A Less Healthy Health Insurance Sector

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There are also some not-for-profit health insurers with established competitive positions, sound balance sheets, and a track record of operational stability that offer meaningful protection against downside development. These companies generally have strong balance-sheet characteristics and are under less pressure to increase operating earnings in what is expected to be a softer market. Examples include Health Care Service (d/b/a Blue Cross & Blue Shield of Illinois, New Mexico, Oklahoma, and Texas) (AA-), Highmark (d/b/a Highmark BCBS & Highmark Blue Shield) (A), Kaiser Foundation Health Plan (A+) and HealthPartners (Minn.) (BBB). We expect them to focus on stable pricing and targeted member preservation and growth strategies in addition to sustained focus on medical management applications. So the prognosis is far from universally poor for the health insurance sector, but it may be some time before the patient is back in good health.

Margin Pressures Remain

For many diversified health insurers, margins are expected to be pressured by a changing business mix. There will be fewer comprehensive commercial group benefit offerings and more public sector government-sponsored products—which are higher medical-loss-ratio products. In addition, we expect hospitals—particularly higher profile ones with strong market leverage—to be more aggressive with commercial health insurers' contract-renewal pricing as they compensate for revenue squeezes from Medicare and Medicaid.

While many insurers are fighting to reduce medical costs, their efforts haven't always borne fruit. Increasingly sophisticated electronic systems allow insurers to handle smaller, routine insurance claims more efficiently. But larger, more complex claims remain more problematic. Adjusting these complex claims can result in higher-than-expected costs for some insurers because of contractual provisions with hospitals that pay the insurer on a percentage-of-charges basis, rather than on a contracted-per-diem or diagnosis-related-group (DRG) basis.

Insurers, of course, seek out the most profitable lines of business when they can. Among those are policies written for small to midsize employers. But this segment is one of the most competitive and price sensitive lines of health insurance. Because health insurance rates for small businesses are also politically more sensitive, these policies can attract regulatory attention that might reduce margins for those insurers offering it. Some insurers still view this segment as potentially very profitable, however, and seek it out, even as opportunities are becoming more limited because of the tough economy, increased competition, customer attrition, and a growing demand for less comprehensive offerings. The inability to achieve growth targets among small to midsize employers contributed to reduced earnings forecasts in 2008 for both WellPoint and UnitedHealth (UNH).

Less Merger-and-Acquisition Activity

While we generally expect to see the pace of deal activity slow in this frosty economic climate, some industry consolidation is still possible, prompted by sluggish organic growth. But because credit markets are tight, smaller cash transactions are likely to dominate.

We could also see some strategic acquisitions that incorporate medical service providers as units of health insurers. If successful, these deals could be expected to support product development and value enhancement, contain costs, and boost efficiency. Earlier this year, for instance, we saw Health Care Service acquire MEDecision, a service company that provides a platform for managing cases, diseases and utilization management, and other health-care information.

Nevertheless, insurers are likely to take more cautious capital-management positions and be generally reluctant to deal with integration risks when their focus needs to be on core business activities. Some regional health insurers, in fact, may no longer have the capacity to compete in key markets and could pursue an exit strategy that includes divestiture.

What Will the Feds Do?

Finally, in addition to waiting out the recession, the sector is also awaiting whatever changes the incoming Obama Administration might bring. In 2009, the new Congress and President, the industry, and the public will likely be debating and shaping the contours of any new federal health-care initiatives. Health insurers have worked hard to position themselves as ongoing players in any new health-care system. Despite the attention on health care and the $2.3 trillion annual price tag (16% of GDP based on total national health expenditures in 2007, according to the Commonwealth Fund and National Coalition on Health Care), there are no universally accepted solutions. In addition, the platforms of the various politicians and political parties vary widely.

For these reasons, we expect competing solutions will mean that federal policy will evolve slowly, which will give insurers the opportunity to influence the outcome. Regardless of the specific plan adopted, it will almost certainly include greater regulation. To date, federal health policy has endorsed public/private partnerships and, contrary to a worst-case scenario, we believe the private sector will continue to have a role in financing health care and managing the cost of care.

McNatt is a senior features editor for Standard & Poor's Securities Services .