Trends in the Valuation of Health Insurers

Political Factors Affecting the Industry

On March 23, 2010, President Barack Obama signed the Patient Protection and Affordable Care Act into law. ¹ Health insurers would no longer be allowed to place annual and lifetime limits on the amounts of coverage offered, thus increasing the amount of claims paid out. ² Prior to the passage of legislation preventing the ban on annual and lifetime limits, insurers could drop individuals who reached their lifetime or annual limit. ³ Dropping high-risk patients has typically been a mechanism health insurers have used to maintain profitability. Given that profitability is one of the key factors affecting value, reduced expectations for future profitability could hurt pricing of health insurers.

Additionally, to ensure that premium dollars are spent primarily on health care, the new law will require that insurance companies spend at least 85 percent of all premiums collected from large employer plans on healthcare services and healthcare quality improvement. For plans sold to individuals and small employers, at least 80 percent of the premiums must be spent on benefits and quality improvement. If insurance companies do not meet these goals, they must provide rebates to consumers. ⁴ As a result, this provision may reduce expectations for future cash flows and increase the risk of achieving those cash flows.

Some segments of the industry will benefit as a result of the new legislation. As noted in Molina Healthcare Inc.'s 10–K, as a result of recently enacted healthcare reform legislation, the Medicaid population is expected to grow from approximately 60 million today to approximately 82 million by 2019. Medicaid eligibility will expand to more individuals; people with income up to 133 percent of the poverty line will qualify for coverage, including adults without dependent children. ⁵ This should provide more opportunities for industry participants that provide Medicaid-related solutions and assist state agencies in administration of programs.

Industry Consolidation

All health insurers primarily focused on the private market are struggling with the downward pressure on growth and profitability associated with the new regulations. ⁶ While all companies will struggle, the larger companies are better equipped with the resources and balance sheets to implement and adopt the new legislation. Smaller industry participants that also focus on the private market, on the other hand, will find the new legislation costly and burdensome.

As a result of these factors, industry consolidation is expected as smaller companies struggle to remain competitive. ⁷ Additionally, large insurers will try to compensate for the lack of organic growth since premium increases will be regulated. Some players that focus on niche markets are not as affected by the legislation and may be able to achieve strong growth and outperform the market. Niche players could be ripe takeover targets for the largest health insurers as political reform depresses future expectations. In an interview, the chief financial officers of Aetna and WellPoint stated that mergers and acquisitions throughout the industry will increase considerably in the near future and the pipeline for acquisitions looks strong. ⁸

Trends in Valuation Multiples

Market valuations are generally influenced by earnings levels, growth prospects, and a variety of risk factors. Industry analysts typically reference price-to-earnings (P/E) multiples, among others, when discussing valuation metrics for health insurers. The P/E multiple can be based on historical earnings (such as net income during the latest 12 months) or forward earnings (such as net income expected in the next 12 months). In this article, we focus on P/E multiples based on the next 12 months, as discussed next.

Figure 1: Companies Used in Our Analysis

Figure 2: Average Forward P/E Multiples for Publicly Traded Health Insurers

As illustrated in the graph above, multiples for the Medicaid Industry Group have traded at a significant premium compared to the Large Cap Industry Group since the fourth quarter of 2009. This is likely the result of the negative outlook expected by the large cap insurers from the legislation signed during 2010. Insurance companies operating in the Medicaid arena are expected to benefit from the new law as eligibility will expand to more individuals. Long-term growth expectations for the Medicaid Industry Group exceeded the Large Cap Industry Group by an average of 487 basis points from the first quarter of 2010 to the third quarter of 2011, compared to a 72 basis point premium from 2006 through 2008. Although other factors could be contributing to the premium at which the Medicaid Industry Group trades, the trend can also be illustrated by the fairly tight range in which both industry groups traded during 2006 and 2007.

Interestingly, some of the highest multiples observed were during the first quarter of 2010. This time period correlates to the lowest earnings growth expectations for both the Large Cap and Medicaid Industry Groups. Because earnings represent the denominator in calculating a market multiple, significantly reduced earnings place upward pressure on multiples from a mathematical viewpoint. However, if the market believed that earnings growth had fallen permanently to a lower level, then multiples most likely would fall over time to offset the impact of lower long-term growth. We note that there were no drastic changes to the multiples after this quarter despite a quarterly trend toward improved growth expectations.

Outlook

The Large Cap Industry Group that primarily services the private market will most likely continue to struggle in the face of economic uncertainty and political reform. To achieve growth expected by analysts, some larger industry participants may look to high growth, niche players as potential acquisition targets. While the larger players may pay a premium for these insurers, the synergies achieved should cause the acquisitions to be accretive to earnings. Thus, the trend of industry mergers and acquisitions is expected to continue in 2012.