Health Insurance Industry Outlook - Feb. 2011

Health insurance companies finished 2010 strongly gaining from a drop in medical utilization by members, driven primarily by the extremely weak labor market. Bad weather also kept them indoors during the final quarter of the year. We believe utilization will remain soft in 2011, which will act as a tailwind for the industry.

Looking at past trends when unemployment increased rapidly in 2008, utilization factor did not see a proportionate drop, indicating that it typically lags the former. Thus, even as the employment scenario improves in 2011, we do not expect an increase in utilization activity until 2012.

Insurers are also buoyed by low flu claims in 2010, but 2011 is predicted to witness normal flu activity, which might increase medical utilization. For health insurers high flu activity translates to higher costs as more people take medication and visit hospitals.

Another primary focus of the health insurance industry will be medical loss ratio compliance provisions of the Health Care Reform Act which has become effective in 2011. Carriers are required to maintain a minimum medical loss ratio (percent of insurance premium dollars allocated to providing care) of 80% for individual and small group policies and 85% for large commercial ones.

Apart from deriving revenue from insurance premiums, health insurance companies also draw revenue from investments, though only a small fraction of industry income is related to investment activity. The majority of industry investments are in short-term securities, since benefits are paid out on a consistent basis. As a result, short-term interest rate movements affect investment revenue. Since interest rates are expected to remain at low levels at least for the first half of 2011, we expect a lackluster investment income.

Fitch Ratings in January upgraded its rating outlook for the health and managed-care sectors to "stable" from "negative,” as it expects the effect of reform act to be manageable. The ratings agency expects overall earnings from the sector to trend in line with the strong earnings achieved in recent years.

Makeover Year

The year 2011 will be a makeover year for carriers in the health insurance industry, as they react to and prepare themselves for new rules. Continuing cost pressures and new customer demands require a fresh look at existing roles of industry players. Industry revenue will, however, decline from 2011 to 2014 due to tighter government regulations, particularly when health care reform takes full effect in 2014.

As the economy recovers, unemployment will decrease and discretionary spending will rise. With employment expected to grow, the demand for employer-sponsored plans will improve. This factor is important because the majority of industry premiums are related to group health insurance plans. Additionally, the rise in discretionary spending will likely support industry growth, since individuals, families and self-employed business owners will be able to afford healthcare coverage again.

Also, the U.S. population is aging, which is an important indicator of demand for health insurance coverage in the long run. Older individuals are more likely to use medical coverage than their younger, healthier counterparts. Consequently, the aging population is expected to support industry growth.

Consolidation

Many of the major players, such as UnitedHealth Group Inc. (UNH - Analyst Report) and WellPoint Inc. (WLP - Analyst Report), made a number of acquisitions during the past five years and are expected to continue such activity over the next five years to 2015. The industry is expected to continue to consolidate, as insurers try to cut costs and improve profitability. At the same time, larger firms benefit from greater bargaining power in determining healthcare rates with medical providers such as doctors, hospitals and pharmacies.

OPPORTUNITIES

Though there remains a cloud of uncertainty over the companies in the sector, there are two names in particular –- CIGNA Corp. (CI - Analyst Report) and UnitedHealth Group (UNH - Analyst Report) − that we would recommend to investors.

CIGNA is relatively safe as it has minimum exposure to medical loss ratio (MLR) regulations, unreasonable rate reviews and health insurance exchanges. The recently completed Vanbreda acquisition should accelerate 2012 international earnings growth. The company has also shown operating momentum and has gained commercial risk membership for four quarters in a row.

We also see a positive risk-reward scenario for UnitedHealth Group. Its diversified product offering will allow it to respond better to the new regulatory changes. Driven by improved customer focus with better systems, completed acquisition network integrations and more regional management, UnitedHealth's performance should continue to improve. Its strong balance sheet will allow it to annex weaker firms that cannot adapt as well as itself to the reformed health insurance system.

Other names which carry a Zacks #3 Rank are WellPoint (WLP - Analyst Report) and Humana Inc. (HUM - Analyst Report).

WEAKNESSES

As the Patient Protection and Affordable Care Act takes effect, notwithstanding recent judicial challenges, more issues driving uncertainty will likely arise requiring healthcare investors in the near future to do more portfolio reshuffling, than just "buy" and "hold." Though the companies will likely suffer share price volatility in the near future, at least until the Health Care Reform Act falls in place, all the businesses are expected to perform well in the long term.

With good fundamentals and an expected boost from the Reform Act, none of the companies have any significant weaknesses, resulting in the absence of any stock carrying a Zacks #4 Rank (Sell) or even a Zacks #5 Rank (Strong Sell). We believe investors should more routinely evaluate the regulatory environment, consider opinion and position accordingly.