The health insurance industry has confronted many external challenges in the recent past, such as federal, state legislative and regulatory reforms, inability to meet the demand of more price- and service-conscious consumers, a fiercely competitive market, shift of customer mix and uncertain economic conditions in the U.S. and abroad, just to name a few.
Notwithstanding the headwinds, the industry is thriving under stress. Most of the top six players -- UnitedHealth Group Inc. (UNH), CIGNA Corp. (CI), WellPoint Inc. (WLP), Aetna Inc. (AET), Humana Inc. (HUM) and Coventry Health Care Inc. (CVH) -- ended 2012 on a high note with impressive earnings growth in the final quarter. Most of the carriers even raised their 2013 earnings estimates.
About the Industry
The 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 huge sums of money spent on health care, millions of Americans lack health insurance coverage or are underinsured. This was largely attributed to a dysfunctional health care system, which was working for the past several years. To rein in the wastage and make health care more accessible effective and affordable, President Obama came out with the Health Care Reform in an attempt to overhaul the nation’s ailing health care system.
Health Care Overhaul
The Patient Protection and Affordable Care Act (PPACA), which was passed in 2010, 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. The primary focus was to 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 were: mandated coverage requirements, rebates to policyholders based on minimum benefit ratios, adjustments to Medicare Advantage premiums, the establishment of state-based exchanges, greater investment in health IT, 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.
The Reform had a rough patch since inception with opponents challenging its individual mandate and Medicaid expansion clause as well as dragging it to court. Insurers lobbied against most of its provisions and opposition political parties swore to repeal the whole law if they were elected. But the law survived the challenges with the Supreme Court upholding the constitutionality of its individual mandate – the core of the reform.
Also, the re-election of Barack Obama provides the necessary ratification to the health care reform. That said, the full implementation of the reform is far from guaranteed given the substantial leeway states enjoy in enforcing key parts of the legislation, particularly the setting up of exchanges and expansion of Medicaid.
The Changing Face of the Health Insurance Industry
Obama’s second term of presidency will see implementation of key provisions across the industry. However, a vexing problem in the short- to mid-term is the uncertainty over how regulatory reform will play out. So far, the carriers in the industry have handled the impact of implementation of some of the less onerous provisions of the reform (relating to MLR requirements, ban on denial of coverage due to pre-existing ailment, dependent coverage up to age of 26, annual rate review) relatively well.
For the moment, however, the biggest wild card in the regulatory reform is how the law’s biggest and most impactful provisions (relating to setting up of insurance exchanges, individual mandate, ICD-10 requirements, pre-existing conditions, Medicaid expansion, an annual insurance industry assessment of $8 billion in 2014 with increasing annual amounts thereafter), which are due to be implemented in 2014, will effect the industry. Investor sentiment toward the implementation in 2014 and beyond will be the key driving factor for managed care stocks.
Exchanges will act as an online marketplace where consumers who are underinsured or uninsured will be able to shop for subsidized coverage and small businesses can buy more affordable plans for their workers. A key risk to insurers is that insurance exchanges will lead to commoditization of insurance products, making product offerings highly standardized. This product standardization along with a framework for strong government price regulation will expectedly lead to very low profit margins for the carriers in the long run.
While the individual mandate provision will bring into loop approximately 32 million of the uninsured, the gain in revenues due to increasing industry enrollment is expected to be offset to a large extent by the costs to realign their business to comply with the new rules (ICD-10 coding) and deal with other challenges.
Several provisions in the Health Reform Legislation – excise tax on medical devices, annual fees on prescription drug manufacturers, enhanced coverage requirements and the prohibition of pre-existing condition exclusions – will likely increase insurers medical cost trends.
Moreover, the annual insurance industry assessment ($8 billion to be levied on the insurance industry in 2014 and it will increase to $14.3 billion by 2018 with increasing annual amounts thereafter) will increase premium cost. Also the temporary reinsurer’s fee ($25 billion to be levied on all commercial lines of business including insured and self-funded arrangements, over a three-year period starting 2014) will increase insurers’ operating costs.
In the meantime, rules of the road remain uncertain. Insurers do not know what exactly will be expected of them, what changes they will be forced to implement, or what expenses they might have to incur to meet new data and regulatory demands. Carriers may see potentially game-changing developments threatening their ability to achieve top- and bottom-line growth.
However, insurers are being proactive, trying very hard not just to survive but to prosper.
