THE U. S. HEALTH INSURANCE INDUSTRY: Steady
Nine Month 2007 Health Insurance Industry Review (December 18, 2007)
A BISM Online contribution from ALIRT Insurance Research, LLC

David Paul and Dan Hausmann are principals of ALIRT Insurance Research, Inc., a Windsor,CT based research firm offering customized credit analytics and competitive intelligence on insurance carriers and the broad insurance industry.

Underwriting and operating profitability declined slightly for the ALIRT 100 Company Health Composite¹ in the first nine months 2007 when compared to the prior year period, with the medical loss ratios rising (deteriorating) 80 basis points. Although underwriting results weakened somewhat, the industry remains profitable with a reported ROE of approximately 16% and organic surplus growth in the 12-13% range (annualized).

Health Care Reform Update

In last quarter’s health review, we discussed several of the proposed plans from both Democratic and Republican presidential candidates. Over the last two months, additional plans have been outlined by non-political sources, further evidence that health care reform remains a topic at the forefront of national attention. In fact, taking a glance at a number of recent national polls, health care was either the second or third issue of importance for Americans behind the Iraq War and the Economy². A November Gallup Pool reported that 56% of respondents answered either Access (30%) or Cost (26%) when asked about the most urgent health problem facing this country.

An Employee Benefit Research Institute (EBRI) paper, released earlier this month, discussed whether the era of employment-based health benefits is coming to an end.³ Their conclusion was that while employment-based health benefits are not in imminent danger of being replaced, employers are proactively questioning the status quo and looking for new solutions to control costs, including having workers assume greater responsibility and accountability for their health care spending. This is the central promise of consumer driven health care.

The EBRI paper sourced an October 2007 proposal by the Committee for Economic Development (CED)⁴, which seeks to somewhat radically alter the current financing model for health care. The plan’s goal is to maintain a private, capitalist-based health care system while restraining cost drivers, improving quality of care, and providing universal coverage - something it calls "market-based universal health insurance." It attempts to do this through regional health exchanges, established by the federal government. Every household would receive a fixed dollar credit, financed by some broadly-based tax revenue, which would cover a basic, low-priced health plan from the regional exchange. Any improvements on that basic plan would be paid for with after-tax dollars.

An important element would be broadly available information on quality and cost metrics of different providers, so that consumers could make "economizing" decisions about the best plan for them during an annual enrollment period. The CED plan states that:

"Health providers would be accountable for quality and cost. To remain affordable while maintaining quality for their customers, providers would move away from fee-for-service episodic treatment to emphasizing primary care, health promotion, disease prevention, early detection and treatment, chronic disease management, and cost-reducing innovation and process improvement." (page 6).

The CED plan is similar in some respects to a proposal released by the ERISA Industry Committee (ERIC) in November.⁵ This proposal, more comprehensive in scope, seeks to have independent Benefit Administrators compete with one another, much as CED’s regional exchanges would. However, in the ERIC plan, the plans would offer a core set of "lifetime security" benefits which would include health care, retirement and short-term savings. In this way, the ERIC plans seeks to shift the responsibility for health care and retirement plans away from employers.

As these proposals show, while approximately 71% of working age Americans receive their health benefits through an employer in 2006 (down from 75% in 2000), new ideas are being promoted which would radically change how U.S. health care benefits are financed. Most of these ideas continue to maintain a central role for private health insurers and providers; that is, a free-market approach to solving health care inefficiencies. However, other plans do foresee a greater role for government, and certainly any plan that depends on tax credits would need the blessing of federal and/or state governments.

HSA Update

According to America’s Health Insurance Plans annual, the lead trade group for U.S. health care providers, approximately 4.5 million Americans (including dependents), were covered by HSA/High Deductible Health Plans in 2007, up from 1.0 million in 2005 and 3.2 million in 2006⁶. This includes 3.4 million in group plans and 1.1 million in individual plans. The Kaiser Family Foundation in its survey of 2007 health costs⁷ reported that 1.9 million workers were covered by such plans (not including dependants or non-group coverage).

