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Insurance Brokers Find Opportunity in ACA

The private exchange business could widen Aon's and Marsh's moats.

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The Stock Strategist article published Jan. 2 provided an overview of the Affordable Care Act. In this Stock Strategist, we 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.

Private Exchange Business Strengthens Moats for Aon and Marsh
Insurance brokers Aon and Marsh & McLennan play a vital role in helping clients assess, manage, and transfer risks. Typically acting as an intermediary, and increasingly as a partner in risk management, an insurance broker advises clients on designing, pricing, and structuring risk solutions and products. Because of the complex nature of risk solutions, analytic capability and breadth of coverage are key determinants in selecting an insurance broker.

In our opinion, high switching costs are the main source of economic moats for insurance brokers. The insurance brokerage industry is a relationship business. Insurance brokers spend decades developing deep relationship with their clients. In fact, insurance brokers have built out large networks of offices to support relationships at a local level to be close to client management teams. From our perspective, the local relationships help insurance brokers gain an in-depth understanding of the risk inherent to their client's businesses, which in turn allows the insurance brokers to maintain a sticky client base and to extract economic rents.

The firms' global presence also provides them with modest economies of scale, as the companies can serve multinational clients better than smaller peers can, thanks to their larger network. However, the scale benefits are limited by the need for a local presence and the very specific analytical capabilities targeted to local markets, lessening the ability for the brokers to derive larger economic benefits, which would result in a wide moat. In contrast, commercial real estate services brokers such as Jones Lang LaSalle and CBRE Group have earned wide Morningstar Economic Moat Ratings because their client relationships are formed on an national level, letting them achieve greater economies of scale and scope.

The decision to move active employees to an exchange involves some heavy lifting at the setup stage. For starters, the plan sponsor, with help from the exchange vendor, invests time to prepare information packages for eligible employees. This initial setup is usually followed by several information sessions leading up to the day of enrollment. Behind the scenes, the plan sponsor works with the exchange provider in designing levels of benefits, outlining breadth of coverage, and negotiating premium rates with multiple insurers. The negotiation generally results in a set of benefit plans that the sponsor will provide for its employees to choose from. The exchange providers will help address employees' questions during the enrollment period. Given the substantial preparation needed to enroll active employees on exchanges, we believe plan sponsors are motivated to renew contracts with exchange vendors, because it yields little economic benefit to switch to another provider.

With the ACA underway, we think the migration to private exchange solutions in the next few years creates a unique opportunity for Aon and Marsh to widen their economic moats, primarily through a strengthening network effect.

As exchange operators, Aon and Marsh benefit from a growing network-effect moat source, in our view, because of the ability to act as a marketplace for clients and insurance providers. A key element of successful exchange implementation is the participation of insurance providers and employers. Insurance providers will compete on their offerings and rates for the large pool of potential employees, and employers will want to join the exchange for access to a wide range of plans and pricing options. The brokers will collect fees for shouldering the administrative burden from the employers, as well as fees from the insurance providers for access to the pool of employers (the client pool). Having a large exchange platform also helps drive down incremental expenses, whether it's capital expenditures on systems and technologies or wages for the administrative staff.

We think the industry dynamics for this model are still developing, given that the exchanges have only been operating since 2014. By 2017, health insurers will have gathered three years of data and experience to reconsider their rates, and at that time, we expect some insurers will either increase the premium rates or pull out completely because the economics do not make sense for them. In this scenario, the exchange providers will need to reconsider their positioning and strategy to keep clients on their exchanges.

Growth of Private Exchanges Has Been More Moderate
While we continue to think Aon and Marsh are well positioned to capture the growth opportunities in private health-care exchanges, our enthusiasm is somewhat tempered by the soft market dynamics we have been seeing in the marketplace.

