Market in Turmoil as Physician Organizations Stumble:

In December 1998, researchers visited Orange County, California, to examine the community's health system, its recent changes and how they were affecting consumers. More than 40 health care market leaders participated in interviews as part of the Community Tracking Study by the Center for Studying Health System Change (HSC) and The Lewin Group. Orange County was one of 12 communities HSC tracked biennially through site visits and surveys. The first visit in January 1997 provided the baseline. The Orange County market included approximately 30 cities situated directly south of Los Angeles County.

Cost Pressures Trigger Dramatic Upheaval

Orange County's health care market had been rocked by dramatic disruption over the prior two years as cost pressures mounted. Area health plans had long delegated financial risk and medical management to physician organizations, giving rise to large intermediaries that played a central role in the delivery system. In 1996, physician organizations, hospitals and several plans were all pursuing large-scale mergers to build negotiating leverage and achieve economies of scale. Between 1996 and 1998, premiums stayed relatively flat even as the cost of medical care rose. Because capitation was so prevalent, physician organizations absorbed the brunt of those cost increases.

Key changes since 1996 included:

• Two national physician practice management companies (PPMCs) filed for bankruptcy, and other physician organizations posted losses or downsized.
• Kaiser Permanente gained market share but experienced its first financial loss in its 50-year history in 1997.
• Hospitals continued a gradual consolidation process, gaining some market leverage.
• Medicaid managed care proceeded smoothly, but safety net providers continued to struggle.

A Market Shaped by Managed Care and Capitation

Situated between Los Angeles and San Diego, Orange County's health care market was shaped by its position within the broader Southern California landscape, where statewide purchasing pools and large regional employers influenced plan and provider strategies. At the same time, the region's geographic scope made it a distinct local market defined by a strong economy, a politically conservative environment and a rapidly growing, ethnically diverse population with wide economic disparities.

Managed care was deeply embedded in the local system. In 1996, 46 percent of publicly and privately insured residents were enrolled in HMOs, compared with 32 percent for all U.S. metropolitan areas, with most of the remainder in PPOs. What truly set Orange County apart was the prevalence of capitation. Health plans delegated substantial financial risk to physician organizations, typically paying capitation for primary and specialty care as well as some ancillary services. Physician organizations also shared risk for hospital utilization and bore responsibility for care management. This created tightly managed gatekeeping systems with clearly defined subnetworks, meaning consumers' access to care was largely directed by their primary care physician and the associated provider network.

By 1996, significant consolidation had occurred across all three market sectors. Four major health plan mergers produced substantial concentration; Tenet Healthcare's 11 local hospitals controlled more than 29 percent of the market's beds; and large physician intermediary organizations were forming and expanding.

Physician Organizations Squeezed by Rising Costs

While the market's organizations grappled with integration, medical costs began climbing. Between 1996 and 1998, premiums remained flat or rose only marginally due to competitive pricing across the region. Physician capitation rates held steady as well, meaning that rising costs fell disproportionately on physician organizations, which were financially at risk for delivering care under prepaid arrangements. Locked into long-term capitated contracts that failed to account for cost inflation, many organizations had to draw on reserves or owner investments to meet their obligations.

Several factors drove costs upward. Federal and state policy changes introduced mandated benefits, requirements for physician-level encounter data for Medicare risk products and new quality and satisfaction reporting obligations. Looser HMO products like point-of-service plans gained popularity, but the out-of-network utilization patterns they encouraged drove up costs while reducing capitated payments to in-network physicians. Pharmaceutical and medical technology costs surged nationally, and where new contracts delegated pharmacy risk to physician organizations, those organizations had to absorb the increases.

Integration Proves Costlier and Slower Than Expected

As costs rose and revenues plateaued, physician organizations struggled to achieve the anticipated benefits of consolidation. Integration efforts proved more difficult, time-consuming and expensive than expected. PPMCs and other buyers bid up practice acquisition prices during competitive expansion. The cost of melding diverse practice styles and translating care management techniques across different settings was greater than anticipated. Organizations needed to renegotiate plan contracts, rationalize physician payment arrangements and build common information systems, adding costly and often redundant administrative layers.

Some organizations achieved modest gains -- MedPartners and St. Joseph's Health System reportedly negotiated better plan rates than individual physicians could have obtained, and MedPartners had begun consolidating physical space. But broadly, physician organizations failed to deliver quick returns on investment or advance the sophisticated clinical information systems they had promised.

PPMCs Collapse, Sending Shockwaves Through the Market

As cost pressures overwhelmed integration benefits, physician organizations faced severe financial distress. The 600-member Monarch IPA reported a 15 percent drop in commercial revenue between 1997 and 1998. Bristol Park Medical Group laid off staff and closed four clinics. But the most significant disruptions were the failures of the two major PPMCs.

