Patients, Profits and Health System Change:

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.

Patients, Profits and Health System Change: A Wall Street Perspective

Issue Brief No. 09 | May 1997

In the spring of 1997, the Center for Studying Health System Change convened a group of prominent Wall Street securities analysts who specialize in tracking health care companies. This was the second such gathering -- the first had taken place two years earlier -- and the analysts reconvened to assess how the industry had shifted since their initial meeting. Over the course of the discussion, the panelists addressed four broad topics: the trajectory of managed care, the changing dynamics between health plans and providers, consolidation across the industry, and public policy developments.

The Trajectory of Managed Care

According to Wall Street analysts, the big publicly traded health maintenance organizations (HMOs) were seeing the strongest membership growth among all types of health plans. Roughly a dozen such companies were posting annual enrollment growth of 15 to 25 percent. They were steadily gaining market share at the expense of Blue Cross-Blue Shield plans, which had shed approximately 15 percent of their membership over the preceding 15 years, as well as other not-for-profit entities.

Several factors were driving the rapid expansion of these large, established, for-profit HMOs. They had strong access to capital markets and maintained solid balance sheets with substantial cash reserves. Their stock was highly valued, which gave them the ability to use equity as currency for acquisitions. They also possessed advanced marketing and operational capabilities, and they were developing new products that responded to what consumers wanted while still keeping costs in check.

Yet despite the impressive growth of this small group of companies, much of the broader HMO industry was struggling financially. The analysts noted that 40 percent of the nation's HMOs lost money in 1995. One analyst put the share of profitable HMOs in 1996 at just 35 percent -- a steep drop from 90 percent in 1993 and 1994. This trend carried significant implications for health care premiums going forward.

Premium levels remained the dominant force shaping health insurance markets, and many purchasers showed willingness to change health plans over relatively small price differences. While the actual cost of delivering health care services per enrollee had been increasing at roughly 4 percent per year, premium increases during the prior two to three years had remained in the 0 to 2 percent range. As one analyst put it, when an industry is losing money, prices typically have to go back up. Premium hikes of 4 to 5 percent were projected for 1997.

Employers would have limited ability to push back against these across-the-board increases. In preceding years, plans had responded to employer demands for lower premiums because they wanted to capture or grow their market share. But with profitability declining across the industry, plans were drawing firm lines on pricing. The key difference in 1997, one analyst explained, was that plans were now prepared to walk away from business rather than chase market share at the expense of their profit margins.

At the same time, employers would keep pursuing reductions in their health insurance outlays through a variety of strategies: steering employees into managed care plans, narrowing the number of health care companies they contract with to concentrate their purchasing power, and passing a growing portion of health care costs along to their workers.

Managed care had developed a negative public image, fueled partly by provider interest groups. Many people believed that managed care companies were withholding necessary treatment to save money or that they cherry-picked only young and healthy enrollees. The analysts said these perceptions were not backed by evidence. One analyst compared HMOs to teenagers -- awkward and large but not yet knowing how to coordinate themselves, bruising people along the way. Still, overall retention levels were high: once people enrolled, they generally stayed.

Consumer demands for wider provider networks and easier access to specialists were shaping what the analysts called the next battlefield for market share. Customer service and quality were becoming competitive differentiators. Companies at the leading edge were building and marketing new products that often commanded premium prices while still attracting large enrollment growth.

Health Plans and Providers: Shifting Roles

The relationship between health plans and providers had been shaped primarily by the industry's drive to control costs. In the early stages, plans used blunt instruments -- mainly leveraging their aggregated purchasing power to negotiate discounts from providers. They then turned to shifting care delivery from inpatient to outpatient settings. At the same time, they pursued strategies aimed at reducing overall demand for services.

By 1997, the analysts believed the industry had reached a stage where meaningful cost savings would come from actually managing care more effectively. As managed care companies invested more heavily in sophisticated information systems, disease management programs, outcomes studies, and detailed cost-effectiveness analyses, the goal was better resource allocation. This shift had major implications for how risk was shared between plans and providers, how care was managed on a day-to-day basis, and how ownership and contractual arrangements between plans and providers were structured.

When it came to risk acceptance, the willingness of various providers and health plans to enter risk-sharing arrangements varied by entity, product, and market. Some providers were eager to take on risk, believing they could profit under capitated arrangements. As one analyst put it, providers looked to HMOs as a pot of gold at the end of the rainbow. They believed they had the ability to control costs and wanted to be rewarded for doing so.

Some plans aggressively pushed risk onto their providers, while others chose to retain risk management themselves, keeping the profits from savings and controlling cash flow. These plans also wanted to protect their own role in the system. As one analyst stressed, HMOs are not just middlemen or brokers -- they are insurance companies that shoulder real risk.

A plan that assumed a capitated provider arrangement freed it from managing costs could face serious trouble if the provider failed to manage the risk properly, the analysts warned. In some cases, plans had been forced to bail out capitated providers with additional payments. Plans maintained a codependent relationship with their providers and had a vested interest in ensuring those providers stayed financially viable.

