Do You Have Any Idea How Close the Affordable Care Act Came to Being Toast?

I expected Supreme Court Justice Anthony Kennedy to vote to toss the individual mandate. I had no doubt the other three conservative justices would want the whole of the Affordable Care Act thrown out.

I also expected the four liberal justices to support both the individual mandate as well as the entire law.

About everyone expected Roberts and Kennedy to vote alike.

If Roberts had gone with Kennedy, that would have been a majority of votes (5-4) to void all 2,900 pages of the Affordable Health Care Act. Not just kill the mandate, but the whole thing. Apparently, just killing the mandate was never an option for this Court--something most of us believed was the most likely outcome!

But Roberts had an opinion of his own. In his mind, like the other conservative justices, the mandate was inconsistent with the Commerce Clause of the Constitution. But, unlike the other conservatives, Roberts believed failure to comply with it triggers a tax. Which it is what it looks like to any regular person outside the Beltway for that matter.

So the law stands.

Four justices to kill it, four justices to keep it, and one justice who saw things dramatically differently than all the rest.

To all my liberal and progressive friends: No more complaining about Citizens United and the "politicized" Supreme Court. Did you notice that the justice your guy did not vote to confirm also sided with liberals to invalidate much of the Arizona immigration law on Monday?

To my conservative friends: Pay the tax or buy insurance and stop your whining. To the extent this is a mandate, it's a pretty tepid one.

This was a hard decision for John Roberts. I like people who think all of this is hard. We need more people who see more than black and white and understand just how hard to solve health care reform--or any of the other of the big problems facing our country--is.

This was an agonizing decision for John Roberts and I think of him as a better person for it.

Except next time, could the Court just skip all the summer falderal making us try to guess which day they were going to grace us with their decision and just tell us which day to be paying close attention?

Will it Be the Bond Market That Finally Forces Serious Health Care Financing Change?

When will the Congress and the White House finally make the hard decisions in order come to grips with the federal deficit problem?

When will we finally deal with real health care reform and get the entitlements, and with them the private health care cost issue, under control?

My focus on trying to answer those questions has always centered on what's going on in the health insurance market: When will costs simply become untenable and therefore force real change?

Watching "Meet the Press" on November 14th, it occurred to me I may have been missing the catalyst for real health care change.

Here is an exchange between moderator David Gregory and former Fed Chair Alan Greenspan:

MR. GREGORY: But don't we have to have an adult conversation with people about what the real [deficit] problem is?

DR. GREENSPAN: Look, I think something equivalent to what Erskine Bowles and Alan Simpson put out [Deficit Commission Chairs' report] is going to be passed by the Congress. The only question is, is it before or after a bond market crisis?

MR. GREGORY: Right.

DR. GREENSPAN: Because there's no alternative. Look, I...

MR. GREGORY: But you got to explain a little bit more what that means. You're talking about debt.

DR. GREENSPAN: Well, here, here's the issue. Right now we have very low bond prices, the markets are functioning in a reasonably good way. The big, serious problem is whether or not the outlook for the longer term deficit spooks the bond market to a point where long-term interest rates and mortgage rates move up very sharply. If that happens, that will cause the double dip. And I'm just basically hoping that we have enough sense to realize that we've got to resolve this issue before it gets forced upon us

"The only question is, is it [our finally dealing with the debt and entitlement problems] before or after a bond market crisis?"

The single biggest driver in our national debt problem is the cost of our health care entitlements.

It may in fact not be the health care system itself and its unaffordable costs that finally force real action for health care cost containment––it may be the global bond market and its lack of confidence in America's ability to finally deal with our debt, and its health care driver, that will cause a crisis that forces health care action.

But would such a crisis force meaningful and rational health care reform or just draconian fee schedule cuts across the board that puts the health care sector––particularly the providers––in a crisis of their own?

Managed Care: Because I'm A Scorpion, And It's In My Nature - An Editorial On Health Reform

Carl McDonald is a Managing Director at Oppenheimer & Company. He is one of the most followed health insurance industry analysts who can regularly make stock prices rise and fall with his comments. Today, he and colleague James Naklicki offer an "editorial" on the current health care proposals pending in Congress. I will suggest that their analysis of the impact of potential "reform" on consumers, the states, and the health insurance industry are well worth your time.

Managed Care: Because I'M A Scorpian, And It's My Nature - An Editorial on Health Care Reform
by Carl McDonald and James Naklicki

The current health reform legislation has a lot of objectives, but two key goals are to provide coverage to all Americans and to control the growth in health care cost trends. The legislation currently pending in Congress would achieve partial success in covering more people, but we think it will fail miserably in slowing health care costs. Because there's so little in the bill that actually deals with cost, we wouldn't be surprised if reform actually caused health care trends to accelerate more than if we'd done nothing. And so while health reform is laudable for its efforts to cover more people, it just isn't a very good outcome for the country.

Key Points

In this piece, we look at where the health reform discussion will turn to in the final few months of debate, with the focus likely on the consumer groups that stand to lose the most, and the issues the legislation will have working in the current health care market.

Seniors in the Medicare Advantage program will face higher premiums and lose valued benefits, while younger people (a key Obama demographic in the last election) will have to pay significantly more for their health care, since they will now be subsidizing the older sicker members of the population.

The relatively modest subsidies to help people buy insurance and the very minor penalties for not having insurance, coupled with a significant illegal immigrant population, mean that the uninsured population will still number 10-20 million even after this legislation, raising the question of whether we should be spending almost $1 trillion on reform.

The taxes levied on health insurers will ultimately be passed onto employers and consumers, raising premium rates by over 1% each year, meaning that the middle class will be funding at least a portion of the coverage expansion.

In addition, states will be covering a large chunk of the Medicaid expansion. Because states have to balance their budgets each year, this will likely result in higher state income, sales, and property taxes, which will have a disproportionate impact on the middle class.

The Scorpion and the Frog

One day, a scorpion looked around at the mountain where he lived and decided that he wanted a change. So he set out on a journey through the forests and hills. He climbed over rocks and under vines and kept going until he reached a river.

