Structure of the Managed Care Industry
The managed care organization (MCO) and health insurance/benefits industry is concentrated, competitive, and still consolidating. The largest publicly-traded MCO by members is WellPoint (WLP), which serves more than 66.5 million individuals through its health plans, but UnitedHealth (UNH), Aetna (AET), Humana (HUM), Cigna (CI), Centene (CNC), Health Net (HNT), and WellCare (WCG) are other key players in the industry.
Revenues are generated primarily from insurance premiums and, to a lesser extent, from administrative fees and net investment income. Expenses are dominated by benefit expense (the cost of health care services), though overhead (selling, general and administrative expense) is also a material portion of the cost structure of the group. Operating margins for some constituents have hit the low double-digit range during the best of times, but net margins generally have hovered in the mid-single-digits.
The strongest MCOs will boast large enrollment levels, diverse product offerings, a comprehensive network of physicians and hospitals, and a demonstrated ability to control costs. WellPoint’s exclusive right to market products under the most recognized brand in the industry, Blue Cross and Blue Shield (BCBS), is a significant competitive advantage, and the provider networks in many of its markets offer cost advantages relative to that of its smaller competitors. The claims-paying ability and financial strength (credit) rating of an insurer by the major ratings agencies are also key competitive considerations. Effectively managing newly-acquired entities can also be a key differentiator given recent merger activity in the group: WellPoint/Amerigroup and Aetna/Coventry.
The MCO industry has been significantly impacted by the Patient Protection and Affordable Care Act (ACA), signed into law March 2010. Some of the changes include a prohibition on some annual and all lifetime limits on amounts paid on behalf of or to members, member cost-sharing on specified preventative benefits, pre-existing condition exclusions for children (and increased restrictions on rescinding coverage), as well as the extension of coverage of dependents to age 26.
The ACA also stipulates that insurers will have to pay rebates to customers when they do not meet or exceed specified medical loss ratio (MLR) thresholds. The MLR is an expense ratio that is determined by dividing an insurer’s direct medical costs by its premium revenues (the latter derived by multiplying the number of current members by the premium rates). The Department of Health and Human Services issued in December 2011 the minimum MLR thresholds: Large Group (85%); Small Group (80%); and Individual (80%).
What this means is that large MCOs such as WellPoint and UnitedHealth are now mandated to pay at least 85% of revenue from premiums on medical care. During much of the latter part of the last decade, for example, the group generated cost ratios a number of percentage points below that threshold, on average. As such, we think much of the pricing power of the group is limited, now that premiums are set by a federal rate-review process–one that could also potentially inhibit the group’s ability to make timely (and necessary) rate changes in the event that healthcare costs skyrocket.
Most of the sweeping effects on the group as a result of the ACA will take place in 2014, including 1) a requirement that insurers guarantee coverage of all individuals regardless of status of health, 2) strict rules on how health insurance is rated, 3) the assessment of new taxes and fees on the group, 4) the creation of new insurance exchanges for individuals and small groups, and 5) substantial expansions in eligibility of Medicaid. Without a doubt, not being able to deny coverage to high-cost individuals and new annual levies will make cost-containment increasingly challenging for the group.
Though there’s much not to like, the legislation requires that most individuals obtain health insurance coverage beginning in 2014 and that certain large employers offer coverage to their employees or pay a financial penalty. According to the Centers for Medicare and Medicaid Services, national health spending is expected to advance 7.4% in 2014 (almost double that of prior years), as coverage expansions related to the ACA result in 22 million fewer uninsured people. We think this provides opportunities for a number of constituents in the group. Further, the expansion of Medicaid may present unique opportunities for UnitedHealth and WellPoint, which are among the largest Medicaid providers.
All things considered, however, the impact of far-reaching healthcare reform remains difficult to quantify, and a large margin of safety would be necessary for us to consider any health benefits company in the portfolio of our Best Ideas Newsletter. We’re comfortable being on the sidelines until the dust settles.
Related firms: Express Scripts (ESRX), Molina (MOH), Magellan (MGLN), Universal American (UAM).