Health Insurers and the Medical Loss Ratio

As Washington continues to micro-manage various industries via royal decree, it is becoming increasingly evident that Congress is afflicted by some combination of the following conditions:

1. Ignorance of industry specific business models
2. An inability to read financial statements
3. Willful disregard of #'s 1 and 2
4. Delusions of grandeur

Now, I will readily admit that the near collapse of the financial system is evidence in and of itself that the pre-crisis regulatory framework was flawed. However, the solution to ineffective regulation is not the passing of more ineffective regulation. In other words, Congress seems to assume that capitalism's regulatory guard rails simply weren't strong enough, as opposed to questioning whether those rails were even in the proper location.



The latest Congressional foray into the ineffective regulation of business is contained within H.R. 3962 (the Health Care bill). Apparently, the likes of Harry Reid and Maxine Waters have secretly been working towards a masters degree in actuarial statistics, and have subsequently determined that the health insurance industry can make coverage more affordable by throwing all actuarial assumptions out the window. This strange brand of ill-informed meddling has culminated in Section 102 of H.R. 3962, in the form of a mandate that health insurer's medical loss ratio never dip below 85%. The medical loss ratio is calculated as medical benefits paid divided by premiums received. Now, all questions regarding the ability of Congress to properly determine a reasonable medical loss ratio aside, I'll turn to an analysis of where this ratio has trended over time. Below is a chart comparing the medical loss ratio's of United HealthCare (UNH), Aetna (AET), Wellpoint (WLP), Humana (HUM) and Coventry Health Care (CVH). Data is based on the 9 most recently reported quarterly results for the above mentioned firms:

The evidence above would suggest that the health insurance industry's major players are already operating at a medical loss ratio of between 80-85%. So why make a point of regulating this metric? I certainly don't purport to know the absolute truth on this one, but one could theorize that Congress intends to start at 85%, and slowly creep up into the 90's. Nevertheless, we can assume that these firms will need to take steps towards putting themselves comfortably within the 85% medical loss ratio mandate. The most likely compliance scenario will involve management's assessment of operating expenses. A little "trimming the fat" analysis if you will. To get an idea of where operating expenses stand relative to premiums at these large firms, I've prepared the analysis below.

As you can see above, medical costs and operating expenses combined have come close to - or in most cases exceeded - premiums received by the major health insurance companies. Therefore, health insurance firms are not able to turn a profit from premium revenue alone. Profitability, it seems, is achieved by two other sources of revenue: fees and investment income. Because investment income is unreliable in many circumstances, and the premiums charged to individuals will henceforth be regulated in arbitrary fashion, I can only see two ways that health insurers will respond:

1. Reduce operating expense via layoffs and off-shoring where possible
2. Increasing fees that Congress didn't remember to regulate

If I could make a recommendation to the industry, it would be to arbitrarily "invent" new fees. Maybe introduce another stage to the application process that would require payment of additional fees. To introduce a little bit of irony to the situation, the industry could pretend that it now faces burdensome ratio compliance costs, and must assess a few cents worth of compliance fee upon every claim. Remember: Focus on the Fees.

*no positions
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A Look at Aetna's (AET) Q2 Income Statement

One of the primary pillars which underpin arguments in favor of health insurance reform is the idea that health insurance companies earn "fat" profits, and it is these profits which stand in the way of an equitable health care system in this country. I feel that this concept has not been properly examined to determine it's validity, a surprising state of affairs considering we are mere weeks away from a possible overhaul of the entire health care system. Below I'll briefly walk through Aetna's (AET) income statement for the three months ended June 30th, 2009. I chose Aetna because it is sufficiently large - it's membership is greater than 45M across the medical,dental, and pharmacy network - to provide a representative view of the industry. The Company also operates in each of the 50 states in the US.

For the three months ended June 30th, 2009, Aetna reported revenues totaling $8,657.6M. I'd like to focus on a top line number that's more applicable to it's core business though - Health Care Premium Revenue - which totaled $7,030.5M for the quarter. During the same period, Aetna incurred Health Care Costs of $6,102.4M. Health Care Costs are essentially what the Company paid out in claims throughout the quarter. Using this measure alone, one might conclude that the difference between what Aetna received in premiums and what it paid out in claims - $928.1M - represents a relatively "fat" 13.2% profit margin. This sort of analysis ignores the fact that Aetna must pay it's 35,500 employees to administer this entire operation; this expense shows up in the General and Administrative expenses line item, which totaled $1,160.2M for the quarter.

You might be saying "what a second, based upon Aetna's three most core measures of revenues and expenses, it appears that they are $232.1M to the negative." This observation would be correct: Aetna is spending more on health care costs and salaries etc. than it is bringing in via premium revenues. We know however, that Aetna reported net income of $346.6M for the quarter; how do we reconcile this?

When you really get down to it, Aetna is relying on fees and investment income to break into the positive. These two items totaled $1,151.2M for the quarter. Once you add in one more revenue item - Other Premiums ($475.9M) - and net out Selling Expenses ($303.8M), Current/Future Benefits ($503.8M), Interest Expense ($60.7M) and Income Taxes ($168.8M), you are left with only $346.6M in Net Income.

What this means is that Aetna's Net Income ($364.6M) represents just 3.997% of it's total revenue ($8670.8) for the quarter. That ratio for Exxon (XOM) during Q2 was 5.3%, for Microsoft (MSFT) it was 23.2%, for Nike (NKE) it was 7.24%, for McDonalds (MCD) it was 19.3%, and for General Electric (GE) it was 7.3%. These figures actually defy some conventional wisdom, as most of the comparison companies own significant amounts of depreciable assets. Depreciation is recorded as an expense against net income, but it is not an event which affects cash flows. This accounting rule often leads to reported net income which is substantially lower than cash flow from operating activities (CFFO). Aetna's business however, deals in the somewhat intangible realm of insurance; thus, they do not benefit - from a taxable income standpoint - from the depreciation charges enjoyed by firm's having large amounts of physical assets.

Let's be honest here. If the government somehow forced Aetna to operate as a non-profit corporation, it would only allow the company to pay out an additional $515.4M (net income before taxes assuming non-profit status) in claims. This would only represent a 7.8% increase in quarterly claim payouts. This calculation of course assumes that the "new" Aetna would have an identical cost of capital to the "old" Aetna. The money just isn't there.

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