The river was wide and swift, and the scorpion stopped to reconsider the situation. He couldn't see any way across. So he ran upriver and then checked downriver, all the while thinking that he might have to turn back.

Suddenly, he saw a frog sitting in the rushes by the bank of the stream on the other side of the river. He decided to ask the frog for help getting across the stream.

"Hellooo Mr. Frog!" called the scorpion across the water, "Would you be so kind as to give me a ride on your back across the river?"

"Well now, Mr. Scorpion! How do I know that if I try to help you, you won't try to kill me?" asked the frog hesitantly.

"Because," the scorpion replied, "If I try to kill you, then I would die too, for you see I cannot swim!"

Now this seemed to make sense to the frog. But he asked. "What about when I get close to the bank? You could still try to kill me and get back to the shore!"

"This is true," agreed the scorpion, "But then I wouldn't be able to get to the other side of the river!"

"Alright then...how do I know you won't just wait till we get to the other side and THEN kill me?" said the frog.

"Ahh...," crooned the scorpion, "Because you see, once you've taken me to the other side of this river, I will be so grateful for your help, that it would hardly be fair to reward you with death, now would it?!"

So the frog agreed to take the scorpion across the river. He swam over to the bank and settled himself near the mud to pick up his passenger. The scorpion crawled onto the frog's back, his sharp claws prickling into the frog's soft hide, and the frog slid into the river. The muddy water swirled around them, but the frog stayed near the surface so the scorpion would not drown. He kicked strongly through the first half of the stream, his flippers paddling wildly against the current.

Halfway across the river, the frog suddenly felt a sharp sting in his back and, out of the corner of his eye, saw the scorpion remove his stinger from the frog's back. A deadening numbness began to creep into his limbs.

"You fool!" croaked the frog, "Now we shall both die! Why on earth did you do that?"

The scorpion shrugged, and did a little jig on the drowning frog's back.

"I could not help myself. It is my nature."

Then they both sank into the muddy waters of the swiftly flowing river.

The parallels between this story and health reform are so good it requires no further explanation.

Investment Thesis

Health reform has a lot of objectives, but two key goals are to provide coverage to all Americans and to control the growth in health care costs. The legislation currently pending in Congress would achieve partial success in increasing insurance coverage in the country, but it will fail miserably in slowing health care costs. In fact, because there's so little in the bill that deals with health care costs, we think there's a greater probability that reform will actually have the opposite effect, and cause health care costs to rise faster than would have been the case without the legislation. So while health reform is laudable for its efforts to cover more Americans, it just isn't a very good outcome for the country.

Let's get my biases out of the way. I follow health insurance stocks for a living, so naturally I'd prefer that the health insurers continue on in their current form. But since all of the provisions that would have put the industry out of business (like a government run health care plan with significant competitive advantages over existing insurers) seem dead and buried, a seismic shift in how the industry does business over the next few years doesn't seem to be in the cards, even if the group's current valuation multiple says differently. So with the group sticking around for the foreseeable future, my job as an analyst is to objectively predict what future stock prices will do, and I can be just as right with a call that reform will change little and that the group's multiple will return to 10x as I can with a view that the legislation will seriously inhibit the ability of health plans to ever earn a margin again. In other words, as long as the group is still around, I don't have a particular bias on whether it does well or not.

But this piece is about the bigger picture, not stock prices, and my friends in politics tell me that negative advertising always gets more attention, so with that in mind, in the list below I've run through some of the issues I have with the legislation, and the consumer groups that stand to lose the most from it. Some of these topics have been discussed extensively in the press over the past month, while others are the stories I suspect will be receiving a lot more attention in the weeks to come. It's not an exhaustive list, to be sure, but it does provide an overview of what the major challenges will be for the health reform legislation in its final few months of debate. The figures cited below are largely derived from the latest Baucus legislation in the Senate Finance Committee, since this bill has the highest likelihood of serving as the framework for the final legislation.

The legislation will put an enormous amount of pressure on the federal budget, because it does almost nothing to control medical cost trends. The current legislation kicks the cost question down the road, and it will ultimately mean that either significant tax increases or painful benefit reductions will be necessary to cover the cost of what will be the country's third significant underfunded entitlement program. When health reform legislation was first being discussed during last year's election, I thought that if it happened, everyone in the health care system would have to share the pain. Consumers wouldn't get as much and would have to pay more, while all the health care industry groups would have to give up their pound of flesh.

As I sit here today, that is not at all the case. Consumers are being told that not only will they receive better and more efficient care, it will also be less expensive. And all of the industry are giving up a little bit, but what the pharma, med device, and health insurance industries are losing is more of a flesh wound than a pound of flesh. Because of all the unnecessary care that is delivered in the country, it is theoretically possible to improve the quality of care without significant benefit reductions or major cuts. But there isn't much in this health reform bill that really goes after that problem, so it just doesn't seem logical that everyone can get more (or least keep the same) and that no one pays the price without the federal deficit ballooning.

To pay for health reform, Congress is proposing a somewhat equal split between Medicare payment reductions and increased taxes. We'll get into some of the taxes below, but let's be clear on the Medicare payment reductions. Reducing what a hospital or doctor is reimbursed by Medicare does not save any money. Numerous studies and examples show that two things generally happen when Medicare rates are reduced. The first is that providers shift additional costs onto paying commercial customers. This is one of the major reasons why commercial medical cost trends always rise at a significantly faster pace than Medicare trends. Second, providers tend to utilize more. In other words, it seems like providers have a revenue target in mind, and they tend to be fairly agnostic as to whether that goal is achieved through unit cost or through utilization. So cutting Medicare rates does reduce federal government expenditures, but from an overall cost perspective, nothing changes. Health care costs simply get moved from the federal bucket onto employers.

It will be years before we have to deal with the cost question, but that doesn't make it any less important. With most of the reform initiatives not implemented until 2013, it will take at least a year or two to see what the true cost of the new entitlement program is. Whatever the year of atonement turns out to be, it will ultimately mean either that the subsidies to purchase insurance will shrink, the benefits provided reduced, or taxes increased.

