Health insurers have called upon themselves the close scrutiny of regulators with Anthem’s proposal to acquire Cigna Corp. (CI Quick QuoteCI - Free Report) and Aetna’s buyout deal with Humana Inc. (HUM Quick QuoteHUM - Free Report) .

Recently, the viability of the proposed merger between Anthem and Cigna, and Humana with Aetna was challenged by the Department of Justice (DoJ) on groundsthat the mega deals would curb competition and hurt consumers. The DoJ has therefore sued all the companies involved in either of the mergers, casting uncertainty over the merger consummation.

Moreover, the presidential candidates are looking at ways to fine tune the provisions of the healthcare legislation, which, if implemented, will see insurers reworking their business strategies.

Democratic presidential candidate Hillary Clinton’s priority includes a crackdown on insurers to limit out-of-pocket costs. These include are expenses like deductibles, coinsurance and copayments for covered services, among others, that aren't reimbursed by insurance. Clinton is pitching for three sick visits per year in insurance plans before deductibles kick in. In her campaign, Clinton pointed to a recent Kaiser Family Foundation study that average deductible for an individual has increased seven times faster than a worker’s average wage since 2010.

High deductibles are barring some people from visiting a doctor because they cannot pay the first few thousand dollars of the bill before insurance kicks in. Having a deductible so high that one cannot afford to go to a physician is akin to having no insurance at all.

The deductible is part of the medical bill which must be cleared before patients can use their insurance coverage. But thanks to a high deductible, doctor visits are being barred by some thousands of dollars that must be shelled out before patients can avail the insurance.

Also on Hillary Clinton’s agenda to provide the Department of Health and Human Services with the ability to block or modify unreasonable rate increases by insurers.

Donald Trump proposes to end Obamacare and replace it with something that would require a lot less money.

Coming back, the legislation has undoubtedly altered the regulatory landscape in ways that are not always beneficial to a private health insurer’s bottom line. But calling it a permanent drag would be an overstatement.

U.S. health plans are expected to operate in a lowered margin environment. Some health plans — especially the smaller ones — may not survive. Pricing pressure, higher taxes and fees, rising medical costs, regulatory compliance costs, increased competition and general marketplace uncertainty are some of the headwinds faced by the players in the industry.

Public Exchanges Woes

Public Exchanges made their debut in Oct 2013, and were considered one of the signature achievements of Obamacare aimed at providing subsidized insurance to millions. The insurers were also sanguine about the exchanges, hoping to make big business out of them. But health insurers are now struggling to profit from the public exchange business.

These insurers are saddling under high medical expenses of individuals who are buying the subsidized policies under the health care law. The public exchanges attracted a disproportionate number of unhealthy individuals compared to healthy ones. A higher percentage of unhealthy patients led to higher claims for the insurers, thus leading to losses from the policies sold to these groups of people.

In Nov 2015, UnitedHealth Group (UNH Quick QuoteUNH - Free Report) disclosed concerns about losses incurred on its individual business from the public exchange.Compelled by the loss suffered from the individual insurance policies sold on the exchanges, the health insurer announced that it will not entertain such losses and may exit this unprofitable market completely by 2017. The company has already scaled back its marketing efforts for individual insurance policies sold on exchanges.

Another insurer, Aetna, also suffered losses from its public exchange business in 2015 and reduced its operations to 15 states this year from 17 states last year. It is, however, taking measures such as re-pricing and product modification to generate profits in 2016. 

Yet another player, Humana, is contemplating dropping individual insurance coverage through exchanges in the states of Alabama, Kansas, Wisconsin and Virginia. The company is considering to exit this business which brought in meager profits in this years’ first quarter and would likely result in a loss for the full year.

If the players realize that the exchanges are not seeing profitable business opportunities, a mass exodus may happen which may hamper the functionality of the exchanges and cause a failure of the Obamacare exchanges, thus defeating the basic aim of providing coverage to millions of uninsured Americans.

Some of the other challenges faced by the industry are briefed below.

Margins Under Pressure

Health insurers are expected to witness lowered margin environment. A host of factors including compliance costs related to health care reform regulation, increased fees and taxes, pricing pressure, stiff competition and rising medical costs will squeeze the bottom line.

A general shift in patient mix from Commercial insurance to Government (Medicare, Medicaid and State-subsidized marketplace or exchange) will also affect profitability to a large extent. Premiums for Medicare, Medicaid and state-subsidized policies tend to be higher due to serious health issues for many enrollees; however, they carry smaller profitability margins compared to commercial insurance.

High Regulatory Cost

Regulatory reform sweeping through the sector has hit insurers with high compliance costs. The expenditures involved in redoing the internal systems can pinch them hard. There has been huge spending on health information technology (“HIT”), 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." Notably, HIT includes electronic health records or EHRs, health information exchanges or 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 health care information technology 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 IT spending.

Consumer Has Upper Hand

Rising consumerism is the reality of the health insurance industry. Until the implementation of the ACA, the insurance companies had an upper hand in choosing to whom to provide coverage, and consumers (people receiving health care) had no active role in the decision-making process.

But now the trend has changed. Health insurance reform has put consumer power and choice in the hands of the people, and ensures that all Americans receive the health care services that they need. Consumers’ increased purchasing power and access to information to take health care decisions are the major threats to insurers.

Prior to reform, big insurers dominating large markets hardly ever bothered to provide consumers with even basic information, such as the performance of health insurance policies, procedures to claim, the size of the provider network and cancellation processes. Now, customers demand transparency, value and convenience, leaving insurers grappling for innovative ways to satisfy these unmet needs. The new mission, however, will not be easy to execute.

Global Economic Woes and Regulatory Challenges

A fragile global economy presents a headwind for insurers looking to expand their international operations. One of the largest insurers, UnitedHealth Group,made an acquisition to reap benefits from the Brazil market but is now facing slowing growth rates in that country.

In the case of India, which remains one of the most profitable opportunities for insurers, the regulatory environment still remains somewhat challenging. China -- which merits the highest risk-adjusted opportunity ranking, largely because of its immense scale -- poses significant investment restrictions to foreign insurers entering and operating there.

HMO Stocks to Avoid for the Time Being

We presently recommend investors stay away from the following HMO stocks, as they presently have an unfavorable Zacks Rank. The other metrics also indicate that they are not profitable investment options at present.

Anthem Inc. currently has a Zacks Rank #4 (Sell). The 2016 earnings estimates have gone down by 0.6% in the last 90 days.

Centene Corp. (CNC Quick QuoteCNC - Free Report) currently has a Zacks Rank #4. The 2016 earnings estimates have gone down by 4.8% in the last 60 days.

Magellan Health, Inc. carries a Zacks Rank #4 (Sell). The 2016 earnings estimates have gone down by 9.8% in the last 90 days. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.  

Bottom Line

The changed regulatory landscape has undoubtedly created hurdles that would weigh on profits and margins of industry operators going forward. But it is hardly the unmitigated disaster that some industry players make it out to be. Beyond the ACA, the investment appeal of the space also reflects its perceived defensive and counter-cyclical orientation, which is crucial amid the current uncertainty.

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