Why HMOs are Cheap, Despite Rising Utilization

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Richard Evans / Scott Hinds / Ryan Baum

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203.901.1631 /.1632 / .1627

richard@ / hinds@ / baum@sector-sovereign.com

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May 17, 2012

Why HMOs are Cheap, Despite Rising Utilization

  • Utilization rises as the economy strengthens; with economic strength comes rising employment. For commercial HMOs, the question is whether the benefits of employment growth (which brings enrollment growth, sales growth, operating leverage, and improving underwriting risks at the margin) can more than offset the gross margin pressure of rising utilization. We say yes
  • The crucial distinction is between rising utilization for the average American, as compared to rising utilization for the average commercial beneficiary. As more households gain employment, household incomes rise, and households shift from less generous (e.g. un-insured, Medicaid) to more generous (e.g. employer-sponsored) forms of health insurance. It’s this national shift of households from under-employed, under-earning, and under-insured to normally employed / earning / insured that drives growth in utilization for the average American
  • The average commercial beneficiary is a different thing altogether. The modal commercial beneficiary has been employed before, during, and since the recession, and her levels of income and health insurance have not greatly changed. The marginal (new employee) commercial beneficiary will consume more than he did when under-employed and under-insured (driving national average utilization higher) – but less than the modal commercial beneficiary who’s been in the risk pool throughout the economic cycle. Thus the average commercial beneficiary isn’t really exposed to what’s driving utilization at the level of the average American
  • For completeness’ sake: rising consumer confidence, including among the constantly employed (i.e. commercial beneficiaries) does increase healthcare utilization, but this effect is smaller than that of shifting households to higher incomes and better health insurance, and in the context of HMOs’ margins more than offset by the benefits of rising enrollment
  • It’s not all good news; turning to the longer-term, we now believe integrated health networks (IHNs) will take a large chunk of enrollees from the commercial HMOs if the Affordable Care Act (and in particular the individual mandate) is upheld. This is plainly an incremental negative to our fundamental view, but there’s room for this news at current valuations
  • Ahead of the Court’s ruling, we believe fair value for commercial HMOs is roughly 0.9x the S&P 500 – a 50:50 weighting of fair values if the individual mandate falls (1.0x the S&P 500) or survives (0.8x the S&P 500). At current prices, the commercial HMOs trade at 0.76x the S&P 500 on FY + 1 consensus earnings, and 0.63x the S&P 500 on FY + 3

Commercial HMOs / Short-term: Why HMOs should work in the face of rising utilization

We believe that US healthcare utilization is rising off of a cyclical trough, and that rising utilization is directly linked to underlying economic improvement. Accordingly we see rising employment – and thus rising commercial HMO enrollment – accompanying the cyclical rise in healthcare utilization. These enrollment gains bring revenue growth, operating leverage, and improvements in underwriting risks at the margin[1]

The fundamental short-term question is whether enrollment gains outweigh utilization headwinds, as we believe they do. The distinction between per-capita utilization for the average American and per-capita utilization for the average commercial beneficiary is crucial. In both cases, part of the cyclical gains in utilization comes from rising consumer confidence – i.e. people may be more willing to spend, even if their employment and/or health insurance circumstances have not changed. However cyclical gains in national average utilization appear to have much more to do with rising levels of employment, reductions in the number of uninsured households, and shifts from less (e.g. Medicaid) to more (e.g. employer-sponsored) generous forms of health insurance. These shifts have a large effect on the rates of per-capita utilization for the average American, but very little impact on per-capita utilization for the average commercial HMO member (who is already employed, and who is not shifting to more generous coverage)

Add to this our contrary view of the MLR cycle, which we believe has little if anything to do with price competition among underwriters, instead being driven almost entirely by sudden changes to risk pools (job loss worsens risk pools, employment gains improve risk pools) and input costs (in particular acceleration or deceleration of medical prices). Jobs and medical prices are unlikely to drive MLRs higher in the near-term: employment is more likely to increase (improving marginal risks) than to fall suddenly, and medical prices are generally stable[2]

The larger commercial HMOs[3] trade 24 percent below the S&P 500 on 2012 estimates, and fully 37 percent below the S&P 500 on 2014 consensus – only Hospitals are cheaper (Exhibit 1). Mid- to longer-term structural challenges rightly should weigh on HMO valuations; however our sense is that valuations are pressured more by near-term fears of a tightening MLR cycle than by longer-term concerns. We see the near-term MLR concerns as fundamentally misplaced, and believe HMOs are cheap even after accounting for various structural challenges in the longer-term

