The U.S. economy is in a recession, and the health insurance industry has not proved immune to what ails the nation. With joblessness on the rise, volatile financial markets, and consumer income either flat or falling by most measures, Standard & Poor's Ratings Services on Nov. 3 revised the outlook on the managed care industry to negative from stable. The impact of the deteriorating economy, slowing top-line growth, aggressive pricing strategies, and negative medical trend development were the key factors in our decision. As a result, over the next six to 12 months, we anticipate there will be more downgrades than upgrades in this sector.
Health insurers will likely face added pressure from a private sector that is stagnant—or even shrinking—and from declining growth opportunities in the public sector. In addition, the pace of Medicare Advantage growth is slowing, and the market for Medicare Part D products (for prescription drug coverage) is now in a more mature phase of development. While we don't expect to see previous "land rush" growth rates in these markets, there will be further growth as the general population ages.
The key factors we'll consider in 2009 will be pricing strategies, medical management, market segmentation, cash-flow generation, liquidity, and capital management strategies. This weak economy can pose a significant risk to insurers' business plans. They will have far less room for miscalculation in terms of estimating medical-cost trends, new product rollouts, new technology introductions, integration of new acquisitions, and the like. Any misstep is, of course, not good, but when margins are compressing and organic business growth is harder to come by, the potential for earnings and cash-flow damage increases with every mistake.
We have seen, for instance, that some insurers, such as Coventry Health Care (CVH) (S&P credit rating, BBB-), Health Net (HNT) (BB), and HealthMarkets (BB-), seriously underestimated medical trends for various market segments, which has led to significant declines in profitability and rating downgrades. Moreover, cash-flow strain could lead to further qualitative capital impairment for companies with high levels of intangibles.
Investment exposure is not expected to emerge as a significant factor in 2009, but liquidity and capital management will continue to be closely scrutinized. An insurer's level of debt does influence our position on ratings and outlooks. If an insurer carries significant debt (and goodwill), we expect specific levels of Ebitda interest coverage to maintain the rating. For example, at WellPoint (WLP), we have cited Ebitda of 10 times interest coverage as the level consistent with the current rating (A-). In 2009, we will continue to monitor closely any aggressive capital-management strategies that may materially increase leverage, especially share buybacks, mergers, or acquisitions. In these trying times, we likely will examine those actions more critically than in prior years, when growth opportunities were better and earnings were above rating expectations.
Bigger Insurers in Better Shape
While the state of the economy is the big issue for most of 2009, challenging some health insurers to sustain their credit profiles, others can be expected to operate through this downturn without a rating change despite some credit-profile strain. This mix of companies includes some of the larger diversified health insurers as well as some more localized plans. The larger companies are likely to benefit from geographic diversity and a meaningful combination of insured and fee-based business, giving them some protection from regional economic woes and underwriting risk.
There are also some not-for-profit health insurers with established competitive positions, sound balance sheets, and a track record of operational stability that offer meaningful protection against downside development. These companies generally have strong balance-sheet characteristics and are under less pressure to increase operating earnings in what is expected to be a softer market. Examples include Health Care Service (d/b/a Blue Cross & Blue Shield of Illinois, New Mexico, Oklahoma, and Texas) (AA-), Highmark (d/b/a Highmark BCBS & Highmark Blue Shield) (A), Kaiser Foundation Health Plan (A+) and HealthPartners (Minn.) (BBB). We expect them to focus on stable pricing and targeted member preservation and growth strategies in addition to sustained focus on medical management applications. So the prognosis is far from universally poor for the health insurance sector, but it may be some time before the patient is back in good health.
Margin Pressures Remain
For many diversified health insurers, margins are expected to be pressured by a changing business mix. There will be fewer comprehensive commercial group benefit offerings and more public sector government-sponsored products—which are higher medical-loss-ratio products. In addition, we expect hospitals—particularly higher profile ones with strong market leverage—to be more aggressive with commercial health insurers' contract-renewal pricing as they compensate for revenue squeezes from Medicare and Medicaid.
While many insurers are fighting to reduce medical costs, their efforts haven't always borne fruit. Increasingly sophisticated electronic systems allow insurers to handle smaller, routine insurance claims more efficiently. But larger, more complex claims remain more problematic. Adjusting these complex claims can result in higher-than-expected costs for some insurers because of contractual provisions with hospitals that pay the insurer on a percentage-of-charges basis, rather than on a contracted-per-diem or diagnosis-related-group (DRG) basis.
Insurers, of course, seek out the most profitable lines of business when they can. Among those are policies written for small to midsize employers. But this segment is one of the most competitive and price sensitive lines of health insurance. Because health insurance rates for small businesses are also politically more sensitive, these policies can attract regulatory attention that might reduce margins for those insurers offering it. Some insurers still view this segment as potentially very profitable, however, and seek it out, even as opportunities are becoming more limited because of the tough economy, increased competition, customer attrition, and a growing demand for less comprehensive offerings. The inability to achieve growth targets among small to midsize employers contributed to reduced earnings forecasts in 2008 for both WellPoint and UnitedHealth (UNH).
Less Merger-and-Acquisition Activity
While we generally expect to see the pace of deal activity slow in this frosty economic climate, some industry consolidation is still possible, prompted by sluggish organic growth. But because credit markets are tight, smaller cash transactions are likely to dominate.
We could also see some strategic acquisitions that incorporate medical service providers as units of health insurers. If successful, these deals could be expected to support product development and value enhancement, contain costs, and boost efficiency. Earlier this year, for instance, we saw Health Care Service acquire MEDecision, a service company that provides a platform for managing cases, diseases and utilization management, and other health-care information.
Nevertheless, insurers are likely to take more cautious capital-management positions and be generally reluctant to deal with integration risks when their focus needs to be on core business activities. Some regional health insurers, in fact, may no longer have the capacity to compete in key markets and could pursue an exit strategy that includes divestiture.
What Will the Feds Do?
Finally, in addition to waiting out the recession, the sector is also awaiting whatever changes the incoming Obama Administration might bring. In 2009, the new Congress and President, the industry, and the public will likely be debating and shaping the contours of any new federal health-care initiatives. Health insurers have worked hard to position themselves as ongoing players in any new health-care system. Despite the attention on health care and the $2.3 trillion annual price tag (16% of GDP based on total national health expenditures in 2007, according to the Commonwealth Fund and National Coalition on Health Care), there are no universally accepted solutions. In addition, the platforms of the various politicians and political parties vary widely.
For these reasons, we expect competing solutions will mean that federal policy will evolve slowly, which will give insurers the opportunity to influence the outcome. Regardless of the specific plan adopted, it will almost certainly include greater regulation. To date, federal health policy has endorsed public/private partnerships and, contrary to a worst-case scenario, we believe the private sector will continue to have a role in financing health care and managing the cost of care.