectively, related to our experience-rated and discontinued products. Refer to Note 6 of Condensed Notes to Consolidated Financial Statements beginning on page 11 for details of gross unrealized capital gains and losses by major security type, as well as details on our debt securities with unrealized capital losses at June 30, 2014 and December 31, 2013. We regularly review our debt securities to determine if a decline in fair value below the carrying value is other-than-temporary. If we determine a decline in fair value is other-than-temporary, we will write down the carrying value of the security. The amount of the credit-related impairment is included in our operating results, and the non-credit component is included in other comprehensive income unless we intend to sell the security or it is more likely than not that we will be required to sell the debt Page 48 -------------------------------------------------------------------------------- security prior to its anticipated recovery. Accounting for other-than-temporary impairment ("OTTI") of our debt securities is considered a critical accounting estimate. Refer to "Critical Accounting Estimates - Other-Than-Temporary Impairment of Debt Securities" in our 2013 Annual Report for additional information. Net Realized Capital Gains and Losses Net realized capital gains were $15 million ($24 million pretax) and $34 million ($52 million pretax) and for the three and six months ended June 30, 2014, respectively. Net realized capital gains for the six months ended June 30, 2014 include a $12 million pretax gain on the termination of interest rate swaps. Net realized capital losses were $20 million ($30 million pretax) for the three months ended June 30, 2013. During the six months ended June 30, 2013, we did not have any material net realized capital gains. Refer to Note 10 of Condensed Notes to Consolidated Financial Statements beginning on page 25 for additional information on the termination of the interest rates swaps. We had no individually material realized capital losses on debt or equity securities that impacted our operating results during the three or six months ended June 30, 2014 or 2013. Mortgage Loans Our mortgage loan portfolio (which is collateralized by commercial real estate) represented approximately 7% of our total invested assets at both June 30, 2014 and December 31, 2013. There were no material impairment reserves on these loans at June 30, 2014 or December 31, 2013. Refer to Note 6 of Condensed Notes to Consolidated Financial Statements on page 11 for additional information on our mortgage loan portfolio. Risk Management and Market-Sensitive Instruments We manage interest rate risk by seeking to maintain a tight match between the durations of our assets and liabilities when appropriate. We manage credit risk by seeking to maintain high average credit quality ratings and diversified sector exposure within our debt securities portfolio. In connection with our investment and risk management objectives, we also use derivative financial instruments whose market value is at least partially determined by, among other things, levels of or changes in interest rates (short-term or long-term), duration, prepayment rates, equity markets or credit ratings/spreads. Our use of these derivatives is generally limited to hedging risk and has principally consisted of using interest rate swaps, forward contracts, futures contracts, warrants, put options and credit default swaps. These instruments, viewed separately, subject us to varying degrees of interest rate, equity price and credit risk. However, when used for hedging, we expect these instruments to reduce overall risk. We regularly evaluate our risk from market-sensitive instruments by examining, among other things, levels of or changes in interest rates (short-term or long-term), duration, prepayment rates, equity markets or credit ratings/spreads. We also regularly evaluate the appropriateness of investments relative to our management-approved investment guidelines (and operate within those guidelines) and the business objectives of our portfolios. On a quarterly basis, we review the impact of hypothetical net losses in our investment portfolio on our consolidated near-term financial position, operating results and cash flows assuming the occurrence of certain reasonably possible changes in near-term market rates and prices. Interest rate changes (whether resulting from changes in Treasury yields or credit spreads or other factors) represent the most material risk exposure category for us. Based upon this analysis, there have been no material changes in our exposure to these risks since December 31, 2013. Refer to the MD&A in our 2013 Annual Report for a more complete discussion of risk management and market-sensitive instruments. LIQUIDITY AND CAPITAL RESOURCES Cash Flows We meet our operating cash requirements by maintaining liquidity in our investment portfolio, using overall cash flows from premiums, fees and other revenue, deposits and income received on investments, issuing commercial paper and entering into repurchase agreements from time to time. We monitor the duration of our investment portfolio of highly marketable debt securities and mortgage loans, and execute purchases and sales of these investments with the objective of having adequate funds available to satisfy our maturing liabilities. Overall cash flows are used primarily for claim and benefit payments, operating expenses, share and debt repurchases, Page 49 --------------------------------------------------------------------------------acquisitions, contract withdrawals and shareholder dividends. We have committed short-term borrowing capacity of $2.0 billion through a revolving credit facility agreement that expires in March 2019. Presented below is a condensed statement of cash flows for the six months ended June 30, 2014 and 2013. On May 7, 2013, we completed the acquisition of Coventry, which is reflected in our cash flows for the six months ended June 30, 2013. In addition, Coventry's results are reflected in our cash flows for the six months ended June 30, 2014 and from the Acquisition Date through June 30, 2013 for the six months ended June 30, 2013. We present net cash flows used for operating activities and net cash flows provided by investing activities separately for our Large Case Pensions segment because changes in the insurance reserves for the Large Case Pensions segment (which are reported as cash used for operating activities) are funded from the sale of investments (which are reported as cash provided by investing activities). Refer to the Consolidated Statements of Cash Flows on page 5 for additional information. |