Aiming Global Markets
With organic growth remaining challenging, carriers in the health insurance sector are flocking toward the international markets, which specifically appear attractive on account of lesser regulations, higher margins and lower competition. 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 active presence overseas, believe that their international business is a positive differentiator and a key driver of higher-than-peer growth rates. Both companies are targeting to penetrate deeper mainly in the emerging economies of Asia and the Middle East.
UnitedHealth is another case in point. The company already has a presence in Australia, the Middle East and UK. In Oct 2012, it expanded its portfolio with the purchase of a controlling stake in Amil Participacoes, Brazil’s biggest health insurer and hospital operator, for $4.9 billion. The deal will give it access to a fast-growing health insurance market with rising middle class.
Though U.S. health insurers had little international presence until the recent past, they are fast catching up. We expect to see more international deals going forward.
Health Insurers Investing in New Technologies
There has been unprecedented spending on health information technology (HIT). 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. Financial incentives offered by regulators to health care providers and hospitals for meaningful use of health care IT products are primarily driving huge IT spending.
Starting 2013, all hospitals serving Medicare patients with the most common conditions will be paid for the quality of care they provide in addition to the number of services offered by them. We expect the trend to continue as pay-for-performance takes root.
Reimbursement Cuts to the Medicare Advantage Program
Medicare Advantage plans are privately run versions of the federally funded Medicare program for the elderly and disabled people. The Centers for Medicare and Medicaid Services recently announced that it expects costs per person for Medicare Advantage plans to fall more than 2% in 2014, which is a cause of worry for insurers as it can result in significant payment cuts.
Medicare Advantage plans also face cuts from the health care overhaul and from the steep federal budget cuts. Insurers’ profits are also expected to be pressured by the growing cost of care and a premium tax imposed to fund the overhaul.
Medicare Advantage Still Remains a Preferred Market
Despite reimbursement cuts to Medicare Advantage, insurers remain attracted to this line of business as they expect to recover the revenues lost due to payment cuts from the significant increase in enrollment for the Medicare Advantage program. Enrollment in such plans is expected to increase in 2013 compared to 2012.
According to U.S. Census data, the population of Medicare beneficiaries will grow 36% by the end of this decade, led by a vast baby boomer population. Until recently, only two of the public providers -- UnitedHealth and Humana were the primary market share holders. However, consolidation in this market is scrambling market share ratios.
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. Some of the examples are Cigna’s acquisition of HealthSpring Inc., UnitedHealth's acquisition of XLHealth Corp., Aetna’s pending acquisition of Coventry Health Care Inc.
Notwithstanding the fact that the health insurance industry has been witnessing copious mergers and acquisitions for the last several years, the landscape created by Health Care Reform has set the stage right for further 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.
Over the next few years, growth opportunities for the players in the health insurance sector will be driven by the following factors:
Gradually increasing health expenditure and reliance on managed care. Centers for Medicare and Medicaid Services total health care spending is projected to grow from an estimated $2.8 trillion last year to $4.8 trillion by 2021, an increase of 70%. 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 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, Cigna Corp. with a Zacks Rank #2 (Buy) and UnitedHealth Group Inc., Humana, WellPoint, Aetna Inc. and Amerigroup with a Zacks Rank #3 (Hold) will offer good investment opportunities in the upcoming years.
Let's have a quick look at some of these companies:
CIGNA Corp. remains attractive given its strong growth profile in the industry with its International segment growing in double digits, significant presence in Medicare Advantage book as well as self insured business. The company has been putting up strong earnings performances and the trend is expected to continue. We are more optimistic about the company as it has reduced exposure to its run off portfolio, which had traditionally been imparting volatility to its earnings.
Aetna has been performing favorably over the past several quarters. The company is also making strong progress in its Medicare business. It is also growing its international business for diversification benefits. A solid balance sheet, well-controlled debt and adequate liquidity will provide overall strength.
UnitedHealth has also been showcasing a favorable earnings performance for the past many quarters. In all likelihood, it will outperform in a rapidly changing industry environment given its best-in-class execution and management, product positioning, scale and technology. We also see the company’s exposure to health reform downside risks as somewhat more contained than what was perceived before.
Though none of the health insurance stocks under our coverage hold a Zacks Rank #5 (Strong Sell) or even a Zacks Rank #4 (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 expenditures 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 still high unemployment rate will adversely affect medical membership, operations, financial position and cash flows.
The overall thrust of healthcare reform and regulatory changes will most definitely change the face of the industry over the long run.
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