Commercial HMOs / Mid- to longer-term: The problem of integrated health networks (IHNs)

We’ve long argued that insurers are better off without ACA, primarily because we see employers shifting employees to health insurance exchanges (HIEs) if the Act goes into full effect. The shift is adverse for commercial HMOs: it reduces the percentage of employed persons who are insured, reduces the average value of the insurance purchased[4], raises insurers’ per-enrollee operating costs, and makes pricing more competitive. Nevertheless despite these headwinds we’ve felt commercial insurers could earn at least somewhat more than current share prices imply, the main reason being a belief that healthcare inflation will continue to exceed CPI, which creates a powerful productivity tailwind

More recently we’ve realized the commercial HMOs’ worst-case ACA scenario may include large enrollment losses to integrated health networks (IHNs). IHNs are vertical organizations of health care professionals and health care settings; often the scope of services within an IHN is sufficient to handle nearly all of a given patient’s, or by extension a given population’s, health care needs. On average roughly half of the patients cared for by an IHN also will be insured by (i.e. ‘members’ of) that IHN; the other half will be insured by a third-party, typically a commercial health insurer. The publicly traded health insurers[5] write about 31 percent of total commercial healthcare premiums in the US; by comparison integrated health networks (IHNs) write just more than 18 percent. On an enrollment basis (including non-risk ‘administered’ lives in the commercial HMO total), the publicly traded HMOs manage about 35 percent of commercial lives, and the IHNs about 11 percent (Exhibit 2)

As IHNs are anchored by their care settings – in particular their hospitals – marketing their memberships is in turn an inherently local proposition. For example Intermountain Health Care is a viable option for a household living within reasonable distance of this IHN’s Salt Lake City facilities. A greater Salt Lake employer might logically choose Intermountain as its provider and its insurer since all or most of its employees live in the area; conversely a multi-state employer (44.5% of US employees work for a multi-state employer[6]) almost certainly will not contract directly with Intermountain if only a modest percentage of its national beneficiaries live in the Salt Lake area. Such a multi-state employer’s handful of Salt Lake beneficiaries might still find their way to Intermountain for care, not as members, but instead through an arrangement wherein their (presumably large, national, commercial) health insurer contracts with Intermountain to be part (or even all) of its Salt Lake provider network

We’ve come to believe that IHNs’ current level of reliance on commercial health insurers has much to do with the simple, practical fact that in today’s market IHNs cannot possibly market the insurance portion of their services to all of the potential beneficiaries in their service area. For example Intermountain can market itself directly to the local Salt Lake employer, but cannot market itself efficiently to the East Coast headquarters of a multi-state employer with a handful of employees living in and around Salt Lake. For the moment, health insurers solve this problem as intermediaries: they go to the multi-state employer and negotiate an arrangement to cover (or manage) that employer’s (multi-state or even national) population of beneficiaries, then in turn contract with local provider networks (IHNs or others) in each of the health care markets where these beneficiaries reside

As long as employees continue to get their health insurance from their employers, and in particular from their employers’ national health insurance agreements, IHNs will continue to rely on health insurers for a large percentage of their patients. However if the Affordable Care Act (ACA) remains sufficiently intact for the States to form 50 more or less homogenous health insurance exchanges (HIEs); and, if (conditional on the existence of HIEs) employers shift their subsidy-eligible employees from employer-sponsored insurance (ESI) to the HIEs (we think this shift is highly likely[7]), then enrollment decisions correspondingly shift from the board room to the kitchen table. More to the point, today’s Fortune 500 employee living in Salt Lake who pays for her Intermountain health services (as a non-member) using health benefits administered (and/or underwritten) by a large commercial insurer, becomes tomorrow’s Fortune 500 employee who enrolls directly with Intermountain as a member. Bottom line: If employees are shifted to HIEs, in those markets where quality IHNs are offered, we believe IHNs capture more of these shifted employees than commercial insurers

There’s more. The preceding arguments are largely passive; in effect we’re asserting that if IHNs are less reliant on commercial insurers for beneficiaries, their enrollment share naturally grows. We also see a series of more ‘active’ IHN enrollment advantages that might come into play:

  • In markets where IHNs are preferred by local beneficiaries (e.g. Intermountain presumably has better brand equity in Salt Lake than most, perhaps all, commercial health insurers), it is clearly more efficient (and thus presumably less expensive) for the beneficiary purchasing on an HIE to enroll directly with the IHN, dis-intermediating the commercial insurer
  • IHNs offer more care for the same money, or the same care for less money. Where the IHN’s operations have greater operating efficiencies than other local non-integrated networks relied on by commercial insurers (almost by definition, more tightly integrated networks are more efficient), IHNs should be able to offer lower premiums
  • All else equal, IHNs appear more likely than commercial insurers to capture healthier enrollees. The non-financial cost to a beneficiary of enrolling in a tighter (e.g. IHN) instead of looser (e.g. commercial insurer) network is a relative loss of choice; i.e. being an IHN member, the beneficiary may be less able to seek care outside of the IHN[8]. At the margin, healthier enrollees should be more willing to make this trade-off, and less healthy enrollees less willing

On top of this, we believe IHNs have a financial motive to ‘capture’ patients as full-risk members, for the simple reason that returns on capital from underwriting healthcare are substantially greater than the returns on capital associated with providing care. Thus all in, IHNs have (we suspect) better brand equity than health insurers, can both market (no need for an intermediary) and deliver (tight network) care more efficiently than insurers (who act as intermediaries between patients and more loosely integrated networks); and, may tend to attract healthier patients that cost less to care for

As a crude measure of the relative ‘IHN risk’ faced by commercial insurers, we examined what would happen if all of the larger IHNs[9] who presently underwrite care (who together write 87% of total IHN premiums) fully converted their businesses to membership only – i.e. rather than providing care for patients insured by others, we assume the IHNs would convert all current non-member patients to fully underwritten members. We further assume that all of these new fully insured members previously were fully insured members of a single HMO operating in the same market. Think of it this way – if all of the large IHNs operating in the markets served by commercial HMO ‘X’ were to convert their non-members to insured members, and all of these new members were pulled only from the existing membership of commercial HMO ‘X’, what would be the percent change in commercial membership for poor HMO ‘X’? The construct is plainly artificial – by no means do we expect, or even mean to infer, that all IHNs will go to full-risk memberships or that all new IHN members will come from a single HMO in any given market. Thus the analysis plainly overstates the commercial HMOs’ absolute ‘IHN risk’, but does produce a useful scale of commercial HMOs’ relative risk. The results are in Exhibit 3

HNT (as a smaller California-focused insurer in a market with a large dominant IHN, i.e. Kaiser) is nearly 5 times more ‘at risk’ than HUM, and everyone else is generally scattered between these two extremes. Among the larger commercial HMOs CI and AET are the most exposed; UNH and WLP are the least exposed. We believe this simply reflects the fact that CI and AET tend to have relatively low average market shares of the geographic markets in which they compete, whereas UNH and WLP tend to have much larger average shares of their local insurance markets

What’s implied at current valuations?

Ignoring for a moment the earnings effects of the Affordable Care Act (ACA), our longer-term commercial HMO model assumes the following: revenue is the product of workforce growth (1%), CPI (2%), real medical inflation (declining from 2.0% in 2012 to zero by 2021), technology-related increases in costs of care (declining from 2.0% to zero over two decades), declining average contract values as consumers opt for higher-risk plans (12% reduction in average value[10] over 10 years, consistent with 80% enrollment in high-deductible plans), and a one-time 3.3% increase in enrollment driven by economic recovery (spread evenly from 2012 to 2014). These assumptions support a 5.2% 10-year revenue CAGR ‘shaped’ as a deceleration from 7.0% revenue growth in 2012 to a terminal 3.0% (CPI × labor force growth). Assuming annual productivity gains of 1% we would expect a 10-year EPS CAGR of 6.3%. Ignoring any difference in risk between commercial HMOs and the broader S&P 500, these assumptions produce a long-term earnings forecast having almost precisely the same present value as our baseline expectation for the S&P 500 (where we assume EPS growth of 5.2% and a discount rate of 9.3%[11]). In other words, before accounting for the effects of the Affordable Care Act, we believe fair value for the commercial HMOs is very nearly a market multiple on forward earnings

However if the ACA is upheld, the preceding scenario changes in three important ways: 1) average contract values fall by 22%[12] rather than 12%, 2) the commercial beneficiary pool grows by an additional 4% (from 2014 to 2017, as households that had no ‘fair offers’ of coverage now have reasonably priced coverage options); and, 3) the commercial HMOs’ share of commercial beneficiaries falls by 17%, as IHNs convert (an arbitrarily assumed) half of their ‘non-members’ to fully insured members. All else held equal, under this scenario the commercial HMOs’ earnings stream is ‘worth’ approximately 0.8x the S&P 500 earnings stream

