The Patient Protection and Affordable Care Act (or ObamaCare) was passed with the abstract goal of universal coverage. This is a hugely personal and political issue for most people and inevitably most will fall passionately on one side of the other (I know I have). But what I’d like to do is remove the passions from it for a few moments and simply look at what its effects will be on the actual insurance companies (NYSE:KIE) it is meant to affect.
Let me warn first that health care policy is an academic study in and of itself. Laws differ by state so I will be presenting an extremely generalized analysis here. I will also be relying somewhat on the empirical evidence we have on the law here in my home state of Massachusetts where an individual mandate was passed back in 2006 (or as we call it here, RomneyCare).
What is the Law?
The law itself is over 2,700 pages long and includes numerous additional riders that were passed during the reconciliation process in the senate, but the bullet points of the law are:
(1) All citizens must purchase health insurance that is approved by the Department of Health and Human Services beginning in 2014 (the aforementioned individual mandate). If they do not, they face penalties of up to $3,800 (in the case of a family of four) as compensation for the expected cost the government will have to pay for their health care.
(2) Citizens can not be denied coverage due to preexisting conditions (this is referred to as guaranteed issue)
(3) Insurers must now permit beneficiaries to keep their children on their policy until the age of 26.
(4) Increases eligibility for Medicaid to those earning 133% of the poverty level.
(5) Makes major cuts to Medicare Advantage, the subsidized private health care plan for senior citizens on Medicare.
During the period leading up to passage of the act, the insurance industry’s main lobbying arm led by Karen Ignani touted the law and supported its passage despite what appear to be numerous provisions that will lead to substantially increased costs for insurers. The conventional wisdom was that the insurance industry was motivated by the possibility of 30 to 40 million new customers all of whom could potentially be subsidized by the federal government. With that many more customers being legally bound to purchase health insurance there would be ample opportunities for economies of scale and additional returns to the new float that would be available to invest.
How the Health Care Law Works in Practice
Float is an insurance term for the premiums insurers take in that go towards funding the contingent liabilities they insure. Because it is unknown when someone will incur major health care expenditures, until that time the insurer is free to invest this float as they see fit. Berkshire Hathaway (NYSE:BRKA) is renowned for its ability to invest its float and all insurers seek to generate a return from their float above and beyond the actuarially defined return needed to meet their expected liabilities. Taken at face value, these would be good reasons to think that health insurers may benefit from PPACA. But there are a whole host of reasons to believe that this isn’t the case.
For one, as the individual mandate in Massachusetts has shown, people game the system. They’ll go on insurance just prior to major health care expenditures which insurers are legally bound to cover and then as soon as those procedures have been covered they’ll cancel their coverage. As the Wall Street Journal reported back in July of 2009, Charles Baker, the former Massachusetts gubernatorial candidate and CEO of Harvard Pilgrim stated that Harvard Pilgrim had seen an “astonishing” uptick in people buying coverage for a few months at a time, running up high medical bills, and then dumping the policy after treatment was completed and paid for. Harvard-Pilgrim estimated that between April 2008 and March 2009 about 40% of its new enrollees stayed with it for fewer than five months and on average incurred about $2,400 per person in monthly medical expenses. That’s about 600% higher than Harvard-Pilgrim would have otherwise expected.
The financial results of such gaming are easy to envision – a combination of either higher premiums and/or lower profits for health insurers. The combination of a tax penalty that is too small when compared to the benefits conferred as well as the requirement that health insurers take all comers results in people doing exactly what they are being incentivized to do which is to bare as little of the costs of their medical treatments as possible. Like any good that has some “free” characteristics to it, health care also suffers from the free rider problem.
The empirical results of the individual mandate in Massachusetts confirm that the result of these reforms will be higher insurance premiums and lower insurer profits. While the goal of a fully insured population has been largely achieved the cost control aspect of reform has definitely not and was likely worsened by reform. This begs the question as to whether the full coverage those Massachusetts citizens who didn’t have health insurance coverage prior to RomneyCare will be temporary once the budget strains become too much. What we do know is that premiums have continued their climb unabated.
