Major health plan Q1 earnings: Profit surprise in commercial risk; multiple reasons why business prospects look good

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Public health insurers startled the market with earnings ~25% above consensus expectations. A key driver was lower-than-expected utilization (particularly in the under 65 commercial lives) which kept medical costs down.

Management teams offered two theories in the analyst calls: bad weather and the beginning-of-the-year reset of consumer directed (CD) deductibles; neither is compelling:

  • A lot of discretionary care has already been squeezed out of the system by the bad economy; it is hard to imagine that bad weather would drive out a lot more. Also the utilization decline was concentrated among the commercial lives (e.g., WLP) but weather affects Medicare eligibles too.
  • CD plans would have had to have grown sharply between 2011 vs. 2010 for such an unexpected impact. CD growth plans did grow fast between 2009 and 2010 (from 8% of lives to 13% per Kaiser Employer Benefits Survey); but it is not clear that 2011 saw equally rapid growth (for example, United said that CD membership grew from 14% of commercial lives end of 2010 to 15% at end of Q1 2011).

Both theories imply that the Q1 surprise is a one-time event. So, while health plans raised earnings guidance for 2011, they did it mostly by the amount of the Q1 earnings surprise (on average, ~77% of the earnings guidance increase was delivered in the Q1 earnings surprise). In other words, the Q1 results were taken to offer very little signal on the rest of the year. Everyone is guiding for utilization to return to normal.

However, investors seem to think something more fundamental is afoot. Share prices have gone up 15-20% since the earnings calls, implying a 15-20% permanent increase in future earnings. What could it be? Three potential hypotheses:

(1) Industry has figured out how to price rationally under MLR rules. Previous expectations for lower profits assumed stronger utilization but also, implicitly, a tough pricing environment. But instead of broad bidding wars over increasingly scarce lives, management consistently reported that competitors were pricing “rationally,” implying sustainable margins and a more profitable industry. Aggressive pricing seems to have been limited to a few markets and segments (e.g., CIGNA’s ASO offering for small employers). Capital accumulations also suggest insurers are contemplating acquisitions to fuel growth rather than “trench warfare” over share.

(2) The lower utilization will last. Perhaps Q1 results presage more lasting consumer caution about utilization. There are plenty of potential drivers: greater cost-sharing (not just CD deductibles), continuing job uncertainty, and other priorities given tight incomes. These conditions may hold for a while and the new habits become engrained. If medical cost growth slows, there will be more room in the premium for health insurer profits. One interesting signal that utilization may not bounce back is Aetna’s recent decision to seek a 10% reduction in premiums on individuals in Connecticut in order to comply with the MLR floor.

(3) Growing confidence that the strategies of individual insurers will pay off. Each of the majors demonstrated the strength of their core strategies through ability to gain share, lower expenses, or access ancillary markets. Some highlights from each:

United

  • Ability to translate scale into share gains (ASO 5% up in quarter).
  • Higher margin services businesses such as OptumInsight (analytics) and OptumHealth (medical management services) growing fast (30%+ vs. year ago) and creating meaningful mix shift in profit drivers.

Wellpoint

  • Ability to translate scale and rate advantage into organic growth (6%+ in ASO; gains in slice accounts where employers are looking for hard savings).
  • Growth in specialty (behavioral, vision) signaling improved ability to cross-sell.
  • Improved performance in admin cost (down 4.5% vs. year ago despite more lives).

Aetna

  • Acquisition of Prodigy, a 600K life TPA which should provide Aetna with another tool to attack low-share markets with an ASO offering for smaller groups.

Cigna

  • Capabilities in driving ASO into smaller and smaller groups (demonstrated by transition of lives from experience rated to ASO and growth in smaller group segments).
  • Strength of specialty insurance (behavioral, dental) and cross-sell across book.
  • Increasingly meaningful international platform (revenues up 7% vs. year ago quarter, expatriate lives up 85% – helped by an acquisition – and overall international policies up 15%).

Humana

  • Medicare winner – both medical (9% in quarter) and most dramatically in drug benefit (40% in quarter) — coupled iwth growing confidence that leaders will figure out ways to maintain profitability as rates decline.

Key implications

  • Utilization over next couple quarters will be important to understand how long consumers will keep their recession mindset regarding utilization.
  • Pricing will be important to see if competitors defect from the rational pricing, seeking a land-grab. As long as players seek share gain by acquisition, this should not be a risk….though acquisition targets might seek to bulk up to increase valuation before acquisition.
  • Majors are developing a number of profit pillars which do not require head-on collision with each other (except in ASO) – thus reinforcing the potential for continued rational pricing.
  • Regional non-profits: watch out! The majors are developing interesting tools to attack smaller groups (ASO + broad stop-loss) and you will struggle to defend given the cannibalization risk. Playing nice with brokers (likely not too excited about an ASO model) could be critical.
  • It's good to know the reasons why it looks good. There are some factors that actually affects it in a nice way that's why it's looking good.

    major medical insurance plans