The health insurance industry is a very large and integrated industry in the U.S. economy. Health insurers, sometimes called managed care companies, are often thought of as the gate-keepers to American healthcare. They tend to control what doctors can be seen and how often, how much you will pay, and what the doctors and hospitals will receive. As such, these companies are perhaps the most important aspect of the American healthcare system today.

Health insurers come in various forms and offer diverse products that distinguish themselves from other insurance companies as well as other businesses. It is often said that this is the only business where the consumer (the person receiving the healthcare) has no active role in the decision-making process, and the provider (the doctors or hospitals providing the care) has no say in how much pay they receive for a service. Thus the health insurer has gained control over the healthcare equation.

These companies set the pay structure they will grant to providers for specific services, and set the rules for the consumers on how they can use the services provided. It seems to be a great role to be in from an investor standpoint — controlling your destiny is advantageous to controlling your success.

Not All Health Insurers Are Alike

There are many categories of health insurance companies and the products offered to consumers, but health insurers can be categorized based on payor structure. Payors include private companies, individuals and government entities. Many health insurers cater to all types of payors, but some specialize in individual categories. The largest U.S. health insurers generally have a diverse payor mix, although some may be more heavily weighted towards one.

Payor mix is important to understand because it often points toward the risk and timing of cash flows and profitability. In general, government entities (Medicare, Medicaid and others) are considered the largest payors, but they are slow and can increase risk of profitability as these entities often change the payment structure for specific services, impacting health insurance companies’ bottom lines. Individuals are generally considered undependable sources of cash flow as well. Private companies tend to be the most stable.

Within private companies, there are two types of products insurers offer. The first is ASO, or self-insure, administration-only products. These products require that the private companies take responsibility for the underwriting risk; the insurer only acts as an administrator for the plan by providing statements, paying the doctors, etc. Under this product, the insurance companies get paid on a contract basis and those fees are very stable and virtually risk-free.

The second product is a full service or at-risk product where the insurance company does all the underwriting and takes on the risks associated with that underwriting. In this product, the insurer is responsible for all aspects of the insurance claims, and this product makes money on a spread basis. The insurer bets that the medical costs will be lower than the premiums received based on its underwriting skills. The higher the spread, the more profitable the company is. In general, large multistate or multinational companies tend to use the ASO product, while smaller or mid-sized companies tend to use the full-service option.

Assessing Investment Potential

As mentioned previously, with the differing payor mix and diverse product offerings, financial results vary among these companies. Despite this, there are key financial ratios that are comparable among all the health insurance companies

Insurers who focus predominately on private company customers generally have two main lines of revenue generation — ASO and full service. Government customers generally fall in the full-service category. The steady but slow growing ASO business pays a flat fee based on a contract. The contract can include some stipulations that may minimally affect the revenue, such as number of members served or performance requirements. While investors are not privy to the individual contracts that a company holds, it is generally a profitable business, but not one with huge margins.

The full-service products provide the opportunity for health insurers to demonstrate their skill level in underwriting and actuarial techniques to provide high profit margins. The following financial statement helps outline the important financial margins and ratios to focus on when reviewing the financial strength of health insurance companies.