Advantage, Medicare Profits

10/25/2011 11:17 am EST


Igor Greenwald

Chief Investment Strategist, MLP Profits

Cigna’s rich deal for HealthSpring shows faith that government spending on health care will remain a major source of private profits, writes senior editor Igor Greenwald.

On the list of self-inflicted wounds holding back the US economy, our health-care system would have to rank second, right after the huge overhang of debt.

We spend roughly twice as much on medicine as the rest of the developed world, to no discernible benefit. Health-care costs permanently soaring far above the rate of inflation have priced millions of Americans out of jobs, spurring the outsourcing by corporations. Mounting health-care spending, largely driven by rising costs, is also expected to be the biggest strain on the federal budgets over the next decade.

The health-care reform law passed last year fixed none of this. It didn’t give households direct control over their health-care spending, and didn’t break up the cozy insurance cartel in charge of rationing overpriced care.

Instead, Democrats opted to tinker around the edges of the uncompetitive industry, to the government’s eventual cost as it begins subsidizing care for millions of previously uninsured Americans starting in 2014.

The health insurance industry traded some of its generous profit margin over the next few years for the promise of more business down the road, as the personal mandate to buy insurance kicks in and the government expands Medicaid.

As the industry stock charts show, it’s been a decent trade. The iShares Dow Jones US Healthcare Provider ETF (IHF) is up 6.8% in the 19 months since health-care reform was signed into law, in lockstep with the S&P 500.

But the industry has been so successful in extracting every marginal dollar out of the broader economy that now the workplace pickings look slim. There are fewer US jobs than there were 11 years ago, and more of them don’t offer health coverage, with the percentage of employers offering this benefit in a slow but steady decline.

More businesses are trimming benefits. Wal-Mart (WMT) announced on Friday that it would no longer offer coverage to new part-time workers. For many current employees, their contribution to their coverage will go up.

According to the Kaiser Family Foundation 2011 Employer Benefits Survey, the average worker contribution to the cost of a family policy is up 131% since 2000, outpacing the 113% increase in overall premium. Since real family incomes have not risen over the same span, it’s not hard to imagine the average worker contribution of $4,129 as a dealbreaker for a growing number of the working poor.

Between benefit cuts and minimal job growth, the growth in medical spending for the foreseeable future will be mostly on the government side, as millions of boomers turn to Medicare.

And if you’re worried that these boomers are going to be subjected to rationing by socialist death panels, it’s probably time to relax, because Cigna (CI) has just made a $3.8 billion bet that this won’t happen. In fact, Cigna just paid a 37% premium for its proposed acquisition of HealthSpring (HS), precisely because its Medicare business is such a golden goose, offering the growth missing in the private sector.

HealthSpring has more than 1.1 million Medicare clients, most of them in the Part D drug benefit. But the real prize was its Medicare Advantage business serving 336,000 patients after the rollup of another provider last fall. (Medicare Advantage is the government program that pays private insurers to siphon off generally healthier Medicare patients, at a greater cost than the government spends on treatment for the rest.)

Despite fears that Obamacare would end this gravy train, it ended up merely evening out the compensation disparities gradually over as many as six years, and promised bonuses for insurers judged to have improved the quality of care.

The end result is that Medicare Advantage remains a rainmaker. Another provider, Coventry Health Care (CVH) recently pocketed premiums of $909 a month per Medicare Advantage member, nearly triple the yield in its commercial group.

Medicare Advantage members cost only slightly more than the commercial members as a proportion of the premiums paid. So each of Coventry’s Medicare Advantage patients was much more profitable than a client from the private sector.

Coventry’s shares jumped on news of Cigna’s HealthSpring buy, having already been the subject of takeover speculation. Humana (HUM) is another well-run insurer with a significant Medicare component.

Why does this business remain so attractive even with government compensation rates set to decline next year? Because, according to a recent Kaiser Family Foundation industry survey, providers planned to offset the lower payments with “benefit tweaks” and “efficiency enhancements”—by cutting external and internal costs, in other words. Many are limiting clients’ out-of-pocket costs in order to continue growing membership.

Political gridlock in Washington makes Medicare cuts that much less likely in the near future...not that they were politically feasible in the first place. And that means Medicare will remain one of the few growth industries out there, and possibly the only one with revenue guaranteed by the government. So Coventry’s forward price-earnings ratio of 9 and Humana’s of ten look more than a tad too low.

The Boomers are not getting any younger, and those death panels remain a fantasy. As Washington debates whether Obamacare stays or goes, Medicare Advantage contractors are poised to thrive regardless.

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