Though the U.S. Health insurance industry continues to be relatively immune to economic difficulties, it has been still grappling with fundamental changes and consequent growth pangs. The industry has been facing its share of problems related to a sluggish economic recovery, uncertainty surrounding the health care reform law and increased regulatory control.
Despite the odds, the industry remains profitable, with the top six players -- UnitedHealth Group Inc. (UNH - Analyst Report), CIGNA Corp. (CI - Analyst Report), WellPoint Inc. (WLP - Analyst Report), Aetna Inc. (AET - Analyst Report), Humana Inc. (HUM - Analyst Report), Coventry Health Care Inc. (CVH) -- reporting year-over-year earnings growth in FY11.
About the Industry
The U.S. Health and Medical Insurance industry is an integral part of the U.S. economy. According to the Centers for Medicare and Medicaid Services, U.S. health expenditures account for about 18% of the country’s GDP. According to the World Health Organization, health care expenditure per person is higher in the United States than any other nation in the world.
Despite rapidly growing spending on health care over the past few decades, the health insurance industry has been characterized by growing premiums, limited policy choice and lack of transparency.
Over the past 10 years, health insurance premiums have increased consistently, outpacing the growth of wages and cost of living. Premium surge (owing to complex connections among health insurance companies, health care providers, pharmaceutical manufacturers and the medical technology industry) has been witnessed in both employer-sponsored insurance as well as individual insurance.
Total premiums for employer-sponsored insurance doubled in the period of 1999-2009. The individual market also saw rapid growth in the cost of premium. As a result, only 5% of non-elderly Americans were insured. According to the United States Census Bureau, in 2009 there were 50.7 million people in the U.S (16.7% of the population) who were uninsured. The percentage of uninsured non-elderly population has been on a continuous rise since 2000. Insurance companies have also been known to deny coverage in case of pre-existing diseases, and for charging higher premium in the individual market.
Increasing industry consolidation also limited insurance choice for Americans, who were reeling under rising health care costs. Since 1996, the industry has witnessed acquisitions worth approximately $90 billion, resulting in dominance by just a few players. During 1990-2000, the industry witnessed approximately 400 big and small mergers and acquisitions (M&A).
Consolidation and market dominance consequently led to a decline in competition. Big insurers dominating large markets hardly ever bothered to provide even the basic information to consumers, such as the performance of health insurance policies, procedures to claim, the size of the provider network and cancellation procedures.
Moreover, in the absence of any reason to lower policyholders’ cost, insurance companies went on increasing profits year after year. Recent economic data from HealthReform.gov showed that the profits of the ten largest insurance companies increased 250% between 2000 and 2009 -- ten times faster than inflation. Though the industry saw lower enrollment (medical membership) due to the latest recession, major health insurance companies managed to remain profitable by increasing their insurance premiums.
Looking at the other end of the spectrum, health insurance companies also benefited from low utilization amid recessionary conditions. A high deductible and high out-of-pocket cost kept the cash-strapped Americans away from the clinics, leading to lower utilization of health care services. A recent analysis by the Kaiser Family Foundation revealed that people with insurance opted for medical checkups less frequently, with the number dropping dramatically after the recession technically ended. The year 2011 saw suppressed utilization trends relative to historical levels.
This trend, witnessed over the past couple of years, has played a prominent role in helping major players in the health insurance sector to earn significant profits. Most of the carriers continued to beat earnings estimates, benefiting from lower claim payments. But recently insurers have started warning that they expect medical utilization patterns to return to normal levels in 2012.
However, low medical utilization is a short-term factor affecting the industry. Over the longer term, issues including the effects of the Health Care Reform and the changing economy and demography will revamp the industry.
Health Care Overhaul
The Patient Protection and Affordable Care Act was passed in 2010, and marked the beginning of a multiyear implementation process. It is the most substantial overhaul in the history of the nation’s health care sector.
The reform was intended to provide coverage to the 32 million uninsured Americans, make health care facilities more affordable, expand coverage for customers with pre-existing health conditions and keep a check over health insurers. The legislation’s detractors contest many of its stated benefits and consider it another entitlement program that the country can ill afford.
