3 Top Health Insurance Stocks to Buy

The passage of the Affordable Care Act led to millions of Americans gaining health insurance through insurance exchanges, employers, and Medicaid, but the impact on insurers has been mixed, and potential reform could lead to unintended consequences for the industry.

In order to pick this industry’s winners and losers, you need to understand how health insurers make their money, what metrics are useful in evaluating these companies, and what the pros and cons are for insurers targeting commercial and government health insurance markets.

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First, some background

Regardless of whether a health insurer’s business focuses on commercial, individual, or government markets, the goal of any insurer is to collect more in premiums than it spends on healthcare for its members.

Insurers manage their profitability by carefully considering markets and only participating in those that present a lower-than-average risk to them. In those markets, health insurers make assumptions about the health of their members and price their premiums accordingly. They also leverage their scale to negotiate lower prices from healthcare providers, such as doctors and hospitals, and drugmakers. Additionally, they may encourage behaviors that prevent disease or hospitalization, such as prescription drug adherence, smoking cessation, and gym memberships.

Generally, it may help to think of health insurers as middlemen that collect a percentage of profit from member premiums in return for managing members healthcare expenses. The percentage health insurers keep for their efforts varies, but operating margins are usually in the single-digit to low double-digit percentages. For example, the following table shows you operating margins over the past 12 months for some of the largest publicly traded health insurers. Typically, diversified insurers, such as UnitedHealth Group, enjoy higher operating margins than government health insurers, such as WellCare Health.

TTM = TRAILING 12 MONTHS.

Because the industry’s operating margins are small, scale is undeniably important. Large insurers — all things equal — can negotiate better prices on behalf of members, can charge more in premiums, and can collect more in interest on premiums that aren’t spent on healthcare.

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Evaluating health insurers’ performance

Paying close attention to an insurer’s ratio of healthcare costs to premiums collected is a good way to separate industry winners from losers. This ratio is called different things by different insurers, but it’s often referred to as the medical loss ratio (MLR), medical cost ratio (MCR), or medical benefit ratio (MBR) in corporate filings and presentations.

Commercial insurers ratios are usually lower than community- and state-focused insurers, so it’s important to only compare ratios between companies competing in the same marketplaces. Overall, a lower ratio is better than a higher ratio, and generally speaking, a ratio that’s in the low 80%’s is good for diversified health insurers, such as UnitedHealth Group and Cigna, and a ratio in the high 80%’s is good for Medicaid insurers. Currently, UnitedHealth’s and Cigna’s ratios are among the lowest of major publicly traded insurers, clocking in at 80.2% and 81.4%%, respectively. In Medicaid, WellCare Health’s 86.9% is better than Centene’s 88%.Humana makes most of its money serving Medicare members and its 82.1% ratio is solid, too.

These ratios fluctuate from quarter to quarter, however, and business decisions, such as expansions into new markets, can increase them in the short term. Centene’s ratio, for example, is higher in part because of it pushing deeper into the ACA exchanges. Alternatively, UnitedHealth Group’s ratio is lower because it’s no longer participating widely in the exchanges.

Since medical costs ratios fluctuate, investors should also consider other metrics, including net income growth. Insurers that successfully expand into new markets, acquire competitors, or price plans accurately will produce higher levels of net income growth than those that don’t. In this next table, you can see which health insurers are delivering the best year-over-year net income growth rates as of Q3 2017. WellCare, Centene, and Aetna are among the standout performers on this measure.

YOY = YEAR OVER YEAR.

Impact of reform

Attempts at widespread health insurance reform fell flat in 2017, but the individual mandate got repealed in the Tax Cuts and Jobs Act of 2017. Repealing the individual mandate could have important consequences for health insurers that derive a significant proportion of their business serving the individual health insurance market.

