So, yesterday we dug into how UnitedHealth makes money. And we saw that premiums make up ~79% of the company’s revenues! We saw that the company covers ~50 million individuals. And we saw that the majority of United’s premiums are actually given to them by the US government!
But that’s enough about revenues! Let’s chat about costs and margins. And as we can see from the chart below, the vast majority of UnitedHealth’s costs are to do with ‘medical costs’.
Now, I’m not sure about you - but ‘medical costs’ is incredibly vague for me! So today, let’s break down what these costs actually are! And get a bit more insight into how an insurance company operates. So, without further ado, let’s dive in!
Okay, so let’s think about it. Insurers like UnitedHealth get loads of premiums from employers, individuals, and the US government. And then it’s their responsibility to pay for the medical costs their members have. What are some of these costs? Well, in the US, having a baby in a hospital costs ~$15k on average. And a hip replacement surgery costs ~$40k on average. Even just staying in a hospital bed for a night costs a staggering ~$2.9k on average! But what’s really behind these figures? I mean, why does a hospital bed cost nearly $3k for one night?!
Well, to answer this, we need to first look at what costs hospitals have! In the chart below, we can see how costs are split up for the Cleveland Clinic (made up of 22 hospitals). And we can see that doctors’ salaries account for most of a hospital’s costs. And I’m not surprised, neurosurgeons in the US get paid a handsome ~$747k/year on average!
Okay, so those are the costs for the hospital. But this is where it gets interesting/controversial. Because hospitals in the US are for-profit institutions! They’re run by people looking to make profits. And like any for-profit business, the hospital will need to generate more revenues than their costs. But where do their revenues come from? Well, their revenues come from charging high prices for operations, scans, hospital stays, etc! Like the hip replacement surgery and ‘having a baby’ prices we saw earlier! The Tisch Hospital in New York made the most revenue of any hospital in the US last year. Making a scarcely believable $6.3bn in revenue!
To illustrate just how crazy medical costs can get in America, listen to this. Back in 2020, a chap named Michael Flor spent 62 days in hospital due to COVID. And when we was about to be released, he got handed a bill for $1.1 million for his stay! Now, who pays for that bill? Well, mostly his insurance provider, like UnitedHealth. But because of co-pays and deductibles, patients usually have to pay a certain amount themselves. That’s on top of the monthly premiums they pay!
And it’s not just hospital stays. Drug prices have been going through the roof. For example, a new drug manufactured by Zolgensma (a manufacturer owned by Novartis) was recently approved by the FDA. The drug cures spinal muscular atrophy - a rare disorder. And the one-time treatment can save a patient’s life! Which is obviously amazing. But what’s the price of this one-time treatment? A staggering $2.125 million! And again, it’s the health insurer who pays for most of this!
So, we’ve seen the prices of hospital beds, surgeries and drugs. But back to UnitedHealth, because they’re the ones footing all these bills. And as we can see from the chart below. The high and rising hospital and drug prices have led to medical costs increasing at 10% CAGR for UnitedHealth!
But here’s a question. If medical costs are increasing so much, why can’t insurers just lift their premium prices more to increase their profit margins? Well, unfortunately for them. But fortunately for US citizens - regulation prevents this!
And by regulation, what I mean is the Medical Cost Ratio (MCR)! Or Medical Loss Ratio - they’re the same thing! The goal of the MCR is to make sure that health insurers who collect these billions in premiums. Are actually spending most of that on healthcare services for their insured members… instead of just growing their profit margins and paying shareholders huge dividends!
So, what percentage of premiums do health insurers have to spend on healthcare costs? Well, it’s a minimum of 80% for plans covering individuals and small groups. And a minimum of 85% for plans covering large groups and the government. But some of you may be wondering, how on Earth does that work? How can UnitedHealth ensure they spend 80-85% of their premiums every year? Surely they don’t know how many hip replacements or baby deliveries they’re going to pay for that year!
Well, of course UnitedHealth can’t see the future. But what they can do is make estimates on how much they’ll have to spend on medical costs for their insured members through the year. And then they set the prices of their premiums, based on those estimates, to get them within that 80-85% range. And as we can see from the chart below, they’ve done a pretty good job! With UnitedHealth’s MCR (yellow line) always staying between the 80-85% range… except in 2020 - COVID-related!
Now, we said the MCR requires a MINIMUM of 80% or 85% spent on healthcare costs. So UnitedHealth could technically spend more than 85% of their premiums on medical costs. But if they did this, they’d just be eating into their gross margin (medical costs is their cost of goods sold). And there’s no chance that’s happening!
And speaking of margins, let’s wrap up now by looking at what UnitedHealth’s gross and EBIT margins have been over the years. We can see that whilst EBIT margin isn’t quite as low as it was for CVS Health (~2%). It’s still a pretty slender margin at ~9%!
But hold on. There’s something odd here. How can UnitedHealth’s gross margin be above 20%? I mean we just saw that the US government say that at least 80% of premiums (revenues) need to be spent on healthcare costs? So what’s going on here?
Well, that’s something we’re going to be tackling tomorrow! Because yes, although UnitedHealth’s health insurance business only makes a gross margin of 15-20% due to the MCR regulation. Health insurance isn’t their only business! And it’s partly because of the margin constraints that MCR brings - that UnitedHealth have diversified into other lines of business. More on this tomorrow!
And that’s a wrap for today! I hope you enjoyed diving into UnitedHealth’s cost structure. Tomorrow we’ll look at how the US health giant manages to have a margin above 20%. And we’ll look at how the company actually spends all its profits!
Have a fabulous day!
The Business Of Team