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An attractive opportunity in the HMO sector

| July 24, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Investors looking for additional yield in the relatively stable HMO sector should consider the Health Care Service Corporation (HCSERV) credit. HCSERV provides for not only a pick-up in g-spread from Humana (HUM – Baa3/BBB+/BBB) but a jump up in ratings category as its senior unsecured bonds are rated A3/A+/A-. With HCSERV, investors can move into a credit that is both lower levered and has a much stronger RBC ratio.

A swap out of HUM 4.875% 4/1/30 bonds into HCSERV 2.2% 6/1/30 allows for a 3 bp g-spread pick up while taking out over 23 points (Exhibit 1). While HCSERV has long managed its RBC ratio above 600%, it currently resides at just over 500% which compares favorably to HUM’s which has averaged 240% over the past three years, and is trending lower.  Additionally, HCSERV is currently levered at just below 1.5x which compares to 2.1x at HUM.

Exhibit 1: Single – BBB HMO Spread Comparison (7- to 10-year)

Source: Bloomberg/TRACE, Amherst Pierpont Securities

A long history of members first

Founded in 1936, HCSERV is actually the nation’s 5th largest health insurer and the largest customer owned health insurer in the U.S. by membership with over 16 million members.  It is an independent licensee of the Blue Cross Blue Shield Association with core markets of Illinois, Texas, Oklahoma, New Mexico and Montana. Illinois and Texas remain its two largest markets with membership of 8.5 million and 5.7 million, respectively. Combined Illinois and Texas account for roughly 89% of total members.  While competition is strong in all five states that HCSERV operates in, the Blue Cross Blue Shield brand provides a sizable competitive advantage for HCSERV for both network relationships and customer recognition.

HCSERV has noted that its members rely on the company to provide health related financial security as well as protection from rising health care costs.  By maintaining strong membership levels, HCSERV is able spread both risk and medical expenditures across a large enough membership base which helps to keep rising costs at a minimum.  Currently, HCSERV’s administrative costs account for roughly 10% of each health care premium dollar.  HCSERV is looking for ways to further reduce that percentage in an effort to keep the premium increase rate low.

Capitalization/leverage are strengths

HCSERV has long maintained strong capitalization and has financial strength ratings of AA- from S&P, A3 from Moody’s and A from A.M. Best.  S&P noted when HCSERV came to market that the company’s capital levels are “comfortably redundant” at the AAA level.  HCSERV has approximately $39 billion in statutory revenue and $18 billion of statutory capital. HCSERV’s $2 billion, three part bond deal issued at the end of May, is the company’s only senior debt outstanding. The deal was essentially leverage neutral as proceeds were used to repay the $1.75 billion of borrowings from the Federal Home Loan Bank.

Even after the deal its leverage remains low and favorable to peers (at just below 1.5x debt/pre-tax income). This compares favorably to UNH’s leverage of 1.7x, HUM’s of 2.1x and ANTM’s of 2.7x. Additionally, HCSERV’s current debt/ statutory capital ratio is just under 10%, which is considered very low. Once again this compares very favorably to its peers’ debt/total capitalization ratios with UNH at 40.9%, HUM at 39.2% and ANTM at 41.7%.

Outlooks are stable

HCSERV’s ratings all currently have stable outlooks. S&P’s stable outlook reflects its view that HCSERV will be able to navigate the impact of COVID without any deterioration of credit quality.  S&P also noted that the issuance does not affect the company’s AA- financial strength rating.  While S&P notches the ratings of the notes one notch from the financial strength rating, they note that the notching purely reflects the subordination of the debt relative to policyholder claims (in the event of insolvency) and does not represent any weakness in the credit.  Fitch’s stable outlook reflects its view that the balance sheet will continue to remain strong and any challenges to profitability presented by COVID, will not materially impact its strong capitalization.

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