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What Does Health-Care Reform Mean for Managed Care?

2009 could be a year of major regulatory change for the MCOs.

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With the Democrats back in control of both Congress and the White House--and with our health-care system facing ever-growing problems such as rising costs, underfunded entitlements, and a large number of uninsured--major health-care reform has returned to the national political debate in a way not seen since the early 1990s. 

Originally, we thought reform was unlikely in 2009, thanks to even more immediate economic and budgetary concerns. However, President Obama has shown that he is determined to pass major health reform legislation within his first year in office, and Congress has moved forward, with three principal bills currently under consideration--one in the House and two in the Senate. The managed care organizations, or MCOs, stand to be the most directly affected by changing U.S. health-care policy.

At Morningstar, we cover most of the publicly traded MCOs. As of Thursday, Aug. 13, two of these companies carry our 5-star rating:  UnitedHealth (UNH) and  WellPoint (WLP), both of which are trading at greater than a 40% discount to our estimate of their fair value. Only these two firms carry our medium fair value uncertainty rating and narrow economic moat rating, with the rest rated high or very high uncertainty and with no economic moat. Regulatory uncertainty is one of the main factors keeping our moat ratings low and our uncertainty ratings high on these names.

There are two fundamental assumptions underlying our coverage of the MCOs at this time. First, we believe that our fair value estimates represent a reasonable middle ground between the many potential outcomes of regulatory reform. Second, we believe that structural reform fundamentally undermining the managed-care business model (a shift to a single-payer, government-operated payment model) is currently very unlikely. Even so, the final outcome of regulatory reform remains highly uncertain. The best we can do is to closely monitor the situation as events unfold in Washington. We expect much of the uncertainty to be resolved within the next several months, and if our thesis appears to have been flawed, we will not hesitate to alter it.

Below, we present the four most important generalized reform proposals of which we are currently aware, our opinion on their likelihood of being enacted, and their potential effect on the managed-care industry.

Cuts to Medicare Advantage
We think reimbursement cuts to MCOs participating in the Medicare Advantage (MA) program are all but certain. The President's budget anticipates $177 billion in savings over 10 years from these cuts, which will be used to fund other health-care priorities. We believe that this reform is logical and that there will be little meaningful opposition (except from the MCOs, who argue that it will mean lower benefits for seniors and could disadvantage rural areas, both of which are true).

The Medicare Payment Advisory Commission (MedPAC) estimated in its March report to Congress that in 2009, MA plans would cost the government 14% more per beneficiary, on average, than the cost of original Medicare. Private fee-for-service plans are the worst offenders, costing the government 18% more than original Medicare. MCOs submit bids against benchmarks to participate in the MA program, and the overpayments result from quirks in the way these benchmarks are set. Private fee-for-service plans were already slated to be eliminated in 2011, thanks to legislation passed last year. We expect reimbursement on HMO and PPO plans to be lowered to parity with original Medicare within a few years.

Because we had anticipated this reform, we believe it is properly accounted for in our models. The immediate effect of reimbursement cuts will be to lower revenue by the amount of the cuts. We expect most cuts to be passed through to members in the form of lower benefits (the extra payments had previously been used to fund extra benefits not available with original Medicare, such as lower cost sharing or prescription drug benefits). Medicare Advantage enrollments have been growing rapidly since 2003's Medicare Modernization Act--total enrollments nearly doubled in five years--thanks in large part to MA plans' more generous benefits. We expect this growth rate to slow dramatically, and there could even be membership attrition back into original Medicare. MCOs may be forced to accept lower margins in some regions in addition to cutting benefits, and some plans may exit unprofitable markets, further lowering enrollments.

Companies that will be most affected are those with a large concentration of Medicare Advantage business, such as  Humana (HUM),  HealthSpring (HS),  Coventry Health Care (CVH), and UnitedHealth. The amount of membership attrition and margin contraction that will actually occur is uncertain, but we believe our models incorporate reasonable estimates of both factors.

Four Intertwined Proposals
Four reform proposals--guaranteed issue, community rating, individual mandate, and public subsidies--are closely related, which is why we have grouped them together. "Guaranteed issue" refers to laws that require health insurers to issue policies to any applicant, regardless of health status or pre-existing conditions. "Community rating" refers to laws that forbid health plans from charging different premiums on the basis of health status. An "individual mandate" refers to laws that require individuals to purchase insurance, similar to the way drivers in most states are required to carry liability insurance. Public subsidies would almost certainly be used to complement an individual mandate, to ensure that it did not place an undue financial burden on low-income families.

