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Health Insurance Stock Outlook - March 2014

Zacks Equity Research

U.S. health insurers ended 2013 on a strong note despite facing pressures pertaining to funding and government-sponsored benefits along with three calendar quarters of sequestration in Medicare. The health insurance industry is confronted by many external challenges 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.
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 annual gross domestic product. According to the World Health Organization, healthcare expenditure per person in the United States is the highest in the world.

Despite a huge sum of money being spent on healthcare, millions of Americans continued to lack health insurance coverage or remained underinsured. This was largely attributed to a dysfunctional health care system in place. To rein in the wastage and make health care more accessible, effective and affordable, President Obama introduced health care reform in an attempt to overhaul the nation’s ailing health care system.

Industry Ranking

Within the Zacks Industry classification, Health Insurance is grouped under the Finance sector (one of the 16 Zacks sectors).

We rank 260-plus industries within 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.

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 health insurance industry features in the top 1/3rd with a Zacks Industry Rank #100. This indicates that the overall outlook is ‘Neutral.’

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 the Earnings ESP or Expected Surprise Prediction helps in predicting the probability of earnings surprises.

Earnings Trends

Currently, we are almost about to end the fourth quarter and full year 2013 earnings season with results from nearly 98% of the S&P 500 companies already released.

Every finance company has reported earnings. The 'earnings beat ratio' (percentage of companies with positive surprises) was 72.2% while the 'revenue beat ratio' was 64.6%. Total earnings for this sector were up 22.8% year over year, compared with 10.5% in the third quarter. Total revenue declined by 7.5% versus flat results in the prior quarter.

We are encouraged by the projected 6.2% growth for the sector in full-year 2014 compared with 8.3% growth for the S&P 500.

For a detailed look at the earnings outlook for this sector and others, please read our Earnings Trends report.

Health Care Overhaul
U.S health insurers have always been criticized for welcoming the healthiest and shunning the sicker population. In order to put a check on this (‘cherry picking and lemon dropping’ policy of these insurers), the health care reform was introduced in 2010.   

The Patient Protection and Affordable Care Act (:PPACA) passed in 2010 marked the beginning of a multiyear implementation process. It was the most substantial overhaul in the history of the nation's health care sector. The reform faced huge opposition from the health insurers which fiercely lobbied against most of the provisions of the act. Finally, the majority of health insurers have accepted the reform.

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; restriction on rescission of policies and elimination of annual as well as life time maximum limits.

2014 - A Water Shed Year for Insurers

2014 stands as a year of transition for all the insurers. So far, the carriers have handled the impact of implementation (from 2010-2014) 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 the age of 26, annual rate review) relatively well.     

For the moment, however, the biggest question is how the most arduous provisions of the law (relating to 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) will affect the industry. Some of these have already come into effect in 2014 and the rest will be realized in the course of the year. Investor sentiment toward the reform implementation in 2014 and beyond will be the driving factor for managed care stocks.

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 incurred by the insurers to realign their businesses 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. 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 amid such changing circumstances.

U.S. Insurers Aim for Global Markets

With organic growth remaining challenged at home, carriers in the health insurance sector are flocking the international markets, which specifically appear attractive on account of lesser regulations, higher margins and lower competition. Additionally, pressure on social healthcare 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 Corp. (CI) and Aetna Inc. (AET), 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 intend to penetrate deeper mainly in the emerging economies of Asia and the Middle East.

UnitedHealth Group Inc. (UNH) 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.

Insurers Diversifying to Provide Health Services

Leading U.S. health plans are now realizing that their core business is necessary but not sufficient. Players are increasingly feeling that their business models need to change significantly to position them suitably in the transforming health insurance industry. No longer seeing commercial medical membership as an option for substantial growth, they are thus diversifying into health services businesses such as technology, health-care delivery, physician management, workplace wellness and financial services that are “much less regulated” than insurance plans.

Sensing the tough industry environment, one of the largest health insurers in the country, UnitedHealth Group, espoused the strategy to grow its health services business, branded as Optum, in 2011. The company maintains that its future growth would come from offering services that are much less regulated than health insurance plans.

Major companies have been making acquisitions aimed at growing their health services businesses. Aetna acquired Medicity, a business that helps hospitals share patient information. Humana Inc. (HUM) acquired Concentra, a Texas-based urgent- and occupational-care provider with clinics in 40 states. WellPoint Inc. (WLP) also started diversifying more heavily into consumer-oriented and health IT businesses in 2011 and is continuing with the strategy. At Aetna, Chief Executive Mark Bertolini is implementing strategies that will see the insurer get more deeply into health-information technology and run the back-end operations of the new accountable-care organizations, or ACOs.

