August 31, 2011
A client recently engaged Everest Group to analyze the U.S. health insurance industry and identify long-term trends and their implications. From the outset, I realized that due to the ongoing healthcare reform, this was an unusual case in which one couldn’t extrapolate existing industry dynamics into future periods. Trying to understand the implications of President Obama’s healthcare reform on overall industry profitability, I discovered many contradicting predictions. As a result, I conducted my own study of the most important elements, and unlike many analysts, concluded that the reform will not negatively affect the industry from a profitability standpoint.
Pre-Existing Condition Threat Demystified
The biggest perceived threat to industry profitability is the legal provision that prevents insurers from refusing to provide, limit, or drop coverage, but this provision alone is expected to add more than 30 million members to the insurance rolls! Granted, pre-existing conditions and other issues will preclude this customer segment from being the most profitable, but the provision will drastically increase overall insurance premium revenues with very little impact to the SG&A cost structure, which will just be leveraged for incremental volumes due to economies of scale.
Benefits from Increased Bargaining Power
The U.S. health insurance industry already achieved a sufficient level of consolidation, driven in large part by an appetite for increased bargaining power. With substantially greater membership, all major industry players will possess even more negotiating clout with medical services providers. Moreover, health insurance providers’ intermediary role in the overall healthcare value chain has been continuously helping the industry to maintain its profitability, as constant increases in providers’ rates have always been successfully passed on to the end-users. Traditionally, the industry operated under a cost plus mentality wherein every year health insurance providers estimated the expected increase in medical costs (hospitals, physicians, and prescription drugs) and factored this increase into their renewal rates. It is not unlikely that, driven by expanded membership, insurance firms’ increased bargaining power will manifest not only on the provider side but also on the buyer side via higher rates for enterprise clients.
Additional Regulatory Pressure on End Users
Government also indirectly contributed to the shift in bargaining power from buyers to insurance providers by establishing a mandatory requirement for employers to provide coverage for their employees with associated tax breaks and penalties for non-compliance. The impact of the latter provision may be partially offset by the proposed monitoring of insurance rate increases on the state level and the quarter billion dollars of funding available to the states, via the PPACA, to establish the necessary monitoring capabilities. But these days the bulk of commercial coverage is sold to large enterprises that purchase benefits on the national level for all geographies in which they have employees, so control on the state level may become irrelevant.
Ambiguity of Medical Loss Ratio Requirement
Another potential impact to profitability arises from newly imposed limits on medical loss ratio (MLR) –the percentage of insurance premium actually spent on medical services – at 80 percent for small groups and 85 percent for large group plans. However, legislation is not very prescriptive in terms of what does/doesn’t go to the numerator and denominator. The National Association of Insurance Commissioners already released an industry-wide clarification allowing exclusion of state and federal taxes from insurance revenues in the denominator. What SG&A costs can be included in the numerator is still an open question. Keeping in mind the “too big to fail” concept employed by the current administration, it is very unlikely that the government will attempt to tighten up the MLR definitions, as doing so would put the solvency of the whole industry at risk.
Health Insurance Exchanges
There is a lot of hype around the provision in the healthcare act calling for the establishment of health insurance “exchanges,” where otherwise uninsured individuals can shop for insurance plans. Some experts believe this kind of “priceline-dot-com” health insurance will essentially drive transparency, intensifying price competition. I am skeptical about the potential of such an outcome. First, wholesale purchases will still comprise a dominant segment of the overall market. Second – just as in the auto insurance industry – it is nearly impossible to conduct an apples-to-apples evaluation of rates. In health insurance, the law still allows substantial differences based on an individual’s risk profile (three to one based on age, three to two based on tobacco use, etc.), which means that even two people purchasing identical medical coverage from the same insurance provider cannot accurately check the rate competiveness.
Aggressive Cost Takeout
Finally, it is quite clear that the industry is undertaking many cost takeout and improved efficiency efforts. Nearly all large healthcare players have initiated different care management programs in an attempt to preemptively address the most expensive items in their cost structure. Along the same lines, all insurance companies have achieved substantial progress in risk management analytics and fraud detection/prevention measures.
It is quite interesting that stock market performance demonstrates investors’ optimism about the future of the health insurance industry. More than a year after the PPACA was signed into law the S&P Managed Health Care Stock Index demonstrates strong performance, and is constantly outperforming not only the S&P 1500 but also the S&P Composite Health Care Index.
The most challenging part of all this is estimating the impact from the second degree of implications, as healthcare reform is not limited just to the health insurance sector. The law brings many regulatory changes to the provider side, and these will quickly cascade through the entire value chain, forcing healthcare providers to make corresponding adjustments to their delivery models. Despite remaining ambiguity around different regulatory nuances, I do believe that under healthcare reform the industry will maintain its profitability.
