Health plan profits: Relying on the market

Insurers aren't making money just from health care. Investment income and share repurchases are helping buoy earnings so plans look good for Wall Street.

By Emily Berry — Posted April 5, 2010

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If you listen to health plan executives on one side, or many of their critics on the other, you might get the impression that insurance companies' profits are determined each year solely by how much they can charge in premiums, minus how much they have to spend on medical care.

If that were the case, it wouldn't make sense that health plans' profits have been going up, because many of the largest insurers are reporting declining enrollments and higher medical spending. So how are they making money?

Administrative cost controls play some part. But there are other factors: First, insurers also make money from investing premium dollars, and the returns they make on those investments have stabilized since the market crash of 2008.

The other factor is plans' billions of dollars worth of share buybacks, which affect the figure Wall Street watches most -- earnings per share. Even if cash profits don't change, per-share earnings will go up, because a company has fewer shares in the market.

For example, thanks to stock buybacks, Aetna's 2009 per-share earnings were up over 2008 -- even as its actual cash profits declined.

Boosting earnings per share keeps Wall Street (and shareholders) happy. And in for-profit health insurance, shareholders come first.

When companies have extra cash, they think of the best way to benefit shareholders. "It is a fairly straightforward decision: they have dollars. They could potentially use those to buy new computers, hire new staff, open new markets, increase reimbursement or deliver more services, but in the for-profit world, their first obligation is returns to their owners," said Joe Paduda, principal for the consulting firm Health Strategy Associates in Madison, Conn. His clients include PPOs, self-insured employers, and hospitals.

Insurers' investments and share buybacks matter, because they can indirectly affect doctors' pay. If the market isn't doing well and investment income drops, insurers feel even more shareholder pressure to raise premiums or cut costs, rather than risk an operating loss. That means less flexibility for doctors in negotiating reimbursements.

"They have less margin for error, because investment returns are so low," Paduda said. If health plans see higher-than-expected spending, "or they sell a policy to folks who, God forbid, actually get sick, then they've got a problem."

Second, every dollar an insurer sets aside to invest or buy back stock is a dollar it does not pay doctors, use to improve administrative processes, or otherwise invest in care for members.

For publicly traded companies, shareholders come first, so repurchases have become the go-to way to spend cash.

Insurers "ask themselves, 'Is this a better benefit for our mission?' " Paduda said. "The answer they come up with is, 'Yes.' "

Third, because health plans make money not only from premiums but also from the interest earned on premiums, the longer they hold on to that money, the more interest they earn. Some have accused insurers of delaying reimbursement to maximize that hold time, thus boosting interest. Once upon a time, that wasn't an insignificant amount of money.

Now that interest rates have dropped so low, the incentive to pay on time is stronger than the upside of holding money, said Dave Shove, a New York-based senior research analyst specializing in managed care for BMO Capital Markets Equity Research Group.

In their 2009 annual reports filed with the Securities and Exchange Commission, many plans did report reductions in how many days it took to pay claims, though they credited that to overall improvements in processing.

"Physicians are sensitive to that issue, but in fact holding on to that money means that claims don't get paid as quickly, and not paying claims quickly makes customers mad," Shove said.

There could still be some companies that stretch out claims payment times to keep cash on hand, Paduda said, but in most cases, "the relationships with their physicians and members is more important than the few additional cents they could get from pushing out a reimbursement from two weeks to four."

Unlike life insurance or property insurance companies, which often hold on to collected premiums for years, health insurers see a quicker turnaround between collecting from customers and paying doctors or hospitals.

Short-term investments

That means health plans' investments are short-term, Shove said. Regulations also require health plans to put premiums into conservative investments (that's why, for example, you didn't hear of insurers crippled by investments in subprime mortgages, though investments did decline in value due to the after-effects of the housing bust).

But short-term, conservative investments bring a smaller return.

When interest rates dropped with the recession, so did health plans' modest investment returns, Paduda said. While they once could avoid a premium increase or offset a bad year by relying on investment income, that's no longer the case.

"Now interest rates are low, so where it used to be 5%, 6% or 7%, now it's 1%, maybe 3% -- it's just not terribly meaningful," he said.