In our opinion, if any of these proposals were to be enacted, all of them would have to be enacted together. For example, guaranteed issue is meaningless without community rating (and vice versa), because insurers could just price relatively sick consumers out of the market (or deny policies at the going premium rate). If insurers are unable to medically underwrite policies, then consumers have to be forced to buy those policies through a mandate. Otherwise, guaranteed issue/community rating could lead to higher costs for everyone and little expansion of coverage, as relatively healthy consumers would opt out of insurance altogether at the going rate, waiting until they become sick to purchase insurance. In a functioning insurance market, healthy beneficiaries are needed to subsidize the costs of relatively unhealthy beneficiaries. Finally, an individual mandate would be infeasible for low-income families unless it were coupled with some combination of means-tested subsidies and expansion of the Medicaid program.

These reforms all appear likely to us, as their key elements are included in all of the bills under consideration, and this would be the easiest route to universal coverage. They are supported by most interested parties, including the MCOs. The main opposition comes from deficit hawks in Congress, who are concerned about the fiscal consequences of public subsidies. Many employers also oppose any pay-or-play proposals, which would force them to offer health insurance or pay a penalty tax. This sort of reform does tend to entrench our current multi-payer system, which has drawn opposition from health policy advocates who support a single-payer system.

Depending on its implementation, we think this kind of reform is likely to be a net positive for the MCOs, as it will give them access to nearly 46 million new customers. In the unlikely event that guaranteed issue and community rating were implemented without an individual mandate, it could potentially destroy the individual market through adverse selection, which would be a significant negative for the MCOs. Also, these sorts of reforms are often bundled with the idea of a new public plan competing with the private MCOs through some form of "insurance exchange." We discuss this possibility below under "Medicare-for-all."


Changes to the Tax Code
The U.S. tax code creates two important distortions to economic incentives with respect to health care. First, the tax code favors employer-sponsored health benefits over other forms of compensation, since these are tax-deductible to the employer but not taxable to the employee. This generally causes employers to offer more generous benefits than they would otherwise, helping to drive up health-care costs. Second, the tax code favors employer-sponsored insurance over individual insurance, since individual insurance must be purchased with aftertax dollars. The latter problem could be rectified by making individual insurance premiums tax-deductible, although this would contribute to cost inflation and act as a drain on the federal budget. Both incentive distortions could be solved (while also generating additional tax revenue) if the government were to treat employer-sponsored benefits as taxable income or forbid employers from deducting the costs of health benefits on their tax returns.

Although we think these sorts of tax code reform make economic sense and would be a relatively good way to raise revenue for insurance subsidies, they enjoy little support in Congress or in popular opinion. If the tax exclusion on employer-sponsored health benefits were eliminated, it might be replaced by a refundable tax credit of similar value. However, offering a tax credit would mean that the tax code changes would create little incremental revenue. Not offering a tax credit would mean a very large tax increase on the middle class, which appears to be politically infeasible, especially given the state of the economy and President Obama's campaign pledge not to raise taxes on those earning less than $250,000 per year.

Substituting the current tax exclusion with a fixed, refundable credit would still have the very important effect of altering the marginal cost of health insurance, even if the average cost remained the same at current coverage levels. In other words, incremental employer-sponsored health benefits would no longer be tax-favored, which would most likely lead many employers to scale back benefits. This could significantly lower health-care cost inflation, and it could also be a major negative for the MCOs, who would see lower revenue. However, we think the general direction of health reform will be to expand insurance coverage and increase benefit levels, and this policy would have the opposite effect. In our opinion, changing the tax code in this way would be a drastic change with subtle benefits, making it unlikely to survive the legislative process.

It is also worth considering whether a change to tax policy--including making individual insurance premiums tax-deductible--would fundamentally undermine the employer-based health insurance system. One of the reasons that health benefits are usually obtained through employers is because of the tax advantages. However, employer-sponsored insurance plans also benefit from lower selling costs, savings from scale in plan administration, and less adverse selection (people choose their employers for many reasons other than their health status). For these reasons, employer-sponsored insurance is likely to remain more attractive than individual insurance even if the tax benefit is removed.

In our opinion, the biggest threat to the MCOs would come from expansions of the Medicare program. For example, both the Democrats' bill in the House of Representatives and the Senate's HELP committee bill propose creation of a new public insurance plan open to the under-65 population. The effect of these proposals on the MCOs would depend heavily on the details of their implementation. In a worst-case scenario for the MCOs, "Medicare-for-all" could fundamentally undermine their business model and move the country in the direction of a single-payer system.

