Why Losing the Individual Mandate is Good for HMOs, and other Earnings Consequences of Various Supreme Court Outcomes

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Richard Evans / Scott Hinds / Ryan Baum

203.901.1631 /.1632 / .1627

richard@ / hinds@ / baum@sector-sovereign.com

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March 27, 2012

Why Losing the Individual Mandate is Good for HMOs, and other Earnings Consequences of Various Supreme Court Outcomes

  • We expect the Supreme Court to rule on the Affordable Care Act (ACA) this June/July (i.e. to find the Anti-Injunction Act does not apply), and to let the Medicaid expansion stand (driving a 13 percent gain in Medicaid spending, & a 1.3 to 1.8 percent gain in total national health spending)
  • Whether the individual mandate (a.k.a. minimum coverage provision) stands or falls remains very nearly a coin-toss, though odds lately seem to slightly favor the mandate being upheld. If the mandate falls, underwriting requirements (mandatory issue and comparable premiums regardless of health status) also are likely to fall, but the balance of ACA is likely to stand
  • If the mandate falls but underwriting requirements stand, we’re convinced state regulators prevent the feared consequences on insurers (skyrocketing adverse selection and falling risk adjusted returns); avoiding these consequences is central to having workable state-by-state health insurance markets (even if these don’t become health insurance exchanges)
  • And, we believe loss of the mandate ultimately is good for HMOs, especially if the underwriting provisions also fall. Losing the mandate opens the door for ACA-reluctant states to scrap plans for health insurance exchanges (HIEs); losing both the mandate and the underwriting provisions opens the door that much further. Without similarly structured and consistently regulated HIEs in all or nearly all 50 states, multi-state employers are unlikely to shift employees from employer-sponsored coverage (ESI) to the HIEs; we estimate roughly 40% of employees work for multi-state employers
  • Under ESI more (we estimate 5%) employees are insured at higher (we estimate 28%) average contract values; operating costs per beneficiary (employer contracts v. individual contracts) are lower; and, pricing is more stable (fewer underwriters can pitch for employers’ business than for individuals’; employers switch underwriters less often than individuals). Ironically, at present valuations we believe HMOs are underpriced even if ACA remains intact, though longer-term earnings power is much greater if the mandate falls and ESI remains the norm
  • We continue to recommend a pro-cyclical bias in healthcare portfolios, and in particular recommend Hospitals and Manufacturers / Distributors of non-Rx Consumables. Because Hospitals are reactive to many potential Supreme Court decisions, and because HMOs should tend to react in an opposite manner to most decisions, we believe it’s important to hold both Hospitals and HMOs around the time of the anticipated decisions (late June / early July)
  • We also continue to recommend against the drug trades (PBMs primarily, and also Drug Retailers and Drug Wholesalers) in anticipation of falling generic dispensing margins as the average wholesale price (AWP) benchmark is replaced. Notably, the statutes that lead to AWP being replaced are in the ACA and at risk of being vacated if the Act is struck down in its entirety; however we see this risk as minimal

As the Supreme Court hears Affordable Care Act (ACA) arguments, we lay out the earnings relevance of various possible outcomes

Four questions are before the Court: 1) whether the Court can rule on the individual mandate (a.k.a. the minimum coverage provision) before any related penalties are collected in 2015 (the underlying law being the Anti-Injunction Act or AIA); 2) whether ACA’s tying of all federal Medicaid subsidies to states’ participation in ACA-related Medicaid expansions is constitutional; 3) whether the individual mandate is constitutional; and, 4) if the individual mandate is not constitutional, whether any, some, or all of the ACA’s other provisions can be left standing

Exhibit 1 summarizes these questions, our view of the odds surrounding each question, and our views of the earnings relevance of various outcomes. To overstate the obvious, we’re much better positioned to address the earnings relevance of Court decisions than the odds of any particular decision, accordingly our efforts here are focused largely on earnings effects