Another way to measure HSA growth is to look at how many companies are offering or plan to offer HDHP/HSA plans in 2008. Watson Wyatt, a global consulting firm, released a number of important benefit trends in September, on of which indicated that 40 percent of companies are going to offer an HSA next year. Additionally, the firm’s research found that 5 percent of employers now offer a CDHP on a total replacement basis and another 4 percent plan to do so in 2008⁸.

Applying U.S. census data on U.S. employment (most recent data 2004), we found that if 9% of all employers providing health insurance offer HSAs exclusively in 2008, that would equate to approximately 8.7 million workers.⁹ This, however, does not take into account those employees which 1) may not qualify for health benefits (e.g. part time workers), or 2) qualify but opt out of the plan.

If 40% of companies with health care benefits offer an HSA option in 2008 (Watson Wyatt Research), this would represent an astonishing 39 million American workers who have potential access to such plans. And this does not include estimations of individual health market participants. If even 1/3 of those employees with a choice (39 million less 9 million offered HSAs exclusively) adopt HSAs, that would represent another 10 million potential HSA candidates.

Looking at the numbers in this light, the rapid growth predicted for this new health care model appears to have some validity.

The U.S. Health Insurance Composite: Executive Summary

Results for the ALIRT Health Composite, comprised of the 100 largest U.S. health insurance companies, ranked by net premium income, are provided below.

• Statutory surplus for the U.S. Health Insurance Composite rose 9.2% in the first nine months of 2007 (12.5% when annualized) to $56 billion, as operating earnings of $6.3 billion and net capital gains of $1.2 billion were offset by shareholder dividends of $2.1 billion and other reductions to surplus of $724 million.
• Net Premium income grew 5.5% in the first nine months of 2007 when compared to the prior year period on continued price increases. Net premium leverage (net premium to surplus) fell to 3.7 times in the first nine months versus 3.9 times for the same period in 2006, as surplus growth outpaced premium growth.
• Member Months declined 100 basis points in the first three quarters of 2007, likely due to the impact of greater self-insurance among larger insurers and the reduction/elimination of benefits by smaller sized employers. This is partially offset by greater growth opportunities for private insurers in the current Medicare and Medicaid markets.
• The medical loss ratio for the ALIRT Health Composite rose (deteriorated) 80 basis points to 85.8% in the first nine months 2007 when compared against the prior year period. This is likely due to compressed margins as competition intensifies and medical cost inflation continues to outpace general inflation. The composite operating ratio also weakened by 40 basis points to 94.9%.
• Pretax operating earnings of $8.5 billion in the first nine months of 2007 were flat when compared to the prior year period. After-tax return on revenues of 4.0% was also in line with the previous year’s figure, while after-tax return on equity declined 180 basis points but remained strong at 15.7% (annualized).
• Net investment yield rose 87 basis points to 4.78% when compared to the prior year period, driven by an improving interest rate environment, especially on shorter term bonds. Interest rates, however, turned sharply lower thus far in the fourth quarter and will likely have an adverse impact on full year net investment yield.

Surplus & Leverage

Composite surplus rose 9.2% in the first nine months of 2007 to $56 billion (12.5% growth rate when annualized). Contributing to this growth were operating earnings of $6.3 billion and net capital gains of $1.2 billion, offset in part by shareholder dividends of $2.1 billion and other reductions to surplus of $724 million. Net capital gains eased in the third quarter 2007 as market growth, while decent, was not nearly as strong as in the 2nd quarter.

The table below highlights composite surplus trends for the U.S. Health Insurance Composite over the last five years and current period, as well as the major items driving surplus changes.

As can be seen in this table, annualized after-tax operating earnings declined 6% when compared to the 2006 result, indicating that the five-year run (2002-2006) of improving earnings may end in 2007.

There were essentially no surplus infusions for composite companies in the first nine months of 2007, while shareholder dividends paid of $2.1 billion were almost exactly the five year average of dividends paid in the period 2002-2006. This pattern of continued robust repayment of surplus is perhaps an indication of lack of present opportunity to put these funds profitably to use.

