Insolvency and Challenges of Regulating Providers that Bear Risk

Originally published by the Center for Studying Health System Change (HSC). HSC was a nonpartisan policy research organization funded principally by the Robert Wood Johnson Foundation.

Linda R. Brewster, Leslie A. Jackson, Cara S. Lesser

Risk contracting and capitation became widely used financial mechanisms during the 1990s that were intended to give health care providers incentives to control costs. Under these arrangements, health maintenance organizations (HMOs) transferred varying degrees of financial risk for patient care to provider groups or intermediary contracting entities. In several communities, however, these risk-bearing arrangements failed, shaking local markets, disrupting consumers' access to care, and generating losses for physicians and hospitals. The failures also exposed gaps in regulatory oversight, raising questions with direct implications for state and national policy. This Issue Brief examines failed risk-contracting arrangements in two of the 12 communities tracked by the Center for Studying Health System Change -- Northern New Jersey and Orange County, California -- and draws lessons for regulators.

The Regulatory Gap Around Risk-Bearing Entities

Despite years of legislative activity focused on HMOs, relatively little attention had been paid to the policy questions surrounding managed care plans' delegation of financial risk to provider groups. The Balanced Budget Act of 1997 allowed provider-sponsored organizations (PSOs) to obtain independent Medicare risk contracts, bypassing HMOs. But the more common form of risk delegation involved HMOs passing financial responsibility for patient care to contractor groups or intermediaries. These subcontracting arrangements were generally treated as ordinary business relationships, with no special regulatory scrutiny.

Few states had extended their oversight of HMOs to cover risk-bearing provider groups. California was among the first, beginning in 1996 to require licensure for organizations entering into global risk contracts with HMOs that involved financial responsibility for hospital, physician, and other medical services. Yet three years later, California experienced major disruptions in its health care system stemming from exactly these types of arrangements -- exposing the limitations of the regulations that had been put in place.

The range of risk arrangements varied widely. At one end, physicians were at risk only for the services they personally delivered. At the other, provider groups accepted global financial responsibility for all professional and hospital services -- effectively assuming insurance-like risk without the expertise, infrastructure, or capital reserves that insurance regulation was designed to ensure.

Case Study: New Jersey

In 1998, New Jersey regulators confronted the collapse of HIP Health Plan of New Jersey, the state's fourth-largest HMO, after a disastrous outsourcing arrangement with PHP Healthcare Corporation, a Virginia-based provider management company. HIP's executives had hoped PHP would rescue the struggling HMO by taking over its entire health care delivery operations. Instead, PHP proved unable to manage medical costs within the contracted payment amount. Combined with other financial difficulties, PHP's failure led to its bankruptcy and, in turn, HIP's insolvency.

The fallout left 190,000 people scrambling for new coverage and more than $120 million in unpaid claims owed to hospitals and physicians. New Jersey had no statutory authority to review the subcontracting arrangement between HIP and PHP or to oversee PHP's operations, yet the state was left responsible for ensuring continuity of care for displaced enrollees.

Case Study: California

California's experience involved the failure of two national physician practice management companies (PPMCs) -- FPA Medical Management and MedPartners -- that held global risk arrangements with multiple health plans. Despite California's licensure requirements for global-risk entities, regulators could not prevent these failures. The complexity of the funds flow through both companies' out-of-state corporate structures severely limited the state's ability to oversee the global risk portion of their business. After the collapses, regulators also confronted solvency concerns about other provider groups with more limited risk arrangements that fell outside the state's existing regulatory framework.

State Policy Responses

Public outcry in both states generated strong support for regulatory reform. The policy debates focused on three areas: strengthening oversight of HMOs themselves, monitoring entities that accept risk from HMOs, and establishing contingency plans for when risk-bearing organizations fail.

New Jersey moved quickly after the HIP collapse to create more stringent reserve and deposit requirements for HMOs, based on standards being developed by the National Association of Insurance Commissioners. The state also increased the frequency of HMOs' financial reporting and proposed legislation requiring HMOs to notify the insurance commissioner of major operational changes. California took a different approach, creating a new regulatory agency to monitor the managed care industry with a dedicated "managed care czar" and a financial solvency standards board.

The two states also diverged on how to monitor risk-bearing subcontractors. New Jersey proposed direct state oversight of provider organizations and intermediaries that contracted for services beyond what they could deliver themselves, with authority to assess their financial capacity and impose reserve requirements. California opted for an indirect model, relying on health plans to monitor their risk-bearing subcontractors, with the state overseeing the plans. New legislation expanded the scope to include all provider groups accepting risk and paying claims, and created a financial solvency standards board to standardize monitoring requirements.

Both states grappled with who should bear financial responsibility when risk-bearing entities failed. New Jersey considered an HMO guaranty fund financed by taxing HMO premiums, but the industry successfully argued that solvent companies should not pay for competitors' failures. In California, providers and plans battled over responsibility for unpaid claims after the PPMCs collapsed. Plans argued they should not pay twice for contracted services; providers sought legal remedies to collect what they were owed. Efforts to create a guaranty fund in California also failed, reflecting policy makers' reluctance to establish costly protections that might merely cushion the effects of financial mismanagement.

Broader Implications for Regulators

The New Jersey and California experiences demonstrated the complex regulatory challenges posed by provider risk contracting. When HMOs delegated significant levels of financial risk to provider groups, states' traditional obligation to protect consumers under insurance arrangements was complicated. Despite the lack of formal oversight over these subcontracting relationships, states were still held responsible for cleaning up after failures -- ensuring consumers could access care, resolving disputes over unpaid claims, and proposing new regulations to prevent recurrence.

The problems were not confined to markets with high managed care penetration. Northern New Jersey had only 24 percent HMO enrollment when HIP collapsed, undermining the argument that risk-contracting failures were relevant only in heavily managed markets. The cases suggested that states needed to adapt their regulatory structures to account for risk-bearing arrangements that had evolved well beyond the traditional HMO model, even as the practical challenges of doing so -- across state lines, through complex corporate structures, and without clear precedents -- remained formidable.

Each regulatory approach carried trade-offs. Direct state oversight offered clearer accountability but risked overburdening regulators and creating barriers to entry. Indirect oversight through health plans leveraged plans' existing relationships with providers but raised questions about whether plans would effectively police their own subcontractors. Both models required resources, expertise, and ongoing attention that most state regulatory agencies were not yet equipped to provide.

Sources and Further Reading

HSC Community Tracking Study site visits to Northern New Jersey and Orange County, California.

Related HSC publications: "How Physician Organizations Are Responding to Managed Care," Issue Brief No. 20, May 1999; "Market in Turmoil as Physician Organizations Stumble," Community Report No. 10, Spring 1999; "At the Brink," Issue Brief No. 33, December 2000.