San Diego-based FPA Medical Management had grown rapidly under Wall Street pressure, acquiring 600 physician members in Orange County in March 1998 through a large medical group purchase. Weeks later, FPA was in crisis -- burdened with acquisition debt, suffering disappointing earnings and plagued by accounting and management problems. It filed for bankruptcy in July 1998 and sold all California practices by year's end. MedPartners faltered after a failed merger with PhyCor in January 1998 and announced its exit from physician practice management nationwide by November. The state Department of Corporations intervened in March 1999 to seize control of MedPartners' risk-bearing subsidiary to ensure plan payments were used to pay local providers rather than bail out the corporate parent.

The fallout raised fundamental questions about accountability under capitated arrangements. An estimated $60 million in unpaid claims from FPA and $73 million from MedPartners left providers seeking answers about who was responsible. The California Medical Association petitioned to force plans to cover FPA's debts, but the issue remained unresolved. Health plans and purchasers moved quickly to establish alternative physician arrangements and protect consumer access to regular providers. The state, however, warned that actions to protect plan and consumer interests could further destabilize struggling physician organizations.

The longer-term implications were substantial. New regulations were proposed to increase scrutiny of risk-bearing provider organizations, and legislation was introduced to limit plans' ability to delegate pharmacy risk to physicians. Health plans tightened their oversight of physician organizations but appeared reluctant to abandon capitation altogether, instead focusing on improving delegated risk contracting. Physicians faced potential financial liability, difficult decisions about whether to stay with reorganizing groups or go solo, and a general climate of unease about declining income and organizational instability.

Kaiser's Rapid Growth Produces Financial Losses

Kaiser Foundation Health Plan, the local market share leader, posted losses of $270 million in 1997 and $288 million in 1998 on its national business, driven largely by California operations. As a group-model HMO, Kaiser had shielded its physicians from the cost increases that other plans passed through to independent physician organizations. But Kaiser had also pursued aggressive market share growth by holding premiums 5 to 20 percent below competitors, boosting its Orange County enrollment to nearly 300,000 members -- a 30 percent increase since 1996. This enrollment surge overwhelmed its physician capacity and hospitals, forcing expensive overflow placements at outside facilities.

To reverse losses, Kaiser abandoned its price-suppression strategy and sought double-digit premium increases for 1999. It expanded hospital capacity statewide and postponed opening two physician clinics in Orange County to reduce costs. Kaiser remained committed to its tightly integrated exclusive group model.

Hospitals Gain Strength Through Consolidation

Against the backdrop of physician market turbulence, hospitals gained ground. St. Joseph's Health System pursued physician integration through practice acquisitions and pushed for increased exclusivity, enabling "single-signature contracts" with plans that encompassed all hospital and affiliated physician services. This reportedly yielded better rates from multiple health plans. Tenet took a different approach, supporting physicians financially and administratively without seeking ownership. It merged contracting functions across its 11 Orange County hospitals, which helped some facilities obtain new plan contracts but did not bring expected payment rate increases.

Despite administrative integration gains, clinical integration remained limited at both systems. As Wall Street exited the physician practice management business, hospitals were increasingly positioned as potential sources of capital for physician organizations. St. Joseph's, for example, acquired FPA's large physician group for a fraction of what FPA had originally paid.

Medicaid Managed Care Proceeds, Safety Net Strained

Orange County's Medicaid managed care implementation had proceeded without major disruption, but safety net providers remained under financial pressure. Community health centers reported declining Medicaid revenue under capitation while facing growing demand for uncompensated care. The county's public medical center was exploring affiliation options to shore up its finances. Indigent care continued to be funded through a combination of state and county resources, but these proved insufficient for a community where significant poverty coexisted with overall affluence.

Issues to Track

Orange County's health care market was in turmoil. The collapse of major PPMCs had disrupted physician-plan-hospital relationships and raised urgent questions about accountability in delegated risk arrangements. Hospitals had gained relative strength through consolidation, while Kaiser adjusted its growth strategy after painful losses. Regulatory attention was intensifying, with new proposals to oversee risk-bearing entities and limit risk delegation. Looking ahead, the key questions included how physician organizations would evolve after the PPMC failures, whether plans would fundamentally restructure their approach to delegated risk, how hospitals would balance their growing leverage against the demonstrated risks of physician practice ownership, and whether struggling safety net providers could remain viable in a market where capitation pressures showed no signs of easing.

Sources and Further Reading

• Community Tracking Study Household, Physician and Employer Surveys, 1996-1997, Center for Studying Health System Change.
• U.S. Census Bureau, Population Estimates, 1997.
• Fountain, D.L., Grossman, J.M., Taylor, R.S., Gournis, E. and Williams, C., "Market in Turmoil as Physician Organizations Stumble: Orange County, California," Community Report No. 10, Spring 1999, Center for Studying Health System Change.