US health insurers

US health insurance stocks have performed extremely well.  Even if you had bought the worst ones, performance would have been similar to the S&P 500.  Why?

While the overall US healthcare system is dysfunctional relative to those in other developed countries, a broken healthcare system doesn’t explain why insurance stocks have done better than hospital stocks.  While hospitals engage in abusive practices such as surprise out-of-network medical bills (balance billing), hospital stocks have been mediocre investments.  A better supported explanation is scale.  One manifestation of scale is in dialysis treatment, a unique market where Medicare is the biggest negotiator with at least 90% of patients.  Commercial payers, with their lack of scale in this situation, are charged many times what Medicare pays.  SIRF’s analysis puts it at roughly $1,050 per treatment versus $250.  Of course, no health insurer enjoys 90%+ market share so their scale advantages are smaller.

Here’s a look at how market cap (a proxy for size) correlates with return on assets:

Scale advantages on a local level kick in when negotiating labour from doctors.  Many contracts state rates as a percentage of the Medicare rate, e.g. commercial insurance often pays 130% of Medicare.  Doctors are less likely to say no to their biggest revenue streams, so the scale players (especially Medicare) end up negotiating lower rates.  Doctors can say no to business from Medicare or health insurance plans.  They have to work out their profit margin on each revenue stream and consider whether or not the additional business is worth it.  The article “How to Negotiate With Health Care Plans” gives a great overview of the doctor’s perspective.  Most doctors will accept Medicare due to the volume of business generated.

On a national level, there would be some scale advantages from fixed cost leverage and from negotiating drug prices (either through their own PBM, or when negotiating PBM rates).

Overall, scale has allowed the larger health insurers to earn unusual profits.  The drive towards more scale has driven industry consolidation, leading to the stocks of smaller industry players receiving takeover premiums.  The consolidation has helped investors in the smaller players do better than they otherwise would.

But, management still matters

The most obvious example of management’s importance is the ACA (Affordable Care Act) or ‘Obamacare’ exchanges.  Centene has been able to turn a profit on ACA exchanges while many of their peers have not (Molina has been occasionally profitable with ACA exchange plans).

How insurers get ahead

When health insurers provide risk-based/full-risk plans, they take on risk and actually provide insurance rather than manage healthcare benefits.  Unfortunately, profits are maximized by dumping expensive patients and by denying claims- including legitimate ones.  Some insurers get very creative when denying benefits.  An insurer can pretend to uphold Catholic values as a pretext for denying abortion claims (some Catholics do not want to be a part of funding abortion) and for denying coverage of contraceptives.  However, switching to a fee-for-service model doesn’t necessarily help either.  In that model, the healthcare company does not provide insurance and does not take on the risk of medical costs being higher than projected.  The healthcare company simply acts as an administrator on behalf of another party.  If the company is also administering prescription drug plans, it has strong incentives to receive kickbacks (so-called “rebates”) from drug manufacturers in exchange for having their client overpay for drugs.

It is very difficult to align the insurers’ incentives with socially-beneficial outcomes.  Insurers are incentivized to game whatever system is placed in front of them… and they will get pretty good at it.

Some free market incentives could lead to better health outcomes and lower costs.  Outside of the US, colonoscopies are often performed without anesthesia.  While most Americans are horrified at the thought of having a camera probing inside them without anesthesia, there is an argument to be made for forgoing anesthesia and the small risks associated with it.  (Some interesting links on colonoscopy without anesthesia can be found here and here.)  Insurers use the argument of better outcomes (and lower costs) when denying coverage of anesthesia for colonoscopies.  On the other hand, insurers will try to deny coverage of colonoscopy in the first place.  In response, the Affordable Care Act required plans sold on ACA exchanges to offer free colonoscopies as they are a preventative screen for colon cancer.  However, insurers looked for dubious loopholes to avoid paying claims.  If polyps were removed during the colonoscopy (some polyps are potentially cancerous), the insurers argued that the procedure was a ‘treatment’ procedure that required the patient to be billed.  The government responded by closing the loophole.  Later, the government required insurers to cover anesthesia (*”if the attending provider determines that anesthesia would be medically appropriate for the individual“… creating incentives for insurers to pay extra to doctors who don’t recommend anesthesia).  Overall, while the profit motivation occasionally induces insurers to create value, it generally causes more harm than good.

