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Health Insurance Stock Outlook - July 2013

Abhijit Ghosh

The health insurance industry has confronted many external challenges in the recent past such as federal, state legislative and regulatory reforms; a challenge 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 players -- including CIGNA Corp. (CI), WellPoint Inc.
(WLP), Aetna Inc. (AET), Humana Inc. (HUM), Molina Healthcare (MOH) and Health Net, Inc. (HNT) -- reported ahead of the Zacks Consensus estimates in 2013 Q1, while UnitedHealth Group Inc. (UNH) reported in line. The earnings outperformance was driven by lower medical inflationary trends and strong operating performance.

Following the first quarter results, most of the carriers raised their 2013 earnings estimates, reflecting optimism for the rest of the year. We, however, expect narrower margins in 2013 compared to the strong margins in the 2010-2012 period, when favorable prior-period claim development and continued lower-than-expected utilization helped the industry witness strong margins.

Margins are anticipated to decline in 2013 and beyond as medical costs will likely return to more normal levels and pricing may not increase to that extent.

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 approximately 18% of the country's GDP. According to the World Health Organization, health care expenditure per person in the U.S. is the highest in the world.

Despite a huge sum of money being spent on health care, millions of Americans lack health insurance coverage or are underinsured. This is largely due to a dysfunctional health care system, in place for decades. To rein in wastage and make health care more accessible, effective and affordable, the current administration came out with a major reform in the shape of the Affordable Care Act, commonly referred to as Obamacare. This massive piece of legislation has elicited mixed responses from the get-go, largely along partisan lines, and is still not fully functional.

Industry Ranking

Within the Zacks Industry classification, Health Insurance is broadly grouped into two sectors: Medical and Finance. The Medical HMO industry is within the Medical sector while the Multi-line Insurance industry is within the Finance sector. The Multi-line insurance industry houses within its category all kinds of operators that have multiple lines of insurance business, including healthcare.

We rank all the industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry. The ranking is available on the Zacks Industry Rank page. http://www.zacks.com/stocks/industry-rank

As a point of reference, the outlook for industries with Zacks Industry Rank #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and
#177 and higher is 'Negative.' The current Zacks Industry Rank for the Medical HMO industry is #18, down 8 spots in the last week, while the Multi-line Insurance industry is currently ranked #17, up 10 spots over the past week. With both these industries located towards top of the Zacks Industry Rank list, the outlook for the healthcare insurance space remains positive.

Please note that the Zacks Rank for stocks, which is at the core of our Industry Outlook, has an impressive track record, verified by outside auditors, to foretell stock prices, particularly over the short term (1 to 3 months). The rank, along with Expected Surprise Prediction (ESP) (Read:
Zacks Earnings ESP: A Better Way to Find Earnings Surprises) helps in predicting the probability of earnings surprises.

Earnings Trends

The broader Finance sector, of which Health Insurance is a part, remains in excellent shape. The first quarter 2013 results for the sector were impressive in terms of both beat ratios (percentage of companies coming out with positive surprises) and growth.

The earnings "beat ratio" was 73.4% while the revenue "beat ratio" was 51.9%. Total earnings for this sector were up 7.7%, slightly moderating from the 10.0% growth in the fourth quarter of 2012. Total revenues moved north 5.5% in the quarter versus 23.1% in the prior quarter.

Looking at the consensus earnings expectations for the rest of the year, we remain encouraged since earnings are expected to grow 19.1% in the second quarter, 7.6% in the third quarter and 27.6% in the fourth quarter, thereby registering full-year 2013 growth of 14.0%.

Health Care Overhaul

The Patient Protection and Affordable Care Act (:PPACA) was passed in 2010 and 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, 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, and restriction on rescission of policies and elimination of annual as well as life time maximum limits.

The Reform has been on a rough patch since its inception, with opponents challenging its individual mandate and Medicaid expansion clause and dragging it to court. Insurers lobbied against most of its provisions and opposition 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 for a second term 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 Health Insurance Industry

Obama's re-election has made it certain that his signature Health Care law is here to stay, putting behind the prevailing ambiguity. Obama's second term will see implementation of key provisions across the industry. However, the main issue in the short- to mid-term is the uncertainty over how the regulatory reform will play out.

So far, the carriers have handled the impact of implementation of some of the less onerous provisions of the reform (relating to MLR requirements, a ban on denial of coverage due to pre-existing ailment, dependent coverage up to the age of 26, annual rate review) relatively well.

For the moment, however, the biggest question is how the most impactful provisions of the law (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 affect the industry. Investor sentiment toward the reform implementation in 2014 and beyond will be the driving factor for managed care stocks.

Exchanges will act as an online marketplace where consumers who are under-insured 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 low profit margins for the carriers in the long run.

While the individual mandate provision will bring into loop approximately 32 million uninsured people, 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 -- 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 costs.

