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.” Big players – including CIGNA Corp. (CI), WellPoint Inc. (WLP), Humana Inc. (HUM), Health Net, Inc. (HNT) – reported third quarter earnings ahead of the Zacks Consensus Estimate, while UnitedHealth Group Inc. (UNH) reported in line.
Following third quarter results, most of the carriers raised their 2013 earnings estimates, reflecting a favorable operating environment. We, however, expect narrower margins in 2014 compared to 2013, as favorable claim development and continued lower-than-expected utilization helped the industry witness strong margins in the prior year. Margins are anticipated to decline in 2014 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 annual gross domestic product. According to the World Health Organization, health care expenditure per person in the United States is the highest in the world.
Despite huge sums of money being spent on health care, millions of Americans lacked health insurance coverage or were underinsured. This was largely attributed to a dysfunctional health care system in place for the past several years. To rein in the wastage and make health care more accessible, effective and affordable, President Barack Obama introduced the Health Care Reform in an attempt to overhaul the nation’s ailing health care system.
Industry Ranking – Positive
Within the Zacks Industry classification, Health Insurance is grouped under the Finance sector (one of the 16 Zacks sectors).
We rank all the 260 plus 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.
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 #6. This indicates that the overall outlook is ‘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 Earnings ESP or expected surprise prediction helps in predicting the probability of earnings surprises.
Currently, we are approaching the end of the third quarter 2013 earnings season with results from nearly 88% of the S&P 500 companies already available.
Among the finance companies that have already reported, the 'earnings beat ratio' (percentage of companies with positive surprises) was 58.2% while the 'revenue beat ratio' was 50.6%. Total earnings for this sector were up 9.9% year over year, moderating from the 32.4% growth in the second quarter. Total revenue moved north 0.6% versus 7.9% growth in the prior quarter.
Looking at the consensus earnings expectations for the rest of the year, we are encouraged by the estimated 32.3% growth for the sector in the fourth quarter and full-year 2013 growth of around 13.7%.
For a detailed look at the earnings outlook of this sector and others, please read our Zacks Earnings Trends report.
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; restriction on rescission of policies and elimination of annual as well as life time maximum limits.
The Reform faced 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 presidential term provided the necessary ratification to the health care reform. But recent implementation challenges, particularly the botched launch of the website, has continued to cloud its outlook.
The Changing Face of the Health Insurance Industry
So far, the carriers have handled the impact of implementation 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 impactful 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), 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.
Insurance Exchanges, which came into effect from Oct 1, are acting as an online marketplace where consumers who are underinsured 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. 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 to 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 intend 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.
Focus on Health Insurance Exchanges
The 2010 Affordable Care Act established online health insurance marketplaces, also known as exchanges, to enable individuals and small businesses to shop for coverage.
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.
Overall, the exchanges are likely to be a major opportunity for large insurers over the coming years. Insurance companies are taking different strategies in approaching the exchanges. We believe WellPoint remains best positioned on the exchanges, given its strong branding and conservative pricing. Another player Aetna Inc. (AET) is likely to accumulate significant market share within its states, driven mostly by the Coventry brand. Others like Centene and Humana are quite active in bidding, while United and Cigna are entering gingerly.
The health insurance exchange with its comparative shopping options and easy availability of consumer information is expected to increase competition among private insurance providers. But before the process could start, consumers will need an easy-to-use and, not to mention, functioning web-based interface to make use of it. The inability to do that thus far has been very embarrassing for the law’s proponents and a boon for its opponents.
Health Insurers Investing in Technology
The country’s seismic shift toward a more digitized way of life was noticed by the health industry. 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 are being paid for the quality of care they provide in addition to the quantity of services offered. Some of the companies are also sharing data. We expect the trend to continue as pay-for-performance takes root.
Reversal of 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. In Feb 2013, the U.S. Centers for Medicare & Medicaid Services proposed to reduce reimbursement payments by 2.3%. This worried insurers so much so that they lobbied against the rate cut.
Following the widespread lobbying The Centers for Medicare & Medicaid Services announced in April that it will increase the rate by 3.3% in 2014, reversing the rate cut announced in February. The originally proposed 2.3% cut, along with other headwinds, would have translated into a 7% to 8% decline in revenues, leaving a majority of insurers unprofitable.
Medicare Advantage Remains a Preferred Market
Insurers remain attracted to this line of business as they expect increasing number of seniors to opt for the Medicare Advantage program. Enrollment in such plans is expected to increase in 2014.
According to U.S. Census data, the number of Medicare beneficiaries will increase 36% by the end of this decade led by a vast 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.
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. 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.
We expect most of the companies within our coverage to benefit from the trend. Specifically Cigna with a Zacks Rank #2 (Buy) and Health Net, WellPoint, Molina Healthcare, Aetna, 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:
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.
Aetna remains uniquely poised to benefit from the changing health insurance market. The company has made huge investment in IT and 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 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 conjecture, 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 5.8% from 2012-2022. 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 a sluggish 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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