Medicare Advantage

Medicare Advantage is a program where insurers take Medicare patients off the government’s hands.  The government will pay the insurer a fixed fee for providing healthcare to the patient; the insurer takes on risk and pays the patient’s medical bills.  On the surface, Medicare might seem like a single-payer system where the government outsources some healthcare administration to the private sector.  In reality, it’s not really outsourcing when insurers are heavily incentivized to game the system.

Patients can choose whether to go with original Medicare or Medicare Advantage (*among other options).  The law requires insurers to accept all patients.  Insurers try to cherry-pick the best patients from the Medicare pool, designing plans that would be attractive to profitable patients and unattractive to unprofitable patients (e.g. ones with expensive health conditions).  One method is to subsidize gym memberships, since those interested in that perk proactively take care of their own health and/or are healthy enough to exercise.  It could be characterized as a bribe to get patients to sign up.  While shuffling money into the hands of profitable patients does not generate benefits for society, it does translate into profits for insurers as they are able to attract a greater number of profitable patients.  To discourage unprofitable patients, plans may use require doctor authorization to see specialists.  They may require higher co-pays to see specialists, as patients who care about seeing specialists are more likely to be undesirable patients with expensive medical conditions.

Insurers do have to pay attention to the balance between cost cutting and attracting patients.  If a patient likes their primary care physician / family doctor, they will look for a plan that will cover treatment from that doctor.  And as mentioned previously, shuffling money into the hands of profitable patients is a great marketing tool.

The MA system is a bad deal for the US government as it is too difficult to align the private insurers’ incentives with good outcomes.  As well, the MA plans are disadvantaged when negotiating rates with doctors as they lack Medicare’s scale- MA plans pay slightly higher rates than Medicare.  The true purpose of MA may be to give private companies money.

Commercial insurance and Medicare Advantage ‘synergy’

If an insurer is in both markets, the insurer can negotiate a deal where the doctor charges less for MA than for commercial insurance.  The fee-for-service commercial clients overpay while the insurer underpays.  In effect, an insurer can use other peoples’ money to pay its own expenses.  The article provides commentary from Dr. James Robinson, who notes:

“Trust me, if the health plan studied here could pay physicians at TM [Traditional Medicare] rates for their commercial as well as their MA [Medicare Advantage] patients, they would,” Dr Robinson writes.

However, note that some insurers don’t have this advantage.  They may lack a commercial insurance business in the same state as their Medicare Advantage business.

Industry outlook

It theory, the US healthcare system is broken and should be fixed.  Fixing the issues (e.g. phasing in a single-payer system) could severely impact the profits of health insurers.  But what have politicians actually done?  They’ve expanded the for-profit healthcare industry.  Medicare Advantage enrollment has steadily increased.

As far as ACA / Obamacare goes, the universal health insurance aspect of it expands the size of the insurance market.  In a free market, insurers won’t cover patients with predictably expensive healthcare bills.  To make a profit on such patients, insurers have to price policies for these patients slightly above the cost of that patient’s recurring bills… making insurance prohibitively expensive for those patients.  An insurance market for those patients will not naturally form.  However, the government can intervene and force healthy people to subsidize the healthcare costs of the sick.  This grows the insurance market for the private sector as more uninsured lives are brought into the system.  In practice however, ACA exchanges haven’t been particularly profitable for insurers.  The ACA exchange system may also collapse as premiums have been steadily increasing and there is little political will to make the healthy subsidize the sick through unpopular mechanisms such as the individual mandate.

