The effect on health insurers of the various industry trends
will become clearer over the next few years as the population continues
to age and healthcare reform is fully implemented. In reviewing
these trends, I will analyze how valuation metrics are affected
by each value driver.
Socioeconomic Trends
Trends in medical care costs and the rising age of the population
have strengthened demand for health insurance and are expected to
continue to do so. According to the Congressional Budget Office's
projections, if current laws remain in place, spending on the major
federal healthcare programs alone will grow from more than 5 percent
of gross domestic product (GDP) today to almost 10 percent in 2037
and continue to increase thereafter.1
Escalating medical care costs as a percentage of GDP will drive
growth for the insurance industry as insurers pass cost increases
on to policyholders in the form of higher premiums. Additionally,
as the baby boomers continue to increase the median age of the population,
more individuals will qualify for financial subsidies, enhancing
the demand for both government programs and private insurance as
many people will supplement their government-funded coverage.2
As mentioned above, much of this growth is due in part to government
healthcare programs and subsidies, which are discussed in further
detail below.
Patient Protection and Affordable Care Act
Although portions of the new federal healthcare regulation have
yet to take effect, it is clear that existing provisions are influencing
both demand and profitability within the health insurance industry.
On March 23, 2010, President Barack Obama signed the Patient Protection
and Affordable Care Act (PPACA) into law.3
Since the law was enacted, numerous provisions have been implemented
that increased the amount of claims paid out by insurers including
expanding the dependent coverage age, eliminating certain annual
and lifetime limits, and removing preexisting condition limits for
enrollees under age 19. Although the removal of these limitations
has increased health insurance demand, it has also raised the number
of risky policyholders that insurers are required to serve.
Furthermore, the PPACA requires insurers to meet new requirements
regarding their medical loss ratios. A medical loss ratio refers
to the percentage of premium dollars that an insurance company spends
on providing health care and improving the quality of care, versus
how much it spends on administrative and overhead costs. As of 2011,
the law required that 80 to 85 percent of the money collected by
insurance companies be spent on healthcare services and healthcare
quality improvement.4 These restrictions
have placed a strain on insurers' profitability.
Starting January 1, 2014, insurers will encounter both higher
demand and increased competition generated by the establishment
of state health insurance exchanges.5
Although it is estimated that 12 million consumers will generate
$60 billion in premium revenues through use of the exchanges in
2014, this growth does not come without risk.6
For health insurers participating in exchanges, the increase in
potential revenue is accompanied by a reduction in switching costs
for customers, allowing policyholders more bargaining power and
the ability to generate greater price competition.
Additionally, although the exchanges are designed to spread costs
incurred by those with expensive medical needs across large groups,
providers of health insurance fear there might be an issue with
adverse selection.7 Adverse selection
is the tendency for people to not attain health insurance until
they fall ill, which results in a greater total cost to be shared
by the pool of policyholders.8 This
concern is a valid one, as an insurer cannot adequately hedge its
risk of large claims associated with greater numbers of unhealthy
and high-risk policyholders entering the marketplace. Although the
results of the health insurance exchange provision remain uncertain,
insurance companies are concerned about the effects competition
and riskier demand will have on pricing and profitability.
In summary, about 30 million Americans are expected to gain coverage
as a result of the PPACA through Medicare and Medicaid, exchanges,
and employer-sponsored coverage.9 While
potential revenue increases as the universe of policyholders expands,
the higher risk policyholders receiving coverage and the restrictions
surrounding the medical loss ratios could create potential risk
and profitability challenges for insurers.
Growth through Consolidation
Although the trends discussed above are generating demand for
the health insurance industry overall, the aging population and
the PPACA are generating greater demand for government-funded insurance
and subsidy programs, specifically. For those health insurance companies
that have not historically provided insurance in the form of Medicare
and Medicaid, acquisition of such providers has become an important
avenue for growth. The following are three significant acquisitions
that have occurred since October 2011 within the industry:10
- Aetna Inc. acquired Coventry Health Care Inc.
for $7.3 billion;
- WellPoint Inc. acquired Amerigroup Corp. for
$4.4 billion; and
- Cigna Corp. acquired HealthSpring for $3.8 billion.
I analyzed the implied price-to-earnings (P/E) multiples for
each of the transactions and compared them to a set of publicly
traded companies described in further detail below.
Price-to-Earnings Valuation Analysis
I analyzed the following publicly traded companies (the "Industry
Group") for the purpose of this article as these companies provide
insight into valuation trends within the health insurance industry.
- Aetna Inc. (AET)
- Cigna Corp. (CI)
- Centene Corp. (CNC)
- Coventry Health Care Inc. (CVH)
- Health Net, Inc. (HNT)
- Humana Inc. (HUM)
- Molina Healthcare, Inc. (MOH)
- UnitedHealth Group Incorporated (UNH)
- WellCare Health Plans, Inc. (WCG)
- WellPoint Inc. (WLP)
Figure 1: Average Forward P/E Multiples for Publicly Traded Health Insurers
As illustrated in the graph above, forward P/E multiples have
been fairly volatile over the past 5 years. However, an upward trend
since the third and fourth quarter of 2011 reflects not only general
economic recovery but also growth expectations, particularly for
the government-funded segment of the health insurance industry.
Industry participants have recognized this growth, as noted previously,
and capitalized on it through consolidation. Implied transaction
P/E multiples for the three acquisitions mentioned above ranged
from 12.0 times to 30.6 times, whereas the most recent P/E multiple
average shown in the graph was just over 12.0 times. I noted that
the targets were purely Medicare- and Medicaid-focused companies
with elevated growth expectations, which may be a key contributor
to the higher multiples observed for these companies.
Superior growth expectations are also reflected in the long-term
EPS growth rates that have been steadily trending upward toward
pre-recession levels. As the PPACA generated greater demand for
health insurance, earnings expectations rose. Additionally, steadily
increasing healthcare costs contributed to revenue growth for the
health insurance industry. However, as the industry shifts toward
publicly funded insurance comprising a greater portion of premium
revenues, operating margins could experience downward pressure.
This phenomenon could be a factor captured in the slight decline
in EPS growth expectations over the past few quarters.
Outlook
The future of the health insurance industry will depend on how
states address the adverse selection problem associated with health
insurance exchanges. To alleviate this associated risk, the PPACA
established a risk adjustment procedure of charging a fee to those
members that have lower than average risk scores to fund payouts
to those members with higher than average risk scores. Additionally,
insurers may temporarily elect to reinsure.11
Going forward, higher healthcare costs are expected to continue
to be the primary driver of growth for the health insurance industry.
Additionally, with approximately 8.6 million more people expected
to enroll in Medicare by 2016, demand for government-funded programs
is increasing exponentially.12 Accordingly,
as stated in a report given by the Congressional Budget Office,
both the aging population and the rising cost of health care should
cause spending on federal healthcare programs to grow rapidly over
the next 25 years.13 Nevertheless,
the shift toward more individuals being insured by government-sponsored
programs in addition to government restrictions on the medical loss
ratio may limit profitability in the future.14