Wall Street Comes to Washington:

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.

Analysts' Perspectives on the Changing Health Care System

Issue Brief No. 21, September 1999

Market forces and recent policy changes were shaking the health care industry to its foundations, according to Wall Street analysts who track health care companies. At the fourth annual Wall Street roundtable convened by the Center for Studying Health System Change, these analysts weighed in on improving health plan profitability, providers' ongoing struggles for market power, consolidation patterns, and the heavy hand of federal legislation across every corner of the industry. This Issue Brief presents the analysts' views on these forces and how they expected them to play out going forward.

The roundtable, sponsored by HSC, took place June 9, 1999, in Washington, D.C. The panelists were Karen M. Boezi (Coral Ventures), Norman M. Fidel (Alliance Capital Management, LP), Geoffrey E. Harris (Warburg Dillon & Read), and Patricia F. Widner (Deerfield Management). Paul B. Ginsburg and Joy M. Grossman of HSC served as moderators.

Rising Premiums and the Underwriting Cycle

After years of thin premium increases and declining margins that started to turn in 1998, managed care was staging a financial recovery. The analysts reported that health plan premiums rose an average of 6 to 7 percent in 1999 and were outrunning cost growth. They expected this pattern to hold through 2001 or 2002 as the industry worked to normalize profitability after a stretch of artificially low pricing when plans were chasing market share.

This was the insurance underwriting cycle at work -- the key to understanding swings in health plan costs, pricing, and profitability. Plans had recently entered the cycle's upward phase. Harris predicted the whole cycle would repeat itself in 2002, with the industry achieving substantial profitability, new entrants returning to the market, and competitive pricing driving the next downward phase.

HSC research conducted after the roundtable, slated for publication that fall, suggested that 1999 premium increases had not yet climbed high enough to surpass cost increases.

For the moment, health plans held strong cards in negotiations with purchasers. The most striking example was the California Public Employees Retirement System's agreement to average rate increases of 9.7 percent for the year 2000 -- the largest jump since the early 1990s. Smaller purchasers with less bargaining power than CalPERS likely faced even bigger increases. The tight labor market was another factor, with employers competing fiercely for workers and absorbing higher premium increases to keep benefit packages attractive, Boezi observed.

Rising premiums were beginning to reshape product design. Purchasers and consumers had pushed for more open access and fewer constraints on choice, driving enrollment toward costlier point-of-service and PPO products. With premiums moving upward, the central question became whether consumers' appetite for freedom would hold up against rising costs. Harris predicted closed-panel products would see a resurgence by 2001 or 2002. He also anticipated a major shift from defined benefit to defined contribution approaches in how employers structured health benefits.

Medical Cost Drivers, Led by Pharmaceuticals

Underlying medical costs were climbing 5 to 7 percent annually -- roughly 1 to 1.5 percentage points higher than 18 months earlier, according to Fidel. But because costs lagged behind premium increases, profitability was improving. Technology and population aging alone drove about 4 percent in annual cost increases regardless of other factors, Harris noted.

The standout cost driver was pharmaceuticals. Fidel identified drug spending as the single biggest contributor to medical cost growth, accounting for nearly half of the trend factor. Drugs had climbed from 12-15 percent to 15-20 percent of a plan's total costs. He forecast continued double-digit increases. Other cost components were better contained: hospital costs rising 0-3 percent, physician costs 2-3 percent, and outpatient costs 5-6 percent.

Providers Lag Behind Plans

Health plans were doing better financially, but providers were not seeing proportional gains. Payment rates to providers were rising only 2 percent versus 7 percent commercial premium growth. Physician organizations that had pursued risk-based contracts were stepping back from capitation. Efforts by large PPMCs to roll out full-scale capitation nationally were described as a big failure. Most physician practices lacked both the infrastructure to manage risk and the patient volume to spread it adequately. Harris concluded there was no future or at best a substantially diminished future for global capitation among physician groups.

Merger Activity and Vertical Integration

The analysts offered mixed assessments of consolidation. Local and regional mergers were seen as more beneficial than cross-market deals. Hospital mergers drew more skepticism than plan mergers. Vertical integration strategies had largely failed. Harris summed up Wall Street's view: any time you hear vertical integration, get out. Capital flows to the health care industry were also slowing.

Prospects for Better Care Management

As risk shifted back from providers to health plans, plans might be better positioned for active care management. Wall Street was currently more focused on plan fundamentals than care management capabilities. Most case management still happened at the individual patient level, though disease management programs targeting conditions like asthma and diabetes had proven effective at reducing hospital and ER admissions.

The Balanced Budget Act Hits Harder Than Expected

The BBA was having a far more dramatic effect than anticipated. Many hospitals had closed skilled nursing units and exited home health care. Roughly 2,500 home care agencies had shut down in 18 months. Nursing homes were cutting services, with rehabilitation therapy use dropping over 50 percent. About 100 HMOs had scaled back or ended Medicare+Choice participation, affecting 450,000 beneficiaries. Fidel believed the worst was still coming and warned the BBA could destroy the Medicare risk contracting program unless changes were made.

What Lay Ahead

As premiums continued climbing, cost would re-emerge as the dominant concern. Harris projected premiums increasing 10 percent annually. Boezi predicted this would produce a tiered health care system with a minimum defined-benefit floor, where consumers who could afford it would buy up to richer coverage.

Understanding the Insurance Underwriting Cycle

Health insurance premium trends and underlying cost trends track each other over long periods. Over shorter intervals, the differences can be substantial, following a cyclical pattern. Because premiums are set up to 18 months before the services plans will pay for, the cycle begins when actual costs diverge from actuarial predictions. A pronounced cycle began in the early 1990s when cost trends fell sharply. The resulting profitability attracted capital, insurers competed aggressively, and premium increases fell below cost trends. As profitability eroded, capital left the industry and plans withdrew from market segments.

Sources and Further Reading

AHRQ — Federal health care quality research agency.

CMS — Quality Initiatives — Federal quality programs.

Health Affairs — Peer-reviewed health policy research.

Robert Wood Johnson Foundation — Health policy research.

Commonwealth Fund — Research on health care quality.