Impact of Healthcare Legislation on Health Insurance Companies
August 2010
With the recent passage of the Affordable
Care Act, several significant health insurance changes are expected to be put
in place within the next several years.
by Jeff
Balcombe
The BVA Group LLC
A few of the notable changes to be implemented by the Act include:
- establishing a competitive insurance market;
- prohibiting annual and lifetime limits on coverage;
- providing free preventive care;
- requiring coverage of individuals with preexisting health conditions;
- regulating the cost of insurance; and
- expanding coverage to many currently uninsured Americans.
With little or no historical precedent as a guide, it can be difficult to
assess the future economic impact that the Act may have on health insurers.
As a result, there is substantial uncertainty in the health insurance industry
regarding the consequences of the expected changes. To measure the value of
firms operating in the health insurance industry in the current regulatory environment,
it is important to understand the potential impacts, both negative and positive,
of the recent healthcare legislation.
Competitive Insurance Market
Beginning in 2014, individuals and small businesses will be able purchase
insurance on new health insurance exchanges established by the Act, which are
expected to create a competitive insurance market. All else equal, increased
competition in the marketplace would likely result in the erosion of premiums,
generally causing profit margins to deteriorate. However, competitive exchanges
could provide larger insurers with an opportunity to capture a share of the
private insurance market from their competitors. For example, one article notes
that WellPoint, Inc., partly due to its sizable share of the private insurance
market, is able to obtain lower prices on medical services, providing it with
the flexibility to undercut competitors' rates if needed.1
As a result, WellPoint, or other firms with similar capabilities, may have the
opportunity to expand their market share by reducing their rates.
While increased market share typically yields a positive impact on a company's
value, the decrease in premiums required to obtain additional customers could
offset any gains from increased market share. Smaller competitors with less
bargaining power may not be able to compete. As a result, some analysts foresee
the industry trending toward a state of oligopoly, where only a small number
of firms offer health insurance.2
A valuation incorporates the subject company's future growth prospects as
well as an assessment of the risks involved in pursuing those prospects. Whether
or not the addition of competitive insurance exchanges constitutes a growth
opportunity depends on the specific insurer's bargaining power and, in turn,
its ability to lower premiums while maintaining profitability. Given that the
typical profit margin for a health insurance plan is under 5 percent,3
the impending introduction of competition may represent a significant risk for
many insurers, yielding a lower valuation.
Ban on Annual and Lifetime Coverage Limits
Under the Act, as of September 23, 2010, insurance companies will no longer
be allowed to impose lifetime limits on the amount of insurance coverage offered.
By 2014, this restriction will also apply to annual limits. It is estimated
that as many as 20,400 people reach lifetime limits each year.4
Furthermore, 102 million Americans are currently estimated to be covered by
insurance plans that are allowed to enforce these limits.5
Given the aging population, one can speculate that these figures will only increase.
Without annual or lifetime limits, insurers will be required to pay out more
in claims than they would have otherwise. As a result, either insurers will
pass on premium increases to the insureds, which may be prohibited as discussed
later, or profitability will decline. By restricting the use of coverage limits,
the Act could increase the probability of additional future cash outflows for
insurers, which reduces a company's valuation.
Free Preventive Care/Acceptance of Individuals with Preexisting Conditions
Certain provisions in the Act will allow for free preventive care for certain
health plans and prohibit discrimination against individuals with preexisting
conditions, both of which expand the coverage offered to individuals in qualified
health plans. While it is uncertain how this will affect insurers, it could
ultimately lead to higher premiums due to companies shifting the cost.6
In addition to free preventive care, an estimated 200,000–400,000 Americans
who have preexisting health conditions are expected to gain coverage. Despite
a patient's previous health conditions, insurers will be obligated to accept
everyone who applies beginning in 2014.7
The requirement to accept all insurance applicants, regardless of their medical
history, increases the risk that certain policies will generate less premium
income than the amount of claims paid, yielding a net cash outflow for the insurer.
As a result, this provision may reduce expectations for future cash flows and
increase the risk of achieving those cash flows, which, in turn, has a negative
impact on value.
Regulation of Cost of Insurance
Insurance companies will be more closely regulated under the Act, which will
require insurers to justify any premium increases and spend at least 85 percent
of premium revenue on healthcare services and quality improvement beginning
in 2011. For small employers and individuals, the rate is slightly lower at
80 percent. If companies do not meet these medical-loss ratios (MLRs), they
must issue rebates to consumers. This provision effectively limits the profit
margins that health insurers can make.