Surplus Development/Underwriting Leverage - Individual Companies

Surplus declined for fourteen composite companies in the first nine months of 2007, in most cases due to dividends paid to parent companies. The largest declines were seen at Anthem Health Plans of Virginia (-37%; $600 million dividend), BCBS of Wisconsin (-28%), and Humana Health Benefit Plan of LA Inc. (-23%). Only two (2) composite companies reported surplus losses due to operating losses: Capital Advantage Insurance Company (-18%, $11 million operating loss) and Kaiser Foundation Health Plan Inc. (-7%; $3 million operating loss).

Surplus growth exceeded 30% for 11 of the composite insurers in the first nine months of 2007, due principally to strong operating earnings. These companies are Aetna Health Inc., TX (52%), Community Insurance Company (52%), and United Healthcare of OH, Inc. (50%). In all, 19 companies reported surplus gains exceeding 20%, and 52 companies reported surplus gains exceeding 10%.

Premium Growth/Membership

As shown below, the net premium growth rate for the ALIRT Health Composite peaked in 2003 at 13%, and has eased considerably since, settling in at the 6%-7% range over the last two years and current period. The lower premium growth rates reflect in part easing prices (discussed below), tighter competition for a finite amount of group commercial business, the growing prevalence of self-insurance, especially among the larger plans¹⁰, higher deductible/higher co-pay insurance policies (including CDHPs), and fewer small employers offering health benefits.

In September, Kaiser Family Foundation and Health Research and Education Trust released the results of its annual survey of private and public employers¹¹. The survey found that annual premium growth rates eased for a fourth consecutive year, from a cyclical high of 13.9% in 2003 to 6.1% in 2007. While a reflection of insurers and employers successful attempt to rein in healthcare costs, these premium increases continue to outpace growth in workers’ earnings and general price inflation, which are estimated at 3.7% and 2.6%, respectively, in 2007.

The survey also found that the percentage of employers offering health insurance fell from 69% in 2000 to 60% in 2007, with the overall rate decline driven by medium and small firms. Another key finding, and not surprising, is that employees are being required to shoulder more of their health care costs, whether through premium contributions, annual deductibles, copayments and/or coinsurance.

Several other studies were released this Fall looking at prospective, 2008 health care costs. PricewaterhouseCoopers estimates that insurer/self-insurer medical costs are expected to rise approximately 10% for HMO/POS’s and PPO’s and 7% for CDHPs, each category down approximately 2% points from the prior year, reflecting lower spending for prescription drugs, cost sharing with employees, better health management, and the impact of technological improvements¹².

Towers Perrin estimates that the total average cost of corporate health benefits will be $9,312 per employee, or a 7% increase over 2007¹³. Towers Perrin research also found that employers will pay 78% of these costs, with the remaining 22% coming from employees. While this split is similar to that in 2006, higher overall premium costs along with decreasing benefits (in cases) means that employees may be paying more out of pocket for less. Additionally, employees will have to continue contributing to their health care costs through copays, deductibles, and coinsurance.

Premium & Member Month Growth - Individual Companies

Year-over-year premium growth of over 20% in the first nine months of 2007 was reported by four insurers, including Ohio Medicaid specialist Caresource (50%), Oxford Health Insurance (37%), BCBS of Florida (24%), and Medicare writer Pacificare of Texas, Inc. (20%).

Of the 25 composite companies whose premium grew 10% or more, 16 were Blue Cross Blue Shield insurers (or affiliates), underscoring the continued importance of the BC/BS license in the private health insurance market. Additionally, six of the top 10 insurers with the highest annual growth rates were dependent on government health business, whether Medicare, Medicaid, or Federal Employees Health Benefit Program.

Twenty six of the 100 composite companies reported declining year-over-year premium flow in the first nine months of 2007 when compared against the prior year period. The largest declines were reported by Minnesota-predominant Medica Insurance Company (-27%), Health Options, Inc. (-21%), Optimum Choice Inc. (-18%), and United Healthcare of Florida, Inc. (-16%).

Most of the companies reporting declining premiums produce business within either HMO or HMO/POS product types, demonstrating once again that this product model is falling out of favor in many areas of the country (unless tied, in cases, to Medicare or Medicaid business). In contrast, the PPO model gains greater traction, due in part to its greater flexibility within high deductible plans and looser state regulation. We note that the three non-Medicaid/Medicare writers with the highest premium growth (above) write their business in predominantly PPO products.