The foundation of economic moats for health insurers is scale: size allows leading MCOs to negotiate the best discounts with health-care providers and to leverage their fixed administrative costs. The problem with allowing Medicare to compete with private plans is that Medicare has much greater scale than any of the private MCOs. Medicare provides health benefits to 45 million beneficiaries, compared with WellPoint's and UnitedHealth's 35 million and 33 million medical members, respectively. More importantly, WellPoint and UnitedHealth each control about $100 billion of aggregate health-care spending, or only about a quarter of Medicare's estimated $477 billion of spending for 2009. All public programs combined provide insurance to more than 83 million beneficiaries and control more than $1 trillion of spending.

Medicare's scale endows it with clear cost advantages over private MCOs. Medicare sets provider reimbursements through a legislated fee schedule rather than through negotiation. Providers have little choice but to accept Medicare's relatively low reimbursements; otherwise, they would forego a very large amount of business. According to MedPAC, Medicare's physician reimbursements are about 20% lower than MCOs' payment rates. Hospital operator  Tenet Healthcare (THC) has said revenue per inpatient admission is about 50% higher for patients with private rather than government insurance.

Medicare's administrative costs are also lower than those of private plans. Medicare can spread fixed costs over a greater revenue base, and it also benefits from the fact that it does not have to incur selling costs, maintain provider networks, manage care, or earn a profit. According to data from the Centers for Medicare and Medicaid Services, only 5% of Medicare's spending went to administrative costs in 2007, compared to about 12% for private insurers as a group.

We would consider Medicare to have a very wide economic moat. Given its cost advantages, if Medicare were allowed to compete with private MCOs, it could potentially steal market share very rapidly, eventually resulting in a de facto single-payer system. We would most likely drastically lower our fair value estimates, raise our uncertainty ratings, and lower our moat ratings for the MCOs if health-care reform goes in this direction. Even if Medicare were only opened to individuals and/or small employers, it would have a very negative effect on the MCOs, spreading their fixed costs over a much smaller base of business.

However, we view this "Medicare-for-all" model as highly unlikely. Conservatives are strongly opposed to such a policy, because it would greatly increase the government's role in health care and the economy. Pretty much every corner of the health-care sector is also opposed: doctors, hospitals, drugmakers, and device-makers all oppose expansions to Medicare because of the downward pressure it would exert on prices and profits. One example of the power of provider lobbies is Medicare's competitive bidding program for durable medical equipment, which has been consistently delayed despite savings shown in the pilot program (which also highlights the perils of leaving Congress, rather than market mechanisms, to determine prices for goods and services). Insurance companies strongly oppose this kind of reform. And although Americans appear much more open to government intervention in health care than they were during the early days of President Clinton's administration, the recent protests at town hall meetings about health reform show that accusations of "socialized medicine" still draw a fair amount of ire from the general public.

A new public plan could be designed for the insurance exchange that would have a much less disruptive impact on the private MCOs. For example, administration of the plan may be outsourced to the private MCOs, in the same way as Medicare Advantage, the Federal Employees Health Benefits Program (FEHBP), and many state Medicaid plans. While government business generally carries lower margins than commercial insurance, this could still represent some incremental upside for the private MCOs, depending on the extent to which the new business cannibalized existing commercial business. The Senate Finance Committee has proposed creating non-profit, member-run health insurance cooperatives instead of a public plan. We expect these cooperatives would be very similar to existing regional non-profit insurers and would have little effect on managed care companies. Following a compromise with the fiscally-conservative Blue Dog Democrats, the current House bill requires the new public plan to negotiate its own provider rates, rather than using Medicare's fee schedule.

In the event the new public plan were linked to Medicare, it would also be interesting to observe whether the government would stand in the way of further consolidation among the private MCOs. While major MCOs like UnitedHealth, WellPoint,  Aetna (AET), and  Cigna (CI) would not be competitive with Medicare on their own, they would come much closer to Medicare's scale if combined. They would also have the incentives to innovate in a way that could make them viable competitors to the public plan. Mergers and acquisitions among major MCOs often face opposition from regulators and lobbying groups for health-care providers, who argue that the consolidating MCOs have too much market power. However, that dynamic may change if the alternative is a single-payer system.

A version of this article appeared in Morningstar Healthcare Observer.

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Leveraging Morningstar's comprehensive industry coverage, Morningstar Healthcare Observer examines complex health-care topics and trends to provide critical insight. Through cross-industry analysis, we bring together Morningstar analysts from different health-care industries to research significant issues. Click here to get Healthcare Observer's entire, 54-page "Healthcare Reform Issue" for only $149 $99.

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� Is U.S. Health-Care Spending Sustainable?
� Health-Care Spending in Other Modern Nations
� What Are Our Policy Reform Options?
� Health-Care Reform by Industry

Matthew Coffina does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.