Obamacare Part I - Will Insurance Companies Survive?

Includes: AET, ANTM, CI, HUM, UNH
by: Deja Vu

Making Money of Off Obamacare:

Part I - The Health Insurance companies

I have been reading the business and popular media for the last few days and I'm struck by how poor both are at explaining the implications of Obamacare for various stake holders in the health industry. I'm writing this multi part series to enable SA readers to choose their investments wisely in the health care sector after implementation of Obamacare.

The first part of the series, deals with the health insurance companies like Aetna (NYSE:AET), Coventry Health (CVH ), UnitedHealth (NYSE:UNH), Cigna (NYSE:CI), Wellpoint (WLP) and Humana (NYSE:HUM). In a nutshell, my thesis is that health insurance companies are dead men walking and the most profitable course will be buy long term puts on any upticks. The key risk factor is that Obama might lose the election and republicans might regain the house and senate and repeal or delay Obamacare.

Why do we need to worry about the survival of the quite profitable health insurance companies? The media will usually mention things like 80% of premiums have to be paid out, no lifetime caps on benefits keeping kids until age 26 etc. However these are manageable burdens. There are three probably insurmountable risks that are not well explained in the media. One is the The reinforcing spiral, the second is the Accountable Care Organization (ACO) and the third is the Commoditization of Policies.

The Reinforcing Spiral

Obamacare means that insurance companies will have to cover people with pre-existing risks starting in 2014 (see Title I, Section 1101 of the ACA, pages 47-48). The individual mandate is meant to ensure that individuals buy coverage or face a penalty. Obamacare also mandates that all employers with more than 50 employees provide health coverage or face a penalty. On the surface this seems like a good way to ensure that everyone buys insurance.

But, the mandates lack teeth. For individuals, the fine is 1% of their income, providing their income is high enough, rising eventually to 2.5%. In practice, this means the fine starts at $95 per year and rises to about $700 over time. Currently if you don't buy insurance and you break a leg or get cancer, insurance will not cover you after the fact and you'll go bankrupt paying medical bills, which is a powerful incentive to buy health insurance. Post implementation of Obamacare, you can choose to pay the miniscule penalty when you are well and then buy health insurance on the way to the hospital. Essentially, Obamacare takes away the catastrophic risk of not buying insurance by forcing the insurance industry to cover pre-existing conditions (such as the leg you broke while you didn't buy insurance).

If you believe in game theory, you believe people act in their own self interest no matter what the other players do. In practice, the effect of forcing insurers to cover preexisting conditions, while having little or no penalties for not buying insurance just means that more and more healthy people will choose not to buy expensive health insurance and will buy it only when they get sick. It's easier to pay a fine of $8 per month than to pay $300-500 per month for health insurance.

Think of it in this way. If it costs you $75 to insure your house and $5 is the penalty for not insuring your house, but the insurance company is forced to sell you a policy after your house burns down, what would you do? You might want to buy homeowner's insurance because you are a decent person. However, when you see your neighbor hasn't bought homeowner's insurance preferring to buy it after his house burns down, you'll feel stupid to be paying for the cost of covering his house after the fact. Then you too will pay the $5 per month and stop buying homeowner's insurance. Similarly more and more healthy people will stop buying health insurance preferring to wait until they get sick to buy insurance.

Thus the proportion of people in the insured pool with expensive illnesses will rise and cost per insured person will rise. This will force the insurers to raise premiums on the dwindling pool of insured people to cover the costs. As costs rise more healthy people who can do without health insurance right now, will stop buying health insurance, forcing insurers to raise the premium even further. The cycle will repeat until all the healthy people who can do without immediate health insurance are forced out and only very sick people remain in the insurance pool.

Now as insurance companies try to raise their rates steeply, there'll be an outcry that they are profiting from the very sick, and regulators will impose price controls and stop premium increases just as they are doing now in Massachusetts. This will squeeze the insurers between a rock and a hard place. On one had the costs of the insured pool will be rising and on the other the ability to raise premiums will be taken away. I predict this effect alone will be enough to question the viability of the insurance companies as functional entities.

