Medicaid HMOs: More Growth, Less Risk

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Richard Evans / Scott Hinds / Ryan Baum


203.901.1631 /.1632 / .1627 revans@/shinds@/


August 27, 2013

Medicaid HMOs: More Growth, Less Risk

  • Enrollment in Medicaid HMOs will grow immediately in 2014 as some states expand Medicaid eligibility under the Affordable Care Act (ACA). Growth continues for some time thereafter as: 1) other states join the expansion; 2) an increasing percentage of Medicaid beneficiaries enter HMO-managed programs; and, 3) as dually-eligible beneficiaries (Medicare and Medicaid eligible, with 5x the spending of a non-dually-eligible beneficiary) increasingly move to HMOs
  • Conversely, revenues for the larger commercial HMOs will grow only gradually. Overall enrollment in employer-sponsored (ESI) plans is moving glacially in a slow employment recovery. And, the larger commercial HMOs’ share of ESI beneficiaries is likely to fall as employees (who today generally have no choice of issuer) are moved to exchanges (both public and private) where they can choose from multiple issuers. An additional consequence is that exchanges for the first time allow employees to choose from a broad range of plan values; on average employees are likely to choose considerably cheaper plans, further impairing revenue growth
  • Even assuming a return to 2006 / ’07 employment levels over the next five years (which reduces Medicaid eligibility, but drives employment and ESI enrollment), we estimate Medicaid HMOs will grow revenues at an average 5 year CAGR between 15 and 20 pct, as compared to total commercial premium growth (average 5 year CAGR) of 2.5 pct to 7.5 pct. Importantly, the high end of this commercial premium growth range assumes CBO’s current estimate of health insurance exchange enrollment is exactly correct (we believe it’s in fact too high). Equally important, we expect the larger ‘national account’ commercial HMOs to lose share of overall commercial beneficiaries, thus these names’ realized revenue growth rates are likely to fall below this 2.5 pct to 7.5 pct range
  • Current valuations imply that relative revenue and earnings growth for the commercial and Medicaid HMOs will be much more similar than we predict. According to our fundamental view CNC, MGLN, and WCG are all at least 20 pct undervalued relative to their HMO peers. Conversely, CI, UNH, HNT, and AET appear overvalued relative to their HMO peers
  • The analytical framework we use in this call differentiates HMOs solely on the basis of their relative exposure (pct of earnings) to each major market segment (e.g. commercial, Medicaid, Medicare). I.e., the framework assumes no difference in strategy for any particular HMO in any particular segment. Of the commercial HMOs, we’ve recently favored CI for what we believe is a better strategy versus their commercial peers – they’ve reduced small group risk exposure, and raised exposure to the services small groups will buy (ASO and stop-loss); and, they’ve been very conservative about seeking enrollment on the individual coverage health insurance exchanges (HIEs). We still think this is the right (relative) strategy for a commercial HMO; however our work on the relative growth prospects of the commercial and Medicaid HMOs convinces us the more compelling investment decision is to favor the Medicaid HMOs at the expense of the commercial HMOs

We believe growth prospects for the publicly-traded HMOs are more divergent than share prices reflect; in particular the Medicaid HMOs (especially WCG, MGLN, CNC) appear undervalued relative to their more commercially-oriented peers (e.g. CI, AET, UNH, WLP, and HNT)

Employment cycle effects

Forecasting relative growth for Medicaid and commercial HMOs starts with the employment cycle – employment growth increases enrollment in employer-sponsored insurance (‘ESI’) (Exhibit 1), aiding the commercial names, but reduces the number of persons below the poverty threshold (Exhibit 2), thus reducing Medicaid enrollment and creating a headwind for the Medicaid HMOs

To set a baseline, we assume that employment returns to 2006 / ’07 levels by 2018 (Exhibit 3), but that the percentage of persons employed full-time remains at a level (81 pct) below the level seen in 2006 / ’07 (83 pct) (Exhibit 4). We do this for two reasons: first, we know that job quality (and thus quality of benefits) typically lags overall employment in a recovery; and, we see evidence that employers have become even more reluctant to offer full-time positions in light of the incremental benefit obligations this creates under the Affordable Care Act (ACA). We further assume that the ratio of employer-sponsored health insurance (ESI) beneficiaries to persons employed full-time continues its gradual erosion (Exhibit 5), again for two reasons. First, as health costs grow more quickly than wages, observed elasticity behaviors show that households will respond at the margin by declining health coverage. And, second, there is evidence that employers are increasingly restrictive about covering household members who may be eligible for other coverage – thus there is reason to believe the average number of beneficiaries per contract will continue to erode. Taken all together, these baseline assumptions lead to a 5-year CAGR of ESI enrollment growth of just 0.6 pct (Exhibit 6)

For the Medicaid HMOs, the flip-side of employment gains is a reduction in the number of persons meeting current Medicaid eligibility thresholds. Judging from the historic relationship between employment levels and the number of persons below the poverty threshold (Exhibit 2, again), we believe a recovery to 2006 / ’07 employment levels over the five years from 2013 to 2018 would reduce Medicaid eligibility by roughly 2.5 million persons

