The managed care industry—broadly defined as health plans that cover medical expenses, planning and administration—is frequently a newsworthy topic that triggers discussion, and sometimes even heated debate. For many people, the end result is confusion and uncertainty about the facts.

While health care is typically considered a defensive sector during periods of economic uncertainty, share prices in the managed care industry have fallen approximately 40% so far this year. This weakness is the result of several factors, including misconceptions about managed care companies, concern for the impact of potential health care reform and uncertainty about the industry’s future earnings growth. While questions and doubts exist, there are a number of trends and indicators that lead us to believe the long-term outlook for managed care is promising.

The Changing Face of the Managed Care Industry

When it comes to the managed care industry, some long-held misconceptions have become accepted truths within the investment community. Negative opinions about managed care companies and their service models are more the norm than the exception. They are often viewed as being in the business of gathering “lives” and then trying to deny quality care to those “lives” they “own.” Many believe that managed care providers can only generate growth by taking business from one another, typically by undercutting prices. This tactic inevitably causes either denial of care or lower profits, in other words, a devil’s choice.

In reality, the concept of managed care companies acting as gatekeepers—granting or denying access to medical care—began to shift several years ago. We have seen significant improvements in the amount, quality and cost of the services that managed care companies provide. This progress has been due in large part to the use of technology, scale and better application of medical knowledge. As a result, these companies are able to focus on providing health care solutions that improve patient outcomes, and further remove themselves from the simplistic formula of equating profit to denial of care.

An enhanced service model has helped the “Big 4,” or large for-profit managed care companies, increase the number of members they serve and generate incremental revenues. From the end of 2003 through first quarter 2008, these companies have added roughly 15.2 million members and seen 23% cumulative membership growth. Excluding CIGNA, which experienced some turbulent times that were not indicative of the industry as a whole, large for-profits made 16.3 million additions or 35% growth. Conversely, over the same period, smaller companies, non-profits and third party administrators lost members.

Previously, managed care was the result of loose arrangements with health care providers that offered health care companies little incentive to monitor or control costs intelligently. Today, the industry is largely driven by a fee-for-service model which incentivizes cost controls separate from denial of care.

Larger for-profit companies have reinvested revenues back into their businesses to expand their service platforms and increase efficiencies. Over the last five years, for-profits have spent billions of dollars on technology enhancements alone. This is just one reason why larger companies have been able to take market share from regional players without cutting services or jeopardizing profitability.

The Prospect for Health Care Reform

The upcoming presidential election has negatively impacted managed care share prices, and not without precedent. Every four years, Americans are exposed to an influx of ideas on how to improve the health care system through government intervention proposed by political candidates. Although some proposals are best characterized as campaign rhetoric designed to get people to the polls, these suggestions often have the added effect of inciting widespread concern for the future of managed care.

We’ve examined the four most significant proposals and assessed their likelihood of passage, as well as the possible impact on the managed care industry.

1. Nationalized Health Care
   Perception A nationalized health care program would severely alter the viability of the managed care industry.
   Reality While several candidates have discussed some form of nationalized health care program, there are a number of reasons why this isn’t likely to occur, or why the actual implementation may be more benign than expected. For the most part, people are satisfied with the employer-paid business model and do not want to pay higher taxes to fund a nationalized program, nor higher premiums to improve their own program. Nationalized health care could also be a political landmine in terms of upsetting the senior population. This increasingly important group is largely satisfied with Medicare and Medicare Advantage, having achieved the long held objective of prescription drug coverage. Additionally, the government does not have the systems in place to offer its own national health care program. While some may point to Medicare as a form of national care, it is essentially a system whereby the federal government sets a limit on what they will pay; the service itself is then farmed out to regional providers. The large shift out of the government Medicare plans and into managed care Medicare programs is proof of that.
   
   There is also a timing factor. The rates and fees paid to managed care companies for Medicare are finalized toward the beginning of the year before next year’s plan (i.e. 2009 rates were finalized in April 2008). Assuming a Democratic President, House and Senate in January 2009, only three months would remain to change the Medicare program by 2010. A nationalized health care program would take even longer to institute, given the hearings, budget compromises, tax increases and program system changes that would need to be addressed. Even if all of these issues were resolved during a new regime’s first 15 months, the implementation would not occur until at least 2011.
2. Providing Health Insurance for the Uninsured
   Perception Helping more of the uninsured obtain coverage will hurt the profitability of managed care companies.
   Reality Helping those who cannot afford health care insurance appears to be a goal of both political parties. However, the implications are not necessarily negative for large for-profit managed care companies.
   
   To demonstrate why, consider Medicaid, the current government program to assist the poor. The onus is on each state to manage its Medicaid program, and costs are split evenly between the federal and state governments. Thus far, 11 states have turned to managed care companies to administer their Medicaid program, as it’s less expensive than running it themselves. When states farm out their Medicaid program, managed care companies bid for the business and, even though the margins are somewhat smaller, they still generate a profit. Should the federal government mandate greater medical coverage through Medicaid, this could turn into a growth opportunity for certain managed care providers.
3. Federal Government-Imposed Profit Caps
   Perception The government may force profit caps on managed care companies (i.e. 85% of money applied to health care services)
   Reality The impetus to “fix” the health care system is, in part, tied to reining in spiraling costs. However, managed care companies are a very small part of this problem, as they currently operate with margins of only 4.6%. In fact, to some extent, managed care companies are one part of the health care system that is attempting to control costs.
   