Certain significant provisions of the legislation pertain to mandated coverage requirements, rebates to policyholders based on minimum benefit ratios (which measures underwriting profitability and is computed by taking the total benefit expenses as a percentage of the premium revenues), adjustments to Medicare Advantage premiums, the establishment of state-based exchanges, greater investment in health IT and an annual insurance industry premium based assessment. The individual mandate requirement of the legislation is being contested in the courts, with the final outcome of that adjudication process far from certain at this stage.
Possible Outcomes of the Reform
The proponents of the legislation claim that upon its full implementation in 2018, the reform will end discrimination policy of insurance companies, create competition amongst insurers through healthy exchange, add value to the overall health care system and lower premiums.
Some of the provisions and their possible effects on health insurers are as follows:
According to the law, any proposed rate increase above 10% will be reviewed more closely by both the state and federal governments, and approval will be granted only if the increase seems justified. This is expected to slow down insurers’ premium escalation, thereby restricting top-line growth.
Beginning in 2011, the provision of maintaining 80% of minimum loss ratio (MLR) on individual policies became effective. Also, the requirement of 85% MLR for Commercial policies will be effective from 2012. These provisions will lead to limited bottom-line growth as carriers will be forced to spend a minimum amount on the insured. A failure to abide by the MLR rule will force carriers to rebate the excess cash back to the insured or to lower premiums.
The law also requires insurance coverage for people with pre-existing conditions at the standard rates. This will lead to lower profit per policy compared to earlier where individuals with pre-existing conditions were charged two to five times more than people with average health for the same policy.
While the federal government has issued a number of regulations, implementing Health Care Reform, many significant parts of the legislation, including health insurance exchanges ("Insurance Exchanges"), premium rate review, the scope of "essential health benefits," employer penalties and the implementation of minimum medical loss ratio (“MLRs”), requires further guidance and clarification at the federal level. As a result, the impact of the Health Care Reform will not be evident in the near term.
Nevertheless, the range of possible changes due to the Health Insurance Reform Legislation could change the way insurance companies do their business. This will potentially impact pricing, product mix, geographic mix and distribution channels. The fundamental and potentially game-changing developments could threaten carriers’ ability to achieve top and bottom-line growth.
Recent Issues Concerning the Sector
The sector is currently being subjected to both legislative and political issues.
Legislative – Certain aspects of the Health Reform Legislation have been challenged in the federal courts, with detractors attempting to challenge the scope of the law or even declare some parts of it unconstitutional. The United States Supreme Court heard arguments on certain aspects of these cases in March 2012, including the constitutionality of the individual mandate and expansion of Medicaid in 26 states. Both these provisions are scheduled to be implemented in 2014.
According to the individual mandate provision, which will be effective since 2014, all individuals will have to purchase a minimum level of health insurance coverage or pay a financial penalty.
Those debating against the law opine that the individual mandate is unconstitutional and thus a violation of the fundamental rights of Americans. A three-day session was conducted in the Supreme Court debating the provisions of the law. The final ruling is expected in July 2012.
There were uncertainties surrounding the Court verdict regarding the legislation. In the buildup to the event, there is a lot of speculation about the final outcome.
The legislation may either be revoked or upheld in its entirety. There are chances that the individual mandate and other controversial provisions are omitted or the legislation passed with minor changes.
Each of these outcomes will affect the insurance companies in varying degrees. In the event of the individual mandate being declared unconstitutional or repealed without corresponding changes to other provisions of the Health Reform legislation, players will face the risk of adverse selection.
Provisions that require revision include the guaranteed issue and renewal requirements, prohibition on pre-existing condition exclusions and rating restrictions. If, however, the provisions are left unchanged, insurers will see an increase in medical claims. Insurers will lose the opportunity to serve the targeted 32 million uninsured Americans.
If the entire law is passed without any amendments and subsequently implemented, then insurers will have to shell out a huge sum to align their business with the changed landscape.
