Health Insurers Raise Premiums In The Face Of Regulators

Includes: AET, ANTM, CI, UNH
by: Margin of Safety Equity Research

Six months after the passage of "Obamacare," in a September 10, 2010 press release from the Department of Health and Human Services, HHS Secretary Kathleen Sebelius issued a warning to health insurers who were making claims that the Patient Protection and Affordable Care Act (PPACA) would lead to increased healthcare costs and thus insurance premiums:

“There will be zero tolerance for this type of misinformation and unjustified rate increases,” Secretary Sebelius said in the press release, which included a letter to the insurance lobby.

“Simply stated, we will not stand idly by as insurers blame their premium hikes and increased profits on the requirement that they provide consumers with basic protections,” Sebelius said. She warned that companies may be excluded from new health insurance markets that will open in 2014 under the law.

On May 19, 2011, HHS stepped up the pressure:

“Today, The Department of Health and Human Services (HHS) issued a final regulation to ensure that large health insurance premium increases will be thoroughly reviewed, and consumers will have access to clear information about those increases. Combined with other important protections from the Affordable Care Act, these new rules will help lower insurance costs by moderating premium hikes and provide consumers with greater value for their premium dollar. In 2011, this will mean rate increases of 10-percent or more must be reviewed by state or federal officials.”

“Recently, insurers have posted some of their highest profits in years … and (yet) they continue to raise rates, often without any explanation or justification,” Health and Human Services Secretary Kathleen Sebelius said in a conference call with reporters. “The framework of the Affordable Care Act is beginning to change this.”

As a sidebar, looking at the profit margins of the top industry payers over the decade, the data simply does not match the rhetoric.

(Click to enlarge)

As an investor who seeks profitable companies with strong cash flow generating ability, the appearance of HHS trying to impose price controls on the insurance industry by regulatory fiat is a red flag for the sector. The economics of price controls are well understood. From a macro standpoint, they distort markets; result in shortages, and end up driving prices higher, usually due to reduced supply. From a company standpoint, they erode profitability.

This week, a study conducted by the Kaiser Family Foundation revealed that the average yearly premium for family coverage through an employer rose to $15,073 in 2011, a 9% increase over 2010. What an amazing coincidence that the industry squeaked by 1% under the 10% standard for premium increases. I’d like to consider this proof of the genius of the market and its ability to run circles around the bureaucrats, but given the uncertainty created by the regulatory freight train that is PPACA, I shouldn’t be too cocky.

Policy-issues aside, how should long-term investors play the health insurance market?

PPACA will have a marginally negative impact on the major insurers. The Medicare Advantage reimbursements and provisions in the PPACA that regulate the percentage of premiums that must be spent on medical care are likely to impose long-term pricing pressure that will impact profit margins. On the other hand, the expansion of the pool of covered individuals and increased subsidies will partially offset this pressure with increased volume. Customer switching costs are high in this sector, and with a critical mass, strong brand recognition, and a network effect, an insurer has the ability to pass increased costs on to a large proportion of its customer base. In addition, I cannot help but to think that the latent opposition to healthcare reform, both political and popular, in addition to strong industry lobbying efforts and an upcoming political season will prevent the industry from becoming a regulated “public utility” as some have feared. With that said, government regulation poses the greatest long-term risk to the business model and the long-term risks posed by PPACA are not fully understood at this time.

Looking at the major insurers Wellpoint (WLP), UnitedHealth (NYSE:UNH), Aetna (NYSE:AET), and Cigna (NYSE:CI), I see the following general picture for investors.

Wellpoint will experience the margin-depressing effect of medical cost ratio floors in 2011 and beyond. However, with the largest medical membership among health insurers, it possesses significant bargaining power with providers over a largely fixed cost structure. With an unmatched regional scale and exclusive license to the Blue Cross and Blue Shield Brand in more than a dozen states, they will be able to take advantage of volume increases and further strengthen their regional networks. With a forward P/E of 8.5, and dividend yield of 1.5%, WLP looks attractive.

UnitedHealth Group

Total medical enrollment into Unitedhealth’s health benefits segment has been growing at approximately 2%/year for the last 5 years and has now reached over 34 million members. This segment offers its services through a network of 730,000 physicians and other health care professionals, and 5,300 hospitals. As Unitedhealth’s membership base grows, more providers are attracted, allowing UNH to negotiate favorable discounts. In addition, the more providers that join the network, the more attractive UNH is to consumers. Through this strong network effect and diversified business model, UNH will be able to ride out the challenges imposed by PPACA. With a forward P/E of 9.6 and after a drop of 13% from July’s high of ~53, UNH looks moderately attractive. My target buy price is ~$40.

On the other hand, Aetna and Cigna appear to lack the network effect and regional scale of UnitedHealth and Wellpoint and will likely suffer from the margin pressures imposed by PPACA (WI more than CI) without a commensurate ability to take advantage of increased pool of insured. My advice to long-term investors is to stick with the best of breeds UNH and WLP.

Disclosure: I am long UNH.