Six hours after the U.S. Supreme Court upset consensus forecasts by upholding the hotly contested Affordable Care Act (ACA) on June 28, 1,826 investors and financial advisors dialed into a Lord Abbett conference call to hear what that ruling might mean for their portfolios and the overall economy. On the call were Deepak Khanna, Lord Abbett Partner and Portfolio Manager for Lord Abbett's Multi Cap Value Equity strategy, and Milton Ezrati, Lord Abbett Partner, Senior Economist and Market Strategist. In the preceding weeks, contrary to most pundits, Khanna was more sanguine about the chances of the Court upholding the far-reaching healthcare reform passed by Congress and signed by President Obama. Now the question roiling the financial world was whether the initial stock market reaction to the Court's ruling provided a clear signal about who the winners and losers might be.

Not necessarily, said Khanna. That's because many short-term investors were unwinding positions they took based on certain assumptions about whether ACA would survive judicial review, and if so, how much. Once investors have had time to digest the ramifications of the effect of the Court's 192-page ruling on Congress’s 2,500-page prescription for healthcare reform, a clearer fundamental view of potential long-term winners and losers and their earnings power should emerge, said Khanna.

Of course, much depends on whether the political backlash in a presidential election season culminates in ACA being defunded or repealed. If nothing changes, many parts of the healthcare sector should benefit, Khanna predicted. After all, up to 35 million new patients will be entering the market, including 16 million currently below the federal poverty line.¹ "A lot of these people have not gone to a doctor for several years," Khanna noted. "The first thing they're going to do is pick up a phone and make an appointment with a physician. So the first beneficiaries will be laboratories handling a tremendous upsurge in blood tests, imaging, and other diagnostics. Hospitals, in turn, will likely see an increase in volumes, as newly covered patients schedule long-deferred surgeries or procedures. All of which leads to the commercial insurers who will be covering all those expenses and helping states to run insurance exchanges required by ACA, and state Medicaid providers who will have to coordinate expanded coverage of that program. And starting in 2014, increased volumes will also be good for the pharmaceuticals, biotech, and drug distribution sectors, all of which have been paying excise taxes to the federal government to subsidize a massive influx of uninsured patients."

The overarching question, however, is how the precarious balance between public opinion and realpolitik turns the upcoming House, Senate, and presidential elections into a referendum on healthcare reform. "The November election will be the next inflection point," said Ezrati. "The Supreme Court has done nothing to lift the tremendous uncertainty that hangs over this sweeping social legislation. With an estimated price tag of $2 trillion, healthcare reform has implications for the federal debt ceiling, sequestration, and tax policy, since the United States has committed to more entitlements than it can afford. It has implications for employment given the higher costs of providing health insurance to existing employees. But whatever voters decide, the long-term challenge will be modifying the existing law or replacing it with something else in an increasingly polarized political environment."

Supreme Headaches
No matter what happens in the political and legislative arena, there is no question that there is no turning back the clock on the reengineering and, in some cases, reinvention of a hydra-headed healthcare system. Just look at how much the United States, ranked fiftieth in the world in life expectancy (age 78.49), already spends on healthcare: $2.7 trillion in 2011. That works out to $8,402 for every man, woman, and child in the nation (see Chart 1), two and half times more than any other industrialized country, according to data from the Organisation for Economic Co-operation and Development. And some experts believe that growing burden puts American businesses at a competitive disadvantage versus other nations.

Of that $2.7 trillion in national healthcare expenditures, $1.2 trillion was financed by the government through the Medicare and Medicaid programs. With rampant unemployment and record poverty levels, 20% of Americans are currently on Medicaid, the healthcare program for the poor that is jointly financed by state and federal governments; in fiscally troubled California, the percentage is 30%,² which of course only adds to strained budgets.

Many patients are already paying for healthcare reform in the form of increased insurance premiums, higher deductibles and co-pays, and higher costs of innovative diagnostics and treatments (see Table 1), while others have lost coverage completely, as employers curtailed benefits given prohibitive costs. And according to the Congressional Budget Office, private health insurance premiums may rise 5.79% a year, on average, through 2022. Those who don't buy health insurance mandated under one provision will have to pay a tax penalty.³ Providers, who are already being taxed in advance to defray the costs of sweeping reforms, face declining reimbursements. Wealthy taxpayers are likely to pay more as millions of poor and uninsured patients are added to the system. Medical innovators will be hard pressed to recoup their investments.

Large Claims Spiral Upward
While the growth of generic drugs has decreased the cost of pharmaceuticals, new specialty drugs for rare or chronic maladies such as cancer have resulted in treatments with exorbitant pricetags. According to the reinsurance company Munich Re America, the number of large claims (i.e., over $500,000) nearly doubled between 2004 and 2008. (See Chart 2.) More disturbingly, claims between $1–2 million more than doubled.

Fast-forward to 2012, and the costs of treating cancer alone will likely add to that alarming trajectory. The American Cancer Society, for example, estimates there will be 1.64 million new cancer cases this year, while the number of people who die from cancer could reach 577,190.

Such cost trends, in turn, threaten to squeeze insurers, who must spend 80–85% of their revenues on actual healthcare under the current law.

"One-million-dollar claims will soon make up 1% of the total average claim cost," Munich Re predicted in a summer 2009 newsletter, well before Congress passed the ACA. "As large claims become a greater percentage of the average claim cost, this must be reflected in the pricing of the underlying plan of benefits."

