AET Aetna Inc. (delisted)

Several health insurers posted strong second-quarter results and raised their full-year outlooks. Most of these gains reflected higher enrollment figures, organizational changes and fewer regulatory reform-related losses. Most of them are moving into the third year of record profits, which continue to benefit from a lingering recessionary mind-set among members, who are postponing medical utilization.

Health insurance companies finished strongly in 2010, helped by reduced medical utilization in a weak labor-market backdrop. This trend has carried into 2011 and is expected to remain in place over the coming quarters as well. We believe soft utilization level will act as a tailwind for the industry.

In 2008, when unemployment increased rapidly, utilization factor did not see a proportionate drop, indicating its lagging nature. Thus, even if the employment picture starts improving significantly in the coming months, which may not turn out to be the case given July’s paltry though better than expected job gains, we may not see any acceleration in utilization activity until much later.

Results for the first half of 2011 also reflect that the impact of minimum medical loss ratio (MLR) regulation that became effective at the outset of the year has remained muted. The overhaul requires insurers to spend a minimum percentage of their premiums (80% for individual and small group policies, while 85% for large commercial ones) on medical claims and quality improvements or issue rebates to consumers.

The goal behind the law is to ensure that a fair share of the premiums an insurer collects goes toward care. Its impact on the sector has been muted so far due to the moderated health care use, which helped offset estimated rebates that the companies have to pay under the MLR requirement.

Makeover Year

2011 is turning out to be a makeover year for carriers in the health insurance industry as they react to and prepare themselves for new rules. Continuing cost pressures and new customer demands require a fresh look at the existing roles of industry players.

Industry revenue will, however, decline from years 2011 through 2014 and 2015. This will likely be far more challenging to the industry, as insurers will be forced to adjust to the law’s greatest changes, like providing coverage to everyone regardless of whether they had an expensive pre-existing condition.

However, as the economy recovers, unemployment will decrease and discretionary spending will rise. With employment expected to grow, the demand for employer-sponsored plans will improve. This is important because the majority of the industry premiums are related to group health insurance plans. Additionally, the rise in discretionary spending would support industry growth as individuals, families and self-employed business owners would be able to afford healthcare coverage again.

The US population is also aging, which is an important indicator of demand for health insurance coverage. Older individuals are more likely to use medical coverage than their younger, healthier counterparts. Consequently, the aging population is expected to support industry growth.

Consolidation Ahead

With the recent developments, particularly the Health Care Reform Act, we expect additional mergers and acquisitions buzz in the health insurance industry as the smaller players find it difficult to cope with increased regulations.

We believe the consolidation of larger for-profit MCOs is imminent. Smaller plans in the industry are struggling with MLR floors and insufficient member pools are reaching out to larger players. Most of the smaller plans, facing fixed costs of ICD-10 and reform, are unable to access capital in advance of the exchanges and thus would not survive. Consequently, the larger players should stand to benefit by making tuck-in acquisitions at attractive levels.

Many of the major players, such as UnitedHealth Group (UNH) and WellPoint (WLP), made a number of acquisitions during the past five years and are expected to continue with such activities going forward. The industry is expected to continue to consolidate as insurers try to cut costs and improve profitability. At the same time, larger firms would benefit from greater bargaining power in determining healthcare rates with medical providers such as doctors, hospitals and pharmacies.

OPPORTUNITIES

Though mostly all the carriers are performing well in the sector, we are positive about CIGNA Corp.(CI), UnitedHealth Group Inc. (UNH) and Aetna Inc. (AET).

CIGNA, carrying a Zacks #2 Rank, is relatively safe, owing to minimum exposure to MLR regulations, unreasonable rate reviews and health insurance exchanges. The company has also seen its bottom line boosted by price increases and exits from non-strategic markets such as the Medicare Advantage individual private-fee-for-service business. The company has also shown operating momentum and has gained commercial risk memberships for four quarters in a row.

We also see a positive risk/reward scenario for UnitedHealth Group, which carryies a Zacks #2 Rank. The country's largest managed-care company by revenue has been realigning its businesses by making management changes and undertaking rebranding efforts, in anticipation of a shifting industry landscape. Its diversified product offering will allow it to adapt to the health care regulations.

Driven by an improved customer focus, with better systems, completed acquisition network integrations and more regional management, UnitedHealth's performance should continue to improve. Its strong balance sheet will allow it to annex weaker firms that cannot adapt to the reformed health insurance system properly. The company has witnessed significant enrollment growth, and its claims costs continue to be muted by consumers’ light use of health services.

Aetna Inc., with a Zacks #2 Rank, is another pick. The health insurer has been making acquisitions and diversifying as well as strengthening its presence in health information technology, accountable-care organizations or ACOs, and Medicare plans. It has stepped up efforts to provide midsize companies with a self-funded insurance option.

Aetna has been benefiting from higher rates and less membership declines. It also has been more assertive on hospital pricing and reimbursements. In May, the federal regulators lifted sanctions that had blocked Aetna from marketing Medicare plans and signing up new beneficiaries. The ban has been lifted just before the onset of the new enrollment season beginning July 1, 2011.

Medicare continues to be a key focus of growth for the company. However, the growth is likely to be slow as regaining of 44000 Medicare Advantage lives, which the company lost following the sanction, would be difficult.

WEAKNESSES

Healthcare investors for the near future will likely require more trading, in our opinion, and less buy and hold. As PPACA gets converted to regulation, more issues driving uncertainty will likely arise, necessitating portfolio repositioning. Though the companies will likely suffer share price volatility in the near future, at least until the Health Care Reform Act falls in place, all the businesses are expected to perform well in the long term.

With good fundamentals and an expected boost from the Reform Act later, none of the companies have any significant weaknesses. Thus, there is no company in the health insurance industry under our coverage carrying a Zacks #4 Rank (Sell) or even a Zacks #5 Rank (Strong Sell). We believe investors should more routinely evaluate the regulatory environment, alter opinion, and position accordingly.
 
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WELLPOINT INC (WLP): Free Stock Analysis Report
 
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