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The health insurance industry has confronted many external challenges in the recent past, such as rising costs, a shortage of primary care physicians, uncertain political and regulatory environments, a shifting customer mix anda struggling economy, just to name a few. However, the final ruling of the Supreme Court on Health Care Reform last month has resuscitated the industry by removing a major source of uncertainty.

Meanwhile, the industry continued to remain 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) and Coventry Health Care Inc. (CVH) -- reporting year-over-year earnings growth for the full year 2011. While some of the industry players -- Cigna, Aetna, Humana, Coventry Health Care, Health Net -- missed earnings projections during first quarter 2012, players like UnitedHealth, Wellpoint performed well.

The earnings performance at each of these players were primarily driven by industry-wide factors like growing competition, gradually rising health care utilization and trends in membership enrollment. We expect a mixed performance from the players in the second quarter as well.

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 annual GDP. According to the World Health Organization, health care expenditure per person in the United States is the highest 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 between 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 premium for employer-sponsored insurance doubled in the 1999-2009 period. According to a survey from the Kaiser Family Foundation, the cost of employer-sponsored health insurance plans grew much more quickly in 2011 than in 2010. The individual market also saw a rapid growth in the cost of premiums. As a result, only 5% of non-elderly Americans were insured.

According to the United States Census Bureau, in 2010 there were 49.9 million uninsured people in the U.S. (16.3% of the population). The percentage of uninsured non-elderly population has been on a continuous rise since 2000. Insurance companies have also denied coverage in case of pre-existing diseases and charged higher premiums 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 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 policy-holder costs, insurance companies went on making increasing profits year after year. Data from HealthReform.gov showed that the profits of the 10 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 cash-strapped Americans away from the clinics, leading to lower utilization of health care services. An 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 the upcoming quarters.

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 (PPACA) 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 on health insurers.

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, reduction in Federal assistance on Medicare Advantage, restriction on rescission of policies and elimination of annual as well as life time maximum limits.

Possible Outcomes of the Reform

The proponents of the legislation claim that upon its full implementation in 2018, it will put an end to discrimination policies of insurance companies, create competition amongst insurers through healthy exchange, lower premiums and add value to the overall health care system. 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 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 became 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 premium.
  • 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.


The possible changes on account of the Health Insurance Reform Legislation will certainly modify the way insurance companies conduct their business. This will potentially impact pricing, product mix, geographic mix and distribution channels. The fundamental and potentially game-changing developments may also threaten carriers' ability to achieve top and bottom-line growth.

Recent Developments - PPACA Becomes Law of the Land

On June 28, in a 5-4 decision, the U.S. Supreme Court upheld the constitutionality of the individual mandate provision of PPACA. The court ruled that current health insurance reform provisions will remain in force and the new law will be implemented, as applicable.

The individual health insurance mandate of expanding coverage to 32 million uninsured Americans will enhance customer base of insurers. While this may help insurers generate better profit margins, these companies will no longer be able to deny coverage or raise insurance rates for individuals with pre-existing conditions. However, new costs to realign their business to conform to the new rules and other challenges is expected to be largely offset by the addition of 32 million customers once the reform laws become fully effective.

Aiming 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 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 -- and its expansion into the Turkish market reflect 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. The company also 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 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 international presence, we expect the exposure 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 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, a computer-assisted coding software and Axolotl Corp., a health-data network, by UnitedHealth Inc. 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 Preferred Market

According to U.S. Census data, the population of Medicare beneficiaries will grow by 36% by the end of this decade led by a vast aging baby boomer population.  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 bipartisan agreement. Major cuts to the Medicare program, whenever it happens, will 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 supplementing 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 -- control more than 10% of the market. However, we expect sharp consolidation in this market. Carriers in the health insurance sector are in a race to win Medicare Advantage market share and the fastest way of achieving the target 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 of 2011.

In August 2011, WellPoint successfully completed the acquisition of CareMore Health Group.

Some investors think that smaller companies like Coventry Health Care Inc. 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 among 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.