The cycle will also be accentuated by the refusal of small businesses initially and large businesses eventually to buy health insurance for their employees. Currently, if employers don't provide health insurance right now, they would have trouble attracting and retaining potential and current employees who would not want to run the risk of falling sick and incurring large medical bills.

Once insurance companies are prohibited from denying coverage due to preexisting conditions, availability of health insurance from a employer is no longer an incentive for working. Employees would, in fact, prefer to get extra pay in lieu of insurance, pay that they can use for other purposes, like taking a vacation. When they break a leg, they'll buy insurance on the way to the hospital and cancel it the next day after they got their treatment.

When business owners esp. small business owners realize that health care coverage is no longer an incentive and doesn't help them retain employees, they'll drop it like a hot potato preferring to pay a fine of $2000 per employee rather than $25,000-$30,000 for a policy for a family of four. Large companies will take a little longer, but eventually they'll arrive at the same conclusion and any company that still buys insurance for its employees will be at a serious competitive disadvantage due to higher costs.

Hence, implementation of Obamacare, far from increasing health insurance coverage, will cause it plummet like a rock, destroying the health insurance companies source of revenues. Regrettably both the popular and business media assert that health insurance enrollment will increase. Logic shows that the exact opposite is going to happen resulting in a self reinforcing cycle of decreasing enrollment, increasing premiums, falling profits, price controls and eventually bankruptcy.

The Accountable Care Organizations (ACO's)

The second probably insurmountable risk to the survival of health insurance companies is that of the Accountable Care Organization . This structure, essentially replaces health insurers and poses a existential risk to the very need for health insurers at all. Starting in 2016, the government will try to expand the present pilot ACO program through out the country.

What is an ACO? In the current system, the insurer collects a premium from you based on your risk and pays a hospital, doctor or other health care provider for the services provided to you. If they provide less services the insurer pays less and if they provide more, they pay more.

Obamacare already more or less takes away the first function, that of adjusting premiums based on risk by eliminating pre-existing conditions and by various rules that govern premiums such as not charging women more, by capping premiums for elderly etc.

The second function of a insurance company is that of assessing claims and paying them out. Under the ACO system this function is transferred from the insurer to the hospital or doctor. Title 3, sec.3023 of the ACA titled "National Pilot Program for Payment Bundling" amends title XVIII Sec. 1866 of the Social Security Act and inserts section 1866D and lays out the initial piloting of the ACO structure and the expansion.

First, the concept of a fixed payment rather than payment for services rendered is introduced. Title 3, sec. 3023 page 135, 3 (NYSE:C) (i)

"IN GENERAL.-A bundled payment under the pilot program shall be comprehensive, covering the costs of applicable services and
other appropriate services furnished to an individual during an episode of care (as determined by the Secretary);"

While initially piloting as a fixed payment for care for 1 month for each episode, Title 3, sec. 3023 amends Title XVIII Section 1866 by inserting subsection D (ii) which states,

"The Secretary, as appropriate, may establish a period (other than
for the period described in clause (i)) for and episode of care under the pilot program"

This essentially gives carte blanche to the secretary of health human services to extend the period for which a ACO hospital to one year (or any number of years) and unlimited episodes of care within that period.

Finally the expansion of the program is introduced in Title 3, sec. 3023, page 139 (NYSE:G) (1)-

"Not later than January 1,2016, the Secretary shall submit a plan for the implementation of an expansion of the pilot program"

The consensus in the hospital industry is that payment will be for period of one year to three years. The hospital or doctor will get a fixed sum of money for each patient per year from the insurance company out of which to meet all the medical needs of the patient. There'll be no need to submit a claim to an insurance company. The insurance company no longer collects a premium (and a profit) for managing risk. The insurance company becomes merely a shell transferring the collected premium from insured to the ACO.

