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Factors To Consider When Investing In Health Insurance Stocks

With America's estimated 77 million baby boomers aging, the health care industry is projected to grow in the coming years. As a result, investors are looking at stocks in health insurance companies as a solid, long-term investment. But when weighing the profit potential, there are several key factors to consider before adding health insurance stocks to an investment portfolio.

The Role Payer Mix Plays

Payer mix (types of revenues) affects both a company's risk and profitability. While health insurance companies and the products they offer differ, some put more weight on specific services. However, large insurance companies usually attribute profitability to a diverse payer mix. Like with other investments, diversification reduces risk.

Government-funded health care plans such as Medicare and Medicaid are large payers, but they are slow to pay, which can affect profitability. They also tend to change the payment structure for certain services.

Private insurers usually are seen as reliable sources of investment income. These companies basically generate revenue in two ways. A company may offer ASO, or self-insure, administration-only insurance products or a full-service, at-risk product. With an ASO product, the insurance company gets paid on a contract basis. There is little risk involved, as fees generally remain stable.

Insurance companies that offer full-service products take on greater risk; therefore, they tend to be more profitable. During the underwriting process, the insurer must determine whether the actual medical costs of the insured will be less than the premiums paid. The risk involves accurately predicting medical expenses of the plan members and receiving enough funds in premiums to pay their health care costs. Therefore, a company needs to be careful not to predict too low.

Investment Potential a Company Offers

In analyzing an insurer's investment potential, investors consider a company's profitability. ASO products are profitable, but while revenue is steady, the profit margins often aren't large. An example of an ASO health insurance program would be an employee health plan that pays insurance claims but hires another organization to provide administrative services. Conversely, full-service health insurers that do everything themselves to earn higher profits need to be skilled at underwriting -- a significant determining factor in a company's profits.

A key ratio that investors look at when assessing investment potential is the medical cost ratio (MCR), which shows the amount of medical expenses a company pays out as a percentage of the premium revenue it brings in. Investors generally are attracted to companies with a medical cost ratio of 85 percent or less.

Additional Factors Investors Consider

The change in pricing from one year to the next as compared to changes in medical expenses is another primary ratio investors consider. Generally, a health insurance company should see its change in pricing grow at a faster or equal rate to the change in health care expenses each year. Investors also track member growth and look to see that a company is not underpricing its products just to gain an edge on its major competitors. For more information on health insurance, talk to a professional like Culbertson Financial Services.