Scott Harrington, PhD, professor of health care management at the Wharton School of the University of Pennsylvania, said the dip in interest rates -- and thus, a drop in investment income -- has had a modest effect on the price of insurance, compared with the main driver, the cost of care. Lower interest rates "would contribute to upward pressure on premiums, and increased pressure to control reimbursement, but it's a small factor," he said.

Nonprofit health plans commonly use investment income to offset losses. Iowa-based Wellmark Blue Cross and Blue Shield has defended itself against criticism of planned rate increases by noting that its board in 2006 approved a "break-even" operating strategy, letting the plan use investment income and reserves to make up for times when premiums don't cover medical expenses.

Shove said that because nonprofits generally operate at such a slim margin --1% or 2% versus 5% in the for-profit sector -- investment income can mean the difference between red and black for a given year. Experts said that has not been the case for the big shareholder-owned companies in the last few years.

Health plans also buy back shares of their own stock. This boosts earnings per share by shrinking the denominator. Fewer outstanding shares means each share is worth more.

Shove said share repurchases are simply a way to reward shareholders. Other options are paying dividends or buying other firms.

But health insurers historically have made very few dividend payments, he said, and "the health insurance business is pretty consolidated now. That just leaves one thing to do, and that is buy back stock, so they're doing it."

In 2009, the largest shareholder-owned plans repurchased a lot of stock, and it mostly has paid off: Stock prices rose, and earnings per share grew, in some cases quite dramatically, compared with 2008.

By its own admission, Aetna had a bad year in 2009 in terms of setting premiums high enough to cover medical costs. The company would have shown a decline in earnings-per-share had it not been for buying back $111 million of its own stock during the final three months of 2009.

With that purchase, Aetna kept 2009 earnings per share stable at $2.84, versus $2.83 for the previous year. That was despite a drop in net income in 2009 to $1.27 billion, from $1.38 billion in 2008.

Common trend

But Aetna was not alone in using profits to buy back its stock, and the trend has held up in 2010.

Health Net, for example, took a loss of 47 cents per share in 2009, but eased the impact of that for shareholders and kept its stock price from dipping too far -- in part through share repurchases -- which totaled about $20.6 million in 2009. Chief Financial Officer Joseph Capezza said, at the company's Feb. 11 Investor Day, that Health Net would spend at least another $90 million on repurchases in 2010.

WellPoint Chief Financial Officer Wayne DeVeydt told investors at a March conference that the company plans to spend nearly $4 billion on share repurchases in 2010, following $2.6 billion in 2009.

"We routinely evaluate alternative methods for deploying capital to our shareholders and continue to believe that share repurchases currently are the most appropriate method," DeVeydt said during the company's conference call reviewing earnings for 2009.

Harrington said health insurers, like other companies, have favored share repurchases over paying bigger dividends, in part because the tax code favors repurchases, but also because if shareholder dividends are increased one year then cut the next, the market interprets that as very bad news.

A share repurchase is a one-time deal that can be done quickly, and analysts won't worry if the company doesn't do the same thing the following year.

Health plans also might repurchase if they feel stock is undervalued. "It might be the case -- in the environment of health care reform -- that they believed prices were depressed because of reform prospects, and some of the companies may have felt it was a good time to buy the shares," Harrington said. In other words, big health plans bet they could profit despite investor uncertainty.

Not everyone likes the way investments and stock prices drive the U.S. health care system. But short of a single-payer, government-controlled system, health system reform proposals are not aimed at changing this part of the way health insurance companies work.

"This is the world we live in," Shove said. "These guys are for-profit, and as long as we have insurance companies, we have to live with the consequences of that."

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Insurers find investing in themselves pays off

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Click to see data in PDF.

Health plans collect premiums from members, then pay doctors and hospitals. But in the interim, those funds are invested. So a poor return on investments can hurt plans' income while a stable market can help income rebound. Insurers also have made a practice of rewarding shareholders by repurchasing shares, which drives up earnings per share, a key metric for Wall Street. Financial analysts don't worry if stock repurchases are done every year, but dips in dividends can raise concerns.

Source: Company filings with the Securities and Exchange Commission

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