The tax on plans with rich benefits will ensnare an increasing number of people each year, because the threshold is set to rise at the rate of inflation, while health care costs grow significant faster than inflation. One of the major revenue generators of the health reform bill is a 40% excise tax on health insurance plans with rich benefits that exceed $8,000 a year for singles and $21,000 for family coverage in 2013. Note that the threshold includes health insurance coverage as well as dental, vision, and other supplementary health insurance coverage.

This provision isn't a big deal today, since $8,000 a year works out to $667 per month, and most people don't have policies that cost anywhere near that much. The key to understanding this excise tax is that the threshold only grows at the rate of inflation plus 1%, and health care costs grow at a significantly faster pace. So it won't be long before many people in the country have plans worth more than $8,000 a year and become subject to the excise tax.

There are some policies out there today that will exceed the $8,000 threshold. These tend to be union health plans, or for employees of city and state governments, or policies for those who work in high risk professions. The latter group appears to be spared some relief along with retired individuals over age 55, since the threshold amount for these two groups will be increased by $1,850 for individuals and $5,000 for family coverage under the latest version of the legislation, but it still isn't clear to us that union leadership will be willing to go along with this provision, since the costs of the excise tax will be passed onto their members.

The taxes on insurance companies will be passed directly onto consumers and employees, resulting in higher premiums that will impact the middle class. The excise tax noted above will technically be assessed to the health insurers, but much like the premium taxes that some states currently charge, the excise tax will be passed onto employers on a dollar for dollar basis. This will result in higher premiums, and in response, employers will likely either slim down the benefit design, or pass on more costs to employees in the form of higher copays and deductibles.

There is a separate assessment of $6.7 billion on the health insurance industry that will also be passed onto consumers in the form of higher premiums. The industry generates around $500 billion in premiums on an annual basis, by our estimate, so a nearly $7 billion annual tax would increase premium rates by about 1% a year, by our calculation. If the tax applies only to commercial insurance (and excludes Medicare and Medicaid), then the impact on premium rates will be even more significant.

If the $6.7 billion tax is implemented in 2010, it will create capital issues for a number of smaller plans in the industry, pushing market share to the larger plans in the industry. As noted above, while this tax will ultimately be passed onto employers and consumers, there is a nuance in the timing. Since this reform bill won't pass until very late in 2009 (if it does at all), most 2010 plans will have already been re-priced by the time companies know whether the tax will be in effect next year. As a result, most plans would be unable to pass the tax onto employers next year, and have to absorb the hit themselves. It would be a pretty meaningful impact, considering that industry profitability is probably about $15 billion or so on an annual basis. Moreover, the tax is not deductible.

Plans like United or WellPoint clearly have no interest in paying the tax, and will do what they can to avoid it, mainly by arguing that it should be pushed until at least 2011. However, in the worst case, United and WellPoint certainly have the capacity and the capital to pay the tax. The same cannot be said across the entire group, as there continue to be a number of smaller non-profit plans with thin operating margins and capital levels that are just above regulatory requirements.

Take Blue Cross Blue Shield of Rhode Island. The company seems pretty well capitalized at the end of 2008, with a risk based capital level of almost 745%, well above the Blue Cross industry average of 700%. However, on a dollar basis, the excess capital held by the Blue amounts to only about $205 million relative to the minimum capital allowed by the Blue Cross Blue Shield Association. In 2008, the Blue generated about $1.76 billion in premiums, or about 0.35% of the total estimated revenue for the industry. That implies that the Blue in Rhode Island would be responsible for paying about $23.5 million of the $6.7 billion tax. With this legislation, over 10% of the excess capital of the Rhode Island Blue would be wiped away.

And that's for a plan that's extremely well capitalized relative to the rest of the industry. Coventry just bought a plan in Kansas this week called Preferred Health Systems. If we look at the larger of the two subsidiaries that was bought, called Preferred Plus of Kansas, it had a risk based capital ratio of 320% at the end of 2008, as it held about $11.6 million of excess capital at the end of the year above the minimum 200% RBC ratio requirement. With $285 million in revenue, Preferred would be responsible for 0.06% of the $6.7 billion tax, or almost $4 million. So the legislation would eliminate about a third of the excess capital of the plan, and reduce its RBC ratio to 280%.

So while paying the tax in 2010 probably wouldn't put many smaller plans out of business, it would create some capital issues that would have to be rectified through higher premium rates in the ensuing years in order to build the capital base back up, which would likely result in further market share gains by the larger plans in the market, resulting in less competition, a direct contradiction to one of the goals of the legislation.

The penalty for not having insurance coverage is too low, and it will result in many people choosing to just pay the fine rather than purchasing insurance coverage. The individual penalty is $750, which is too low, but it will also be phased in over many years. In 2013, for example, there is no fine for not having insurance. By 2014, the penalty is $200, and it rises to $400 in 2015, $600 in 2016, and $750 by 2017. So there really won't be an individual mandate in 2013, but plans will still be required to issue a policy to anyone that wants one, and charge premiums based on community rating, rather than individual underwriting. This is a recipe for adverse selection, which will raise premium costs across the entire health care system. In 2014, when the penalty is $200, the decision to not buy health insurance will be pretty easy for most, since consumers will be faced with paying the $200 penalty once, or paying over $200 every single month to buy insurance. Individuals will be exempt from the excise tax if the premium of the lowest cost option available exceeds 8% of their adjusted gross income.

This decision will be particularly easy for the younger, healthier segment of the population with few health care costs. They will see little value in buying an expensive health care plan, and many will gladly pay the penalty. However, for community rating to work with any reasonable degree of success, young and healthy people are necessary to subsidize the cost of coverage for the older and sicker. Otherwise, you end up with a situation that New York currently suffers through, as the cost of a real individual policy in the state can exceed $1,000 per month because of the guaranteed issue, community rating requirements without an individual mandate.

