Before proceeding with the financial numbers, it is important to highlight that the insurance industry is in the midst of consolidation.
These health insurance issuers are merging to better their business, operations and margins. In fact, they already have their paperwork pending to be approved by the government. Given the interviews of the CEOs of these companies, it appears that they do not expect their plans be rejected.
So, who is acquiring who?
Aetna (AET, Financial) is buying Humana (HUM, Financial), and Anthem (ANTM, Financial) is buying Cigna (CI, Financial). Further, Aetna is purchasing Humana for $208.10 per share, while Anthem is buying Cigna for $166.97 per share. These deals are expected to close within this year—at least that is what Aetna has been telling the media:
On Jan. 12, Aetna CEO Mark Bertolini said "so far, we have nothing to believe it will be any slower than that, or any faster."
Further, both Aetna-Humana and Anthem-Cigna made websites to educate the investors about their acquisition strategies.
Interestingly enough, Mr. Market has not valued the target companies near to the offer prices of the acquirers:
Bargains? Maybe.
Mr. Market is still probably weighing in that these merger procedures may fall through. At the moment, the Senate is set to hear out the top U.S. antitrust bosses in March.
Profit margin
Engaging in the health insurance business may appear to be lucrative, but I believe using profit margin of the health insurance group and comparing it to a similar industry (property insurance) may provide a better picture:
Property and Casualty insurance group average yielded better profit margins than Health Care Insurance Group as a whole.
Included in the P&C group were the following companies: Progressive Corp. (PGR, Financial), WR Berkely Corp. (WRB, Financial), Chubb Ltd. (CB, Financial), The Travelers Companies Inc. (TRV, Financial) and Allstate Corp. (ALL, Financial).Ă‚
Obviously, for any conservative investor, these numbers would automatically deter him from picking up any shares from these health insurance companies. But what about those "huge" upsides in the offer price for Humana and Cigna? Or, a better question would be, what triggered this industry consolidation starting mid-last year anyway?
Answer: Obamacare.
Obamacare
Three facts about Obamacare:
- Obamacare is lawfully known as the Patient Protection and Affordable Care Act.
- PPACA was signed into law by President Obama on March 23, 2010.
- Obamacare’s vision was to put more non-insured U.S. citizens into health insurance.
Nevertheless, Obamacare seems to be working. The number of people uninsured people has certainly decreased since implementation.
Further, Obamacare has not totally disrupted the health insurance business. In fact, revenue for the group has been growing more since it was implemented:
The improvement in growth, I assume, was a result of the Obamacare mandate, among others.
Still, the margins of these health insurance operators have been reduced (see profit margin graph above).
Dissecting the law gave a couple of interesting directions that are possible contributors to this low profit margin effect, as the law orders health insurance issuers:
- To no longer increase its clients’ premiums for profit.
- To implement a medical loss ratio (MLR) in their business operations.
- To perform rebates if MLR implementation was not met.
Medical loss ratio
MLR was implemented under ACA whereby:
- Health insurance issuers are instructed to perform an 80/20 MLR rule. Eighty percent or 85% of the premium dollars collected per client goes into the client’s medical care. Fifteen percent or 20% of the premium dollars collected per client goes into the health insurance issuers’ administrative costs and profits.
- Rebates (initiated by ACA in 2012) are to be provided to clients who have not received the appropriate 80% to 85% medical care support from the health insurance issuers.
Health insurance premiums
Premiums paid by clients (anyone enrolled in a health insurance) are the lifeblood of the insurance business.
Specifically, premiums collected by the health insurance issuers have contributed roughly more than 70% in its sales.
Market leaders
UnitedHealth Group (UNH, Financial) leads the group in sales. If I were to combine the merging insurers’ revenue, UnitedHealth Group still leads among them.
Interestingly, Medicare and Medicaid appear to be one of the leading sales contributors in these health insurance issuers business, as seen in the graph below.
In Aetna’s 2014 annual report, Chairman and CEO Mark T. Bertolini describes the importance of Medicare Advantage membership growth.
“One of the keys to our 2014 results was the strength of our Government business, which now represents over 40 percent of Aetna’s total health premiums. During 2014, premiums in our Government business grew by over 38 percent, primarily driven by Medicare Advantage membership growth of almost 18 percent and Medicare Supplement membership growth of nearly 20 percent, well above industry growth rates. We achieved these results despite one of the largest Medicare Advantage rate cuts in the program’s history. Our Medicaid business also had an excellent year and contributed to the growth in Government premiums.”
Interestingly, Medicare Advantage growth has actually been slower for the past five years compared to the first five years of this decade:
Nevertheless, United Healthcare still leads the pack in terms of profits (even after the mergers):
Looking further beneath these numbers revealed that profit margins are identical in this group of insurers:
This may be one of the reasons why Anthem and Aetna would want to merge with the latter competing companies. Regardless of mid-single digit profitability, increased volume in clients would increase profits.
Additional data
D/E ratio
Total shareholder return (dividends plus share buybacks, not including capital appreciation):
P/E ratio (annual)
Anthem has been noticeably flying under the radar and not being very much appreciated by Mr. Market, while Humana is almost always highly valued.
Looking at 10-year P/E average revealed the following:
None of the big health insurance issuers are at discount at the moment when compared to the previous decade of P/E data.
Take away
I can observe two reasons why Anthem and Aetna are willing to pay hefty premiums to acquire Cigna and Humana. First, health insurance issuers are now forced to earn small profits with their premium business, thanks to ACA’s MLR. Second, combining the number of clients may present an opportunity to improve profitability and to further cope with the slowing down of the Medicare Advantage enrollees.
No one can ever predict whether the government would approve the proposed mergers, but it is sure to be interesting to see how the health insurance industry evolves this year. I would refrain from investing in highly criticized business by the government. Nevertheless, those 28% to 30% margins of safety between Cigna and Humana’s share price sure look enticing.
Happy investing!
Mark