Managing risk required providers to be able to manage care. While risk could be successfully extended to large, well-resourced provider groups that could handle managed care functions, providers in most markets were not yet equipped for these responsibilities. The success of providers at managing care depended largely on how much of the care continuum they themselves provided and managed. Having a solid working relationship with physicians was particularly critical for hospitals. As one analyst commented, a hospital accepting global capitation without salaried physicians was opening a can of worms it could not possibly control.

Regardless of how the relationships evolved, physicians, hospitals, and health plans all needed to figure out how to share information. Each had its own information systems designed to support clinical management and other functions, and their needs differed. There had to be a common highway, one analyst said, and outside vendors were expected to build the connections between systems.

Providers and plans were also exploring new ownership and contractual arrangements as they tried to determine how best to position themselves. Intricate contractual relationships were seen as the wave of the future, with the largest and most desirable plans, hospitals, and physicians aligning more closely through these arrangements in some markets. However, the analysts agreed that the delivery system would remain largely separated from the payment system in terms of ownership. Combining provider and payer functions in a single organization created conflicting incentives that proved difficult to resolve internally. Large payers such as Prudential, Aetna, and Cigna had been largely unsuccessful at owning and managing delivery systems, and the analysts expected even Kaiser to divest itself of facilities in certain markets.

Consolidation and Its Consequences

Scavenger hunting was how one analyst described the ongoing wave of consolidation among health plans. The most recent round of health plan consolidations involved strong companies acquiring weaker ones. Nearly every company that had agreed to be acquired in the prior 12 months had stumbled badly. Examples included Cigna's acquisition of Healthsource, PacifiCare's purchase of FHP International, and Foundation Health's sale to Health Systems International. The analysts expected this pattern to continue, producing some surprising combinations along the way.

Despite the rapid pace of these transactions, there remained considerable room for further industry consolidation and plan growth. Even the largest companies still represented a relatively small percentage of their markets. One analyst predicted that Americans would ultimately be served by 40 to 50 large national or regional plans. Smaller players could survive if they maintained critical mass in their markets and possessed comprehensive service capabilities.

Meanwhile, many of the larger health care companies -- both plans and providers -- were working to develop branded identities and build public awareness around them. Several were already creating brand images in their markets, including Oxford Health Plans and Columbia/HCA.

In the hospital sector, despite considerable merger activity, there had been little actual reduction of excess bed capacity. Political and financial factors both played a role. In most communities, people strongly opposed closing their local hospitals. Hospital directors, administrators, and physicians were often prominent community figures, and elderly people in particular, wielding considerable political power, did not want to travel far for their health care.

On the financial side, hospitals were enjoying high levels of profitability that shielded them from competitive pressures. One analyst noted that when looking at cash flow margins excluding depreciation, hospitals were actually far more profitable than HMOs in many cases. The hospital industry had also responded shrewdly to demands for lower costs -- for instance, by redirecting inpatient capacity to control outpatient service delivery. More than 80 percent of outpatient surgeries in the United States were performed in hospitals. This combination of political and economic strength meant that hospitals were unlikely to act aggressively to reduce excess bed capacity anytime soon.

Public Policy

The managed care backlash had led to the passage of several state and federal length-of-stay laws governing childbirth and mastectomy, but the analysts said these laws would have little effect on overall costs. Other proposals that posed more serious risks to the market's ability to control costs had not yet been enacted. The analysts expected that purchasers would oppose such laws vigorously out of concern about costs.

Managed care plans were taking a wait-and-see approach to proposed changes in Medicare capitation rates. If Medicare did cut rates, plans would face several choices: raising premiums, reducing benefits, or abandoning Medicare for more profitable business. Since Medigap insurance premiums were climbing, HMOs would remain a relatively attractive option for beneficiaries choosing between an HMO and traditional Medicare supplemented with Medigap coverage.

At the time, managed care plans had a relatively small stake in Medicare -- only 12 percent of Medicare recipients were enrolled in HMOs. One analyst suggested that policy makers might be wise to wait until HMOs were more deeply invested in Medicare before attempting to reduce their reimbursement, noting that Medicare was not yet a powerful enough purchaser of managed care services to dictate prices. If rate cuts did come, the analysts believed beneficiaries would bear the impact through higher premiums, reduced benefits, or fewer choices.

Publicly traded managed care companies had been serving the Medicaid market in some states, but significant cuts by several Medicaid programs had reduced profitability, with at least one company facing major financial losses. A number of companies had abandoned the Medicaid market altogether in response to what they viewed as policy instability.

In closing, the analysts concluded that the health care industry had evolved rapidly over the two years since their first convening. The direction of change, while slightly different in some respects than predicted two years earlier, had not altered in a fundamental way. But the cumulative effect of two years of change had clearly altered the system. They noted, however, that significant variations existed in the changes taking place across regional and local markets, and that these variations would continue.

Panelists

Geoffrey E. Harris -- Smith Barney; Margo L. Vignola -- Merrill Lynch; Roberta L. Walter -- Goldman Sachs, Inc.; Patricia F. Widner -- Warburg, Pincus Counsellors, Inc.

Moderators: Paul B. Ginsburg and Joy M. Grossman, Center for Studying Health System Change.

This Issue Brief is based on a roundtable sponsored by the Center for Studying Health System Change, which took place in Washington, D.C., on March 21, 1997.

Sources and Further Reading

Center for Studying Health System Change, Issue Brief No. 09, May 1997.