The Anti-Injunction Act

We believe the Court will find that the AIA does not apply, and so will rule on the constitutionality of the ACA provisions in question, in very large part because a large majority of lower-court judges found that the AIA did not apply (Exhibit 2). The earnings relevance of whether the court rules before or after the first penalties are collected (2015) obviously is limited to the timing of a ruling. If the court were to rule that the AIA applies, it could in theory still address the constitutionality of ACA provisions before 2015 if: 1) Congress added a related exemption to the twelve existing AIA exemptions; or, 2) the litigants found or established other precedent that was not subject to AIA. Both of these pre-2015 options seem remote possibilities, therefore if the Court finds the AIA applies we would not expect a ruling before 2015

Medicaid Expansion

The Court seems unlikely to overturn the Medicaid expansion as it has never struck down a similar condition on funds to states as ‘coercive’; accordingly we believe ACA’s Medicaid-related health spending gains eventually will come about in whole and on schedule. Here we’re swayed by several facts: 1) ACA expands states’ total Medicaid outlays by only about 1.4 (Urban Institute) to 2.4 (our estimate using CBO figures) percent versus the pre-ACA baseline; 2) the Federal government picks up 90% or more of the marginal costs of coverage expansion[1]; 3) the states’ argument suffers from the lack of any clear threshold at which Federal matching moves from beneficial to coercive, and given the very small percentage expansion in state spending it’s unlikely the justices will establish that such a vague threshold was crossed in the narrow confines of a 1-2 percent change in state outlays; and 4) because the far-ranging repercussions of overturning the ACA Medicaid provisions include such consequences as disrupting federal / state partnerships in education, transportation and other critical areas, it seems incredibly unlikely the Court would choose the current case to test the constitutional underpinnings of the federal / state balance of power. Nevertheless in the event the Medicaid expansion is overturned, we trace its earnings relevance. Practically all health sub-sectors would be negatively affected as a result of lost demand potential; the ACA-related Medicaid expansions are expected to substantially boost Medicaid enrollment, Medicaid spending by roughly 13 percent, and total national (all payor) health spending by roughly 1.3 to 1.8 percent. Hospitals and Medicaid-focused HMOs would be most negatively affected. Hospitals, particularly those in areas with large potential gains in ACA-related Medicaid coverage (Appendix II) would lose a significant opportunity to lower their costs of uncompensated care. Medicaid HMOs clearly would lose a potential surge in enrollees; Exhibit 3 lists for-profit HMOs in descending order of Medicaid as a percent of total direct premiums written

The Individual Mandate

Moving to the heart of the matter, whether the Court overturns or upholds the individual mandate seems very nearly a coin toss; our belief is that odds slightly favor the mandate being upheld. The immediate earnings relevance of the mandate is frankly marginal; the penalty collected under the mandate provision is simply too small to have a major effect on enrollment decisions[2]. In practical terms finding the mandate unconstitutional opens the door to the far more earnings-relevant questions of whether the balance of ACA is upheld in its entirety, in part, or not at all

Severability: If the mandate falls, what happens to the rest of ACA?

If the individual mandate is overturned, we believe that the two main underwriting provisions directly tied to the mandate (mandatory issue of insurance to all applicants irrespective of pre-existing conditions; and premiums that are set independent of medical status) would also be overturned. Absent the mandate and underwriting provisions, we believe the state-level health insurance exchanges (HIEs) become less viable, and further believe that ‘ACA-reluctant’ states take such a ruling as an ‘out’, the result being a mixed-landscape of health insurance exchanges – some states establish HIEs, others don’t, and the exchanges that do exist are in and of themselves a much more varied set of approaches than would have been the case if the mandate and underwriting provisions had been upheld

Since soon after the Act was passed, we’ve expected employers to shift subsidy-eligible employees from employer-sponsored insurance (ESI) to the health-insurance exchanges if the Act remains intact. To our minds 50 consistently regulated state-level HIEs is a necessary pre-condition to employers moving subsidy-eligible workers from ESI to the HIEs; by our estimates roughly 40 percent of workers are employed by an employer that operates in two or more states. If the mandate falls, and particularly if the underwriting provisions also are overturned, the states’ HIEs should instead become quite varied, with state-level approaches ranging from an ACA-compliant HIE to no HIE at all. In such an event we doubt larger employers, particularly multi-state employers, are likely to shift beneficiaries from ESI to the HIEs. It follows that the magnitude of an ESI to HIE shift is closely linked to the fate of the individual mandate and related underwriting provisions