The Municipals Perspective
From a municipal bond perspective, the Supreme Court's decision to uphold the individual mandate is a positive because it removes some uncertainty about reimbursements, said Dan Solender, Lord Abbett Partner & Director of Municipal Bonds. Within the municipal bond market, healthcare bonds are typically issued by either hospitals or senior living facilities, with the majority being hospitals. Hospitals typically receive revenues from Medicare, Medicaid, private health insurers, and private payments. They also provide care to the uninsured and do not receive payments for those who do not have the means or willingness to pay. Also, some patients without insurance do not use preventative medical services, so that reduces a source of income as well. The hospitals can't turn away uninsured patients, so that creates losses for them.

"With the individual mandate, a good portion of these nonpayers will have insurance, and so the hospitals can receive some payment," said Solender. "On the other hand, Medicaid reimbursements are going to drop as some forms of payment disappear, so there will be an offset. But hospitals have been preparing for these reduced reimbursements and other changes under ACA by aggressively cutting expenses."

Drilling further into the Supreme Court's ruling, Solender is more concerned about the doctrine that the federal government cannot reduce Medicaid payments to states if they don't comply with the ACA's expanded coverage of Medicaid, the costs of which would be mostly covered by the federal government through 2020, leaving states to pick up a relatively small portion of the cost afterward. "Between the unpredictable responses to the ACA and constant political disagreements in a presidential election year, the Supreme Court ruling on Medicaid creates some uncertainty, particularly in heavily Republican states that are opposed to this form of healthcare reform," said Solender. "Still, it is hard to imagine such states limiting the number of lower-income people covered by Medicaid, especially if such patients could move to surrounding states that did expand Medicaid."

Within the municipal bond market, there has been no reaction to the Court's ruling so far, Solender said. One reason, perhaps, is that many aspects of healthcare reform won't take effect for another year or more, and hospitals have a lot of time to prepare.

More significant is the fact that before the Supreme Court ruling, there was a lot of new issuance in the healthcare sector. "The fact that healthcare facilities have been able to sell a lot of bonds means that the market has been receptive to the credit quality of this sector despite the uncertainties," Solender added. "And now that the individual mandate has been upheld, it should have a positive impact on investors looking at the healthcare sector because hospitals don't have to worry as much about collecting on services that have gone unpaid in the past, for the time being at least."

Nitty-gritty Challenges
Two years ago, as the nation began wrestling with the implications of healthcare reform, Lord Abbett began focusing on such questions as: 1) Will the uninsured buy insurance? 2) Will employers pay a penalty, lose their tax deduction for health benefits costs, and walk away from health insurance? 3) Will all states be able to establish health exchanges by 2014, and accommodate expansion of Medicaid and children’s health insurance programs, while stepping up oversight of health insurance and delivery systems? 4) Will new integrated delivery approaches, under categories such as accountable care organizations, the medical home, value-based purchasing, comparable effectiveness, and bundled payments, work?⁴

Of course, there were no illusions about the daunting complexity of such change. But the philosophy has been to focus on market leaders that we expect will take disproportionate share from competitors over time and also have the dollars left over to innovate and deliver better care, said Khanna.

From a fixed-income perspective, Bill Carpenter, a Research Analyst for Lord Abbett's fixed-income investment team, said most healthcare names will continue to be affected more by industry and company-specific issues than the Supreme Court's decision. When it comes to hospitals, the ongoing focus on cost containment is likely to result in improved productivity and efficiency, he said.

Part of that trend will be driven by new business models, technology, and health-delivery methods, which in turn should drive continued consolidation, both in terms of hospitals acquiring other hospitals and in hospitals acquiring financially squeezed physician practices at attractive prices. Hospitals, in turn, will then be able to market such services to larger audiences at potentially higher margins, now that they will be paid for indigent care services that have long been a drag on their bottom line.

Whether all this will affect the healthcare cost burden of U.S. businesses remains a very debatable topic. While ACA provides a range of incentives to control costs, improve quality, promote comparative effectiveness research, and streamline reimbursement schemes, the competitive landscape will be rife with obstacles.

Competition operates at the wrong level, according to a recent book by Harvard Business School professor Michael E. Porter and Elizabeth Olmstead Teisberg, a professor at the University of Virginia's Darden School of Business. "Competition is both too broad and too narrow," they wrote. "Competition is too broad because much of the competition now takes place at the level of health plans, networks, hospital groups, physician groups, and clinics. It should occur in addressing particular medical conditions. Competition is too narrow because it now takes place at the level of discrete interventions or services. It should take place for addressing medical conditions over the full cycle of care, including monitoring and prevention, diagnosis, treatment, and the ongoing management of the condition."⁵

In a recent interview with Time magazine editor-at-large Fareed Zakaria, Daniel Vasella, the chairman (and former chief executive) of Novartis, stressed that there is no single healthcare delivery model that works best, but he noted that Britain and France have a better track record dealing with lung disease and diabetes, given a systemic approach that provides incentives for early detection and cost-effective treatment. "In America," he said, "no one has incentives to make quality and cost-effective outcomes the goal. There are so many stakeholders, and they each want to protect themselves. Someone needs to ask, 'What are the critical elements to increase quality?' That's what we're going to pay for, nothing else."⁶

No matter how such systemic change works out, part of the cost of the Affordable Care Act will be defrayed by a 3.8% surtax on investment income and 0.9% tax on earned income, effective January 1, 2013. As a result, some investors may want to accelerate investment income into 2012, allocate more funds to tax-free municipal bonds, and considering converting a traditional IRA to a Roth IRA, which would enable tax-free withdrawals.

—Reported by Steve Govoni