U.S. Health Insurers: A Cloudy Prognosis

Standard & Poor's Ratings Services is maintaining its negative outlook on the U.S. health insurance sector due to the deteriorating economy of the past year and the uncertainty regarding the state of health-care reform. The ongoing recession is generating high unemployment in the private sector and is putting pressure on earnings at many health insurers. In addition, we believe that competitive conditions will likely add to heath insurers' difficulties in the near term.

Our outlook on the health insurance sector is now influenced less by specific company or industry financial metrics and more by dour economic conditions, an intensified competitive landscape, and the state of industry reform. As a result, we continue to expect that downgrades will exceed upgrades over the next six to 12 months.

National health-care reform remains a wild card, with serious discussions in Washington this year, but the outcome is far from clear. We could revise our outlook to stable if legislative reform doesn't marginalize the industry—and if the economy doesn't deteriorate further than we anticipate. Until the particulars of any reform become clear, the near-term cause of negative rating actions will likely be the state of the economy. Further deterioration in the economy would pressure our expectation for a more stable set of financial metrics. Overall, those metrics now reflect performance below the most recent three-year historical trend.

Increase in Speculative Category

We can see the effects of the recession and operating performance pressure reflected in both the rating outlook distribution and in the actions taken in the last half of 2008 and the first quarter of 2009. Although we've downgraded only one issuer so far this year, the trend has been decidedly negative, as reflected by the ratio of downgrades to upgrades in 2008. In particular, there was significant unfavorable rating action development in the back end of last year, which is when we revised our industry outlook to negative.

The tough economic times partly contribute to the increase of speculative-grade companies. Although the majority of the 35 insurers we rate remain in the A category, the share of insurers in the BBB category has decreased to 23% from 30% three years ago, while the share of speculative-grade issuers has increased to 23% from 13%. The growth in the speculative category has been a function of downgrades from the BBB category as well as new ratings for companies with niche market profiles and riskier balance sheet fundamentals.

Better news, however, is that we've seen a very modest rise in higher-rated companies since 2006. At that time, no health insurers were rated in the AA category or higher. Today, one company falls into this rating category, Health Care Service Corp. (AA-), which conducts business as Blue Cross Blue Shield of Illinois, Oklahoma, New Mexico, and Texas.

No Positive Outlooks

Because of the bleak economy we've also assigned negative outlooks on a larger share of insurers than we did a year ago. As of May 4, 2009, no health insurers had positive outlooks and 29% were assigned negative outlooks, compared with 23% one year ago. Conversely, 71% of health insurers have a stable outlook, down modestly from 74% last year. The companies with negative outlooks include some of the largest in the industry: UnitedHealth Group (UNH) (A-), WellPoint (WLP) (A-), and CIGNA (CI) (BBB).

In the six months since our last outlook update, our baseline economic forecast has changed, from anticipating a moderate recession to expecting the worst economic downturn since the Great Depression. We now expect a mild economic recovery in the fourth quarter of 2009. The real worry, however, is that the U.S. economy could do worse than our most pessimistic scenario, which calls for a 4.8% decline in real gross domestic product this year with a 1.4% decline in 2010, 9.5% unemployment in 2009 rising to 11.5% next year, and payroll employment of 131.7 million this year falling to 128.4 million in 2010.

The weakening economy can pose a significant risk to insurers as they execute their business plans. There will be far less room for miscalculation in terms of estimating medical cost trend, new product rollouts, new technology introductions, integration of new acquisitions, and the like. Any misstep is, of course, not good, but when margins are moderating and organic business growth is harder to come by, the risk of underperformance increases. Furthermore, cash flow strain could also lead to qualitative capital impairment for those companies with high levels of intangibles.

