Why You Shouldn't Sell Insurers as Obamacare Exchanges Open

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Washington has created a sea of uncertainty for health care investors, and the latest impasse isn't likely to add clarity anytime soon. While you can't control of Washington any more than you can control Mr. Market, you can take steps to position yourself to benefit when markets get back on track.

One area that is receiving a lot of attention thanks to Washington is health care insurance. The opening of long-feared health care exchanges is ushering in a seismic shift for the HMO and PPO industry, fueling one of the most significant opportunities since supplemental Medicare.

Should the profit cap scare you?
A lot of attention has focused on the Affordable Care Act's limit on industry profits, which went into effect in 2011. The law, commonly known as Obamacare, mandates that insurers use 80%-85% of premium revenue on clinical services and quality improvement. Those failing to meet those ratios will need to return money to policy holders in the form of a rebate. Insurers in the individual market will need to hit the 80% target while large group insurers will need to hit the 85% level.

Those caps shouldn't make you overly nervous. The mandate is essentially set at levels that most insurers have been meeting for years.

Also, the ratio doesn't penalize company spending on quality improvements, suggesting that a good deal of money spent on innovation for cost control can be included in the medical loss ratio, or MLR, calculation. Exemptions are also provided for high-risk pools where insurers fail to meet the required MLR, but their absence from those markets would disrupt them. That exemption was put in to protect small states where fewer insurers compete and to protect insurers who are providing high-deductible plans, which typically result in lower ratios.

So, how did insurers do in the first year of implementation? Most insurers met the required MLR standards. 90% of insurers in the individual markets, 89% in small group, and 88% in large group insurance achieved the mandated rates.

Of course, that means some insurers did have to pay rebates to consumers. According to research by Invotex in the CCIIO MLR Report issued this past February, United Healthcare (NYSE: UNH  ) , Wellpoint (NYSE: ANTM  ) , and Humana (NYSE: HUM  ) each rebated $304 million, $78 million, and $74 million, respectively. Cigna (NYSE: CI  ) and Aetna (NYSE: AET  ) similarly returned $77 million and $106 million to customers.

Are insurers on track in 2013?
United Healthcare entered 2013 guiding analysts to expect an MLR of 82%. United hasn't stuttered since the MLR implementation. From 2009 through 2012, the company's operating earnings are up 46%, leading to 18% compounded annual earnings-per-share growth. In the second quarter, United's earnings per share grew 10% year-over-year and the MLR came in at 81.5%. The company's cash generation has been so strong it boosted its buyback authorization to $3 billion and now pays dividends of over $1 billion annually to shareholders.

At Wellpoint, the MLR in 2012 was 85.3%, and in 2012 the company bought back 11.7% of its shares outstanding, spending about $2.5 billion. Heading into 2013, the company guided analysts for $7.60 per share in earnings and a benefit expense ratio of 86%. In the second quarter of 2013, earnings per share grew 27% from a year ago to $2.60, allowing the company to boost its full year earning guidance to $8. The company's MLR was 83.9% in the quarter.

Over at Humana, results were similar. The company headed into 2013 guiding for $7.60-$7.80 per share after earning $7.47 in 2012. Those full-year earnings were $0.17 better than the company's midpoint expectation. In the second quarter of 2013, Humana's earnings came in at $2.63 per share, $0.18 higher than the midpoint of its guidance. This allowed the company to boost its 2013 earnings forecast to $8.65-$8.75.

Cigna and Aetna have similarly seen earnings per share climb. In Q2, Cigna reported earnings per share of $1.78, up 19% year-over-year, and guided the street to expect an MLR of 81.5%-82.5%. Over at Aetna, operating earnings hit a record high in the second quarter, resulting in earnings per share of $1.52, which were up 16% from a year ago. That prompted the company to boost its full year forecast to $5.80-$5.90 per share, up 14% year-over-year at the midpoint and reflecting compounded annual growth of 17% from 2010-2013.

The final Foolish take
So far, insurers have been able to innovate and adjust to MLR mandates. This suggests that there's little reason to doubt that the industry will adapt to its upcoming challenges. Assuming the industry's cost-saving initiatives can offset ACA-driven risks, rising enrollment leveraged against similar operating cost ratios should allow more total dollars to fall from premiums to earnings per share. If this occurs, selling insurers on risks tied to the ACA exchanges opening may prove short-sighted.

More ways to play Obamacare
Obamacare is rewriting the rules for the health care industry, and in the process of doing so, it's creating massive opportunities for investors to get ridiculously rich. How? By investing in a handful of specific health care stocks. In this free report, our analysts walk you through these opportunities and the companies that are positioned to exploit them. The informational edge contained in it is invaluable, but can only be exploited profitably while the rest of the market remains in the dark. To access this free report instantly, simply click here now.

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