Only five of the 26 companies reporting declining premiums were BCBS licensees, with the majority being subsidiaries of the largest public national healthcare groups, including Aetna, Humana, UnitedHealth, and Wellpoint.

Profitability & Earnings

Profitability metrics for the ALIRT Health Composite declined in the first nine months of 2007 when compared to the prior year period, as the medical loss ratio (and combined ratio) deteriorated (rose) 80 basis points to 85.8%, likely reflecting compressed margins on growing competition. This is the highest medical loss ratio for the past six years. The composite operating ratio deteriorated 40 basis points to 94.9%.

Annualized after-tax Return on Revenue and Return on Equity fell to five year lows of 4.0% and 15.7%, respectively, for the first nine months of 2007. This is in part the result of continued strong surplus growth in the first nine months of 2007, in the case of the ROE figures. In line with our general thesis, these metrics indicate that profitability is now weakening (driven by rising medical loss ratios on the downside of the current market cycle), though earnings remain reasonable.

Individual Company Results - Return on Revenue (ROR)

Only three composite companies reported after-tax RORs exceeding 10% (annualized) in the first nine months of 2007, including Geisinger Health Plans (11.6%), Humana Health Benefit Plan of Louisiana, Inc. (10.4%), and Oxford Health Plans NY, Inc. (10.1%), while 34% of the composite companies reported after-tax RORs of over 5%, the same as at six months 2007. It is interesting to note that five of the 10 insurers reporting the strongest ROR are writing half or more business in the Medicare line on an HMO model, an indication of how profitable government business can be.

Only four composite carriers reported negative ROR in the first nine months of 2007, including Hawaii Medical Service Association (-1.5%), Capital Advantage Insurance Company (-1.3%), Kaiser Foundation Health Plan, Inc. (-0.5%), and BCBSM Inc. (-0.55%). Hawaii Medical’s already high medical loss ratio jumped 170 basis points to 94.3% at nine months, contributing to their loss, while Capital Advantage’s medical loss ratio jumped a staggering 780 basis points on much higher prescription drug payments.

Investment Results

The graph below shows the investment returns (both net yield and total return on invested assets) for the ALIRT Health Composite over the past five years and current period (annualized).

Net investment yield for the composite improved sequentially over the past three years, from 2.94% in 2003 to 4.51% in 2006, before rising again in the first nine months of 2007 (4.78%). This reflects the boost to short-term interest rates over that time period, with the Federal Reserve raising rates from a low of 1.00% in mid-2003 to 5.25% in 2006. Health insurers particularly benefited from this rate improvement, as yield gains were strongest in shorter term securities in which most health insurers invest (to match the shorter-tail business line).

It should be noted, however, that the Federal Reserve lowered its key discount rate 75 basis points over the past two months in an attempt to curtail potential recessionary trends occasioned by the subprime mortgage meltdown this summer. Shorter-term rates, as measured by U.S. government paper ranging in maturity from 3 months to two years, have now fallen to their lowest levels in the past two years, which if maintained will likely adversely impact reported yield rates going forward.

The composite’s Total Return on Invested Assets improved in the first nine months of 2007 as stock indices rose in the third quarter, despite the onset of market woes in August tied to the subprime mortgage meltdown. Given that the ALIRT Health Composite has 14% of invested assets in unaffiliated stocks, total return tracks closely to equity market performance (see weak results in the bear market years 2001 and 2002, followed by a sharp increase in 2003). Equity markets are down sharply thus far in the fourth quarter (as of December 17th, the DJIA = -5.2%, S&P = -4.7%, and the NASDAQ = -5.3%), so we will likely see full year total returns lower than those currently reported.

Subprime Mortgage Exposures

Given the current interest in potential insurer exposure to sub-prime mortgages, we take a quick - and admittedly crude - look at where some of this exposure, if it does exist, would lie. Direct exposure to sub-prime mortgages losses would be found in either Collateralized Mortgage Obligations (CMOs = residential, multi-class mortgage) or in Other Asset-Backed and Mortgaged-Backed Securities, which would include any exposure to sub-prime mortgages bundled into Collateralized Debt or Collateralized Loan Obligations.