Along these lines, because of community rating, young people in the population (a demographic that was a major supporter of Obama in the last election) will be forced to pay significantly higher premiums for health care coverage, because they will now have to subsidize the costs of older, sicker workers in the population. Aetna has been particularly vocal on this topic, which is likely because it is one of the newer entrants to the individual market, and likely has one of the youngest and healthiest books of individual business in the market. Senator Jon Kyl, a Republican from Arizona, noted in a Senate Finance hearing that a family of four, including two 35-year-old parents and two children, currently could buy a CIGNA PPO plan in Phoenix for $512 per month. Under the reform plan being pushed by Senator Baucus, Senator Kyl claimed that the price of the policy would nearly double to almost $1,000 a month. While the premium figures may not be exactly correct, directionally, the comment makes a very important point.

The subsidies provided to enable people to purchase insurance through the exchange are not large enough, and will result in a number of people being forced to buy insurance that they can't afford, or pay a penalty. Individuals with modified gross incomes up to 300% of the federal poverty level would be eligible for what the legislation calls a premium credit. The subsidy available will be determined on a sliding scale based on income. For someone with an income at 100% of poverty, premium costs would be capped at 2% of income, while someone at 300% of poverty would have premium costs capped at 12% of income. Those with income between 300-400% would also have premium costs capped at 12%.

The federal poverty level for a family of 4 today is $22,050, so at 400% of poverty, that works out to $88,200. Using the 12% of income threshold works out to nearly $10,600. That's not to say a family of four would need to buy a policy that expensive, but they wouldn't receive any federal assistance or exemption from the penalty, unless their insurance costs exceeded that amount. The point here is that this family of four in our example that is today uninsured will receive almost no assistance from the government in paying for their health care coverage, and it seems unlikely that most families in this situation will have the resources to come up with the $6,000 ($500 per month) it would take in most states to purchase a reasonable family policy.

The result of the small penalty for not having insurance and the relatively small subsidies means that tens of millions of people will remain uninsured following this legislation, so it isn't wise to believe that the uninsured problem will disappear with this bill. Keep in mind that of the 45 million uninsured today, something in the neighborhood of 10 million people are illegal immigrants who will receive no coverage under this legislation. Add to that the millions of people who will choose to go without insurance and pay the penalty, or simply won't be able to afford the cost of the premium, and the uninsured issue will remain a major problem. We suspect this will be a major focus of the Congressional Budget Office (CBO) as they review the changes made by the Senate Finance Committee during the mark-up process, and it will raise the question of whether we should be spending something around a trillion dollars on a health reform bill that could still leave 15-20 million people uninsured.

States will incur significant new costs covering the expanded Medicaid population, forcing them to raise taxes, which will impact the middle class. One of the reasons the Senate Finance bill is less expensive than some of the prior versions is because the SFC chose to push more of the costs of Medicaid expansion onto the states. The legislation would establish 133% of the federal poverty level as the new mandatory minimum Medicaid eligibility level, beginning on January 1, 2014, which would increase the Medicaid population by around 10 million by most estimates. Beginning in 2014, additional assistance would be provided to states to cover the cost of all newly eligible beneficiaries, with states that currently offer no coverage for the newly eligible population receiving more assistance than states that already have programs in place. Between 2014 and 2018, that additional assistance would be adjusted so that by 2019 all states would receive the same level of additional assistance. Additional payments would be made to "high need states" that would cover the full cost of the new eligible population for five years between 2014 and 2018.

For states that are already struggling to pay for their Medicaid programs today, the idea that they will be responsible for covering a huge influx of new members seems impossible. In addition, states are concerned that people currently eligible for Medicaid but not enrolled in the program will come forth in greater numbers. The state of Tennessee has estimated the bill would add about $1 billion in extra Medicaid costs for the first five years after expansion, while California has estimated the expansion could cost around $8 billion each year.

Because states are required to balance their budgets, these additional Medicaid costs will result in major funding cuts to other areas, or more likely tax increases that will cause income tax, sales tax, and property taxes to rise. On this point alone, it's hard to argue that the middle class will be spared from paying for a big portion of the health expansion.

Seniors, particularly those enrolled in the Medicare Advantage program, will see premiums increase and benefit reductions because of the funding cuts proposed in the legislation. While it has been a favorite saying of the Administration to note that seniors will not see benefits reduced because of the proposed Medicare cuts, even the Congressional Budget Office concedes that Medicare Advantage premiums will rise and benefits will be reduced as a result of the funding cuts proposed in the legislation. While it's certainly reasonable to question whether it is fair that seniors enrolled in the Medicare Advantage program receive extra benefits, the fact of the matter is that those benefits will be reduced or eliminated over the next five years if the health reform legislation passes.

With all the focus on providing health insurance coverage to beneficiaries, no one seems to have focused on whether we have the infrastructure and provider access to actually provide care to all these newly insured members. Massachusetts appears to have had some issues with provider access after passing their health reform legislation, as an Urban Institute report earlier this year found that one in five adults reported being told in the past 12 months that a physician or clinic was not accepting new patients or would not see patients with their type of insurance. Lower income residents had greater difficulty finding a physician, according to the study, as 24% of residents enrolled in state-subsidized health plans were told a doctor didn't accept their insurance, compared with 7% of residents with private coverage. So while the legislation may be successful in adding 10 million people to the Medicaid rolls, reducing the uninsured rate through health insurance exchanges, it isn't clear that physicians have the capacity and willingness to serve all the newly insured members, particularly if they are being paid at Medicaid reimbursement rates.

All in, if the health reform legislation currently pending is enacted, it seems the goal of expanding health care access will achieve limited success while making health insurance more expensive for many.

Market Capitalism and Health Care--It Will Never Be the Same

Washington Post business page columnist Steven Pearlstein's Friday column, "Toward a New International Capitalism," caught my eye.

