Summary

• Given the overall American healthcare landscape, CVS Aetna is well positioned to participate in some of the best segments with lower risk.
• Aetna has been posting strong growth in membership, although it is shifting around between employer commercial plans and government plans.
• As Aetna becomes a larger portion of the CVS business and debt decreases, valuation should reflect the benefit of premium the market offers insurers relative to CVS' other business lines.

My wife's employer offers a choice between a defined benefit (traditional pension) and a defined contribution plan (like 401k) for retirement, and I was recently looking at some of the benefits of the defined benefit option. One of the current benefits is a provision for retiree health insurance, in which the benefit would provide what amounts to a subsidy for premiums for enrolling in a Medicare Advantage plan offered by Aetna (CVS). While we've opted not to take the direction of the defined benefit plan, I found it interesting to wrestle with the questions on a personal level by attempting to guess what our healthcare needs might be twenty years down the road when we are about to retire. Due to political pressures for change in American healthcare delivery and payment models, twenty years may as well seem like eternity. In other words, it may look nothing like the current landscape at all by then.

I have written previously on why I like CVS Health, and in a nutshell it boiled down to attractive valuation, growth prospects and dividends. In this article, I aim to provide an overview of two elements in the American healthcare system - providers and payers - and then bridge from that to why I think these elements point to CVS Health being a good prospect for long-term investors on the specific basis of Aetna business. The thesis ultimately boils down to this: the convergence of declining debt and increasing value of the insurance business within CVS should lead to a higher equity premium for the whole business.

American Healthcare: It's Messy

In broad strokes, the United States healthcare system is fractured. This may be the understatement of the day, but consider just the relationship between two of the key parties, the providers and the payers.

• The providers of health care include your physician, nurse, dentist, clinic, hospital, etc. Many individual providers are part of a professional or group practice, and are certainly trying to operate as a profitable enterprise. However, when it comes to hospitals, the overwhelming majority are legally set up as non-profits, by a three to one ratio.
  • A sort of specialty provider is the pharmacy, which is currently largely regulated separately from physicians, although some have advocated for allowing physicians to dispense.
• In order to pay the providers, most patients carry insurance, thus insurers are counted as the payers. Some party pays a premium in exchange for insurance to underwrite risks associated with the potential for medical expenses. When a medical cost occurs, insurance steps in and pays, normally a portion, on behalf of the patient, with the patient still sharing some of the costs. These payments are mostly based on contracts between providers and insurers (contracts which the current presidential administration wants to shed light on, and Congress is looking into as well).

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