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HARTFORD, Conn.-Aetna Inc.'s reserve charge and lower-than-expected third-quarter earnings are a temporary glitch caused by its absorption of U.S. Healthcare Inc., analysts say.

Most analysts expect Aetna will put its problems behind it by next year.

Aetna, which acquired U.S. Healthcare in April 1996 for $8.9 billion (BI, April 8, 1996), has 11.1 million members in its HMO, point-of-service and preferred provider organization plans.

Aetna announced last week that it would report earnings per share of 95 cents to $1.10 a share, rather than analysts' estimated $1.31 a share. The company also said it would post a $75 million to $105 million aftertax charge to increase its health maintenance organization medical claims reserves.

The third-quarter announcement follows first-half operating earnings of $392.6 million, excluding unusual items, up 35.2% over 1996's first half (BI, Sept. 15). U.S. Healthcare was not included in first-half 1996 earnings.

Following the announcement, Aetna's share price dropped by $9.50 on Monday, to $81. The stock closed Friday at $77.94 a share.

"Recently it became clear that HMO medical costs in this and prior periods were higher than we originally estimated," Aetna Inc. President Richard Huber said in a statement. "This new information has affected our outlook for the third and fourth quarters."

CIGNA Corp., which acquired Healthsource Inc. this year, said it also expects to report third-quarter earnings 3% to 4% below analysts' estimates. It attributes the drop to higher-than-expected medical delivery costs and the general medical cost trend.

Mr. Huber attributed part of Aetna's problem to its U.S. Healthcare Inc. acquisition. "First, the impact of an increase in the level of unpaid claims was larger than we originally realized. The level increased as we continued toconsolidate claims offices and convert claims processing to common systems. Second, medical costs will be adversely affected by the timing of the implementation of new contracts with medical service providers."

Mr. Huber said Aetna has taken steps to better analyze and manage unpaid claims and improve claims handling. Progress on provider recontracting and medical management consolidation should help the company to control medical cost growth, he added.

An Aetna spokeswoman said the company had been trying to accomplish several things at once, including consolidating its 44 service centers, with 17 already closed or about to close; combining its 63 patient management centers into eight regional centers and a handful of others; and recently completing the integration of Aetna's computer system platform into U.S. Healthcare's.

While those tasks were undertaken, however, the level of unpaid claims increased. "You don't realize the financial impact" of those unpaid claims "because then there's an information lag" on issues such as number of doctor visits per month, she said.

Another factor, she said, is "provider recontracting was slower than we thought, by about three to six months." Because of the claims backlog, lower utilization rates and prices were factored into the contracts.

The spokeswoman said about half of the company's commercial HMO business renews in January, and the majority has either already been put out for bid, or is in negotiations, where a rebid is not feasible. "That is why we are saying the higher medical costs are going to impact third- and fourth-quarter results and also into 1998," she said.

The remaining half, which renews throughout the year, "would be open to higher pricing," she said, which could take the form of higher copayments or adjustments in benefit levels.

Analysts say Aetna's integration of U.S. Healthcare may have been more complicated than originally anticipated.

"It's somewhat uncommon for difficulties with medical costs to come to light at this point," said Rob Mains, an analyst with Advest Inc. in Albany, N.Y. Usually, companies become aware of these difficulties in the first or second quarter. "I think in Aetna's case it underscores some of the issues that can be faced when completing a large acquisition."

"Two things have happened with them," said Arun N. Kumar, director at rating agency Standard & Poor's Corp. in New York. "One is the backlog of claims, which is probably the cause of an accelerated integration with U.S. Healthcare, and the second one is an overall increase in the medical loss ratio for the year."

The first problem, said Mr. Kumar, is "due to larger bumps in the integration plan that they originally anticipated or expected. They expected the integration to go fairly smoothly, although it was on a very aggressive scale and they're finding out.*.*.*that's causing them a lot of problems" from both an operational and a financial perspective. "That was clearly not apparent to them," and all of a sudden the company found itself faced with a backlog of claims and a pretax charge of $75 million to $105 million, he said.

"That's a pretty big number, because nobody expected this and neither did they, and I'm sure if they had to do it all over again, the integration would have gone on at a less aggressive scale," said Mr. Kumar.

