Several health insurers reported better-than-expected first-quarter earnings, with the outperformance driven by higher enrollment figures, organizational changes and fewer regulatory reform-related losses. Most of them are moving into a third year of record profits, which has been augmented in recent months by a lingering recessionary mindset among Americans who are postponing medical treatment.

This trend in medical utilization benefited the group’s results last year as well. Unfavorable weather late last year and early this year were also at play in the utilization numbers. We expect utilization to remain soft in 2011, which will act as a tailwind for the industry.

Looking at the past trend when unemployment increased rapidly in 2008, the utilization factor did not see a proportionate drop, indicating its lagging nature. Thus, even if the employment scenario improves in 2011, we do not expect any acceleration in utilization activity until 2012.

A primary focus of the health insurance industry will be the Medical loss ratio compliance provision of the Health Care Reform Act, which came into effect this year. Carriers are required to maintain a minimum medical loss ratio (percent of insurance premium dollars allocated to providing care) of 80% for individual and small group policies and 85% for large commercial ones.

Apart from deriving revenue from insurance premium, health insurance companies also draw revenue from investments, though only a small fraction of industry income is related to investment activity. The majority of industry investments are in short-term securities, since benefits are paid out on a consistent basis.

As a result, short-term interest rate movements affect investment revenue. Since interest rates are expected to rest at low levels for quite some time, we expect a lackluster trend in investment income over the near to medium term.

Makeover Year

2011 will be a makeover year for carriers in the health insurance industry as they react to and prepare themselves for new rules. Continuing cost pressures and new customer demands require a fresh look at existing roles of industry players.

Industry revenue will, however, decline from years 2011 to 2014 and 2015, which are likely to be far more challenging as insurers will be forced to adjust to the healthcare law’s greatest changes, like providing coverage to everyone regardless of whether they have an expensive pre-existing condition.

However, as the economy recovers, unemployment will decrease and discretionary spending will rise. With employment expected to grow, the demand for employer-sponsored plans will improve. This factor is important because the majority of industry premiums are related to group health insurance plans. Additionally, the rise in discretionary spending will likely support industry growth, since individuals, families and self-employed business owners will be able to afford healthcare coverage again.

The longer-term demographic trends also remain favorable. The U.S. population is also aging, which is an important indicator of demand for health insurance coverage. Older individuals are more likely to use medical coverage than their younger, healthier counterparts. Consequently, the aging population is expected to support industry growth.

Consolidation Ahead

Many of the major players, such as UnitedHealth Group (UNH) and WellPoint (WLP), made a number of acquisitions during the past five years and are expected to continue such activity going forward. The industry is expected to continue to consolidate as insurers try to cut costs and improve profitability. At the same time, larger firms benefit from greater bargaining power in determining healthcare rates with medical providers such as doctors, hospitals and pharmacies.

OPPORTUNITIES

Though a cloud of uncertainty still hangs over the companies in the sector, there is no shortage of attractive investment opportunities in the group. Two names in particular — CIGNA Corp. (CI) and UnitedHealth Group — stand out in their earnings and business profiles in the current environment.

CIGNA, carrying a Zacks #2 Rank, is relatively safe as it has minimum exposure to minimum MLR regulations, unreasonable rate reviews and health insurance exchanges. The recently completed Vanbreda acquisitions should accelerate 2012 international earnings growth. The company has also shown operating momentum and has gained commercial risk membership for four quarters in a row.

We also see a positive risk-reward scenario for UnitedHealth Group (UNH), currently with Zacks #1 Rank. Its diversified product offering gives it the flexibility to adapt to the regulations that will likely follow the healthcare reform legislation.

Driven by improved customer focus with better systems, completed acquisition network integrations, and more regional management, UnitedHealth’s performance should continue to improve. Its strong balance sheet provides it the ability acquire weaker firms that cannot adapt as well to the reformed health insurance system. UnitedHealth recently came ahead of expectations in first quarter results and guided higher.

Other names which carry a Zacks #1 Rank are WellPoint Inc. (WLP) and Humana Inc. (HUM).

WEAKNESSES

Healthcare investors for the near future will likely require more trading, in our opinion, and less buying and holding. As PPACA is converted to regulation, more issues driving uncertainty will likely arise necessitating portfolio repositioning.

Though the companies will likely suffer share price volatility in the near future, at least until the Health Care Reform Act falls into place, all the businesses are expected to perform well in the long term. With good fundamentals and an expected boost from the Reform Act later, none of the companies have any significant weaknesses, resulting in an absence of any carrying a Zacks #4 Rank (Sell) or even a Zacks #5 Rank (Strong Sell). We believe investors should more routinely evaluate the regulatory environment, and alter opinion and position accordingly.
 
CIGNA CORP (CI): Free Stock Analysis Report
 
HUMANA INC NEW (HUM): Free Stock Analysis Report
 
UNITEDHEALTH GP (UNH): Free Stock Analysis Report
 
WELLPOINT INC (WLP): Free Stock Analysis Report
 
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