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Stock Strategist Industry Reports

What the ACA Means for Insurance Brokers

Private exchanges could offer growth catalysts but face challenges, writes Morningstar's Vincent Lui in Part 1 of a series.

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This Stock Strategist article provides an overview of the Affordable Care Act. In the next Stock Strategist, to be published Jan. 5, we will examine the ACA's effect on two insurance brokers we cover, Aon and Marsh & McLennan.

The Affordable Care Act aims to broaden coverage for 30 million uninsured and low-income families through the use of state-operated health-care exchanges. Likewise, private-sector employers are starting to offer health-care benefits to employees through exchanges operated by  Aon (AON) and Mercer (a subsidiary of  Marsh & McLennan (MMC)). The 2015 enrollment results have been less than stellar so far, casting doubts of the future growth of the private exchanges and their ultimate contributions to Aon's and Mercer's financials.

We think the biggest challenge for the exchange operators is to convince private-sector employers of the long-term benefits and cost savings of delivering health-care benefits through the exchanges and help them overcome concerns about the potential loss in employee productivity and morale as well as the stringent reporting requirements. In our base-case scenario, we assume a 1% exchange adoption rate of the 125 million active employees and a 5% adoption rate for the 15 million retirees, with the adoption rates growing 0.5% each year through the end of our projection period. At this rate, we project a 2.5 times and 3.5 times increase in enrollment by 2018 for Aon and Mercer, respectively.

The Affordable Care Act added at least "10 essential health benefits" to basic coverage, some of which were not always covered in individual health plans previously. While the social goals of the law are admirable and fairly straightforward, its implementation so far has been controversial, including the individual mandate and the penalty imposed for noncompliance. The law sets out an individual mandate that requires nearly everyone to get health coverage or risk paying a penalty. The penalties, which became effective in 2014, started at $95, or 1% of household income if greater, for someone who doesn't have health insurance coverage. The penalties go up every year, and by 2016, the fines rise to a minimum of $695, or 2.5% of income if greater. The government hopes that the penalties might be big enough to make everyone--healthy or not--obtain coverage.

The ACA also changes what used to be a risk-based model for premium pricing to a "community rating" model, in which the health insurance provider can establish pricing only with four basic parameters: age, geographic location, family composition, and smoking status. As a result, premiums for less-healthy people should be, in theory, more affordable than they otherwise would be because of the subsidy from the healthier participants. Additionally, because health is not a risk factor for underwriting under the law, all else being equal, even people with pre-existing conditions can expect to get coverage and be charged the same premiums by the participating insurers.

ACA Intends to Slow Health-Care Spending, Promote Higher-Quality Care
Health-care spending accounted for 17.4% of the U.S. GDP in 2013. The share of the economy devoted to health spending has remained relatively stable since 2009, as health spending and the GDP grew at similar rates between 2010 and 2013.

In 2013, the U.S. economy spent $2.9 trillion on health care, rising 3.6% from the previous year and representing the fifth consecutive year of slow growth in the range of 3.6%-4.1%. Looking more closely at the spending by sponsors, health-care spending financed by private businesses increased 4% in 2013, rising sharply from the average increase of 0.7% between 2008 and 2010 caused by job losses and declines in private health insurance enrollment during the recession. Health-care spending by the federal and state governments increased 3.4% in 2013, from 2.3% in 2012. Faster growth was in part a result of the increase in Medicaid payments to primary-care physicians mandated by the ACA.

According to the Centers for Medicare & Medicaid Services, health spending is projected to grow at about 6% in the next 10 years thanks to improving economic conditions, ACA coverage expansions, and an aging population. As a result, health spending is projected to reach 19% of GDP by 2023, up from 17.4% in 2013. The larger share of health spending is consistent with the coverage expansions required by the ACA. However, ACA provisions that reduce Medicare overpayments to private insurers and medical providers can have the effect of slowing the growth in health-care prices and spending. Additionally, ACA reforms that aim to improve the quality of care are reducing hospital readmission rates and increasing provider participation in payment models designed to promote better-quality care. While future growth in health spending is expected to be faster than recent experience, it is still slower than the elevated growth observed over the longer-term history, reflecting structural changes in the U.S. health-care system under the ACA.

Exchange Model a New Way to Purchase Coverage
The centerpiece of the ACA is the implementation of health-care exchanges run by the states. Health-care exchanges are based on the idea that market competition and choice among health-care providers will ultimately drive a cost-efficient way for the government to deliver benefits while allowing consumers to choose plans that meet their specific needs. Currently, 15 states and the District of Columbia are running their own public exchanges, with 7 other states sharing the work with the federal government; the feds are running the remaining 27 exchanges. Public exchanges are set up for providing insurance to an estimated 30 million people who are currently uninsured, including part-time and seasonal workers who do not qualify for employer-sponsored plans or opt out because the plans are too expensive.

We expect that the public health-care exchanges will attract sizable enrollments by offering subsidies to lower- and middle-income Americans and to small employers. At the same time, the individual mandate and the penalties imposed on businesses that fail to provide their employees with adequate insurance coverage will drive individuals and employers to the exchanges.

Parallel to the development of public exchanges is the establishment of private exchanges by the insurance brokers and consulting companies. These private exchanges aim at serving an estimated 140 million participants (15 million retirees and 125 million active employees) who are currently covered by employer-sponsored plans. The potential group is further divided into exchanges for retirees and exchanges for active employees.