Projecting Massachusetts onto the Nation
If we take the Massachusetts experience with premiums after the individual mandate and transpose it to the nation as a whole, what we end up with is higher premiums and a large portion of the population who is better off gaming health insurers when they expect to have substantial health expenses and paying the tax penalty. On net, this will sharply reduce the profitability of health insurers as it has in Massachusetts.
The individual mandate also creates an artificial minimum which all health insurers (NYSE:KIE) can charge. While collusion may be illegal, it is also not necessary when customers are required to buy the product. In this case because rates have to be approved by the state government, we have empirical evidence of just how a law designed to provide health insurance to citizens results in government providing an implicit subsidy in the form of customers to health insurers. If everyone in the state is forced to buy health insurance then the theoretical price for health insurance is automatically greater than zero (the price someone who doesn’t buy health insurance would pay). In this manner, PPACA will serve as a boost to health insurer’s bottom line.
The other disturbing aspect of PPACA is that by pushing more people on to Medicaid it will exacerbate the phenomenon whereby Medicaid under-compensates doctors and hospitals for the care of the citizens it covers. The result is that the shortfall must be passed on to private insurance. Especially in the case of emergency care, this is an additional cost that will force the cost of private insurance up. Since PPACA empowers the Department of Health and Human Services with the ability to turn down rate increases (and since most states already had such powers in the first place) the likely result will be a split between lower profits for the insurers and higher costs for the insured. The pricing processes will become even more politicized than they already are which will inevitably lead to what price controls always lead to: lower profits and lower quality of the product in question.
Do Insurance Companies Win or Lose?
While the insurance industry will gain customers because of the individual mandate it will likely lose customers due to the cuts to Medicare Advantage. Medicare Advantage allowed seniors to receive some of their medicare benefits through private insurers. It was a very successful program that received high marks from its customers and showed a better ability to control costs than medicare itself. With the cuts that have been made to this program it is likely that a large number of seniors who were on it will end up dropping their private insurance due to the higher cost they will have to bare. Estimates vary but most expect the number of lost customers to number in the millions so it will be material to those companies who offer such plans.
Taking PPACA at face value, my overall expectations would be for lower industry profits. But because the law is fairly unpopular I also suspect that there will either be substantial changes to the law or full repeal of it. How either situation would affect health insurers I can not forecast. Democrats offer a more centralized, heavily subsidized, command and control vision whereby health insurers are heavily regulated and permitted a negligible return on their investment. But lower profits will inevitably result in fewer firms and less choice and may ultimately lead to a more oligopolistic health insurance market with a few massive players. In other words, lower overall industry profits but very high profits for the players that remain.
Republican reforms center around opening competition across state lines, repealing the individual mandate, and transforming the health insurance market into a very decentralized and consumer centric market. Their version, best codified by Congressman Paul Ryan’s Roadmap for America plan, centers on altering the tax code to allow consumers to choose their own health insurance rather than have it be employer provided. It would also call for means tested subsidies and would alter medicare and medicaid into voucher based systems whereby the respective beneficiaries of both plans would also be able to choose their own health insurance and purchase it with their voucher. Because Ryan’s plan involves less regulation and centralization and because it gets rid of the ability of individual states to effectively select a handful of firms to offer health insurance plans within their borders, it would also lead to large scale consolidation of health insurers. It is also highly likely it would lead to sharply lower total industry profits as well since even with consolidation there would still be a very large number of health insurers who would now be competing nationwide for business. As consolidation of firms progressed, economies of scale would force prices down as it has in all other competitive industries. Without the individual mandate to prod people into purchasing insurance an implicit price floor would no longer exist.
The likely outcome will be somewhere in between and it would be a fools errand for me to even try to predict what that will look like. All I can confidently say is that with the regulations related to PPACA still being rolled out this is a highly risky industry to invest in and I personally will be keeping my distance. But here are 3 Defensive ETFs to Hedge a Market Pullback.