Debut of Health Insurance Exchanges: Are Insurers Wary Now?

Health Insurance Exchanges, known as pillars of Obamacare, became operational on Oct 1, 2013. These online health insurance marketplaces were set up to provide subsidized insured plans to the uninsured.

Per data from Kaiser Family Foundation and the Congressional Budget Office (CBO), the exchange market is expected to grow quickly, with approximately 22 million purchasing coverage on the individual exchanges by 2016. By 2023, an estimated 24 million will buy their insurance on individual exchanges.

Despite widening the insurance net, insurers remain wary of these online market places as they expect that the exchanges will initially attract a greater population of people who have been most sick and lacked insurance. Insurers fear that this adverse mix of members would jack up claims bills, rendering their business unprofitable. As such, most of them have taken a cautious approach by limiting participation at the moment, waiting to see how these would work going ahead.

Another 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.

Nevertheless, it is believed that over the coming three to four years, employers might increasingly drop their coverage of workers, which in turn would flood the exchanges with more healthy customers, thus generating profitable mix of business for health insurers.

Sequestration Harming the Insurers

Simply put, sequestration means reduction in government funding in order to reduce the budget deficit. The sequestration imposes reimbursement cuts on Medicare Advantage (MA) payments to the insurers. Cuts to MA plans are part of the $716 billion in Medicare spending reductions that the health law requires over the next decade.

Insurers fear that Medicare Advantage reimbursement cut will erode their bottom-line margins. UnitedHealth Group expects funding pressure to drain the company’s earnings by more than $1.50 per share in 2014. Rate pressure in this business will force players in the industry to make business modifications in order to protect MA margins to some degree and maintain program sustainability. These changes would include exiting certain markets, reducing plan offerings, slashing benefits, and narrowing some networks.

Consumer Gaining Prominence

The reform has introduced a sea of changes within the operations of the industry. While traditionally the insurers have dictated policy, this has gone into the hands of the consumers now. A changing landscape (shift from employer-sponsored health coverage to individuals directly buying coverage) is putting pressure on healthcare organizations to introduce customer-centric strategies.

The market is forcing insurers to design products for consumers as customers are actively engaging themselves using information to compare and shop. Players have also realized the urgent need to implement changes fearing that if they do not make the requisite changes, consumers may graze away elsewhere.

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 the following factors:

  • Health expenditure and reliance on managed care are gradually increasing. According to the new estimates from the Office of the Actuary at the Centers for Medicare and Medicaid Services (CMS), aggregate health care spending in the United States will grow at an average annual rate of 5.8% for 2012-22, or 1.0% faster than the expected growth in the gross domestic product (GDP). The health care share of GDP by 2022 is projected to rise to 19.9% from its 2011 level of 17.9%.  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 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.

Though the journey may remain bumpy over the near term, in the longer term, most of the companies within our coverage are expected to benefit from the changing trends. Specifically Aetna with a Zacks Rank #2 (Buy), and Health Net Inc. (HNT), WellPoint, Molina Healthcare Inc. (MOH), UnitedHealth Group all with a Zacks Rank #3 (Hold) will offer good investment opportunities going forward.

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

Aetna remains uniquely poised to benefit from the changing health insurance market. The company has made huge investments in IT and is making strong progress in its Medicare business. It is also augmenting its international business for diversification benefits. A solid balance sheet, well-controlled debt and adequate liquidity provide overall strength.

Cigna 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.

UnitedHealth has also been performing well for the past many quarters. The company has developed a distinctive health services platform with Optum which is expected to generate long term growth. The company’s international expansion which provides higher margin will also lead to margin contribution over the coming quarters. A solid balance sheet with strong cash flows and moderate leverage, disciplined capital management strategy are other positives.


Apart from the regulatory hurdles, the industry will continue to suffer from tepid growth in the U.S. economy. Workforce reductions have caused corresponding membership losses in insurance companies' fully-insured commercial group business. Continued weakness in the U.S. economy and a sluggish unemployment rate will adversely affect medical membership, operations, financial position and cash flows.
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
MOLINA HLTHCR (MOH): Free Stock Analysis Report
HEALTH NET INC (HNT): Free Stock Analysis Report
UNITEDHEALTH GP (UNH): Free Stock Analysis Report

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