An article published in Forbes magazine
indicated that some insurance companies, most notably, those serving the small
group and individual markets, will need to lay off employees and cut costs to
meet these requirements.8 The article notes that
"depending on how the law is implemented by Kathleen Sebelius, the Health and
Human Services secretary, it could end up driving many insurers out of business."9
Increasing the Number of Americans Covered
Most individuals will be required to either obtain minimum coverage or pay
a fee; furthermore, tax credits will make insurance plans easier for some to
afford. These provisions expand the demand for insurance plans as more Americans
will have health insurance. An estimated 1 million currently uninsured Americans
will have health insurance by 2011.10 By 2014,
tax credits will aid those who cannot afford insurance and more low-income individuals
will become eligible for Medicaid, with an estimated 30 million Americans expected
to gain coverage.11
The future increase in demand for insurance may represent a significant growth
opportunity for some insurers, "particularly those specializing in coverage
for the poor."12 In fact, some private equity groups,
such as The Carlyle Group, have shown increased interest in medical insurers,
due to the potential growth in the number of people receiving health insurance.13
Private equity interest may offer the potential for acquisitions at premiums,
since private equity groups may be able to consolidate multiple insurers, realize
economies of scale, and then sell to a larger industry player.
Recent Market Valuation of Health Insurance Companies
Below is a group of publicly traded companies (the "Industry Group") that
are representative of the healthcare insurance segment of the insurance industry.
- Aetna Inc. ("AET")
- AMERIGROUP Corporation ("AGP")
- CIGNA Corporation ("CI")
- Coventry Health Care Inc. ("CVH")
- Health Net Inc. ("HNT")
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- Humana Inc. ("HUM")
- Unitedhealth Group, Inc. ("UNH")
- Universal American Corp. ("UAM")
- WellPoint Inc. ("WLP")
|
Click here for
Figure 1, illustrating the trend in the Industry Group's average price-to-latest
12 months earnings (P/E) multiple and the average forecasted long-term growth
rate. With the election of President Obama in 2008, the market likely began
to "price in," if it had not already, the potential impact of healthcare reform,
especially given that the issue was on the top of President Obama's agenda coming
into office. As shown in the graphical analysis, expected growth rates and P/E
multiples for the Industry Group trended downward significantly between 2007
and 2009, which was likely attributable to not only the prospect of changes
to healthcare but also the general economic recession. This hypothesis is supported
by the fact that, as general stock market conditions improved in early 2010,
the Industry Group's P/E multiples increased as well, although the expectation
of healthcare legislation had not changed.
Interestingly, during the same time frame, the Industry Group's estimated
long-term growth rate continued to decline, possibly reflecting anticipation
of the imminent passage of the healthcare legislation. As discussed previously,
the Act places premium increases under greater scrutiny, which could limit growth
potential for many health insurers.
Subsequent to the passage of the Act, the average expected long-term growth
rate for the Industry Group has remained unchanged while the average P/E multiple
has fallen substantially. In fact, the average P/E multiple of the Industry
Group as of the writing of this article was lower than the average multiple
during any of the years shown, including 2009 in the midst of the general economic
recession. This suggests that the market perceives less growth opportunity and
greater uncertainty as to how the Act will ultimately impact the Industry Group's
earnings and growth. As an example, health insurers are uncertain as to how
regulation of profit margins will ultimately be implemented. As noted previously,
"depending on how the law is implemented by Secretary Sebelius, it could end
up driving many insurers out of business."14 Because
of the risk surrounding this and other provisions of the Act, market valuations
of health insurers have been reduced accordingly. However, offsetting this downward
pressure on multiples is the potential for increased demand for insurance. While
industry analysts expect some insurers, "particularly those specializing in
coverage for the poor,"15 to benefit more than
others, it is unclear what the eventual net impact will be. Only once the provisions
in the Act are fully implemented will the current uncertainty subside. According
to valuation theory, assuming growth expectations remain unchanged, increased
visibility within the industry should provide a positive influence on valuation
multiples, potentially allowing multiples for some health insurers to revert
back to historical levels.
Conclusion
Reactions to the recent changes in healthcare generally appear to have been
negative within the health insurance industry. Not only will the Act have a
direct impact on insurer's margins through the establishment of a minimum medical-loss
ratio, but it also contains several provisions that may lead to a decrease in
profitability. For example, by prohibiting annual and lifetime limits on coverage,
requiring companies to accept patients with preexisting conditions, and offering
free preventive care services, there is an increased likelihood that insurers
will have to pay out more of their premiums earned. Furthermore, the new health
insurance exchange may significantly increase competition in the industry, making
it more challenging for insurance companies to maintain premium prices.
On the contrary, the Act will also allow millions of currently uninsured
Americans to gain coverage, which could provide a boost to volume for some insurers.
In determining how these provisions may affect the valuations of health insurers,
one must weigh the potential increase in policyholders against the negative
impacts of the Act, such as margin erosion. Based on the trend in the valuations
of health insurers, it appears that the market perceives lower long-term growth
prospects and greater risks surrounding the ability of insurance companies to
maintain historical levels of earnings. Once the implementation of the Act is
fully understood, increased valuation multiples may be warranted for those companies
that will be able to adapt and continue to grow earnings.
Note: See the 2011 update of this article,
Recent Trends in the Valuation of Health Insurers.
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