Reform effects

Fortunately for the Medicaid HMOs, eligibility standards become more generous in 2014. Assuming all states eventually set eligibility thresholds at 100 pct of the federal poverty level (i.e. 100 FPL), we would expect roughly 13.7 million new Medicaid beneficiaries by 2018, roughly 8 million of whom should enroll as early as 2014. If instead we assume all states eventually set eligibility at 138 FPL, we would expect roughly 30 million new beneficiaries by 2018 (but still only around 8 million in 2014). Despite the fact that at present some states are expanding to 138 FPL and some are not expanding at all, we see an eventual landscape of most / all states having Medicaid eligibility thresholds of 100 FPL[1]. Even under this more conservative assumption, the 13.7 million beneficiaries gained by raising the eligibility threshold more than offset the 2.5 million beneficiaries lost by rising employment

Independent of employment cycle effects, total demand for commercial insurance also should rise as a result of ACA reforms. We estimate baseline (pre-reform) demand for individually-purchased coverage as a percentage of the population that is less than 65-years old, not covered by ESI, and not covered by Medicaid (Exhibit 7). This percentage (currently +/- 67 pct) has been gradually but steadily declining, which we presume reflects the elasticity consequences of health premiums growing more rapidly than incomes

Beginning in 2014, those seeking individually-purchased coverage will have the benefit of the health insurance exchanges (HIEs). These benefits include most importantly the availability of federal subsidies that considerably reduce the costs of purchasing health insurance for a large number of persons and households. And, structural features of the HIEs (e.g. community rating, guaranteed issue) should tend to raise the overall efficiency of the market for individual coverage; i.e. on average, beneficiaries in this market should receive more actual healthcare per premium dollar spent. Nevertheless as we’ve argued extensively there are very real limits to the utility of the HIEs[2]: despite subsidies, the marginal cost of coverage for the typical subsidy-eligible household is on par with the cost of a car; persons can elect coverage in the next upcoming annual enrollment period even if they have become ill while uninsured; minimum coverage standards in the small group market are pushing these purchasers to self-insure; and, the narrowing of age-based premium bands rather dramatically reduces the relative attractiveness of HIE-based coverage for younger / healthier beneficiaries

Thus on net we’re quite skeptical that HIE enrollment will meet expectations. As a high-end estimate, we adopt CBO’s current (May 2013) assumption of net marginal enrollment gains attributable to HIEs (5 million persons in 2014; 20 million in 2018); as a low-end estimate we assume HIE participation is only one-third the CBO estimate. This translates to an expansion of enrollment in individually-purchased plans ranging between 6.1 pct and 13.5 pct (5 year CAGR). Because current individual market enrollment (+/- 25 million) is so far below ESI enrollment (+/- 156 million), net growth in commercial beneficiaries overall remains slight – from 1.4 pct to 2.4 pct (5 year CAGR), with the range being entirely dependent on the rate of participation on HIEs

Other details and summing up – 5-year growth expectations by market segment

We see considerable risk that ESI spending growth falls below the simple 6.7 pct product of enrollment growth (0.6 pct) and growth in per-beneficiary health costs (6 pct). Specifically, as (both public and private) exchanges become a more common format for purchasing ESI, beneficiaries for the first time have a range of plan ‘values’ to choose from, and this range extends from 60 to 90 AV[3]. Generally speaking we expect the well to choose 60 AVs and those who are less well to choose 90 AVs, for an enrollment-weighted average of roughly 65 AV – well below the current 82 AV average. This downdraft in AV has a potentially profound effect on total premium growth. Assuming 0.6 pct annual ESI enrollment growth and average per-beneficiary cost growth of 6 pct, we would expect 6.7 pct growth in overall ESI premiums (Exhibit 8). However if we assume average AVs fall to 75 this growth would slow to 4.8 pct; or if we assume average AVs fall to 65 premium growth would fall to 1.8 pct. All in, including the potential for individually-purchased demand to grow as a result of the HIEs, we see 2013 -2018 commercial beneficiary premium growth ranging between 2.5 pct and 7.5 pct (5 year CAGR, Exhibit 8, again)

On top of the matter of how fully the states choose to expand Medicaid eligibility, we have to factor in changes to the underlying mix of beneficiaries – generally speaking, eligibility expands for the less expensive non-dually-eligible beneficiaries, but not for the far more expensive dually-eligibles[4]. And, we expect per-beneficiary cost growth to lag the 6 pct commercial rate owing to the fact that government has authority over Medicaid (and Medicare) payment rates, and that these tend to grow more slowly than commercial rates (particularly when enrollment expands). Accordingly we assume 4 pct per-beneficiary cost growth for both Medicaid and Medicare. Medicare beneficiary growth is straightforward – it’s almost exactly the rate of growth in persons aged 65 and older (3.3 pct for the period in question). All in, we see a range of spending growth for Medicaid of 10.7 pct to 17.3 pct, driven entirely by whether states expand to 100 FPL or 138 FPL; and we expect roughly 7.5 pct growth in Medicare spending (Exhibit 9)