These assumptions are summarized by scenario in Exhibit 4; Exhibit 5 shows the sensitivity of our model to changes in each assumption

Ignoring any other effects, and assuming key provisions[13] of the ACA are equally likely to be either overturned or upheld, our modeling supports a commercial HMO ‘fair value’ of 0.9x relative to the S&P 500, as compared to the present range of 0.76x (fPE on FY+1 consensus) to 0.63x (fPE on FY+3 consensus). We believe the gap between our estimate of fair value and current valuations is driven by some combination of: 1) a greater risk discount on commercial HMO than on S&P 500 earnings, presumably as a consequence of political / regulatory overhangs; and 2) a market expectation that rising utilization in the near-term will compress gross margins. Of these, we suspect the latter concern is fundamentally flawed (we see stable gross margins and expanding enrollment), and is the greater drag on valuations. Thus the commercial HMOs are a compelling value, albeit complicated by the pending Supreme Court decision. The Court’s decision should have a significant effect on commercial HMO valuations, though in what direction we cannot tell. And, because our fundamental thesis is unlikely to play out before the Court’s decision is known, we see little reason to rush into HMOs (unless they’re held in combination with Hospitals, whose valuations should move opposite HMOs’ on the Court’s decision, and who we also see as cheaply valued beneficiaries of an economic recovery)

  1. We recognize and account for the fact that, unlike prior periods, gross margins are now effectively capped
  2. Please see “What Next for the MLR Cycle”, June 10, 2011, SSR; and “Why Insurers Work in a Recovery…”, April 5, 2010, SSR
  3. HMOs with market cap >$1B and significant commercial mix: UNH, WLP, AET, CI, HUM, CVH, and HNT
  4. Please see “Post-2014 Reform-Related Volume Gains are Modest”, March 2, 2011, SSR
  5. Includes HMOs with market cap >$1B: UNH, WLP, AET, CI, HUM, CVH, AGP, WCG, HNT, CNC, MOH, MGLN
  6. US Census, 2009 County Business Patterns
  7. Please see “Why Losing the Individual Mandate is Good for HMOs…”, March 27, 2012, SSR; “Why Employers are Likely to Drop Health Insurance – a Simplified View”, July 11, 2011, SSR; and “Post-2014 Reform-Related Volume Gains are Modest”, March 2, 2011, SSR
  8. A disadvantage that is inversely proportional to both the potential beneficiary’s health status and the IHN’s share of local service provision
  9. IHNs with 2011 premium revenue >$1B
  10. The decline in average contract value is calculated relative to the contract that would have been sold if the household had not chosen to take greater risk
  11. We estimate long-term S&P 500 earnings growth of 5.2% as the product of population growth (1.1%), CPI (2.0%), and an assumption of longer-term productivity growth (2.0%); the population growth and CPI assumptions are taken from the Congressional Budget Offices’ Long-Term Budget Outlook (found here:
    http://www.cbo.gov/sites/default/files/cbofiles/attachments/01-31-2012_Outlook.pdf
    ). We believe we err on the high side with respect to our productivity assumption; this is conservative in the sense that our lower HMO productivity assumption (1.0%) tends to reduce HMOs’ relative value. Our discount rate of 9.3% is equivalent to the long-term (1926 – 2004) total return on stocks (10.4%), less an adjustment of 1.1% to account for our expectation of slower CPI growth (2.0%) as compared to inflation (3.1%) across the period from 1926 – 2004. This total return figure is taken from “History and the Equity Risk Premium”, by Goetzmann and Ibbotson; the figures are in Table II and can be found here:
    http://www.econ.ucsb.edu/conferences/equity05/papers/Goetzmann.pdf
  12. When covered under employer-sponsored insurance, beneficiaries’ plan choices are narrow; however on the HIEs beneficiaries can choose from a much broader range of ‘coverage generosity’. The HIEs in effect create the option to buy cheaper plans than were available from the employer, which we believe results in lower average contract values
  13. In particular the individual mandate – we think the odds of ACA being overturned in its entirety are very low. However if the individual mandate is overturned, the states are unlikely to develop a consistent national landscape of health insurance exchanges (HIEs). This in turn would seem to preclude the shift of employees out of employer-sponsored insurance (ESI), thus preventing many of the longer-term negative effects of the Act on commercial HMOs
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