UnitedHealth is Better Positioned Than Its Competitors for Federal Reform

In a talk at Yale University this year, I outlined our view of Reform’s impacts on managed care. Short of a new business model, I believe the largest health plans, like UnitedHealth, are those best suited to deal with Reform’s impacts. Before discussing some of Reform’s more important consequences in the context of large plans like UnitedHealth, I should briefly summarize my interest in the topic.

For the past year, I have been developing a new business model for U.S. health insurance. I want to make it possible for institutional investors to directly underwrite health insurance policies. My work focuses on markets that may be structurally unattractive to managed care after Federal Healthcare Reform.

While policies in these markets are unprofitable to conventional health plans at current premiums, I and others I am working with have discovered a way in which they can be made attractive to institutional investors. We primarily accomplish this by paying different returns to investors underwriting different policy risks, something a stand-alone health insurance company cannot do. I believe this approach will become especially valuable when Reform mandates a minimum medical loss ratio for all plans beginning 2011 and restricts the range of premiums a plan can charge its patients beginning 2014.

So far, my approach appears to strongly interest health plans looking for additional underwriting capacity and grow their service segments post-Reform. I am eager to hear from more.

Despite the challenges presented by Reform, my conviction is that the managed care industry, through this approach or one like it, also has an historic opportunity to lower  costs, expand coverage, and offer patients and providers more robust, long-term monetary rewards for wellness than today’s one-year policy, one rate-of-return system can.

Returning to the topic at hand, UnitedHealth recently raised guidance by 20 cents a share, enjoyed a 2.10% lower medical loss ratio in the second quarter of this year than the second quarter of the past one, and earned 50% more cash from operations in the first half of this year than the past one. I believe Reform's underwriting restrictions may enhance the competitive position of UnitedHealth more than any other publicly traded managed care company offering risk insurance lines for three reasons.

Reform Rewards Size, and UnitedHealth is a Giant

Usually, investors find that large companies are the least likely to grow. However, in health insurance today, by capping medical loss ratios and restricting patient premium differentiation, Reform will most adversely impact smaller managed care companies.

Larger insurers will be better positioned to take short-term losses on underwriting both because of their absolutely larger balance sheet depth and the marginally greater adverse impact of each plan member loss they experience.

After Reform is implemented, many smaller, independent insurance plans, if they begin to experience higher loss ratios or less overall market share in this way, may be acquired. This will make what is already one the most consolidated industries in America - health insurance - even more so.

In 2009, UnitedHealth bought HealthNet's plans for New York, New Jersey, and Connecticut. In countless other states with smaller managed care companies vulnerable to Reform, local executives mention UnitedHealth to me as a prime, potential acquirer in the regulation's aftermath.

Reform Stirs Price Wars Most Down-market, and UnitedHealth is a "Luxury" Provider

Concerns about the taxes levied on so-called Cadillac plans, while valid, often underestimate the degree to which they can be passed through to insurance buyers. Conversely, UnitedHealth's outsized presence in up-market health insurance products means its corporate customers are more willing and able to pay higher premiums when UnitedHealth needs to raise them. (Though many large employers will no doubt prefer to self-insure post-Reform, the analytical question for our purposes is, among the employers still buying insurance, which are best able to bear rate increases.)

Employers such as those UnitedHealth serves may be more inclined to retain their white collar employees by keeping trusted doctor networks and customer service. By contrast, health insurers focused on more down-market products may not have employer clients who are so price-insensitive when it comes to paying for health benefits.

A related issue is the minimum benefit requirements in Reform legislation. These provisions try to standardize comparability between the benefits of competing health plans to further force explicit price competition.

Reform's minimum standards for a "Gold" plan accords much more with the benefits UnitedHealth plans already offer than the "Bronze" or "Silver" standards that might be required of more down-market products. This implies higher future benefits expenses for UnitedHealth's competitors, health insurers for whom a greater fraction of business comes from these more down-market products.

Reform Rewards Information, and UnitedHealth Owns Ingenix

Finally, Reform will makes health information a more important competitive advantage in health insurance than ever, rendering Ingenix, the leading health analytics and actuarial consulting firm owned by UnitedHealth, a jewel. Consider that key provisions of Reform include

• Restricting contractual liability caps in policies (That is, putting a dollar limit on total illness claims an insurer will pay for a patient.)
• Limiting rescission (That is, the practice of suing to patients to de-enroll them once they become ill)
• Mandating coverage (forcing insurers to quote a price to almost all patients, even if they have pre-existing conditions).
• State-exchanges on which insurers must quote their prices for offering nearly identical bundles of health benefits

In each case, the net economic impact of these provisions is similar. They force insurers to focus on patients and claims costs in considering the risk-reward value of an individual policy.

In any form of investing, if you can't write the contract in your favor, control incentives, or control outcomes, your main advantage is better information. In this sense, health insurance underwriting is no different.

Long-term winners under Reform's restrictions will be those companies that determine the most accurate fair-value prices for the health risks they are underwriting. That is, those companies with the best predictive health information.

Corporations like Verisk and Reed Elsevier own health analytics firms that offer meaningful competition to UnitedHealth's Ingenix. But UnitedHealth is the only major American health insurer to have its own such health information and analytics firm.

To be sure, near-term, Health Reform will have negative profitability consequences for all health insurers. And, until the Department of Health and Human Services and U.S. state governments more explicitly implement these laws and lawsuits are settled, uncertainty as to Reform's exact consequences remains.

But, even after its upbeat announcements this quarter, UnitedHealth is still selling at 7x last year's free cash flow. Despite the economic downturn, it has enjoyed an over 16% return on non-goodwill assets during fiscal year 2009.

If American health insurance is being transformed as I describe, UnitedHealth is a company worth watching.

Sahil Gujral is an investor and consultant.