NEW YORK (TheStreet) -- Now that the Affordable Care Act's official enrollment date upon us, investors could be forgiven for thinking insurance companies are no longer viable investments.
After all, proponents of "Obamacare" promised lower insurance costs from squeezing insurance company's profits and administrative costs. A smaller share of the pie normally results in severe news for investors.
The market has taken the opposite approach, driving shares higher.
WellCare Health Plans
are trading above the level of when Obamacare was sent to the White House for signing.
First, let's look at the some key provisions that appear to negatively impact upon insurers, and how the mandates turn them into the insurer's advantage.
Insurance companies will no longer turn down customers because of pre-existing conditions. This provision was championed by many advocates because insurance companies won't knowingly take a customer expected to cost the company money.
How this helps insurance companies is they no longer have the expense of the underwriting process along with investigating claims that may be suspect. In a free market, this provision would financially destroy insurance companies.
In a free market, many people would simply choose to wait until an insurance policy is a "sure thing" before buying. An uninsured person finding out they need expensive long-term treatment is the type of person expected to have a quick change of heart in determining their insurance needs.
Obamacare addresses the "wait until you need it" strategy with its arguably most contentious mandate, the individual requirement to buy insurance. Some people without insurance in 2014 will have to pay a fine starting in 2015.
If reality departs too far from theory, and healthy people don't sign up in significant numbers to offset sick people, the next provision may turn into a disaster for insurance companies and their shareholders.
Consumers and insurance companies are no longer allowed to agree upon a lifetime cap of insurance coverage. Not having a lifetime cap is like buying home insurance and not telling the insurance company what your home is worth.
A homeowner's insurance company may not know what your home and content are worth, but they know what the average is and what they can expect to pay out. The same is true for health insurance companies. They don't know how much they will have to pay out for you, but instead of selling policies that have a $2 million dollar limit of coverage, they will now get to sell the much more expensive (and hopefully) more profitable policy without a limit.
The reason United States has anti-trust laws is to prevent insurance companies from colluding with each other to limit competition. Because of Obamacare, insurance companies will no longer have to compete on price based on coverage limits. Everyone is required to buy the expensive plan and, at the end of the day, more insurance purchased means more revenue and profit.
Not all companies are willing to take on the additional exposure, especially at the start when everything is theory and no one knows for sure what will happen. For companies that remain, the lowered competition should result in greater revenue.
The potential fly in the selling limitless policies ointment is if individual and company mandates don't produce enough new healthy customers, profits may evaporate quickly. Exacerbating the situation and why I believe investors may wish to take money of the table comes from the medical loss ratio allowed.
Before Obamacare, health insurance companies may have suffered large losses in any given year, but that was offset by previous and presumably future years. Now, insurance companies are limited to the 80/20 rule. The 80/20 rule requires at least 80% of revenue to be paid out in claims and limits insurance companies to a maximum of 20% of revenue to cover administrative costs. After paying administrative costs whatever is left over is for insurance companies to keep as profit.
If claims fall short of 80%, insurance companies are required to issue rebates to customers. Investors face a possibility they may have several relatively profitable years, followed by massive losses that wipe out many years of work.
It's not hard to imagine happening, especially when none of the above companies currently enjoy profit margins of 5%. With such a small margin for error, a company suffering from above average losses could wipe out years of profits, with a tough road back. It doesn't take much when some claims will total in the millions of dollars.
The possibility of massively large losses is further increased because clients have nearly zero incentive to avoid or mitigate multi-million-dollar claims. To illustrate, when claimants are offered a choice between a $600,000 health care solution or a $3 million solution with the smallest benefit to the customer, the client can reasonably be expected to take the $3 million solution every time. Why not, it doesn't cost them anything extra.
When randomizing anything, always expect a degree of clustering. Unfortunately, insurance companies experiencing clustering of large claims may not have the ability to quickly recover losses.
Considering the political uncertainty and high share prices, now may be an opportune time to ring the register.
At the time of publication the author had no position in any of the stocks mentioned.
This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Robert Weinstein is an active trader focusing on the psychological importance of risk mitigation, emotion and financial behavior of market participants. Robert co-founded the investing blog
, where he writes a journal about his trading activity and experiences.
In addition to
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