The sector will not be spared even if most of the provisions of the Reform are held back. The health insurance sector will continue to be under tight observation and scrutiny. Some new rules will definitely come into effect to rein the exorbitant rise in health care costs, due to unfair practices adopted by many of the insurance companies over the past several years.
Opponents to the legislation claim that the clauses concerning Medicaid expansion will create a burden on the states, in violation of the Congress’ power as per the Spending Clause and the Tenth Amendment.
Political – The forthcoming November presidential election will see Congress struggling with its own legislation. The new Republican majority in the House and increased membership in the Senate may cause incremental changes to a complete revocation of the health care reform.
To sum up, the U.S. health insurance sector, as a whole, is in a state of flux and the situation will not see much improvement until final regulations fall into place.
Meanwhile, the carriers continue to invest through the development of new products, strategic acquisitions and new business alliances to reshape and restructure their business.
Aiming for Global Markets
Carriers in the health insurance sector are also focusing on international markets, which specifically appear attractive on account of lesser regulations. Additionally, pressure on social health care systems along with increasing wealth and education in emerging markets are leading to higher demands for health insurance and financial security. This provides carriers with a vast market opportunity.
Companies like Cigna and Aetna, which have an active presence overseas, believe that their international business is a positive differentiator and a key driver of the higher-than-peer growth rates.
Cigna’s recent acquisition of UK-based First Assist, a joint venture with TTK Group for selling health insurance products in the Indian market, reflects the company’s urge to grow its international business. Last year, the company acquired Vanbreda International, which makes it a global leader in providing expatriate benefits.
Aetna recently finished a two-year licensing process to begin selling policies in Shanghai. In June, the company entered the Indian market by acquiring Indian Health Organization, a fast-growing medical discount card provider. The Indian company serves approximately 80,000 individuals in 18 major cities.
Both the companies are targeting growth mainly in the emerging economies of Asia and the Middle East.
Recently, UnitedHealth also made an effort to expand into the Middle East via an agreement with Sagr National Insurance Co.
Though the U.S. health insurance industry currently has little presence internationally, we expect the presence to grow as players pursue global expansion opportunities.
Health Insurers Spending More on Technology
Following the implementation of The American Recovery and Reinvestment Act of 2009 (ARRA), or “Recovery Act,” which contains the Health Information Technology for Economic and Clinical Health Act, or the “HITECH Act,” there has been unprecedented spending on Health Information technology (HIT) in the sector.
The HIT includes electronic health records (EHRs), health information exchanges (HIEs) and other (HIT) initiatives. The federal government’s emphasis on the use of health IT, which helps providers communicate better with each other about patient care, reduces medical errors, paperwork, and needless duplicate screenings and tests, leading to better coordinated patient care and lower health care costs. These have increased current health care information technology (IT) spending.
Financial incentives offered by regulators to providers and hospitals for the implementation of the meaningful use of health care IT products are primarily driving huge IT spending.
According to Health Data Management, 100 HIT acquisitions were recorded from May 2010 to April 2011, compared with 76 during the same period in 2009-2010. Some of these include the acquisition of Picis, an acuity information systems vendor, A-Life Medical, computer-assisted coding software and Axolotl Corp., a health-data network, by UnitedHealth Inc. (UNH - Analyst Report) and Aetna’s buyout of Medicity.
Approximately $89 billion was spent by providers in 2010 on developing and implementing electronic health records (EHRs), health information exchanges (HIEs) and other (HIT) initiatives.
Medicare Advantage: A Favorite Market
According to U.S. Census data, the population of Medicare beneficiaries will grow by 36% by the end of this decade as the massive baby boomer generation ages into the nation’s largest health insurance program. In fact, in the next 25 years, compounded annual growth rate of the Medicare population is expected to increase to 2.7% from 1.5% at present.
Revenue from managed-care plans of Medicare Advantage is expected to grow significantly as baby boomers retire. Medicare Advantage is a privately-run version of the government's Medicare insurance program for the aged and disabled.
Managed-care is expected to get a lot more attention as the federal and state governments try to reduce costs. The now unsuccessful Congressional "Super-Committee" looked into trimming some of the funds out of the federal health care programs, but failed to reach a bi-partisan agreement. Major cuts to the Medicare program, whenever it happens, will have to shift some of the costs to seniors.