Projected Enrollment in Public and Private Exchanges, 2014-18

Retiree Exchanges Represent Biggest Growth Opportunity for Now
Favorable market dynamics continue to fuel the growth of private exchanges in the retiree market. Because compensation and productivity are not consideration factors for the retiree group, employers have had a much easier time moving their retired employees to the exchanges. Retiree exchanges are set up for the country's 15 million retired employees who are eligible to participate in Medicare and currently participate in employer-sponsored plans to supplement Medicare. Future opportunities for the insurance brokers and exchange operators are the estimated 30 million retirees who are not in employer-sponsored plans and are ineligible for Medicaid as well. For employers sponsoring retiree health benefits for Medicare-eligible retirees, the retiree exchange has become an alternative to traditional employer-sponsored health insurance. Through the retiree exchange, the employer offers a subsidy toward the purchase of individual coverage. The retiree exchange serves as a centralized place to help retirees pick the plan that best suits their needs, complete the enrollment process, and receive ongoing customer service.

The first wave of migration happened in 2013 when several high-profile employers including AT&T, Walgreen, Sears, IBM, Time Warner, and Verizon announced the intention to move their retired employees to retiree health exchanges starting in 2015. Given the estimated 10%-15% cost savings that can be generated from the use of exchanges, other mature businesses with material postretirement health-care obligations are likely to follow suit. At least one survey shows that large employers are equally happy to keep their retirees in traditional plans or to move them to the exchanges. In contrast, small to midsize businesses are seemingly less motivated to adopt the retiree exchanges, presumably because their retiree benefit obligations are a relatively small expense in their overall budgets.

Growing Interest in Private Exchanges for Active Employees
Following the early success in the retiree exchange market, a growing number of employers are considering moving their active employees to private health-care exchanges. Through the exchange model, employers and plan sponsors hope to gain better control over soaring health-care costs and push off much of the administrative and enrollment work to the exchange operators (the insurance brokers/consulting firms).

It is worth noting that the private exchanges are completely separate from the public exchanges, they predate the passage of the ACA in 2010, and they are not specifically governed or enabled by the ACA.

Employers thinking about switching over to exchanges first need to decide how much "credit" to provide employees to purchase coverage. Similar to the current model, the amount of credit varies based on the employee's family status, with higher credits given to employees looking to purchase coverage for the entire family. Employers that offer wellness programs to employees may provide additional credits to reward healthy behaviors, such as credits for joining a weight-loss or smoking-cessation program. The employees then use these credits to buy coverage of their choice, with the bronze benefit plan being the least expensive, followed by silver, gold, and platinum.

Adoption of Active Exchanges Off to Slow Start
While we believe the ACA will make it easier to transition from an employer-sponsored model to an exchange model, we don't see quick adoption of the private exchange model. In fact, one industry survey shows that nearly 70% of employers are unsure about when they will actually make the move. Another survey by Aon shows that just 5% of employers allow employees to purchase benefits through a private health exchange today, although 33% of the sample group indicates that private exchanges will be their preferred approach in the next three to five years.

In our view, several factors contribute to the slow adoption of active exchanges. First, there is a growing concern that the cost savings promised to employers through the use of exchanges may never be realized. An attractive feature of the exchanges is the potential for employers to save on administrative costs and enrollment expenses, in exchange for a periodic fee to the exchange operator. More important, employers should save on broker commissions during renewals, which can amount to 10% or more of the cost of the individual insurance in the first year. In practice, most exchanges to date have not been able to reduce administrative costs significantly, and some exchanges have actually increased costs for employers partly due to the additional fee of $63 per participant for employers to ensure the financial health of the exchanges. Another implicit cost to the employer is the additional reporting and disclosure needed for participants using the exchanges.

Second, starting in 2015, larger employers with 50 or more employees will be facing penalties under the ACA for failing to provide health benefits to their full-time employees. The ACA defines a full-time employee as someone who works at least 30 hours a week. Because of this technicality, we have seen some businesses--especially in the retail and restaurant industries--start to tweak employee schedules to keep them below the full-time employment line, so that these part-timers are not included in a health-care exchange.

Third, the so-called "Cadillac tax" is a growing concern for large employers, even though it doesn't kick in until 2018. The Cadillac tax was put in the law to discourage businesses from providing too much health coverage. If employees are shielded from the many costs of medical care, they are likely to overuse the medical services and not pay enough attention to costs, and as a result, health-care spending will keep rising. Starting in 2018, the ACA will impose a 40% tax on health insurers, which will be passed on to employers, for any health coverage exceeding $10,200 for individuals and $27,500 for families. The Cadillac tax is designed to aim at the most generous coverage, but businesses are worried that by the time it becomes effective, it will apply to a broader group of plans than just the so-called Cadillac plans.

Finally, we think large employers are less motivated than smaller employers to adopt the exchanges because of the lack of tax credits. Current tax law allows small employers (fewer than 100 employees) to take tax credits for buying insurance for their employees through the exchange. These tax credits are available for two years after the exchanges go live. By contrast, no such tax credits are available to large employers (more than 100 employees) at this time, making them more likely to stick with their current plans.

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