A Less Healthy Health Insurance Sector

The weakened economy will pressure profits—and credit quality—in the managed care industry

By Robert McNatt From Standard & Poor's RatingsDirect

The U.S. economy is in a recession, and the health insurance industry has not proved immune to what ails the nation. With joblessness on the rise, volatile financial markets, and consumer income either flat or falling by most measures, Standard & Poor's Ratings Services on Nov. 3 revised the outlook on the managed care industry to negative from stable. The impact of the deteriorating economy, slowing top-line growth, aggressive pricing strategies, and negative medical trend development were the key factors in our decision. As a result, over the next six to 12 months, we anticipate there will be more downgrades than upgrades in this sector.

Health insurers will likely face added pressure from a private sector that is stagnant—or even shrinking—and from declining growth opportunities in the public sector. In addition, the pace of Medicare Advantage growth is slowing, and the market for Medicare Part D products (for prescription drug coverage) is now in a more mature phase of development. While we don't expect to see previous "land rush" growth rates in these markets, there will be further growth as the general population ages.

The key factors we'll consider in 2009 will be pricing strategies, medical management, market segmentation, cash-flow generation, liquidity, and capital management strategies. This weak economy can pose a significant risk to insurers' business plans. They will have far less room for miscalculation in terms of estimating medical-cost trends, new product rollouts, new technology introductions, integration of new acquisitions, and the like. Any misstep is, of course, not good, but when margins are compressing and organic business growth is harder to come by, the potential for earnings and cash-flow damage increases with every mistake.

Rating Downgrades

We have seen, for instance, that some insurers, such as Coventry Health Care (CVH) (S&P credit rating, BBB-), Health Net (HNT) (BB), and HealthMarkets (BB-), seriously underestimated medical trends for various market segments, which has led to significant declines in profitability and rating downgrades. Moreover, cash-flow strain could lead to further qualitative capital impairment for companies with high levels of intangibles.

Investment exposure is not expected to emerge as a significant factor in 2009, but liquidity and capital management will continue to be closely scrutinized. An insurer's level of debt does influence our position on ratings and outlooks. If an insurer carries significant debt (and goodwill), we expect specific levels of Ebitda interest coverage to maintain the rating. For example, at WellPoint (WLP), we have cited Ebitda of 10 times interest coverage as the level consistent with the current rating (A-). In 2009, we will continue to monitor closely any aggressive capital-management strategies that may materially increase leverage, especially share buybacks, mergers, or acquisitions. In these trying times, we likely will examine those actions more critically than in prior years, when growth opportunities were better and earnings were above rating expectations.

Bigger Insurers in Better Shape

While the state of the economy is the big issue for most of 2009, challenging some health insurers to sustain their credit profiles, others can be expected to operate through this downturn without a rating change despite some credit-profile strain. This mix of companies includes some of the larger diversified health insurers as well as some more localized plans. The larger companies are likely to benefit from geographic diversity and a meaningful combination of insured and fee-based business, giving them some protection from regional economic woes and underwriting risk.