This could, in turn, be good for health insurers, making their Medicare Advantage plans more attractive than traditional Medicare plans. Moreover, many individuals would look forward to supplement government coverage with private insurance, boosting demand for Medicare Advantage plans. But reforming the government health care program has proven to be very difficult politically.
Until now, only two of the public providers -- UnitedHealth and Humana -- controlled more than 10% of the market. However, we expect sharp consolidation here. Carriers in the health insurance sector are in a race to win Medicare Advantage market share and the fastest way of doing this is to acquire a company in the same business. Following are some of the recent M&A activities in this arena:
Cigna acquired HealthSpring Inc. for $3.8 billion in January this year.
UnitedHealth’s acquisition of XLHealth Corp, a sponsor of Medicare Advantage health plans in November 2011, is the next big deal worth $2 billion. The acquisition of Preferred Care Partners (Preferred Care) and Medica HealthCare Plans (Medica) are pending. Earlier in 2011, UnitedHealth acquired Inspiris, which serves patients in Medicare, Medicaid and commercial insurance populations.
On October 1, 2011, Aetna closed its acquisition of Genworth Financial Inc.’s (GNW) Medigap business for $290 million.
AMERIGROUP Corp. (AGP) also announced the purchase of Health Plus from Lutheran HealthCare for $85.0 million in October 2011.
Similarly, Humana struck two deals for small Medicare Advantage plans: it acquired Arcadian Management Services and MD Care during the third quarter 2011.
In August 2011, WellPoint successfully culminated the acquisition of CareMore Health Group.
Some investors think that smaller companies like Coventry Health Care Inc. (CVH) and Health Net, Inc. (HNT - Analyst Report) along with Medicaid specialists like Centene Corp. (CNC - Snapshot Report), Molina Healthcare Inc. (MOH - Analyst Report) and Amerigroup may soon become takeover targets.
Emerging Dual Eligibles Opportunity
Health Insurance Reform Legislation created a federal Medicare-Medicaid Coordination Office to serve dual eligibles. This Medicare-Medicaid Coordination Office has initiated a series of state demonstration projects to experiment with better coordination of care between Medicare and Medicaid.
Dual eligibles (8.3 million individuals according to CMS) attracted government attention in the recent times as they drive up government costs. Federal and state governments spend approximately $300 billion annually on the dual eligible population. According to the Centers for Medicare and Medicaid Services, they make up 17% of Medicaid enrollees but incur 39% of its expenses.
It is imperative to enhance care options for dual eligibles as the numbers are expected to shoot up with an aging population and increased life expectancy amongst Americans with disabilities. As such, dual eligibles have become an immediate target for spending reductions and quality improvements in care.
America's Health Insurance Plans (“AHIP”), the insurers' trade group, estimates that better management of duals by engaging managed-care plans can save approximately $125 billion from the government exchequer during the next decade.
Presently, only about 12% to 15% of the duals are covered by private health plans. Federal and state governments are looking to place them into managed care to improve coverage and cut down on unnecessary spending and duplicate tests for a population that generates a lot of medical claims.
The acquisition of XL Health by UnitedHealth was one of the most notable events in this space recently.
Though the health insurance industry has been witnessing mergers and acquisitions for the last several years, the landscape created by the health care reform has significantly increased the pace of consolidation. In the changed environment, small insurers are becoming inefficient. The inability to achieve the required scale to be profitable is forcing these small institutions to get acquired.
Moreover, a continued low interest rate environment is encouraging health insurers to seek more acquisitions as they prefer to keep money away from their investment portfolio.
Over the next few years, growth opportunity for the players in the health insurance sector will be driven by:
Higher health expenditures and increased reliance on managed care. According to the government, national health spending is expected to touch $4.6 trillion by the end of this decade from $2.6 trillion currently, representing a CAGR of nearly 7%. This clearly points to the fact that the health care industry will most certainly outstrip broader economic growth. Moreover, over the same time frame, managed care penetration is expected to grow to about 1/2 of the total national health care spending, up from approximately 1/3rd at present, driven by increased reliance on insurers in managing government’s fee-for-service Medicare and Medicaid products.
