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.
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, 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")
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.
Figure 1: Average P/E Multiples and Long-Term Growth Rates
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. 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.
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.
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