Here's a snippet:

"From the Latin American debt crisis of the 1980s to the Asian financial crisis of the 1990s to the Internet craze at the turn of the century to today's economic conflagration, the past 20 years have provided ample evidence that uncontrolled flows of private capital have created massive booms and busts that have overwhelmed the financial system and destabilized the global economy. The booms have misallocated capital, widened the gulf between rich and poor, and eroded the norms of behavior that had contributed to social and political harmony. The busts have brought financial hardship and ruin to innocent businesses and households and saddled governments with huge debts that will take generations to pay off."

Wherever you stand on the longstanding debate over the free market versus government regulation, I will suggest that the recent confluence of catastrophic financial events have pushed the pendulum hard over from the market side to the pro-government regulation side of the debate.

With a new Democratic White House and big Democratic Congressional majorities, all driven by the most recent burst bubble and the resulting financial meltdown, the notion that the market is the place to fix and manage our dysfunctional health care system is clearly out of vogue.

For the last eight years, the health care debate has been dominated by market ideas to deliver better quality and sustainable costs--private Medicare Advantage plans, Part D drug benefits for seniors, a reinvigorated health savings account (HSA) market, and proposals like those offered by President Bush and Senator McCain to restructure our private health insurance system from the traditional employer chassis to one of individual responsibility.

My sense is that the recent election outcome is more than a change in the political cycle. It was also a public verdict on their level of trust in capitalism. Market arguments as a solution for the health care challenges will not be able to avoid the public's overall loss of confidence in the relatively unfettered market.

Does that mean we are all about to become socialists in the European tradition? Does it mean the American people will have lost confidence in American business generally? No. I expect we will always have confidence in the ability of most business--particularly small business people--to build real value. But it does mean that it will be a long time before we put an almost blind confidence in the notion that the market by itself will always go up--the stock market, the housing market, the Internet driven "New Economy."

Read another part of Pearlstein's column but this time think of publicly traded health care industry managers instead of financial executives when you do:

"But there is also no denying that American-style capitalism has been undermined by its own success. In its present incarnation, it rewards manipulation over innovation and speculation over genuine value creation, resulting in massive misallocations of capital and the accumulation of unheard-of wealth in the hands of money managers and top corporate executives who are more lucky than they are skilled."

When the Clinton Health Plan failed in 1994 the consensus was that the health insurance market would have have a wide open shot at proving itself since no one would dare put a government health care plan back on the table in the wake of that failure--for at least 10 years.

Let me be clear that I have always believed in the market. But I also believe the past 15 years have amounted to an enormous squandered lost opportunity for the market to prove its value to our health care system.

Fifteen years later, the market has not brought health care costs under control because too much of the entrepreneurial energy in the health care market was used to simply manipulate the massive cash flow provided by a sector of our economy that made up 16% of our GDP. There was no reason to manage health care costs and quality to a better outcome if soaring costs just meant more cash flow to manipulate. Faced with longer-term business objectives--like a sustainable business model based on creating real value--or making shorter-term earnings objectives and stock options, the choice was easy.

Fifteen years later, the health care marketplace has little or nothing to point to in its defense in the face of Democratic control of our government and our capitalist system in a shambles.

At the wild west Wall Street alter everyone has been worshiping at, I suppose there was no alternative.

Will for-profit health care become extinct and replaced by a government-run health care system? As bad as things are, I doubt it. We aren't anywhere near the point where Americans are about to trade their general fear of big government for that.

But the days of the private market saving Medicare and Medicaid, or a reinvigorated private health insurance market, as part of our future? Just a few weeks after John McCain was preaching the virtues of the market as a solution for our health care problems all of that sounds pretty passé now.

For-profit health care players--particularly health insurers--will continue to have a big place in our system. We really have no alternative--that's what the system is built upon.

But trusted to save it? Trusted to operate less regulated? Looked upon as the means to improve cost and quality? An attractive growth stock in the face of the regulation that is coming?

In Pearlstein's words, here is how I will suggest health care capitalism will be seen for many years to come:

"...it rewards manipulation over innovation and speculation over genuine value creation, resulting in massive misallocations of capital and the accumulation of unheard-of wealth in the hands of money managers and top corporate executives who are more lucky than they are skilled."

And it will be so treated.

The Long-Term Viability of Medicare Advantage--Why Aren't the Analysts Asking for the Numbers to Add-Up?

I have been struck by the optimism regarding private Medicare presented by health plan executives during the recent earnings season and the analysts failure to press them on just how their numbers will add-up to sustain the long-term viability of a private Medicare strategy.

The typical private Medicare health plan operates on a medical cost ratio in the mid-80s. Let's assume 86% for medical costs and the remaining 14% for overhead, profit, and taxes.

Government-run Medicare operates on about 3% overhead. One can argue that many federal Medicare costs are paid for elsewhere but that is the number the private plans have to compete against.

So private Medicare plans spend 14% on overhead and Medicare charges itself 3%--that's an 11% disadvantage for the private market right out of the box.

Private plans have to offer better benefits in order for seniors to want to buy the private plans. Let's use 6% as the amount health plans spend for the extra benefits needed to attract seniors to their plans.

So, in this example, the disadvantage for private Medicare is not only the 11% overhead shortfall but another 6% for the benefits needed to keep selling the plans to seniors--or a total burden of about 17%.

Today, the government pays private Medicare plans an average of 13% more than it does the government-run plan--17% more for the private fee-for-service (PFFS) version that will sunset in 2011.

These extra payments are what make private Medicare so attractive to seniors and HMOs today.

Let's say our HMO has half of its private Medicare growth in PFFS. Their average payment above what standard Medicare gets would be about 15%. So this hypothetical HMO gets 115% of what Medicare pays itself for the same senior population. Take the 11% overhead disadvantage from that as well as the extra 6% they spend on attracting seniors with better benefits and the HMO would have a medical care cost of 98% of what Medicare spends (115%-11%-6%=98%) in order to balance the books today.

So, today my hypothetical HMO is managing its medical costs at about 98% of what Medicare spends for the same senior population.

But what happens if the extra Medicare payments to private Medicare go away? It is almost certain that is going to happen--presuming the Democrats increase their majorities in the fall.

