Even as the S&P 500 Index sits at a multi-year valuation peak (see chart), some sectors aren’t faring as well.

Any investor who watches the news could guess that financial companies are among the laggards. Many bank shares, for instance, are still stymied by bad loans.

But a subset of the financial world is being held back by another factor entirely.

I’m referring to health insurers. And it’s clear that Uncle Sam is to blame for their troubles.

Government action is usually a boon to companies. Washington’s stimulus efforts, for example, have helped scores of firms. Most experts say the spending has added between two and three percentage points to U.S. economic growth in the second and thbid quarters.

But the debate about health care, and the looming possibility of a government-run “public option” plan, is holding back health insurers’ share prices.

Investors have a laundry list of fears about the current health-care proposal:

The short-term worry is companies will drop their existing coverage to participate in the government-run option, which may prove cheaper. Losing policyholders and their premiums en masse would hurt insurers and significantly alter the ability to generate earnings.

Long-term, investors are worried that the government will drive any surviving health insurers out of business. Wall Street doesn’t buy the notion that the government will negotiate payment rates with medical providers in good faith. Medicare, the largest purchaser of health care in the United States, doesn’t negotiate. It sets prices that providers must accept.

This threatens insurance companies because they have to pick up the slack. Medicare generates a net loss for health-care providers that they can only make up by charging higher rates to private insurers. As government buys more health care at lower and lower costs, insurers will be forced to pay more and more. Wall Street is worried this cycle will feed on itself until the last private insurer goes belly up.

Investors also bear the fear of legislative unknowns. Congress is coming back from its recess and will be back to work in earnest next week, with health-care reform at the top of its to-do list. Wall Street fears the unknown, and heaven can only guess what Congress has cooked up while on vacation.

These concerns about government action are amplified by the nation’s unemployment rate. The more people without jobs — which is nearly 10% of the work force — the fewer participants in the nation’s health care plans. That means less premium dollars.

But rising unemployment has another consequence: More health-insurance claims. Workers afraid of losing their jobs begin to use their employee benefits more aggressively. If you begin to think you’re going to lose your job — and, say, your dental plan — then the first thing you’d do is make sure everyone in the family is up-to-date on their checkups. So insurance companies have fewer people paying premiums but more people filing claims.

That’s one of the reasons earnings were off -36.9% from 2007 through the end of 2008.

Debate Drags Down Values
As I noted earlier, the S&P 500 Index, the market’s broadest benchmark, is trading at a peak, not in terms of index value but relative to earnings. The index is at 18.4 times earnings, slightly ahead of its typical valuation of around 16.5. That underscores Wall Street’s deeply held faith — and perhaps overconfidence — in these companies’ ability to deliver continued earnings growth.

Wall Street has no such confidence in the health insurers, and traders have devastated the sector’s six largest companies. The best performing of the six, Cigna, trades at a -21.7% discount to its typical valuation (See table). The hardest hit, Humana, sells at a -62.1% discount.

 
This data illustrates the fear Wall Street has of a potential shift in the nation’s health-care policy and of its effects on these companies. The average health-insurance company, which should be valued in line with the overall S&P, can now be bought at a -52.7% discount to the benchmark average. Almost all of this can be attributed to the uncertainty of the health-care debate.

Cigna, Wellpoint and Coventry have all mounted impressive rallies this year. Cigna is up +75.5%; Coventry shares have gained +47.8%. Yet Humana and Aetna still trade at a wide discount to their norm, and Wellpoint and UnitedHealth — which cover 100 million Americans between them — are also grossly undervalued.

Betting on the Demise of the Health-Care Plan
Removing the legislative threat appears to be the catalyst that would right-size valuations at health-insurance companies. Conventional wisdom is that the plan is in real trouble, though the Democratic Party still has a big enough majority to win along a party-line vote.

Investing in health insurers is casting a vote with your dollars that the public-option plan put forth by Obama will fail. Investors who are willing to shoulder this political risk could see a healthy gain should the plan be defeated.