Health insurers come in various forms and offer diverse products that distinguish themselves from other insurance companies as well as other businesses. It is often said that this is the only business where the consumer (the person receiving the healthcare) has no active role in the decision-making process, and the provider (the doctors or hospitals providing the care) has no say in how much pay they receive for a service. Thus the health insurer has gained control over the "healthcare equation".
These companies set the pay structure they will grant to providers for specific services, and set the rules for the consumers on how they can use the services provided. It seems to be a great role to be in from an investor standpoint - controlling your destiny is advantageous to controlling your success.
Not All Health Insurers Are Alike
There are many categories of health insurance companies and the products offered to consumers, but health insurers can be categorized based on payor structure. Payors include private companies, individuals and government entities. Many health insurers cater to all types of payors, but some specialize in individual categories. The largest U.S. health insurers generally have a diverse payor mix, although some may be more heavily weighted towards one.
Payor mix is important to understand because it often points toward the risk and timing of cash flows and profitability. In general, government entities (Medicare, Medicaid and others) are considered the largest payors, but they are slow and can increase risk of profitability as these entities often change the payment structure for specific services, impacting health insurance companies' bottom lines. Individuals are generally considered undependable sources of cash flow as well. Private companies tend to be the most stable.
Within private companies, there are two types of products insurers offer. The first is ASO, or self-insure, administration-only products. These products require that the private companies take responsibility for the underwriting risk; the insurer only acts as an administrator for the plan by providing statements, paying the doctors, etc. Under this product, the insurance companies get paid on a contract basis and those fees are very stable and virtually risk-free.
The second product is a full service or at-risk product where the insurance company does all the underwriting and takes on the risks associated with that underwriting. In this product, the insurer is responsible for all aspects of the insurance claims, and this product makes money on a spread basis. The insurer bets that the medical costs will be lower than the premiums received based on its underwriting skills. The higher the spread, the more profitable the company is. In general, large multistate or multinational companies tend to use the ASO product, while smaller or mid-sized companies tend to use the full-service option.
Assessing Investment Potential
As mentioned previously, with the differing payor mix and diverse product offerings, financial results vary among these companies. Despite this, there are key financial ratios that are comparable among all the health insurance companies
Insurers who focus predominately on private company customers generally have two main lines of revenue generation - ASO and full service. Government customers generally fall in the full-service category. The steady but slow growing ASO business pays a flat fee based on a contract. The contract can include some stipulations that may minimally affect the revenue, such as number of members served or performance requirements. While investors are not privy to the individual contracts that a company holds, it is generally a profitable business, but not one with huge margins.
The full-service products provide the opportunity for health insurers to demonstrate their skill level in underwriting and actuarial techniques to provide high profit margins. The following financial statement helps outline the important financial margins and ratios to focus on when reviewing the financial strength of health insurance companies.
Figure 1: Sample Income Statement
Sample Income Statement | Year 20XX |
| Premiums | 25448 |
| Fees | 3118 |
| Premiums & Fees | 28566 |
| Investment & Other Income | 257 |
| Total Revenue | 28823 |
| Medical Expense | 20714 |
| Administration Expense | 5065 |
| Total Expense | 25779 |
| EBITDA | 2787 |
| EBIT | 2488 |
| Interest Expense | 95 |
| Taxes | 948.94 |
| Net Income | 1701.06 |
| Average Diluted Shares (mn) | 1233.6 |
| EPS | 1.37 |
Figure 2: Margins and Ratios
| Margins and Ratios | |
| EBITDA (EBITDA/Revenue) | 9.7% |
| EBIT (EBIT/ Revenue) | 8.6% |
| Net Margin (Net Income/Revenue) | 5.9% |
| Consolidated MCR (Med Expense/Premiums) | 81.4% |
The medical cost ratio (MCR) in Figure 2 is the key ratio investors consider. It basically tells the investor how much the medical expenses are as a percentage of premiums. The calculation is medical expenses divided by premiums. Investors like to see a low medical cost ratio.
Another key ratio to review is the change in pricing year over year relative to the change in medical expenses year over year. Ideally, the change in pricing year over year should grow at a faster or equal rate to the change in medical expenses year over year. If that happens, insurers will see their pricing yield go lower. However, if the opposite occurs, the pricing yield will increase.
In addition to analyzing these ratios, member growth targets are tracked by companies and investors alike. These statistics provide insight into the competitiveness of a company's products. Strong member growth is positive, but can also be deemed a negative. If a company is fighting to gain or retain customers, they may underprice their products. As a result, the key ratios and margins will start to deteriorate. As such, tracking member growth is an important data point for investors to be aware of to ascertain the financial direction of a company.
Here's one last point to consider when reviewing the financial performance of health insurance companies. There is a lag effect between a member using medical services and when the insurance company receives a bill. As a result, insurance companies try to predict what these expenses will be and reserve adequate funds to pay them. Sometimes the companies predict too high or too low. As a result, the financial results can be impacted positively or negatively in any given period due to this timing mismatch, but this should smooth out over time. You need to be aware of this as an investor.
Potential Pitfalls
Many of the health insurers in the U.S. branched out into different business lines over the past several years, mostly in the hope of providing a full array of products to meet the health care needs of their members. As a result, some of the financial results may be unrelated to the core business or health insurance. In addition, like other insurance companies, health insurers also invest the premiums received in the financial markets to gain investment income. During certain cycles of the market, the companies may have investment losses that will impact the profitability.
The Bottom Line
In general, health insurers are non-cyclical, recession-resistant companies because they provide a necessary service. That said, these companies can feel the pinch of a rising unemployment rate, as their member growth will slow. In addition, during economic downturns, insured companies will try to reign in expenses, including healthcare, by increasing copays or deductibles for members or reducing medical services covered under the plan, resulting in a lower utilization by members and potentially lower medical costs for the insurer, but also lower premiums paid by the companies insured. As a result, investors need to track pricing and premium levels, medical costs and member growth over time, as well as the regulatory noise related to covered charges through the government health programs.
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