Private Medicare will always need to offer seniors something extra to get and keep their business--that extra 6% our hypothetical HMO spends today. Why would seniors buy it if there wasn't an incentive to do so?

The whole private Medicare experiment is about the notion that the market can manage Medicare costs better than government-run Medicare. If the private market cannot get a better long-term cost outcome the whole strategy simply is not viable.

The day private Medicare gets the same payments as public Medicare the private sector is going to have to make up for that higher overhead level (11%) and better benefits (6%) by managing to a lower medical cost outcome than government-run Medicare.

Instead of private Medicare operating at 98% of the medical cost level of public Medicare, as our hypothetical HMO does today, my HMO will need to have medical costs at 83% of public Medicare in order to sustain a medical cost ratio 11 points higher than Medicare and 6% in better benefits (100%-11%-6%=83%).

For any private Medicare strategy to be viable post-excess payments to the private plans, the private plans have to beat Medicare's costs. In my example, which I will suggest is a pretty fair approximation of the market reality, no health plan can sustain its private Medicare business plan unless it can ultimately get its medical costs to about 83% of the government-run Medicare plan. And, that would just be a tie with the public program's costs. To prove the private market is better than government-run Medicare the result would have to be even better than that.

Most private plans are in the 95% to 100% range today. And, some of the markets they are in have much better payments than the average extra government payment of 13% and 17%.

During this past earnings season about every health plan manager has boasted that Medicare is in their future and they can achieve their earnings objectives while competing head-to-head with the public program.

But for that to happen, the typical HMO needs to reduce its Medicare benefits ratio from 95% - 100% today to about 83% to just match the performance of the government-run plan.

Not a single investment analyst challenged HMO managers on any conference call I heard on just how they are going to get from here to there before the Democrats zap the extra payments private Medicare plans now get.

It would seem to me that would be at the crux of whether their private Medicare strategy had any long-term viability.

The End of Medicare Private Fee-For-Service--the Questions to Ask the Health Plans During Earnings Season

"Wall Street Comes to Washington"

The event I look forward to every year is "Wall Street Comes to Washington," Paul Ginsburg's (Center for Studying Health System Change) annual merging of Wall Street and policymakers in a lively discussion of health care from both perspectives.

The last few years I have gotten to participate on the health insurance market panel. The session also had a panel concentrating on hospital, physician, and pharmaceutical trends.

Other panelists include leading health care analysts from Morgan Stanley, Goldman Sachs, Lehman Brothers, and Dreyfus. It's sort of an east meets west discussion of the health care system. The prognosis for earnings, bringing costs under control, the latest fads in health care, and prospects for reform are all discussed.

You can see both a transcript and video of the meeting on the Kaiser Family Foundation site.

Coventry Health--Another Reminder That This Isn't an Easy Business

Here are some comments from a first quarter earnings call Coventry management would sure like to take back.

Yesterday, Coventry reported that its Medicare private fee-for-service business will miss its second quarter medical cost ratio projections by more than 300 basis points and that it will miss its prior second quarter estimates for its commercial medial cost ratio by a whopping 200 basis points.

Today, Aetna and Humana reaffirmed their prior earnings guidance leading people to conclude the sheer size of the Coventry earnings problem is largely internal.

What really troubles me about the Coventry announcement is that:

• Their private fee-for-service (PFFS) problem should have been obvious to to their actuaries since Coventry had apparently not issued ID cards to new PFFS customers and claims weren't coming in as they should have been. The PFFS data had to be too good to be true and that should have been obvious.
• Their explanation for seeing their commercial trend jump by 200 bps is inadequate. They said they are seeing an increase in large claims and hospital claims generally. That is true of other health plans but not to anywhere near the same degree as Coventry. It is not clear to me that Coventry has really gotten to the bottom of all of this.

CEO Remarks from the transcript of Coventry Health's first quarter conference call on April 25, 2008:

We've said for the last three years that the core operating growth rate in a purely commercial business was not as high as some were suggesting. We took some flak for that. But more recently, the reality of that seems to have become more evident. But that is away different from an underwriting cycle. Underwriting cycles are also not caused by variations in medical cost trends. Variations in medical cost trends generally do not happen quickly and given the progress in analytics within the industry, will be pretty closely anticipated in pricing. That doesn't suggest we will never make a mistake and miss it a little, but that's far from an underwriting cycle.

Underwriting cycles are caused solely by lack of pricing discipline, either consciously, which I actually think is less common, or unconsciously, through lack of financial control. This isn't a new topic either. We've been, for many years, answering the question of whether there's an underwriting cycle. We've cited a consolidation in the industry, growth of for-profit blues, improved analytics and so on and on and on. Those reasons are as valid and real today as they have been for the last five years. It makes no economic sense to chase market share at the expense of pricing discipline.

I'm reasonably confident that that's understood across the industry, but I'm absolutely certain that it's understood at Coventry. So don't look for the operating margins of our commercial operations to fall off the table. They won't. If we have to shrink a little, which we don't think we will do, but we will, we will not sacrifice margin at the expense of market share, and that is the only thing that causes an underwriting cycle.

From the CFO on the same call:

At the risk of sounding like a broken record, I want to reiterate our views on commercial trend in pricing as well. We continue to see no evidence of an overall acceleration of cost trend in 2008 versus 2007. Our outlook remains that trend will be stable in 2008 versus 2007, in the neighborhood of 7.5%. Over a long period of time, we have exhibited an attention to detail and an unwavering discipline in the pricing arena, and to no surprise, this will not be changing. We remain firmly committed to having our commercial price increases at least equal to medical cost trends. The competitive environment is, as always, a very competitive arena. Growth is not easy to come by, but despite isolated local market skirmishes, it is still a rational environment where those that have a low-cost structure, those that are disciplined, those that are close to the details and fundamentals of the business, will succeed over the long haul.

Less than two months later Coventry is reporting 9% commercial trend.

I guess the moral of the story is that you never want to get cocky in this business.

Coventry Health Care--What the Heck Is Going On?