Moreover, the annual insurance industry assessment ($8 billion to be levied on the insurance industry in 2014, increasing to $14.3 billion by
2018, with increasing annual amounts thereafter), which is not deductible for income tax purposes, and the temporary reinsurer fee ($25 billion to be levied on all commercial lines of business including insured and self-funded arrangements, over a three-year period starting in 2014), will increase insurer operating costs.

In the meantime, rules of the road remain uncertain as the recent delay business mandate provision of the legislation shows. 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 for Global Markets

With organic growth remaining challenged, 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 instance. 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 AmilParticipacoes, Brazil's biggest health insurer and hospital operator, for $4.9 billion. The deal will give it access to a fast-growing market bolstered by a rising middle class.

This acquisition attests the fact that insurers are desperately seeking to graze international pastures. The company already has a significant presence in Portugal, India and the Middle East through joint ventures.

Though the U.S. health insurance industry currently has little international presence, insurers are fast catching up. We expect to see more international deals going forward.

Health Insurers Investing in Technology

There has been unprecedented spending on health information technology (HTHIY). HIT includes electronic health records (EHRs), health information exchanges (HIEs) and other initiatives.

Health IT, which helps providers communicate better with each other about patient care, reduces medical errors, paperwork and needless duplicate screenings and tests, leads to better coordinated patient care and lower health care costs. These have increased current health care information technology spending. Financial incentives offered by regulators to providers and hospitals for the meaningful use of health care IT products are primarily driving huge IT spending.

From 2013, all hospitals serving Medicare patients with the most common conditions will be paid for the quality of the care they provide in addition to the quantity of services offered. Some of the companies are also sharing data. We expect the trend will continue to grow 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. Last month, the U.S.
Centers for Medicare& Medicaid Services proposed to reduce reimbursement payments by 3.5% every year during 2014 to 2017.The proposed reduction in rates comes in addition to the 2% reduction in reimbursement rates related to mandatory cuts to U.S. government spending -- known as sequestration -- that went into effect earlier this year. This has left the insurers worried since this could translate into big payments cuts.

Medicare Advantage plans are also challenged by the health care overhaul and the steep federal budget cuts. Insurers' profits also are expected to be pressured by the growing cost of care and a premium tax imposed to help fund the overhaul.

Medicare Advantage Remains a Preferred Market

Despite reimbursement cuts to Medicare Advantage, insurers remain attracted to this line of business as they expect to make up the lost revenues from the ever-increasing number of seniors opting for the Medicare Advantage program.  Enrollment in such plans is expected to increase in 2013.

According to U.S. Census data, the population of Medicare beneficiaries will grow by 36% by the end of this decade led by a vast aging baby boomer population. Until recently, only two of the public providers -- UnitedHealth and Humana -- were the primary market share holders. However, consolidation in the market has led to a scramble for market share.

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. This is evident from instances like Cigna's acquisition of HealthSpring Inc. UnitedHealth's acquisition of XLHealth Corp. Aetna's acquisition of Coventry Health Care Inc. and WellPoint's acquisition of Amerigroup Inc.

Consolidation Continues

Notwithstanding the fact that the health insurance industry has been witnessing copious mergers and acquisitions for the last several years, the landscape created by the 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:

  • Health expenditure and reliance on managed care are gradually increasing. 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 50% of the total national health care spending, up from approximately 33% 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 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, Molina Healthcare with a Zacks Rank #1 (Strong Buy), and Aetna, Cigna, UnitedHealth Group and WellPoint with a Zacks Rank #2 (Buy), and Humana witha Zacks Rank #3 (Hold) will offer good investment opportunities going forward.

Let's have a quick look at some of these companies:

Cigna (CI) remains attractive given its strong growth profile, significant presence in Medicare Advantage and a growing commercial self insured business. Its International segment has also been growing at a double digit rate.

The company has been delivering solid earnings and the trend is expected to continue. We are more optimistic about the company now that it has shed its exposure to its run off portfolio, which had traditionally been imparting volatility to its earnings.

Aetna (AET) has also been performing well over the past several quarters. The company is 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 provide overall strength.

UnitedHealth (UNH) has also been performing well for the past many quarters. We are optimistic that it will outperform in a rapidly changing industry environment, given its industry-best execution and management, product positioning, scale, and technology. Contrary to earlier conjectures, the company has limited exposure to the downside risks associated with the health reform.


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 expenditure 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 high unemployment rate will adversely affect medical membership, operations, financial position and cash flows.

The overall thrust of healthcare reform and regulatory changes will certainly change the face of the industry in the long run.

AETNA INC-NEW (AET): Free Stock Analysis Report

WELLPOINT INC (WLP): Free Stock Analysis Report

CIGNA CORP (CI): Free Stock Analysis Report

HUMANA INC NEW (HUM): Free Stock Analysis Report

UNITEDHEALTH GP (UNH): Free Stock Analysis Report

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