John Edwards' Fuzzy Insurance Math

Let me preface this column by saying that I've got a lot in common with presidential candidate Sen. John Edwards. We're both Southern Democrats. Both lawyers. Both fathers. Chances are, I'll even be voting for the former Senator from North Carolina in the primary. But as an investor, I must break with Sen. Edwards on one point: His latest health-care plan doesn't add up.

Judging from the health-care reform idea that Edwards floated yesterday, he's got a little problem with basic mathematics. In a nutshell, here's his thesis: The health-care insurance industry currently spends just 70% of the premiums it collects on actual reimbursement of medical costs. (In investing terms, he's saying that insurers average a 30% gross margin.) Edwards thinks that is too low, and that insurers should spend less than 30% of the premiums they collect to fund administrative costs, and deliver profits to their shareholders. He thinks 15% should suffice, and advocates passing a law forbidding insurers from grossing more than 15%.

On the surface, it's an attractive idea. After all, the primary activity of insurance companies, so far as most of us can tell, seems to be telling their customers: "Pay for this yourself," "No, we won't cover that," and "Here, fill out these forms before we'll ante up for the other thing." These guys are so unpopular, in fact, that I hear in the 2006 "Person of the Year" issue of Time, vampires and insurance CEOs were the only people whose visages failed to materialize in the little reflective silver square. They should easily be able to do that on less than 15% of revenue, and still have cash to spare for some dividends, right? Wrong, and for three reasons.

Oops! No. 1
Edwards' argument has three major flaws. First and foremost, his basic premise is mistaken. According to Yahoo! Finance (citing data from Hemscott Americas), the average gross margin in the "Health Care Plans" industry is not 30%, but 21% -- so right there, we see that 9% of the senator's hoped-for savings don't exist to be saved in the first place.

Oops! No. 2
This is the one that should concern investors most. Assuming that Edwards ignores the first flaw in his basic premise and mandates at least a 15-percentage-point reduction in margins, he risks putting the insurers out of business entirely. Consider the margins currently being enjoyed by a few of the nation's major health-care insurers:

	Gross Margin	Operating Margin	Net Margin
Aetna (:AET)	30%	11%	7%
Cigna (NYSE:CI)	43%	11%	6%
Coventry Health Care (NYSE:CVH)	29%	10%	7%
Humana (NYSE:HUM)	18%	3%	2%
UnitedHealth Group (NYSE:UNH)	25%	10%	6%
WellPoint (NYSE:WLP)	25%	9%	5%

Margins are trailing-12-months.

As you can see, not a single major health-care insurer currently sports the 15% operating margin necessary to fund Edwards' 15-point-reduction in margins with anything left over for profits. As a result, reducing operating profits by the desired amount would cause each of these moderately profitable companies to begin losing money. The consequences for the companies' stocks should be obvious -- they would fall.

Oops! No. 3
Of course, Sen. Edwards argues: "Mandating more dollars going directly to patient care will force insurance companies to be more efficient." And I suppose that's true. Faced with a decision between heading inexorably towards bankruptcy as a money-losing business, or becoming more "efficient," the insurers would certainly choose the latter option.

That, however, is just one more reason why Edwards' proposal won't fly. Because we all know what happens when a company faces the need to become more "efficient" in a hurry. It automates some functions, outsources others, and lays off employees in droves. Whatever effect his plan may have on the state of health care in America, I know one thing for sure. If this plan ever gets enacted, it's going to put a minimum of 189,650 voters' jobs (that's the combined payroll of the six firms named above) at risk.

Hard to get elected on a platform like that, Senator. Better break out the old calculator and work up a better plan.

Coventry Health Care and UnitedHealth Group are Stock Advisor recommendations. UnitedHealth has also been recommended in Inside Value.

Every time UnitedHealth hands him a form or denies a claim, Fool contributor Rich Smith tries to console himself with the fact that, because he's a shareholder, he's saving himself money. This doesn't work too well. The Fool's disclosure policy will never deny you anything.