(Underlying growth by market segment) × (exposure by segment) = a rough estimate of growth by company

The individual HMOs participate at various levels and in various ways across the major market segments – commercial (ESI and individual), Medicare, and Medicaid. Assuming for the moment that the estimated percentage of earnings each company derives from each segment (Exhibit 10) remains constant, and that the companies neither gain nor lose share in any of their markets, ‘baseline’ company-by-company top-line growth expectations are the simple product of exposure by market segment and the (range of) expected rates of spending growth in each segment. Exhibit 11 shows an estimated range of 2013 – 2018 spending growth for each company, produced using this approach. For reference, FY+3 consensus revenue growth is provided for each company

Changes to market share: downside risks for the commercial names; upside risks for Medicaid names

Exhibit 12 is a re-cast of Exhibit 11, however in Exhibit 12 we increase the revenue growth expectations of the Medicaid HMOs to reflect the likelihood that a higher percentage of Medicaid beneficiaries become members. Our low case assumption is that the Medicaid HMOs increase their share of non-dually-eligible beneficiaries to 80 pct from the current 75 pct, and of dually-eligible beneficiaries to 33 pct from the current 25 pct. Our high case assumes shares of 85 pct and 66 pct for non-dually-eligible and dually-eligible beneficiaries, respectively. This has the effect of increasing the mid-point (and extremes) of revenue growth estimates for the more Medicaid levered names, particularly MGLN, WCG, CNC, and MOH. Depending on whether we assume states expand eligibility to 100 or 138 FPL, for each 10 pct further share of non-dually-eligible beneficiaries enrolled in Medicaid managed care, Medicaid HMOs’ growth should rise an additional 2.1 to 2.4 pct; each 10 pct further share of dually-eligible beneficiaries would increase the Medicaid HMOs’ growth by 2.1 pct to 1.7 pct

Conversely, we believe the commercially-oriented HMOs face a net risk of market share losses, which would reduce their realized growth rates to something less than the overall rate of commercial segment growth summarized in Exhibit 8. The reasoning is straightforward – in the current ESI market (which is 86 pct of 2013 commercial enrollment, and 92 pct of commercial spending), about half of beneficiaries have only one plan choice, and most of the remaining beneficiaries have just two plan choices – which usually come from the same issuer. Moving forward, we expect current ESI beneficiaries to increasingly choose their coverage on an exchange – whether that exchange is public or private. On these exchanges, we expect ESI beneficiaries to have a range of plan choices from a broad selection of issuers – thus many of the ESI beneficiaries that are currently enrolled with the larger publicly-traded commercial HMOs as part of a large national account are likely to choose coverage from some other issuer once they have that option. Local underwriters (including in particular integrated health systems) are put on a more equal footing vis-à-vis large national underwriters when it comes to recruiting beneficiaries, thus we anticipate a net share loss for the large national underwriters

Growth expectations in the context of current valuations: CNC, MOH, and WCG look cheap; and, the commercial names price in little or no risk of share loss

Exhibit 13 compares relative revenue growth expectations (taken at the mid-point of the growth estimate ranges, and ignoring the potential for Medicaid share gains or commercial share losses) across the HMOs (x-axis, simple weighted 5-year revenue growth rate across all names on the graphic) to relative forward price:earnings (fPE) ratios on 2013 consensus estimates. Ignoring relative risks, we would expect higher fPEs for companies with greater growth expectations, and lower fPEs for companies with lower growth expectations. That general pattern holds, however the relative fPEs for CNC, MOH, and WCG are lower than we would expect if these companies’ share prices fully reflected what we believe is their true relative growth potential. Where actual fPE’s differ by 20 pct or more from expected fPE’s, the percentage difference between actual and expected is provided (names that appear undervalued in this framework are highlighted in green; those that appear overvalued in this framework are highlighted red). Exhibit 14 is identical to Exhibit 13, with the exception that revenue growth expectations in Exhibit 14 reflect the potential for enrollment share gains by the Medicaid HMOs

  1. For reasons beyond the scope of this note, but explained more fully in our prior research, expanding Medicaid to 100 FPL is the economically optimal strategy for practically every state, thus our expectation that a 50-state expansion to 100 FPL is the natural (and eventual) equilibrium. Please see: “Why Medicaid eligibility will (still) level off at 100 FPL”, SSR Health LLC, December 17, 2012
  2. See for example: “Buckle-up: a summary of adverse selection pressures on the HIEs” SSR Health LLC, May 16, 2013
  3. AV = ‘actuarial value’, which is the percentage of allowed claim costs paid by the plan
  4. Dual eligibility simply designates that the beneficiary is eligible for both Medicaid and Medicare
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