Here's What Health Insurers Have in Common With Grocers

Investing in health care insurers is a lot like investing in supermarket chains. Grocery stores are low margin businesses that rely heavily on volume for profit growth. Often, that growth comes at the expense of another competitor. This year, a shifting of insurance enrollment from commercial plans to Medicaid programs means volume will be particularly important to insurers too.

At the biggest diversified insurers, including United Healthcare (NYSE: UNH  ) , WellPoint (NYSE: WLP  ) , and Aetna (NYSE: AET  ) , the ability to beat or miss earnings projections this year is going to depend in part on whether enrollment grows more quickly in commercial insurance plans than low margin Medicaid products.

Commercial headwinds create uncertainty
United, WellPoint, and Aetna derive a substantial portion of their revenue from commercial and individual markets. Those markets benefit when employers enroll new hires and suffer when employers reduce or eliminate coverage.

United covers 45 million people in its commercial and individual insurance plans, and that business accounts for $45 billion of its $114 billion in annual sales. WellPoint gets $9.8 billion of its $17.6 billion of revenue from commercial business. And $24 billion of Aetna's $44.4 billion in sales came from commercial markets last year.

However, enrollment in commercial plans may suffer as employers reduce or eliminate coverage for part-time employees. Wal-Mart, Target, and Home Depot all have planned or have already eliminated such coverage. Similarly, supermarkets are also trying to cut costs by actively negotiating with unions to eliminate coverage for part-time grocery and check-out clerks.

As a result, part time workers moving off commercial plans may weigh down profit at United, WellPoint, and Aetna, because more people may end up receiving insurance through Medicaid. http://www.nytimes.com/packages/pdf/business/26walmart.pdf

Alongside the broader expansion of Medicaid coverage, which boosts eligibility from 106% of the poverty level to 138% of the poverty level in states that adopt it, insurers may find product mix tilts increasingly toward their less-profitable private Medicaid plans.

How much less profitable are they?
United and Aetna paid out between 80% and 81% of the commercial premiums they collected on patient care for their commercial customers last year in medical costs for those customers. This ratio is also known as the medical loss ratio (MLR).  That's far less than the industry is paying out to care for Medicaid enrollees.

For example, Molina Healthcare (NYSE: MOH  ) , an insurer targeting state Medicaid markets with nearly 2 million members, anticipates an MLR of 89% this year. Aetna, which made $3.8 billion in revenue managing State Medicaid programs in 2013, had an 85.6% MLR on Medicaid accounts last year.

One of the reasons insurers' Medicaid products are less profitable than commercial and individual plans is that those enrolled in them tend to be heavy consumers of health care, particularly expensive care provided by hospital emergency rooms. Another reason they're less profitable is because insurers have to under-bid one another in order to win the right to run each State's Medicaid program.

That suggests a shift in members from commercial and individual plans to thinner margin Medicaid programs could drag on earnings at big insurers. Two of the three are already predicting profit will stall this year due at least in part to the Affordable Care Act.

United is guiding for earnings of $5.40 to $5.60 per share in 2014, about even with the $5.50 it made in 2013, and WellPoint expects earnings to be above $8, but that would mean it could end up shy of the $8.20 it earned last year.  Only Aetna expects earnings to grow, anticipating EPS will improve to $6.25 in 2014, up from $5.85, and some of that growth likely reflects the acquisition of Coventry Health last year.

Fool-worthy final thoughts
While United and WellPoint are guiding for a profit pause, insurers like Molina are increasingly optimistic. Despite its operating margin of just 2%, the company expects rising Medicaid enrollment will result in adjusted EPS of between $4 and $4.50 per share this year. If so, that will mark a solid jump from the $3.13 the company earned in 2013.

How much of a headwind the move to Medicaid creates for insurers will depend on how many of those no longer covered by their employer will shift to a parent's plan -- many part-time employees are younger than 26 -- rather than Medicaid. It will also depend on how many have earnings that remain above the Medicaid threshold, which differs by state.

Additionally, the impact of lost part-time members may be blunted if the economy creates more full-time jobs that include insurance. Since some states don't embrace private Medicaid, other states chose not to expand Medicaid with the Affordable Care Act (also known as Obamacare), and individual insurers don't participate in every state's Medicaid program, there are a lot of moving pieces in finding industry winners and losers this year. Regardless, I think changes mean that volume will be even more important to insurer profits than in years past. 

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