Margin Improvement Possible

A key reason for our recent downgrades and negative outlook on the sector has been earnings deterioration. Weaker earnings have three primary causes: unanticipated changes in business mix, an underestimation of medical cost trends, and the mispricing and/or costly benefit design of some insurers' Medicare Advantage and Part D prescription drug programs. Because of last year's pressure on margins, we expect that health insurers are likely to more strongly focus on undertaking corrective pricing actions in 2009, which has the potential to drive incremental earnings improvement even in the face of a sluggish economy.

For many diversified health insurers, however, margins might still be pressured by a changing business mix that could well include more lower-margin government-sponsored plans. In addition, we expect hospitals, particularly the higher-profile ones, to leverage their considerable market share to push for higher contract renewal pricing with commercial health insurers that would compensate them for any cutbacks in Medicare and Medicaid revenue.

Margins might also come under pressure in some private-sector lines. Small to midsize commercial group health insurance has historically been a relatively lucrative segment for insurers. But it is also traditionally a very competitive one, as well as a segment where rates are politically sensitive and can attract regulatory attention that might result in insurers lowering their rates or accepting lower margins. Although some insurers still view this segment as potentially very profitable, the downside is that opportunities in this segment are becoming more limited because of the economy, increased competition, customer attrition, and a growing demand for a wider variety of coverage options.

Consolidation Opportunities Abound

Although the pace of deal activity has slowed, partly as a result of diminished access to financing and the weak economy, we believe that some industry consolidation is still possible. When organic growth is sluggish, those with the means to do so may make an opportune acquisition. But we believe that smaller transactions are much more likely than larger ones, given the growing uncertainty about prospective earning stability, cash flow generation, and access to capital. So far this year, no deals have been announced.

In addition to recessionary and competitive challenges, the sector must also contend with changes linked to national health-care reform, which we see as a high priority for the Obama Administration in the second 100 days. We've yet to see a real consensus about what health-care reform will look like, but we believe that we could see a health-care reform bill emerge before September. Amid the Washington debate over health care, insurers have worked hard to position themselves as ongoing players in any new health care system.

To this end, they have been strongly engaged to justify their value and role in the pursuit of wider access to affordable care, either individually or through America's Health Insurance Plans (AHIP), the primary industry lobbying group. More recently, President Obama was joined by constituents representing a broad cross-section of the health-care industry to announce a joint commitment to achieve what they consider to be a sharp reduction in the growth of national health spending. Their target, which corresponds with the Administration's goal, is to reduce the rate of spending growth by 1.5% each year for the next 10 years, which is expected to generate $2 trillion or more in savings. Ultimately, challenges are likely to emerge as specific proposals take shape. Several industry experts have cited concerns about the potential for turf battles and enforceability provisions.

All Eyes on Washington

One potentially unfavorable scenario for the health insurance industry would be migration to a universal health-care model with broad-based price and utilization controls. Under this scenario, it would be more difficult for health plans to differentiate themselves. The need for specialty companies—such as network management companies—would end, but there would be a greater need for benefit design, such as wellness incentives and disease management capability if insurers want to differentiate themselves from their competitors.

We believe that without the ability to compete on network costs or benefit design, health plans would likely consolidate into large claim-processing vendors for the government. To date, federal health policy has endorsed public/private partnerships and, contrary to a worst-case scenario, we believe that the private sector is likely to remain engaged in the financing, coordination, and delivery of health care.

Although the state of the economy is the big issue for most of 2009, we believe that some health insurers will be challenged to sustain their credit profiles in the coming year, while others can be expected to maintain the rating on them through the credit strains of this cyclical downturn. This mix of companies includes some of the larger diversified health insurers as well as some of the more localized plans that have strong balance sheets and are in areas of the country less hard-hit by the recession.

Waiting for Recovery

The larger companies are likely to benefit from geographic diversity and a meaningful combination of insured and fee-based business, giving them some added measure of protection from regional economic woes and underwriting risk. But we believe that regardless of size or location, almost every health insurer will spend 2009 hoping that the economy turns around soon—and that any Washington reforms leave them with a viable business in the years ahead.

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