When WellPoint, Humana, United, and others had earnings warnings this spring I pointed out their issues were largely unrelated and amounted to more rounding errors as the helpful five year deceleration in health care trend came to an end and the business just wasn't as easy.

But today, Coventry hit us with a 300 - 340 basis point adjustment in their expected Medicare Advantage medical loss ratio for the second quarter. They pointed to a problem with private fee-for-service (PFFS) claims coming in from prior periods. Because PFFS does not rely on provider networks the claim patterns look a lot more like old time fee-for-service--and this block is acting like it.

The hit to PFFS has to be a lot bigger than 300 bps because that is the impact on their whole MedicareAdvantage block--of which their PFFS is only one part.

They also said their commercial MLR popped in the second quarter. They are estimating a second quarter MLR about 200 bps higher than its overall first half MLR.

This puts a lot of doubt into the sector and one has to expect health plan stocks are going to get hammered tomorrow morning on Wall Street.

The other health plans are going to have to reaffirm their prior earnings guidance real soon or they will pay a big price in the stock market--especially those who have made a big play in PFFS Medicare.

Either Coventry has lost control of their financials or the sector is seeing something big--neither being a good development.

Generally, I have not seen anything in the health plan market recently that would lead me to believe something major is going on that would affect everyone in the sector. However, PFFS by its very nature is a business you drive by looking out the rear view mirror. I think it is important for the other big PFFS players to clarify their outlook.

Hate to see what Coventry's numbers would look like if the Dems do cut private fee-for-service. If Coventry can't make money at 117% of what Medicare gets for the same seniors how will they make money?

This is scary.

Prior post: What Good Has Private Medicare Done for Shareholders?

Joe Paduda's great post phone conference take on Thursday morning.

HMO Executive Earnings Are the Subject of Criticism--37 Execs Paid $277 Million in 2007

I have had two different emails today on the subject of health plan executive compensation.

The first cited a link to an article in the Baltimore Sun that reports the $17.65 million severance settlement with the former CEO of CareFirst (Maryland Blue Cross) is under scrutiny by the State of Maryland.

The second was a reference to an Industry Radar post that compares HMO executive compensation from the six biggest publicly traded health plans to what the federal government pays our leaders. They have also juxtaposed a long list of disputes these health plans are currently engaged in with customers, investors, and other providers in the column to the right of their salary chart.

Taken together, these six health plans paid 37 executives three times what the top 562 leaders in the federal government (executive, judicial, and legislative) received.

I am not sure whether I should be angry or jealous.

Wall Street Continues to Be Disappointed in Managed Care--Just Where Did They Think It Was Headed in the First Place?

United Health's earnings and revenue grew by 7% this quarter year over year and the stock fell by almost 10% yesterday.

I'd hate to see them really screw up.

United is the first to admit that they have some service and persistency issues but the fundamentals of their business continue on track.

Wellpoint followed with another disappointing report today.

Wall Street finally seems to be figuring out that the health insurance business is, and has been for years, on a long walk off a short pier. What's sustainable about a business whose costs have continually exploded at 2-3 times the growth rate of the rest of the economy or the wage rate? Just where did Wall Street think this business was headed all those years the sector has been the darling of Wall Street?

Perhaps most telling was the recent comment by one analyst in the Wall Street Journal, "What we're seeing is a market that's gotten so mature and beyond its customer that people can literally no longer afford to buy the product," said Sheryl Skolnick, an analyst with CRT Capital Group. "The number of uninsured is growing faster than any player in the game, and it's getting bigger at the expense of the Uniteds, the WellPoints."

Ya, and it was five years ago.

Allow me to let you in on another gem Ms. Skolnick--and the other health care analysts out there: Pet Stark is getting ready to slash those fat private Medicare payments and either a Democratic president or one of the only Republican Senators to vote against the whole thing in the first place isn't going to veto it the next time around (that would be any nano second past noon on January 20, 2009). And, that's after the growth in these private Medicare products has already started to level off.

We are way past the time the really smart people on Wall Street (that would be all of you) needed to start asking just what the future of this business is. If the answer you get is that the future of managed care is just to ride an unsustainable health care cost trend rate many more years into the future you might just want to dig a little deeper this time.

Related posts:
Health Plan Stock Prices Hard Hit Recently--Then There is John McCain

Today's HMO Carnage on Wall Street

Nonprofit Hospitals Hardly Unprofitable––A Bad Time to Find Out Hospitals Are Making Big Money

Senator Charles Grassley (R-IA) has for years been complaining that non-profit hospitals have lost their way--that the tax benefits they get, originally intended to help pay for their charity care, simply aren't going to charity care anymore.

Last Friday, the Wall Street Journal ran a front page story on the enormous profits many of the nonprofit hospitals are recording. The article made a number of points:

• The combined net income of the 50 largest nonprofit hospitals increased nearly eight times to $4.27 billion between 2001 and 2006.
• At least 25 nonprofit hospitals each now earn more than $250 million a year in profits.
• Nonprofit hospitals are more often profitable than for-profit hospitals--77% of the 2,033 nonprofits are profitable while 61% of for-profits made money last year.
• Nonprofit hospitals received $12.6 billion in annual tax exemptions on top of another $32 billion in federal, state, and local subsidies the entire industry receives.
• "One reason for hospitals soaring profits is the gradual increase in Medicare reimbursements" in recent years.
• Hospital profits have also increased because of consolidation and increases negotiating leverage with payers, demanding upfront payments from patients, hiking list prices to "several times their actual cost," selling patients debts to collection companies, focusing on expensive procedures, and issuing tax exempt bonds and investing that cash in better yielding securities.

The article cites at least two specific cases where the hospital's tax benefits are multiples more than the charity care they provide. The story also cites the salaries of nonprofit hospital CEOs and lists 10 executives paid between $3.3 million and $16.4 million a year.

The WSJ article also makes clear that many hospitals, particularly inner city hospitals with substantial numbers of low income patients, are having a tough time making it.

But clearly, most community hospitals and major medical centers are well into the black.

