How The Republican Wins Are Benefiting HMOs

By Kristina Zucchi, CFA | November 11, 2010 AAA

This week, the HMO/health insurance stocks reported what was a widely expected lower medical cost ratio and improved margins. Aetna (NYSE: AET) reported 84 cents per share on an adjusted basis, beating the consensus estimates of 68 cents per share. Consistent with peers UnitedHealth (NYSE: UNH), Humana (NYSE: HUM) and Wellpoint (NYSE: WLP), Aetna reported that its growth in profits was due to lower utilization of medical services resulting in higher commercial underwriting margins. This softening of utilization reverses a trend of increased costs seen in 2009. The market had anticipated these results, and the stocks reacted positively ahead of these announcements, with Aetna's stock rising over 15% since the beginning of September and Wellpoint rising over 17% in the same period.

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How HMOs Make Money

The profit model for the HMOs is a typical spread model between premiums paid versus medical costs incurred by members. Receiving higher premiums than is spent on medical care per member results in a positive spread. The higher the spread, the higher the profits or medical cost ratio. The model, to a lesser degree, also depends on membership gains. HMOs are worried about adverse selection - that is, having a membership pool that is tilted toward a sicker population rather than a healthy one - resulting in greater expense on medical care. Therefore, the higher the membership, the lower the chance high-cost medical care will dominate, because the costs will be spread over a higher membership base. HMOs do not want adverse selection, so the larger the membership pool, the lower the risk of unhealthy individuals tainting the insurance pool.

Mid-Term Election Impact

Despite the strong and favorable medical cost trends that have benefited the HMOs all year, the stocks still have the overhang of the Health Reform Act. However, as a result of the mid-term election wins for Republicans, the impact of this legislation may be muted. Although it appears that the legislation will still be implemented, the HMOs now have a voice. The companies are not against the Act entirely. They like that there will be some 40 million new customers. The risk of adverse selection should be reduced, as some of those that are uninsured today are the young and healthy. However, unknowns about the current pool of uninsured and their potential usage patterns create underwriting risk.

Additionally, there is the risk that the law gets changed in such a way that the healthy candidates elect out of the coverage, and the more undesirable members dominate the pool. Additionally, the companies are faced with certain regulations, most of which have not been fully defined. A regulation that appears to be the strongest headwind is the requirement for medical loss ratio maximums and sharing of excess profits, both of which will impact margins. These companies hope that the Republican voice will be heard to tone these down, because by all appearances the companies feel these limit market-based forces. As it stands now, HMOs are not able to benefit from doing a good job of lowering healthcare costs, reducing the incentive to focus on this as a core goal.

Conclusion

Investors have been waiting for the details of the Health Reform Act and its impact on HMO earnings power. While the details are still forthcoming, the mid-term election wins by Republicans in Congress provide a much-needed cushion between the Democratically controlled government and the HMOs. With the injection of some business-friendly allies, the HMOs, at least for the time being, are feeling the heat lift. (For more, see Healthcare Funds: Give Your Portfolio A Booster Shot.)

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