The Medicaid (‘Medicare for poor people’) expansion aspect of the ACA does increase government involvement in healthcare.  However, this is mostly a good thing for the for-profit industry as the Medicaid managed care programs are somewhat analogous to Medicare ‘outsourcing’ patients to Medicare Advantage.  Insurers profit from Medicaid largely by denying claims and discouraging patients from seeking expensive care (e.g. specialists).

The big picture is that both left-wing and right-wing politicians have enacted changes that help the health insurers make money.  It’s possible that politicians may lower healthcare budgets due to necessity (US government spending is ultimately unsustainable) or for political reasons (e.g. they think that cutting budgets will be popular with voters).  However, health insurers generally aren’t dependent on government spending to make money.  And perversely enough, the state governments often ‘cut’ spending by sending patients into the Medicaid managed care programs.  What actually happens is that the insurers do what the politicians don’t want to be seen doing- cutting costs to the bone and reducing the quality of care.  For-profit insurers can profit from ‘saving’ states money.

The real risk to the insurance industry is a single-payer healthcare system.  However, American voters have certain ideologies about governments being inefficient.  As well, many American politicians enjoy lobbying and funds from healthcare companies.  Overcoming the opposition to a single payer system would be difficult.  The state of Vermont tried to implement a single payer system but those efforts ultimately failed.

Winners and losers

Obviously the losers will be poor people, those with expensive medical conditions, and those with big medical bills.  While free markets and regulated markets often create a lot of value for society, they aren’t the best solution for everything.

As far as shareholders go, I’m most interested in United Healthcare (UNH) and Centene (CNC).  This isn’t entirely what you would expect from looking at the chart at the very beginning of this post:

  • It should be obvious as to why I like United- they are the biggest and they have good returns.  Their PBM side looks strong too.  Their PBM, Optum, is better managed than Express Scripts (ESRX) and others as Optum almost certainly took advantage of free drugs from Valeant.
  • Centene has high earnings per share growth (roughly 34% annualized), performing much better than its size would suggest.  Their execution with ACA exchange plans was clearly excellent as they are one of the very few insurers expanding in that market.  They seem to be making excellent use of what negotiating power and scale they have.

*Disclosure:  Long CNC and UNH (and ESRX).




Upcoding: Evidence from Medicare on Risk Adjustment (non-digest version)

(The Incidental Economist) Medicare Advantage upcoding

The dangerous gym membership – Using gym memberships to attract desirable enrollees.

Rates paid by insurers

Medicare Advantage Pay Rates Similar to Traditional Medicare

How to Negotiate With Health Care Plans

Do Medicare Advantage plans pay providers different rates than traditional Medicare?


(Bloomberg) How to Make a Fortune on Obamacare (

CMS (Centers for Medicare & Medicaid Services; government regulator)

The CMS’ sometimes behaves in way that do not serve the American people.

Medicare Halts Release of Much-Anticipated Data

Reporter says he was threatened with ban from press calls after declining to alter story: report

Medicaid Managed Care

ELI5: What is Managed Care and how was it supposed to decrease the cost of health care?


A past blog post on Pharmacy Benefits Managers / Express Scripts

7 thoughts on “US health insurers

  1. Hi Glenn,

    How are you pricing UNH? The p/e doesn’t seem low, what kind of growth do you expect in earnings in the following years, considering the company’s size.

    • Here is my highly unsophisticated way of looking at it:
      2014 diluted EPS: 5.70
      2016 diluted EPS: 7.25
      12.8% growth

      Whereas for many companies size is a disadvantage, that’s not the case for healthcare. e.g. if you pay for 90% of dialysis patients, your cost advantage is ridiculous. (Of course, it is highly unlikely that the government will allow a health insurer to have that much market share.) So I think that they have a long runway of growth ahead of them.

      Regarding P/E. If you project out 10 or 20 years, then it’s likely that the industry will consolidate and that a few companies will earn the majority of the profits. And these “high” p/e health insurers will likely grow their earnings a lot and outperform low p/e stocks like department stores and phone books. So I think the right way of looking at it is… some stocks are actually undervalued at a p/e of 20… and others overvalued at a p/e of 10.

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