The growing data about the wealth of these nonprofit hospitals may kill the golden goose by giving the Congress permission to take away or modify their tax status. Just think of the incentive these hospitals would have to provide charity care if they actually paid taxes and could deduct the cost of their services to the uninsured.

But all of this publicity will have another very important effect.

We are about to start the 2008 budget debate as we face a looming 15% Medicare physician fee cut on top of an emerging problem in funding both Medicare and Medicaid in the coming years. The Bush budget calls for Medicare and Medicaid cuts for both hospitals and doctors. The providers respond that it is the Medicare HMOs and their "over payments" that should take the hit.

We are about to see a major "food fight" between hospitals, doctors, and HMOs over whose hide Medicare and Medicaid cuts will come out of. Each of them will be pleading their own version of poverty.

News that the nonprofit hospitals are not so nonprofit comes at exactly the wrong time for them.

Health Plan Stock Prices Hard Hit Recently--Then There is John McCain

The recent hit HMO stocks have taken in the market has come because Wall Street has the jitters over revised earnings outlooks. Many health plan stocks have fallen by 50% in recent weeks.

The Street is right to worry that the health plans are going to have difficulty pumping out more of the great and predictable earnings we've seen from them in recent years. But they also continue to miss a very large political risk that still looms as the Congress looks to trim private Medicare payments.

Health plan profit expectations are going to be harder to make in the next few quarters. The health care trend rate has stopped its five-year deceleration and the easy days are over. Now, a health plan has to hit its numbers on the head without the help of falling trend rates and the good things that result like "positive reserve development."

Wellpoint upset the market when it said it missed its health care cost trend assumptions by half a percentage point--that's little more than the margin for error in this business. I've missed it by multiples of that! Management reports that the fundamentals in the Wellpoint businesses continue to be strong even if the business is getting harder.

Universal American and Humana announced they miscalculated on their Part D pricing--Universal American because of mistakes in a health plan they later acquired and Humana because they once again blew their anti-selection assumptions. The other parts of the business for these companies--they tell us--continue to perform as expected.

We are at a point in the underwriting cycle where profit windfalls from a five year deceleration in the medical trend rate are gone. Growth in Medicare Advantage and Part D plans are both slowing as the low hanging fruit in those markets are gone. A slowing economy makes growth in the commercial health insurance market all but impossible unless you steal someone else's business.

So, the easy money days are over. But the wheels are not coming off. Margins continue to be at historically high levels.

If medical cost trend picks up the business will get even tougher. Two things would cause that to happen--an increase in underlying health care price inflation and/or cuts in Medicare and Medicaid payments to providers that force them to shift costs to the private sector. Cost shifting can assert itself both in higher prices and higher utilization. Both may be on the way, but neither has happened yet.

So, the health plan business is at a point where there is neither any profit windfall from decelerating health care cost trends nor is there a real pick-up in costs. The current environment isn't helping or hurting health plan results much--but we are at a place where a health plan has to hit its marks perfectly to come in on expected results.

So, the recent HMO sell-off was probably overdone--but with the easy results past us not entirely wrong.

But on top of legitimate earnings concerns there is still a pretty big political risk the stock market seems to be ignoring. That is the risk that payments to private Medicare plans--particularly Private Fee-For-Service plans--will be cut in the next year.

A recent article in Forbes.com by David Whelan has it about right. He points out that the health plans have made a lot of money on private Medicare and that is their real risk these days.

As David points out, Clinton and Obama would waste little time trying to kill private Medicare--and would have plenty of allies in a presumably Democratic Congress.

The only reason the Congressional Democrats haven't clipped that program's wings so far is that President Bush would veto any attempt. But this President is out of a job on January 20, 2009. Bush hopes John McCain will succeed him.

Will John McCain defend the terrific private payments the 2003 Medicare Act has given the health plans?

Well, McCain was one of the only Republicans to vote against the private Medicare legislation calling it a big boondoggle.

United, Wellpoint, and Aetna have only a single digit percentage of their profits tied up in the private Medicare Advantage business. Good for them.

Humana and Universal American have a whole lot more--Humana about half it its profits.

Humana and Universal American have both lost about half of their market cap in recent weeks because of earnings worries in the wake of disappointing news from both. But what about the political risk they are taking?

Doesn't look like John McCain has the same attachment to the 2003 Medicare Act George Bush has had.

Today's HMO Carnage on Wall Street

Maybe times have been just too good for so long that people have forgotten just what a challenging business this can be.

After easy profits for the industry during a multi-year period when trend rates fell, today Wellpoint let us know nothing can be taken for granted.

When the trend rate is steadily falling a monkey can make money. If an employer sees their claims go up by 9% the year before, it's pretty easy to sell them a 9% rate increase even though actual trend maybe 8%--thereby creating a one point windfall. That had been the case for five years--up until 2007. That's why earnings reports at Wellpoint, and other HMOs, had been full of comments referring to their being able to renew business at levels higher than actual claim costs and to be able to take down even more profits from "favorable development" in prior periods.

The last year or so, we have hit a sort of health care trend bottom. Trend hasn't been rising but it hasn't been falling either. Unlike the prior years, you actually have to hit your numbers. The result has been medical cost ratios (adjusted for business mix) by all of the companies that have been clustered close together varying by no more than the usual margin for error in pricing.

With a small margin for error, missing your numbers can cause problems--especially when analysts watch every nuance and don't like to be embarrassed when you miss that margin for error as Wellpoint said today it is going to do. The analysts aren't about to tell investors they don't really understand this business and its risks so they end up putting all the blame on management and the punishment is, and will be, harsh.

The analysts were surprised to today.

Anyone who has been in this business for a while was not surprised.

The wheels are not coming off and fixing this type of problem is really pretty easy. Management can clearly see the pricing errors and respond over the next renewal cycle. In 18 months, someone at Wellpoint will be the new darling of Wall Street for turning it around. (The easiest job in this business is inheriting an operation already in the dumpster--the hardest job is keeping it out of one.)

Welcome to the health insurance business at a time when you can't count on windfalls!