The reserve increase and lower-than-expected earnings "reflects the real difficulty in acquiring and integrating a health insurance operation," said Douglas L. Meyer, an analyst with Duff & Phelps Credit Rating Co. in Chicago.

"It's a very difficult process, effectively integrating a business of this nature, because of the short-tail nature and the real potential for mispricing.

"And that's essentially what happened with these guys. They focused a lot on merging a lot of the claims operations in order to realize the expense savings that was contemplated as part of the acquisition, but in doing so.*.*.they missed the increasing claims costs that they were experiencing," which went undetected for a long period of time, Mr. Meyer said.

"The whole issue of pricing, when it comes to health insurance, is looking at your claims experience, and where that is going-up, down or sideways-and you make pricing decisions based on your claims experience. So, to the extent you have good information with regard to your claims experience, you can make good pricing decisions."

In Aetna's case, said Mr. Meyer, the claims deterioration "went undetected for a period of time because of all the integration activity." That not only affected results but also resulted in some mispricing, he said.

Aetna's experience is not very different from "other company consolidations that have taken place in the health insurance business" and "just reflects the difficulty in integrating two different health insurance operations," he added.

Mark Jamilkowski, an HMO analyst with Conning & Co. in Hartford, Conn., said he believes many of Aetna's problems actually lie with the core system the company had before the merger.

Conning's impression of U.S. Healthcare's systems before the merger was that they were complete. Aetna's system, though, was "very much based off the indemnity platform, and when Aetna acquired HMOs, they did not consolidate their information bases, leading to disjointed and often inconsistent databases or systems. So, when they went forward to integrate the two, they most likely found more holes in the Aetna data than could be filled simply by expert opinion."

These holes would have hampered targeting of cases or individuals that need medical management, said Mr. Jamilkowski.

When former U.S. Healthcare personnel putting Aetna information into the system found information gaps, "they had to fill those gaps with something, some sort of guesstimate. It seems plausible to assume that some of their estimates may have been off the mark," Mr. Jamilkowski said.

Michael LeConey, an analyst with National Securities in New York, cited inadequate pricing. "It should be no surprise it's taken them longer than they had expected" for prices to improve. "It always takes longer to turn pricing in the health insurance business or health benefits business than people think, and that's exactly what's occurred here."

Most observers believe Aetna can solve its difficulties, however. "They're definitely going in the right direction, and they have a strong management team, so I think they've addressed the problem, and I think they'll continue to monitor the situation," said Ken Frino, a financial analyst with A.M. Best Co. in Oldwick, N.J.

"It'll probably be about six to nine months before you can really see something, but you will see improvement," he predicted.

"I think margins will turn sometime in 1998, and we will have earnings from Aetna that are surprisingly good, not surprisingly bad," said Mr. LeConey. "But that's probably two quarters away," he added.

Aetna has a "clear, excellent franchise in the business" and can overcome its problems in 1998 and "continue to be the very strong player that they are," said S&P's Mr. Kumar. "Their earnings, despite these one-time charges, will be strong for the year relative to other managed health care companies," he said.

"The company should be able to turn this around," probably next year, said David Matthews, associate director at Fitch Investors Service in New York. He added Aetna's operations include international and retirement services businesses, "so the entire franchise is fairly broad, and what may have been a glitch in this area of their business shouldn't drag everything down with it."

"To the extent the other businesses are going well," once this situation is turned around, "the company should return to good, steady operating performance," said Mr. Matthews. Additional time, he added, will give Aetna the experience needed to assimilate the U.S. Healthcare business.

"If you recall, years ago, when Aetna still had its P/C operations, they had bigger problems to deal with back then, and I think, they had the wherewithal and the resources to get through. I think this situation is probably not as serious as that was back then," said Mr. Matthews.

However, Mr. Jamilkowski said there is a "relatively uncertain future at this point. I think a lot of people are going to sit back and wait and see" over the next six months if Aetna can solve the issue it has identified in its announcement. This has really "hurt their credibility," he said.

"By the same token, the stock has fallen to a point where it is trading at a relatively low multiple of its book value, so there's the potential that at some point. . .it becomes a value play" for some investors.