If the mandate were upheld, we would eventually expect most subsidy-eligible households (roughly 65% of total US households) who presently receive ESI to be shifted to HIEs[3]. This has three major earnings effects: 1) a reduction in the percentage of former ESI recipients who are insured; 2) a reduced average value of insurance purchased by former ESI beneficiaries; and 3) higher per-beneficiary administrative costs and reduced pricing power for HMOs. Taking these effects in turn, the percent of ESI beneficiaries electing coverage on an HIE should fall as a result of several factors, the most important being the ‘opt-out’ and ‘opt-in’ dynamics in ESI and HIE respectively. ESI recipients generally must opt-out of ESI to become uninsured, whereas HIE beneficiaries by definition must opt-in to become insured – i.e., under ESI the default status is ‘insured’, and under HIE the default status is ‘uninsured’. Adding in that ESI beneficiaries pay premiums through payroll deduction while HIE beneficiaries (with few exceptions) write checks, that the perceived value of health insurance among subsidy-eligible households is low, and that the marginal cost of purchasing HIE-based coverage is on par with a car payment, we conclude that substantially fewer households will be covered if shifted to an HIE than if offered ESI. To put some numbers to this, in today’s market a hypothetical group of 100 workers will include roughly 68 with ESI coverage, 16 covered from a non-employer source (total 84/100 covered), and 16 uninsured. All else held equal, we estimate that shifting all subsidy-eligible workers from ESI to HIE in this hypothetical group of 100 workers would produce a balance of 80 insured and 20 uninsured, with the net loss of 4 insured workers being the result of 6 previously uninsured workers gaining coverage on the HIEs and 10 previously ESI-insured workers electing not to purchase coverage on the HIE[4]

To our point of falling average insurance values, under ESI beneficiaries have a narrow range of generosities to choose from, and the enrollment-weighted average is an actuarial value of roughly 82 percent[5]. On the HIEs beneficiaries can choose from a much broader range of coverage options; we estimate the enrollment-weighted actuarial values of former ESI beneficiaries moving to HIEs would fall to roughly 64 percent[6]. Thus on net, in crude terms ‘baseline’ insured demand from 100 workers in the current ‘ESI-predominant’ market roughly equals the product of 84 workers times an 82% actuarial value, or 69. In an HIE-predominant model insured demand is roughly the product of 80 workers times a 64% actuarial value, or 51, a 26 percent drop (69 v. 51) in insured-worker ‘effective coverage’ as compared to the ESI-predominant baseline. Finally to the matter of productivity losses in the HMO business model: In the current ESI-predominant market HMOs sell directly to employers, operating costs tend to be amortized over large groups of employees, and switching from one carrier to another at the employer level is relatively infrequent. In contrast, in an HIE-predominant market insurers sell to individual beneficiaries who are far more willing to change carriers, thus per- beneficiary operating costs are much higher, and pricing arguably becomes more competitive. Despite these pressures we believe HMOs’ earnings power in an HIE-predominant market is in excess of what’s implied by current valuations; nevertheless their earnings power is far greater under ESI, thus HMOs ultimately would benefit from the individual mandate being overturned

This leads immediately to the question of whether HMOs are at risk if the individual mandate is overturned, but the rest of ACA (e.g. the underwriting provisions) remains intact. In theory this leads to a world in which buying health coverage is optional, and in which HMOs must sell policies to any applicant at a price independent of the applicant’s health status, which in turn leads to adverse selection, rapidly escalating premiums, and falling risk-adjusted returns to insurers. In practice, such an outcome is unlikely, as these threats to HMOs also are threats to state insurance markets. State regulators remain the primary authorities with respect to health insurance markets irrespective of anything the Court may decide on ACA; in the event the mandate falls but the underwriting provisions remain intact, the states can and almost certainly will request whatever waivers are necessary to maintain smoothly functioning local markets, and CMS[7]is almost certain to grant the necessary waivers