Immediately following the hearing of the Health Care reform, which upheld the expansion of Medicaid in 26 states, WellPoint announced its plans to acquire Amerigroup Inc. The ruling has made the Medicaid line of business especially attractive as the states (Florida, South Carolina, Louisiana, Texas and others) ruled by Republicans have chosen not to participate into the mandatory federal programs and instead pick up private insurers to provide Medicaid in these territories.

Private insurers recognized the huge growth opportunity in these states where 17 million people are eligible for Medicaid. The acquisition of XL Health by UnitedHealth is another notable recent development in this space. Buyouts of smaller Medicaid players like WellCare Health Plans (WCG), Molina Healthcare and Centene Corp.
by giants such as Aetna, Cigna, UnitedHealth seem most likely going forward.

Increasing Popularity of ACOs

Accountable Care Organizations (ACOs), or "collaborative accountable care," is one of the several ways through which President Obama has sought to improve the quality of health care for all Americans. It is viewed as a tool that would deliver seamless, high quality care for the overall population.

ACO is an organization of health care providers that are jointly accountable for the quality, cost, and overall care offered to patients. These ACOs work to provide quality as well as seamless and exceptional service at an affordable cost. By focusing on the needs of patients and linking payments to outcomes, this delivery system aims to improve the health of individuals and communities and curb rising health care costs.

The Health Care Reform aimed toward such an arrangement in a bid to eliminate inordinate expenses associated with lack of coordination between multiple physicians and health care providers. A majority of Americans with multiple chronic conditions often receive care from multiple physicians. Lack of coordination often mars the quality of care administered to patients and they end up receiving duplicative care.

A number of patients thus become victims of medical errors and are readmitted within days of their discharge from hospitals. ACOs are formed to reduce the exorbitant amounts spent due to lack of managed care.

Insurers are keen on forming ACOs as this will help them share expense and get some extra earnings. Some of the largest health insurers -- including Humana, United Healthcare and Cigna -- have already formed their own ACOs. Going forward, we expect acceleration in the formation of such patient-centered collaborations.

Consolidation Continues

Though the health insurance industry has been witnessing mergers and acquisitions for the last several years, the landscape created by Health Care Reform has further 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 players to get acquired.

Moreover, a continued low interest rate environment is encouraging the health insurers to seek more acquisitions as they prefer to keep money away from their investment portfolio.

OPPORTUNITIES

Over the next few years, growth opportunities for the players in the health insurance sector will be driven by:

  • Health expenditure and reliance on managed care gradually increasing. 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 compounded annual growth rate (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.
  • Recent 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 (AET - Analyst Report) with Zacks #1 Rank (Short-term Strong Buy), UnitedHealth (UNH - Analyst Report) with Zacks #2 Rank (Buy), and Cigna (CI - Analyst Report), Humana (HUM - Analyst Report), WellPoint (WLP - Analyst Report) and Amerigroup (AGP), each with Zacks #3 Rank (Hold) will offer good investment opportunities in the upcoming years.

Let's have a quick look at some of these companies:

Aetna has been beating the Zacks Consensus Estimate 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 the Centre of Medicare and Medicaid Services sanctions 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 Health Care Reform. A solid balance sheet, well-controlled debt and adequate liquidity will provide overall strength.

Our next pick would be Cigna. 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 comes next in line. With over 34 million members, the company is a dominant player with a vast provider network. The recent announcement to acquire Amerigroup will make it a top player in the Medicaid business. Other acquisitions in this area include the buyout of CareMore Health Group, which will further 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 also offers potential for solid growth going forward. The company has been surpassing earnings estimates for the past several quarters. Management raised its fiscal year 2012 guidance, citing better-than-expected operating trends.

UnitedHealth has also been beating the Zacks Consensus Estimate for the past several quarters. It has strengthened its position in the Medicare Advantage market with the acquisition of XLHealth. We believe that 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.

WEAKNESSES

Though none of the health insurance stocks under our coverage hold a Zacks #5 Rank (Strong Sell) or even a Zacks #4 Rank (Sell), 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 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 high unemployment rate 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.

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