2010 Census figures show that seniors constitute a larger share of the American population than ever before. The trend will only gain steam in the years ahead. Consequently, the aging population is expected to drive industry demand as they would aim to reduce their health-related costs.
We expect most of the companies within our coverage to benefit from the trend. Among others, Aetna with Zacks #1 Rank, UnitedHealth with Zacks #2 Rank, Cigna, Humana, WellPoint, Amerigroup each with Zacks #3 Rank will offer good investment opportunities in the upcoming years.
Aetna (AET - Analyst Report) has been beating our estimates for the past several quarters, on the back of declining utilization, strong performance across all the product lines, disciplined pricing and medical cost trends. The company is also making strong progress in its Medicare business. The lifting of sanctions from the Center of Medicare and Medicaid Services and the acquisition of Genworth's Medicare Supplement business will upgrade its Medicare platform.
The company is also aggressively looking to generate incremental fee revenues by managing the infrastructure necessary for care organizations. It is growing its international business for diversification benefits. Moreover, its deployment of $1.2 billion for acquisitions will position it well to deal with the consequences of the Health Care Reform. A solid balance sheet, well-controlled debt and adequate liquidity will provide overall strength.
Our next pick would be Cigna (CI - Analyst Report). Though the company was heavily biased towards commercial business, it made timely acquisitions to ramp up the government business, placing itself amongst the top five providers of Medicare products. Its unique and growing international presence is also a positive differentiator. A strong balance sheet and adequate liquidity will further lead to continued share buybacks, thereby contributing to the bottom line.
WellPoint (WLP - Analyst Report) comes next in line. With over 34 million members, the company is a dominant player with a vast provider network. WellPoint has strengthened its portfolio through the acquisition of CareMore Health Group in order to expand its presence in the U.S. government program for the elderly.
The company has been witnessing substantial earnings growth over the past few quarters, spurred by membership gains, improvements in operating cost structure, strategic acquisitions and capital transactions. The company is also well poised to benefit from economies of scale and favorable demographic trends.
Being the second-largest provider of Medicare Advantage plans, Humana (HUM - Analyst Report) also offers potential for solid growth going forward. The company has been surpassing earnings estimates for the past several quarters and management raised its fiscal year 2012 guidance, citing better-than-expected operating trends.
UnitedHealth (UNH - Analyst Report) has also been beating the Zacks Consensus Estimate for the past several quarters and has recently raised its fiscal year 2012 guidance. It has strengthened its position in the Medicare Advantage (MA) market with the acquisition of XLHealth.
We believe the company’s diversified business model in the managed care industry, with a leading market share in the Commercial, Medicare and Medicaid markets, a solid balance sheet, a highly conservative investment portfolio and expansion into higher margin Health Services segments (Optum) will provide investors with a high risk -- return investment opportunity over time.
Though none of the health insurance stocks under our coverage hold a Zacks #4 Rank or even a Zacks #5 Rank, we expect the following factors to negatively impact the industry:
Health insurers are expected to face challenges related to medical-cost inflation. The Centers of Medicare and Medicaid Services expects U.S. health expenditure to increase at an average annual rate of 5.7% to $3.3 trillion during the next five years. Furthermore, the demand for Medicare is expected to increase as the baby-boomer generation goes into retirement. Consequently, insurers will likely face increased pressure to maintain medical-benefit ratios due to the lack of funds for these programs along with government’s initiatives to control costs.
The U.S. economy continues to experience a period of slow economic growth and high unemployment. Workforce reductions have caused corresponding membership losses in insurance companies’ fully-insured commercial group business. Continued weakness in the U.S. economy, and any continued high unemployment, will adversely affect medical membership, operations, financial position and cash flows.
The U.S. “Super-Committee” is working on reducing overall budget by $1.2 trillion. This will keep state budgets under pressure, leading to very low rate increases for managed care providers.