As can be seen below, at year-end 2006 (data not available quarterly), the Health Composite held 6% of invested assets and 9% of surplus in these investment classes. The Health Composite companies with the highest surplus exposures to these classes are as follows:

It should be carefully noted that these are large buckets of investments, many of which likely have no relationship with sub-prime exposures. In fact, many insurers who have exposure to collateralized securities containing sub-prime mortgages have been quick to point out that they hold only the higher tranches of such instruments. These higher tranches are more highly rated and, in theory, pay out income streams even when losses are reported in the more risky tranches. It is also possible that the securities held in any of these buckets were sold since year end 2006.

Conclusion

Financial results for the U.S. health insurance industry in the first nine months of 2007 reflect a slow but marked decline from a cyclical peak reached in 2003, in terms of surplus development, premium growth and underwriting profitability.

We expect that premium growth will continue to ease in the near to medium-term as the U.S. health care system turns increasingly to consumer-directed solutions to control health care costs that well exceed wage growth and inflation rates. These solutions involve more out-of-pocket cost sharing with end consumers coupled with a heightened emphasis on prevention, disease management, and customer choice. It is hoped that consumers, armed with more health care information (costs and quality), will incent insurers and providers to innovate in hopes of attaining greater market share.

Also contributing to lower premium growth are: 1) larger firms turning to self-insurance (with mostly larger health insurers drawing fee income from servicing these plans), as well as a decline in the number of smaller firms offering health insurance.

Some of this lost revenue in the commercial group space may be offset by greater activity in the government markets, with Medicare Advantage and Medicare Part D products offering positive growth prospects, especially for the large national insurance groups and regional BCBS organizations. Smaller, non-BCBS insurers are increasingly at a competitive disadvantage due to lack of scale both in terms of breadth of services offered and the ability to build strong multi-state networks.

Lastly, there is much discussion, within the beltway and without, regarding changes to what many are now considering a "broken" U.S. health care system - at least in terms of the way health care is financed and delivered. A corollary concern is the number of uninsureds which currently stands at approximately 47 million, as estimated by the U.S. Census Bureau. As a major political season approaches, we are certain to see new solutions bruited about both from the political stump and in the press. How or if any of these innovative ideas are actually put into practice, given the constraints of political consensus-making and the potentially enormous costs of any such approach, waits to be seen.

¹ The ALIRT Health Composite comprises health insurers which issue statutory financials on the orange health blank. These companies include, but are not limited to, HMOs and write largely group medical business. Employee Benefits products are also written through companies that file as life insurers (NAIC "blue book"). These products include group medical health, but also 401(k) business, group Life, DI, and LTD, and critical illness insurance. For more information on the quarterly performance of the life insurance composite, please see our separate quarterly release on that industry.
² LA Times/Bloomberg, NBC News/WSJ, Newsweek, CBS News, ABS News polls, September - November 2007.
³ EBRI: Issue Brief No. 213: The Future of Employment-Based Health Benefits: Have Employers Reached a Tipping Point?
⁴ CED: Quality, Affordable Health Care for All: Moving Beyond the Employer-Based Health-Insurance System
⁵ Erisa Industry Committee: New Benefit Platform for Life Security
⁶ AHIP: : January 2007 Census Shows 4.5 Million People Covered by HSA/High Deductible Health Plans
⁷ Kaiser Family Foundation/Health Research and Education Trust: Employee Health Benefits: 2007 Summary of Findings.
⁸ Watson Wyatt Identifies Major Benefit Trends During Open Enrollment Season: September 24, 2007.
⁹ Our rough estimate is based on approximately 3 million U.S. firms with over 3 workers in 2004 offering health insurance, employing 97 million workers.
¹⁰ A number of carriers - especially the largest ones - are instrumental in the administration of self-insured plans. This Administrative Service Only (ASO) business produces sizeable fee income, though most of this income is in affiliated life insurers.
¹¹ Kaiser Family Foundation/Health Research and Educational Trust: Annual Employer Health Benefits Survey: 2007 Summary of Findings
¹² PricewaterhouseCoopers’ Health Research Institute: Behind the Numbers: Healthcare Cost Trends for 2008
¹³ 2008 Towers Perrin Health Care Cost Survey.