The insurance company will no longer need actuaries, risk analysts, claims processing, sales people, even executives and management. There'll no benefit to the insurance company to do any of the above. And since they would just be collecting and handing over the premiums to the ACO without doing anything further of value, there would be no need for health insurance companies to exist at all, and I predict that health insurance companies will cease to exist by 2017-2018 as the ACO model becomes widespread. The ACO model means local hospital will become the insurance company and care provider in one. The New York Times in a rare moment of candor predicted the same things as I am predicting now except that Emanuel and Liebman predict that the end for private insurance companies will come by 2020.

"Here's a bold prediction for the new year. By 2020, the American health insurance industry will be extinct. Insurance companies will be replaced by accountable care organizations - groups of doctors, hospitals and other health care providers who come together to provide the full range of medical care for patients.

... thanks to the accountable care organizations provided for by the health care reform act, a new system is on its way, one that will make insurance companies unnecessary.

And with the end of fee-for-service payments, insurance companies will no longer be needed to handle complicated billing and claims processing, nor will they need to be paid a fee for doing so. Payments can flow directly from an employer, Medicare or Medicaid to the accountable care organizations."

Commoditization of Insurance Policies

The third probably insurmountable risk to insurance companies is the certainty (as long as the companies still exist) of commoditization of policies. Under Obamacare, every insurance company in the United States will sell exactly one policy. You can have any choice of color so long as it is black. The ACA mandates certain generous minimum levels of coverage. Title 1, Section 1301 (a) (1) (NYSE:B) page 85 defines a "qualified health plan" as one that

"that such plan meets the criteria for certification [through the health exchanges established by Obamacare] ...or...provides the essential health benefits package described in section 1302(a);"

Section 1302 in Title I, of Obamacare page 87, titled "ESSENTIAL HEALTH BENEFITS REQUIREMENTS" has a exhaustive list of gold plated benefits.

No insurance company can sell a cheaper policy that offers less coverage than the generous minimum prescribed by Obamacare as that would not qualify. The corollary is that, thanks to the inability to deny coverage due to pre-existing conditions, no company can sell a policy that offers more coverage for a greater price.

Imagine a company X that offers more coverage for hemophilia than the required minimum. As soon as a person finds out that they have hemophilia, they'll switch to the policy offered by company X, This is a phenomenon called adverse selection. The effect of this is that if any company offers better coverage for a higher price, people will wait until they are sick and then enroll in the policy that offers better coverage, thus creating enormously high cost for that company, bankrupting it. As a result of adverse selection, after Obamacare is fully in force, companies can offer one and only one identical policy, to remove the incentives to switch policies when a person gets sick. This will remove any competitive advantages insurance companies have now by tailoring policies to different segments of the market (high deductible for young people etc).

This also removes any ability for the insurance companies to compete with each other on the basis of coverage or benefits. Neither can they compete on the basis of price since all policies are identical, people will choose policies that cost the least. Hence it will be the classical race to the bottom for insurance policy prices, where all the profits are competed away and margins shrink to zero.

The Investing Thesis

Shorting any health insurance company (AET, UNH, CI, CVH, HUM, WLP) has a very high probability of yielding a strong multiple ROI. If Obama looks like he'll be re-elected, then there is nothing that can either delay or repeal Obamacare and the three factors I've outlined above guarantee that health insurance companies will probably not survive before the end of Obama's second term. Each of the three factors I've outlined above is probably insurmountable in itself and taken in conjunction, they constitute a perfect storm for the health insurance companies.

As for timing, I believe that the full effects of Obamacare have yet to sink into the collective consciousness. Pending the Supreme Court ruling it was a roll of the dice as to the fate of the insurance companies. In the coming months as the sell side analysts and consultants their reports to the decision makers, I believe the writing on the wall will become more distinct. If it looks like Obama will be re-elected, I believe that the health insurers stock prices will crater. Conversely, if Obama loses, I expect prices, if not to soar, at least to maintain current levels.

Recommendation: Short AET, UNH, CI, CVH, HUM, WLP if it looks like Obama will be re-elected.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in AET, UNH, CI, CVH, HUM, WLP over the next 72 hours.

Additional disclosure: I am not a registered investment advisor. This article is for informational purposes only. You should do your own research and due diligence before investing in any equity.