In the health insurance industry, the margin for error is slim. Companies like WellPoint (WLP) and UnitedHealth Group (NYSE:UNH) must pay particular attention to a single metric that separates the winners and losers in this massive market. This statistic is the benefits expense ratio - also called the medical loss ratio - simply, the cost of providing health care to members divided by the revenues from the premiums paid by these members.
When the implications of the benefits expense ratio are drawn out, it gets a little more interesting. Take WellPoint, for example. Its B/E ratio was 82.4% in 2007, as seen above. If it had knocked this down a single percentage point - in effect, lowered its costs (which are much more volatile than the stable revenue base of $55.9B in 2007), it would have bumped its net income 17 percent, about $600 million. If WellPoint could have kept its medical losses to the rate that its top competitor UnitedHealth Group achieved, it would have meant and additional billion on the company’s bottom line.
WLP is almost twice as large as its nearest competitor UNH, with over 30 billion enrolled customers, and it benefits from its scale when negotiating contracts with national hospital operators and physician networks. But the cost savings from favorable agreements were far outweighed by a miscalculation of risk in 2007. The company altered the benefits structure of its Medicare Advantage Part D plan so that members would have no copay for prescription drugs received under the plan, driving senior citizens to switch to WellPoint. Enrollment in the company’s Medicare D plan increased 15 percent after the change, but these new customers needed more medication than the company had bargained for. As a result, the company’s medical costs increased 200 basis points, 160 of which the company blamed on Medicare D expenditures.
This was enough to drive the company’s benefits expense ratio up for the third straight year - a big reason why WLP is down nearly 40% from its 2007 historical high point of $89.72.
WLP’s stock did get a nice boost from second quarter ‘08 earnings that beat expectations, but it issued a dour outlook for the rest of the year. It forecast rising medical costs and decreasing enrollment in the coming months - which means, of course, another year with an inflation in the benefits expense ratio. Investors should be wary of WLP’s inability to control its own B/E - a better measure of successful health insurance stocks than price to earnings or earnings per share.
Stock position: None.