Recent Trends in the Valuation of Health Insurers
November 2011
This article provides an
update to my August 2010 article,
Impact of Healthcare Legislation on Health Insurance Companies,
regarding several significant health insurance changes that are
expected to be implemented within the next several years.
by
Jeff Balcombe
The BVA Group
LLC
Three primary drivers of value are growth, profitability, and
risk. This article focuses on the impact that political reform
has on the key drivers of value and the market's pricing for
different segments of the health insurance industry.
Political
Factors Affecting the Industry
On March 23, 2010,
President Barack Obama signed the Patient Protection and
Affordable Care Act into law.1 Health
insurers would no longer be allowed to place annual and lifetime
limits on the amounts of coverage offered, thus increasing the
amount of claims paid out.2 Prior to the
passage of legislation preventing the ban on annual and lifetime
limits, insurers could drop individuals who reached their
lifetime or annual limit.3 Dropping
high-risk patients has typically been a mechanism health
insurers have used to maintain profitability. Given that
profitability is one of the key factors affecting value, reduced
expectations for future profitability could hurt pricing of
health insurers.
Additionally, to ensure that premium dollars
are spent primarily on health care, the new law will require
that insurance companies spend at least 85 percent of all
premiums collected from large employer plans on healthcare
services and healthcare quality improvement. For plans sold to
individuals and small employers, at least 80 percent of the
premiums must be spent on benefits and quality improvement. If
insurance companies do not meet these goals, they must provide
rebates to consumers.4 As a result, this
provision may reduce expectations for future cash flows and
increase the risk of achieving those cash flows.
Some segments
of the industry will benefit as a result of the new legislation.
As noted in Molina Healthcare Inc.'s 10–K, as a result of
recently enacted healthcare reform legislation, the Medicaid
population is expected to grow from approximately 60 million
today to approximately 82 million by 2019. Medicaid eligibility
will expand to more individuals; people with income up to
133 percent of the poverty line will qualify for coverage,
including adults without dependent children.5
This should provide more opportunities for industry participants
that provide Medicaid-related solutions and assist state
agencies in administration of programs.
Industry Consolidation
All health insurers primarily focused on the private
market are struggling with the downward pressure on growth and
profitability associated with the new regulations.6
While all companies will struggle, the larger companies are
better equipped with the resources and balance sheets to
implement and adopt the new legislation. Smaller industry
participants that also focus on the private market, on the other
hand, will find the new legislation costly and burdensome.
As
a result of these factors, industry consolidation is expected as
smaller companies struggle to remain competitive.7
Additionally, large insurers will try to compensate for the lack
of organic growth since premium increases will be regulated.
Some players that focus on niche markets are not as affected by
the legislation and may be able to achieve strong growth and
outperform the market. Niche players could be ripe takeover
targets for the largest health insurers as political reform
depresses future expectations. In an interview, the chief
financial officers of Aetna and WellPoint stated that mergers
and acquisitions throughout the industry will increase
considerably in the near future and the pipeline for
acquisitions looks strong.8
Trends
in Valuation Multiples
Market valuations are generally
influenced by earnings levels, growth prospects, and a variety
of risk factors. Industry analysts typically reference
price-to-earnings (P/E) multiples, among others, when discussing
valuation metrics for health insurers. The P/E multiple can be
based on historical earnings (such as net income during the
latest 12 months) or forward earnings (such as net income
expected in the next 12 months). In this article, we focus on
P/E multiples based on the next 12 months, as discussed next.
The pop-up below shows a graphical analysis of the trends in
P/E multiples from July 1, 2009, through September 30, 2011. We
reviewed P/E multiples for two distinct groups of companies
operating in the health insurance industry. We categorized the
companies in two groups based on size and operational
characteristics. The first group focuses on large capitalization
insurance industry participants (the "Large Cap Industry
Group"), while the second group focuses on niche players in the
Medicaid arena (the "Medicaid Industry Group"). Click
here for a list of companies used
in our analysis.
Click here for graph of
average
forward P/E multiples for publicly traded health insurers.
As illustrated in the graph above, multiples for the
Medicaid Industry Group have traded at a significant premium
compared to the Large Cap Industry Group since the fourth
quarter of 2009. This is likely the result of the negative
outlook expected by the large cap insurers from the legislation
signed during 2010. Insurance companies operating in the
Medicaid arena are expected to benefit from the new law as
eligibility will expand to more individuals. Long-term growth
expectations for the Medicaid Industry Group exceeded the Large
Cap Industry Group by an average of 487 basis points from the
first quarter of 2010 to the third quarter of 2011, compared to
a 72 basis point premium from 2006 through 2008. Although other
factors could be contributing to the premium at which the
Medicaid Industry Group trades, the trend can also be
illustrated by the fairly tight range in which both industry
groups traded during 2006 and 2007.
Interestingly, some of the
highest multiples observed were during the first quarter of
2010. This time period correlates to the lowest earnings growth
expectations for both the Large Cap and Medicaid Industry
Groups. Because earnings represent the denominator in
calculating a market multiple, significantly reduced earnings
place upward pressure on multiples from a mathematical
viewpoint. However, if the market believed that earnings growth
had fallen permanently to a lower level, then multiples most
likely would fall over time to offset the impact of lower
long-term growth. We note that there were no drastic changes to
the multiples after this quarter despite a quarterly trend
toward improved growth expectations.
Outlook
The Large
Cap Industry Group that primarily services the private market
will most likely continue to struggle in the face of economic
uncertainty and political reform. To achieve growth expected by
analysts, some larger industry participants may look to high
growth, niche players as potential acquisition targets. While
the larger players may pay a premium for these insurers, the
synergies achieved should cause the acquisitions to be accretive
to earnings. Thus, the trend of industry mergers and
acquisitions is expected to continue in 2012.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author's employer or IRMI. Expert Commentary articles
and other IRMI Online content do not purport to provide legal, accounting, or other
professional advice or opinion. If such advice is needed, consult with your attorney,
accountant, or other qualified adviser.