We think 2014 enrollment has been lower than expected, partly due to remaining questions about the marginal economic benefits for exchange operators concerning expanding the enrollment base on their exchanges. As a result, we do not think a mass migration of employees to the exchanges is likely in the near term. While we believe health-care exchanges can ultimately become a multi-billion-dollar revenue opportunity for the firms, we think the path to get there has just gotten a bit longer.

Enrollment Results Respectable, but Not as Good as We Expected
The Aon Active Health Exchange has been in operation since 2012. According to company data, more than 150,000 employees and their dependents from several large employers signed up with the exchange for the 2013 coverage year. Aon's active exchange follows a fully insured multicarrier model that offers a set of standardized plans. During the 2013 enrollment period (for the 2014 coverage year), 18 companies signed up with Aon, adding 600,000 active employees and dependents to its exchanges for a total enrollment of 750,000.

For the 2015 coverage year, Aon expects more than 1.2 million employees, retirees, and their families to choose individual and employer-sponsored health benefits through its private health exchanges. This represents a 60% increase in covered lives and a 40% increase in the number of participating companies.

On the private exchange adoption for active employees, Aon expects more than 30 companies, including all 18 companies that participated in previous years, to use Aon's exchange solutions. This adds 150,000 new employees and dependents to the active exchange, bringing the total enrollment to 850,000.

Aon expects similar growth on the retiree side, with 350,000 retirees from more than 50 companies joining the Aon Retiree Health Exchange. Through the this exchange, retirees gain access to more than 90 health insurance carriers and have access to benefit advisors who provide one-on-one counseling sessions.

At Aon, Exchange Enrollment Slows Considerably for 2015

Enrollment growth for the active market (in which we have included dependents) for the 2015 coverage year is respectable, adding an estimated 6,200 active employees on average for each newly enrolled company. Yet this is not as impressive as the 133% year-over-year growth for the retiree exchange market, giving support to our view that employers are more ready to move participants to the health-care exchanges when they are not concerned about morale, productivity, or compensation for that group. It seems to take more effort to convince employers to adopt the exchange model for their active employees. In our view, cost savings through the use of the active exchanges is simply not compelling enough for the additional reinsurance fees and reporting work required at this point.

We see similar enrollment trends at Marsh. The firm reported that through the first nine months of 2014, 247 companies had chosen the Mercer Marketplace exchange for their active and retiree exchange solutions for the 2015 coverage year. The newly enrolled companies bring 500,000 active employees and retirees to the Mercer exchange, allowing more than 1 million lives access to the exchanges. This compares with 52 companies and 220,000 covered lives for the 2014 benefit year. It is worth noting that of the 247 new companies, 40 of them are new clients not previously served by Mercer's health consulting business.

Mercer Sees Explosive Growth in Exchange Enrollment Following First Year

However, if we dig a little deeper into the enrollment data, the enrollment trend is not as robust as we would expect. With an average plan size of 2,600, these newly enrolled exchange clients are mostly medium-size businesses that probably see offering health-care benefits through an exchange as an economical way of satisfying the ACA requirements. In this case, workers' productivity and morale are less of a concern, as turnover rate tends to be high in these businesses' industries, and health-care benefits are not used as an incentive to retain employees. This item again gives support to our view that large employers continue to hold back on moving their active employees to the health-care exchanges.

We See Favorable Market Dynamics in the Longer Term
While we expect the adoption of private exchanges to be relatively slow in the near term and any near-term earnings impact to be minimal, we expect several industry trends to drive long-term exchange adoption.

First, while the addressable market size for retirees, 15 million, is small compared with that for active employees, 125 million, we think the retiree exchange market provides a good testing ground for employers that are considering moving their active employees to the exchanges. Moving retirees to exchanges involves few considerations and concerns for maintaining employees' morale and productivity. Ongoing costs associated with the exchange operations is really the only consideration for employers. With the ongoing costs for the retiree group being more predictable, mainly because of its stable demographic trends and plan sponsors' discretionary control over benefit levels they offer, it's generally easier for an employer to decide whether to move its retirees to an exchange. We believe plan sponsors' experience with retiree exchanges plays a crucial part in the decision to send their active employees to the exchange.