A final potential outcome is for the individual mandate to be overturned and found non-severable, leading to ACA being overturned in its entirety. Obviously this eliminates any ACA-related gains and losses, and we attempt to summarize the major earnings-relevant ACA provisions in Appendix I. Assuming the market prices in consensus (e.g. CBO, JCT, OACT) estimates of ACA’s effects on total national health demand (an approximately 3% increase v. the pre-ACA baseline), we would expect longer range earnings forecasts to fall by a commensurate amount, net of any risk discount that has already been priced in. Special taxes (e.g. HMOs, pharmaceuticals, devices) would be eliminated; Medicaid discounts for pharmaceuticals and generics would return to 15.1% and 11% from 23.1% and 13%, respectively; brand drug manufacturers discounts to seniors in the Part D donut hole would be cancelled[8]; pending reductions in hospitals’ disproportionate share (DSH) payments would be cancelled; likely future cuts to drug and device pricing by an Independent Payment Advisory Board (IPAB) would be sidestepped[9]; and, the Secretary of HHS presumably would lose her ACA-related authority to replace average wholesale price (AWP) with either average manufacturer price (AMP) or national average drug acquisition cost (NADAC), to name only a few


Exhibit 4 summarizes healthcare sub-sectors’ relative valuations at various points in the history of the ACA; Exhibit 5 provides a timeline of key events. From the inauguration through passage of ACA we believe Hospitals gained the most from ACA-related expectations, and innovators (Device Innovators, Drugs, Biotech) lost the most. Looking forward, we believe Hospital and HMO valuations will be the most reactive to the Court’s decisions. A decision to uphold the mandate presumably means Hospitals trade up in expectation of greater volumes and better collections (notwithstanding our view that a shift from ESI to HIE’s neutralizes volume gains, and creates collections headwinds as beneficiaries shift to cheaper policies). HMOs presumably trade down on a decision to uphold the mandate, as it eliminates any odds of other mandate-related restrictions also being vacated. A decision to overturn the mandate presumably results in Hospitals trading down on expectations of lost ACA volumes and continued high costs for uncompensated care. If the mandate is overturned HMOs’ reaction should turn on whether other mandate-related provisions stand or fall; if no other provisions fall (e.g. underwriting restrictions and MLR floors remain) HMOs presumably will sell off on fears of adverse selection (notwithstanding our view that state regulators would maintain orderly insurance markets). Ironically we would see such a sell-off as an entry point, believing states would manage their insurance markets effectively in the near term, and that HMOs would benefit in the longer term by virtue of fewer employees being shifted from ESI to HIE. If on the other hand mandate-related ACA provisions (in particular underwriting restrictions, MLR floors, and the HMO tax) are vacated, HMOs presumably will gain

Medicaid HMOs (Exhibit 3, again) and Hospitals both would react very negatively to the Medicaid expansion being vacated, though we think this is extremely unlikely

Innovators (Device Innovators, Drugs, Biotech) gain or lose potential volume like everyone else under various possible decisions, but also have an outside shot at benefitting from the loss of targeted provisions in the unlikely event ACA is overturned entirely – namely taxes, higher Medicaid rebates (Drugs and Biotech), and pending pricing pressures from the Independent Payment Advisory Board (IPAB)

  1. The Federal share of marginal ACA-related Medicaid costs is 100% in 2014 thru 2016; 95% in 2017, and 90% thereafter
  2. Please see: “ACA at the Supreme Court …”, October 24, 2011, SSR
  3. Please see: “Why Employers are Likely to Drop Health Insurance – a Simplified View”, July 11, 2011, SSR
  4. Please see: “Post-2014 Reform-Related Volume Gains are Modest”, March 2, 2011, SSR
  5. I.e. the plan pays for 82% of the costs of eligible products and services
  6. Ibid “Post-2014 …”
  7. Center for Medicare and Medicaid Services
  8. However because we believe these are generally beneficial to brand manufacturers, in all likelihood these discounts would soon reappear
  9. Please see: “Why the Market Assumes too Much Margin Pressure on Insurers, too Little on Innovators”, April 19, 2010, SSR
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