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Hot Stock Health Insurance/Managed Care
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Insurance and managed care firms are subject to intense regulatory pressure and widespread litigation, making them somewhat less attractive than some other health care industries. They typically don't have wide economic moats. Although firms that focus on making a profit can throw off large amounts of free cash flow, we'd tread carefully and require a hefty margin of safety before investing in most companies in this industry. Most health care consumers don't spend much time thinking about how money gets from their pockets to their physician's because they're not responsible for paying the full bill at the end of the day. As a result, there's little incentive to shop around for the best prices, and insurance companies are the ones who ultimately foot the bill if they underestimate the growth in health care costs.

Starting in the 1980s, insurers tried to gain some pricing control by creating managed-care organizations (MCOs) to coordinate and consolidate providers and buyers. MCOs make money in two primary ways. One is by underwriting medical insurance. Because it's tough to predict future medical expenses, this is known as risk-based business. Under this model, the MCO bears the risk of rising health care costs. The other way that MCOs make money is by providing administrative services—such as claims processing or network access—for a monthly fee. In this instance, employers underwrite their employees' medical insurance, and the MCO simply administers the health plan. In this model, called fee-based business, the employer bears the risk of rising costs.

Companies "with a greater proportion of fee-based business hold less risk because cash flows are more predictable. In risk-based accounts, each trip to the hospital takes more money out of the MCO's pocket. So the upside might be great because if nobody gets sick, the MCO keeps all the premiums. But if hospital costs or prescription drug prices increase more than expected, a company's profits can be wiped out. Because medical costs are generally increasing, we think fee-based businesses are usually more attractive.

Hallmarks of Success for Health Insurance/Managed Care Companies

Although managed care generally isn't the most rewarding place for your

health care dollars, some companies manage to do well. Here's how to find

them:

Effective medical cost management and underwriting: The medical loss ratio (medical costs paid divided by premium revenue) is the best measure of a firm's effectiveness in this area. Be sure not to include fee-based revenues and investment income when calculating this ratio, though. The average medical loss ratio has been about 84 percent to 85 percent over the past several years, and this measure captures both pricing and medical cost management, reflecting a company's overall success and consistency in managing its risk-based business.

Minimal dual-option business: Managed care organizations often give individuals the opportunity to choose from two or more types of plans (such as an HMO, PPO, or traditional indemnity plan). Watch out for companies with a large portion of this dual-option, also known as slice, business. These slice accounts not only often promote hypercompetition among managed care groups, but also are more susceptible to mispricing because demand for each option in a sponsoring company is difficult to predict.

Large mix of fee-based business: Underwriting health insurance has proved to be risky business, and lower exposure to this risk is generally a positive in our book. For example, UnitedHealth Group increased its fee-based membership to 64 percent of total members at the end of 2OO2, up from Jj percent at the end of 1999, and its overall financial results improved over the same period.

Minimal exposure to government accounts: Government-funded programs,
such as Medicare and Medicaid, aren't increasing reimbursement rates in
tandem with rising medical costs. Companies with less exposure to govern­
ment accounts will outperform those that rely on government revenues.

The company's Web site will have information about products and services offered—it's also a good way of seeing how customer-friendly the company is. The 10-K will have information about underwriting, account mix if any customer is a large source of revenues (10 percent or greater), as well as product information and financial statements.

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