Humana Inc (HUM), CIGNA Corporation (CI): Obamacare is No Bust for Insurance Stocks

Thought Obamacare was sure to crush the insurance industry?

Think again.

After the markets closed Monday, the US government reversed its decision to lower payouts to Medicare Advantage plans, offering a 3.3% increase in payment rates instead of the 2.3% decrease it had previously announced.

Why Medicare payment rates matter

Falling reimbursement rates can crush health insurance companies like Humana Inc (NYSE:HUM) or United Healthcare of the Midwest, Inc.. Health insurance companies generate their profit from the spread between premiums and expenses, including medical costs and operating costs.

Humana Inc (NYSE:HUM)

In a typical health insurance company, one would expect approximately 80% of premiums to be paid out in medical costs, and 15% in operating costs. The remaining 5% is the tiny leftover profit margin for insurance companies.

This slim profit gives little room for error. Assuming a 5% gross profit margin, an increase in medical costs of 2% would cut an insurance company’s profits by 40%.

Insurance companies don’t need to sweat Uncle Sam’s next move, though. Despite all the hooplah about cutting the cost of health care in the United States, there doesn’t seem to be much more than a boondoggle behind tough campaigning against health care inflation.

Why expensive healthcare is here to stay

You know what they say – there is a correlation between cost and quality.

Politicians may act tough when it comes to slashing the cost of healthcare, especially healthcare services tied to the entitlement system, but recipients of entitlements are much more likely to be consistent voters – older retired Americans who turn out to the polls in droves.

Who’s going to let grandma and grandpa have a bad trip to the doctor’s office over a few billion bucks? Here’s a hint: it won’t be your congressman.

So let’s look at how investors can play healthcare in the current political environment. Here are three stocks to think about, all with varying exposure to Medicare Advantage.

Humana

This company is the king when it comes to making a profit on entitlement programs, generating 66% of its net revenues and 58% of its total profits from Medicare Advantage. It isn’t turning away from a reliance on government money, either. Humana Inc (NYSE:HUM) recently doubled down by acquiring a leader in low-cost healthcare, Metropolitan Health Networks, Inc. (NYSE:MDF), in a deal worth $500 million.

The upside for investors is in the roll out of Metropolitan’s coding skills to Humana Inc (NYSE:HUM)’s vast network, lowering the medical loss ratio on all its managed accounts.

The downside is a crippling blow to the company should Medicare ever take a cut. At 10 times earnings, this is a value stock of all value stocks, especially given the robust growth ahead for any player with strong exposure to retirees and seniors. If Uncle Sam keeps writing checks for Medicare, investors will compound their wealth quickly. But boom would turn to bust on any reduction in Medicare spending.

United Healthcare

Solidly in the middle of the risk pool, United Healthcare derives roughly 38% of its revenues from Medicare programs, balancing its government risk with private and corporate insurance and a growing business in Brazil.

The company posted solid full-year earnings growth of 8% in just the past year, aided by growth across all the company’s operating segments. Revenue also grew by 9% in the same period.

The upside is a diversified health insurance company trading at a slight premium to government-centric insurers. The diversification comes at a low cost, though, seeing as United Healthcare trades at 11 times earnings, which isn’t all that much more costly than Humana Inc (NYSE:HUM) given its balanced exposure.

Forward earnings growth should be stellar in public and private plans, since the company has the scale necessary to hedge expansion plans with expansion in business from other sources, public or private.

CIGNA Corporation (NYSE:CI)

Scared of the government’s cost-cutting activities but want exposure to the perennial value in health insurance stocks? Look no further. CIGNA Corporation (NYSE:CI) generates less than 1% of its revenue from government entitlements, instead earning the bulk of its sales and net profits from private contracts from businesses and individuals looking for a capable company to manage their medical risks.

When it comes to quality of the customer, CIGNA Corporation (NYSE:CI) is at the top of the food chain. CIGNA Corporation (NYSE:CI) trades at a relative premium of 11.2 times earnings after surging 27% in the last year.

Those who would prefer to take a little political risk off the table in exchange for a slightly pricier stock will like the near pure-play exposure on private plans, which substantially avoid all risk of a Medicare pricing fiasco.

Wagering intelligently

While Medicare cuts are a long way away, investors who want exposure to this industry should rethink Humana Inc (NYSE:HUM) after its recent surge. At a slight discount to more diversified players, United Healthcare and Cigna offer much more favorable risk-adjusted valuations to Humana Inc (NYSE:HUM), which carries far too much risk with a single customer – the government.

United Healthcare looks to be the best of the breed. It’s exposed to public and private reform and regulation, whereas CIGNA Corporation (NYSE:CI) and Humana are virtually pure-plays on their respective corners of the public and private health care market.

At any rate, an industry growing at high single digits with earnings multiples far lower than the broad market is worthy of a second look from investors. Health care is here to stay, and so are insurance profits. What won’t be here to stay are earnings multiples one-third less expensive than the S&P 500 index, so take a look at this industry group as others give it the cold shoulder.

The article Obamacare is No Bust for Insurance Stocks originally appeared on Fool.com is written by Jordan Wathen.

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