Second, the first wave of migration to exchanges was mostly made up of small employers in service industries with high employee turnover. These employers do not generally hold the view that employee benefits are an important element in attracting talent and maintaining productivity. Larger employers are sitting on the sidelines, taking a wait-and-see approach to moving their active employees to private exchanges. These employers are more reluctant to make changes to health-care plans that could negatively affect employee morale and productivity. However, the proposed 2018 "Cadillac tax" might give these large employers a needed push to make the switch.

What Is Potential Impact of Exchanges on Aon?
Given Aon's 2014 enrollment results, we continue to think the exchange market is pointing to moderate growth in 2015. In our base-case scenario, we assume 1% of the 125 million active employees and 5% of the 15 million retirees will enroll with Aon's private exchanges in 2015. As the exchange model continues to gain popularity, we assume both active and retiree population enrollment to increase as well. Because of its first-mover advantage and its established platform, we think Aon will capture 30% of the flows in 2015. In other words, the firm is looking to pick up approximately 1.6 million new participants for its exchanges. However, as the competition continues to intensify, it will be increasingly difficult for Aon to win new cases. As a result, we assume the firm's capture rate to decline each year, ending at 20% in 2018. Under these assumptions, we expect Aon's private exchanges to grow at an average annual rate of 37%, reaching a total enrollment of 4.2 million participants by 2018. We assume that Aon earns $275 per retiree and $240 per active employee.

Our base-case scenario yields a fair value estimate of $90 per share. We expect revenue from the exchange business to reach $1,141 million by 2018, up from $300 million for 2015, representing a four-year compound annual growth rate of 40%. We expect Aon's exchange business to earn $230 million in 2018, or a 20% operating margin, up from $88 million in 2015. Combining Aon's exchange business with the rest of its consulting operations results in 3% annual revenue growth for the entire HR solutions segment for 2015. We expect the firm's consulting revenue to grow 3.5% in 2016 and another 4% in the back end of our projection. Our $90 fair value estimate implies a price/earnings multiple of 14 times our 2015 projected earnings and 13 times our 2016 projected earnings. We estimate that future profits from Aon's exchange business make up 10% of our $90 fair value estimate. Our outlook for the insurance brokerage business remains positive, with the firm benefiting from a hardening of insurance rates in the near to medium term. The net result is a 5% CAGR for firmwide revenue from 2014 to 2018, and the average return on equity over the five-year projection period is 21%.

In our upside scenario, private-sector employers see the potential savings and the long-term benefits of exchange solutions, which leads to massive migration of active and retired employees to Aon's platform and a fair value estimate of $123 per share. In this scenario, we assume 2% of the addressable active employees and 7% of the addressable retirees will join the Aon private exchanges, and the enrollment reaches 2.3 million in 2015. With active and retiree enrollment also increasing, total enrollment reaches 5.8 million by 2018. In turn, exchange revenue tops $1,565 million in the same year, up from $300 million in 2015. Our fair value estimate of $123 per share implies a P/E multiple of 19 times our 2015 estimated earnings and 17 times our 2016 estimated earnings. In this scenario, Aon's exchange business makes up 10% of our $123 fair value estimate, and we estimate that the average return on equity is 23% over the forecast period.

In our downside scenario, we assume tepid growth in exchange enrollment, as employers shun the idea of offering health-care benefits through private exchanges. In this scenario, which assumes a $59 fair value estimate, Aon succeeds in convincing only a small number of employers to migrate their employees to its exchanges, while the majority of the employers continue to fund and self-insure their plans as they always have. We believe this scenario is quite possible in the service and retail industry, where employee productivity and morale are less of a concern for the employers, simply because replacing an underperforming employee is relatively easy. We further assume that the current exchange clients will remain with the exchange, as the cost of switching back to a traditional health-care plan is substantial. As a result, consulting revenue grows only 1% per year, and total enrollment doubles to about 2.4 million by 2018. Our $59 downside scenario implies a P/E multiple of 9 times our 2015 earnings estimate, with Aon's exchange business making up 7%.