If repealing the individual mandate results in healthy Americans canceling their health insurance policies to avoid premiums, then membership pools could skew toward sicker patients, causing the medical cost ratio at these companies to climb. If that happens, then insurers like Centene and Anthem that have invested heavily in the ACA marketplaces could see their profitability fall more dramatically than their competitors.

Although Medicaid reform hasn’t passed Congress, Republicans have proposed shifting Medicaid to a block grant program. If they succeed in doing that, then some states with more generous Medicaid programs may be forced to restructure their programs in ways that reduce Medicaid enrollment. Since Medicaid insurers are paid by states based on Medicaid enrollment, such a change to block grant funding could create revenue and profit headwinds.

Tax reform that increases employment also has an impact on the industry because many employers provide workers with employer-sponsored health insurance. If lower corporate tax rates translate lower unemployment rates, then revenue at insurers with exposure to the commercial market should increase.

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3 insurers to buy

Given the pros and cons of reform, UnitedHealth Group, Aetna, and Humana are currently my favorite health insurance stocks to include in portfolios.

What’s attractive about UnitedHealth Group is that it isn’t very exposed to the repeal of the health insurance mandate. It’s already exited most of the ACA exchanges, so individual membership from the ACA represents a small proportion of its business. Instead, it makes most of its moneyby selling employer-sponsored health insurance plans and Medicare plans. Those markets are likely to remain strong. Unemployment is only 4.1% and aging baby boomers are increasingly enrolling in Medicare Advantage plans that cap risks associated with unlimited coinsurance under Medicare Parts A and Part B.

UnitedHealth’s operating margin is among the industry’s best and its medical loss ratio is low thanks in part to the negotiating power associated with being the nation’s biggest health insurer. The sheer size of UnitedHealth Group is also a plus in a rising interest rate environment because a lot of the company’s unspent premiums are held in short-term investments that react more positively to rate increases. Furthermore, its Optum segment has become a leader in managing corporate pharmacy benefits and healthcare analytics. Because UnitedHealth insures so many people, it can offer better insight into healthcare trends, exploiting insights for its clients to use to reduce their costs. It also doesn’t hurt that UnitedHealth’s shares yield 1.3%, the highest yield within the large-cap health insurance industry.

Aetna is intriguing for a few reasons. First, it operates a large Medicare business that’s benefiting from baby boomer demand. Second, it has broad exposure to the employer market. Third, pharmacy giant CVS Health (NYSE:CVS) is attempting to acquire it for $207 per share.

Currently, Aetna’s shares are trading below CVS Health’s offering price because of fear that regulators will block their merger. That’s possible, but there isn’t a tremendous amount of overlap between these two companies. CVS Health does sell Medicare Part D plans under the SilverScript brand name, but it’s a pharmacy retailer and pharmacy benefits manager first and foremost, not an insurer. If regulators approve the deal, then Aetna’s shares will close the gap to CVS Health’s offer price, but even if regulators block it, Aetna should do fine on its own.

Finally, I’m a fan of Humana’s reliance on Medicare enrollment. Although it dabbles in other markets, it’s the largest pure-play Medicare insurer investors can buy. If you believe (I do) that an increasingly larger number of seniors are going to live longer than ever before, then it’s hard to dislike Humana’s Medicare-heavy business model. I’m also intrigued by the company’s recent decision to acquire parts of senior housing company Kindred Health (NYSE:KND). That deal could provide it with intriguing opportunities to better serve its members and control costs.

Something else to keep in mind

Washington, D.C.’s whims and whispers can make health insurers more volatile than other stocks, and dividend yields on health insurance stocks aren’t as enticing yields for other insurers, such as property and casualty stocks or reinsurance stocks. Because there is a significant political risk and these stocks don’t offer much in the way of income, an argument can be made that health insurers aren’t the most attractive insurers to own. While that may be true, health insurers enjoy big demographic tailwinds to revenue and profit. It’s also possible that health reform is done in a way that’s more friendly to insurers’ profitability. If that happens, then health insurance stocks could outperform other investment opportunities.