   It’s also important to point out that the insurance industry is managed on a state-by-state basis. By instituting a profit cap, the federal government would have to remove the insurance powers of all 50 states. As would be the case with nationalized health care, the earliest a profit cap could likely be put in place would be 2011. If a profit cap was instituted, large for-profit managed care companies would be the least affected, given their scale and efficiency of operations.
4. Nationwide “Guaranteed Issue” Program
   Perception A guarantee program would require managed care companies to accept any applicant who seeks insurance and throw the industry into turmoil.
   Reality While a guarantee program would negatively impact managed care companies, we do not believe it will come to pass, as it would lead to higher health care costs. Several states currently have a guaranteed issue program. For example, New York’s guarantee program heavily impacts the cost of the state’s individual premiums, which are up to three times more than premiums in states without similar programs. This is due, in part, to managed care companies’ need to charge more, since guaranteed programs serve as an incentive for only the sick to obtain insurance. In essence, if insurance could be obtained at any time, people would only need to purchase insurance when they were sick.
   
   By and large, state governors understand that the guaranteed issue will increase their costs and are likely to oppose such a program.

The Future of the Managed Care Industry

While the government is ill-equipped to take over the health care system, we do believe that some changes are likely. Based on our analysis, here are some of the most crucial changes that we foresee:

Increased Coverage of the Uninsured

We expect the government to make a concerted effort to increase health care coverage for the uninsured, as the number of individuals without health insurance has been on the rise since 2000. The most likely way to accomplish this is to relax the standards for a Medicaid-type program, managed at the state level.

This would be the most politically expedient approach, as it is relatively easy to enact and maintains the balance between the federal and state governments. This approach could be beneficial to large managed care companies, as it presents them with an opportunity to increase the number of lives they cover while continuing to generate a profit.

Industry Consolidation

Smaller regional companies have neither the scale nor the financial resources to effectively compete with larger for-profit firms. The advantage of the larger firms can be as much as 2% of sales, or 40% of available profits. Therefore, we support the belief that consolidation in the managed care industry will continue.

Expanded Capabilities

We believe large for-profit managed care companies are well positioned to expand their capabilities in the future and address more extensive medical, social service, behavioral health and, in some cases, financial needs of their members. Specific programs may include Special Needs Plans (SNPs) and Geriatric Care Management Rounds (GCMR) programs. SNPs provide coverage for certain groups, such as those individuals with chronic conditions and those in nursing homes. GCMR programs provide comprehensive care management solutions, including regular phone calls from nurses, follow-ups with physicians and helping subscribers access transportation and other community resources. A number of providers also employ nurse case managers to help members with chronic conditions. These nurse “coaches” not only help members follow care plans set up by their doctors, they also develop goals and strategies to help meet a member’s health objectives.

Increased Adaptation of Health Savings Accounts (HSAs)

We are likely to see an increase in the usage of HSA by employers. Briefly, an HSA is a tax-advantaged medical savings account available to taxpayers who are enrolled in a High Deductible Health Plan (HDHP). In addition to employee contributions, employers can also make contributions on their behalf. We expect employers to encourage the use of these accounts as a way to lower their health care costs. That’s because the premium payments for an HDHP are less than for traditional health insurance. In addition, there is evidence that HSAs lead to lower levels of health care utilization, as employees become more responsible for their own health care choices. The transition from the current employer-paid health care plans to HSAs could be similar to the shift we’ve seen from defined benefit to defined contribution pension plans. An increase in usage of HSAs would positively impact large for-profit managed care companies, as they would often be called upon to help employees make medical-related decisions.

Research: Sorting Investment Opportunity from Speculation

We believe the long-term outlook for the managed care industry appears bright. The current uncertainties in the industry are largely transient and politically driven. As the disconnects between perception and reality are resolved, investors should return their focus to the compelling fundamentals in this industry.

Large for-profit managed care companies appear to be especially attractive, as they have become increasingly cost efficient and have the scale and resources to prosper in the future. In particular, we are encouraged by:

• Share buybacks, as large for-profit companies are buying back 5-10% of their shares per year
• Earnings growth potential greater than the broad markets
• Further consolidation, which will lead to lower administration and servicing costs and less price competition for larger companies as weaker players have typically been the most aggressive on price
• Competitive dynamics and a larger breadth of offerings

From an investment perspective, it appears that the worst-case scenario has been priced into the stocks of managed care companies. Given this year’s decline in managed care stocks, they are now trading at 12-15 year lows in terms of valuations and at a 40-50% discount to the overall market. At the same time, they continue to have free cash flow yields in the mid-teens.

We know that there will be distinct winners, as well as underperformers, in this sector. By anticipating these leaders and laggards, our research can make a significant impact in meeting clients’ investment objectives.