What Is Potential Impact of Exchanges on Marsh?
Our base-case scenario yields a fair value estimate of $50 per share for Marsh & McLennan. Similar to the assumptions we use for Aon, we expect 1% of the 125 million active employees and 5% of the 15 million retirees to enroll with Mercer Marketplace in 2015. We also assume future active and retiree enrollment will increase each year through the end of our projection in 2018. Given Mercer's breadth of coverage and its long list of corporate clients, we expect the firm to pick up 30% of the flows in 2015, 35% in 2016, then go back down to 30% in 2017 and 25% in 2018. In other words, Mercer is looking to add approximately 1.6 million new participants to its exchanges in 2015, and under these assumptions, full enrollment in 2018 reaches 4.6 million. Finally, similar to Aon, we assume Mercer to earn $275 per retiree and $240 per active employee.

In this base-case scenario, we expect revenue from the exchange business to reach $1.243 billion by 2018, up from $250 million for 2015, representing a four-year CAGR of 49%. We expect Mercer Marketplace to earn $251 million in 2018, or around a 20% operating margin, up from $50 million in 2015. On a combined basis, we expect Mercer's HR consulting revenue to grow 5.5% in 2015 and 2016 and go down to 5% in the back end of our projection. Our $50 fair value estimate implies a P/E multiple of 17.7 times our 2015 projected earnings and 16.8 times our 2016 projected earnings. In our valuation, we estimate that future profits from Aon's exchange business make up 6% of our $50 fair value estimate.

Our outlook for the insurance brokerage business also remains positive, with the firm likely to benefit from a hardening of insurance rates in the near to medium term. We also believe that investment returns on the company's float assets will start to pick up and revert to more normalized levels by the end of our projection period. The net result is a 6% CAGR for firmwide revenue from 2013 to 2018. We expect operating margins to improve from around 17% this year to around 18% by the end of our five-year forecast as higher float income and a significant falloff in amortization expenses lead to higher levels of operating income over time. We use a 10% cost of equity in our valuation.

Our upside case for Marsh is $67 per share. In this scenario, we again assume that 2% of the addressable active employees and 7% of the addressable retirees join Mercer Marketplace, and the exchange enrollment reaches 2.1 million in 2015 for the firm. With the enrollment number growing at an average annual rate of 62%, we expect total exchange enrollment to reach 6.5 million by 2018 and revenue from the exchange business to top $1.740 billion in the same year. This compares with $251 million in 2015. Our fair value estimate implies a P/E multiple of 24 times our 2015 estimated earnings and 22 times our 2016 estimated earnings, the firm's exchange business making up 10% of our $67 fair value estimate, and we estimate that the average return on equity is 23% over the forecast period.

In our downside scenario, we assume tepid growth in exchange enrollment, with enrollment growing at an average annual rate of 24%, leading to a total enrollment of 2.4 million by 2018. Our downside scenario yields a fair value estimate of $36 per share, with Mercer's exchange business making up about 5% of our fair value estimate. In this scenario, we expect revenue from the exchange business to reach $644 million by 2018, up from $251 million for 2015, representing a four-year CAGR of 27%. From a profitability perspective, we expect Mercer's exchange business to earn $116 million in 2018, which implies operating margins of 18%, up from $43 million in 2015. Our downside fair value estimate implies a P/E multiple of 12.8 times our 2015 earnings estimate and 12 times our 2016 earnings estimate. Our downside scenario also assumes that depressed insurance prices, a sluggish job market, and challenging economic conditions all weigh on Marsh's top-line growth and operating margins. With revenue growing at only a 3% compound annual rate during the projection period, operating margins remain below 14.5% for an extended period.

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