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Critical Condition

Why health care CFOs have the toughest finance jobs in America.
Joseph McCafferty, CFO Magazine
January 1, 1999

A little less than a year ago, the CFO of Kaiser Permanente, Susan Porth, said she was leaving the nation's largest nonprofit health maintenance organization after 20 years, 10 as finance chief, "for personal reasons." Just four days later, Kaiser announced a whopping $270 million loss for 1997, the first ever in the 50-year history of the Oakland, California-based HMO .

Porth wasn't alone in making an inauspicious departure. A number of other health care companies announced that their CFOs were retiring in their 50s or stepping down "to pursue other interests" tellingly close to disclosures of staggering losses or other difficulties. "Not many CFOs of managed-care companies survived last year," says Eleanor Kerns, a health care analyst at BT Alex. Brown Inc. in Boston. "There was a 'shoot-the-messenger' mentality, and the bodies started to pile up," she says.

Consider the carnage:

If these CFOs served as scapegoats for a flailing industry, now it's their replacements who occupy the hot seats. Nineteen ninety-eight was another tough year for health care companies. Although many showed improvements in the second half, a fall survey of managed-care operations conducted by rating agency Standard & Poor's Corp. indicated that roughly a quarter of them are "financially vulnerable," with ratings of BB or below. "[The sector] has stabilized a bit, but it's still a tough time to be the CFO of a health care company," says Kerns.

While CFOs of managed-care companies are feeling the most heat, executives at all companies in the health care sector, including large hospital companies, insurers, and physician practice management companies, face difficult decisions and competing interests. Costs are climbing, and purchasers of health care-- employers and the government--have enjoyed the fruits of intense market competition, resulting in low premium increases and declining margins for health care companies. And cost-cutting is difficult in an industry in which cuts in service can lead to the loss of lives. Health care insurers, burned by market-share tactics and awkward consolidations, are returning to the fundamentals in order to survive, including more- aggressive, line-in-the-sand pricing.

Perhaps the biggest difficulty of being a financial manager in the health care sector is that, for the most part, the payer and the end user--to borrow a term from the high-tech world--are separate entities with competing interests. The payers pursue low costs, while the patients pursue the highest level of care. Thomas McNulty, CFO of Henry Ford Health System in Detroit, calls it "working against an insurmountable monster." He says the third- party payers want economy, while the patient wants service. At for-profits, add to the mix a group of shareholders who want to maximize profits. Indeed, setting prices and levels of service, a task that partly falls to the CFO, is a daunting responsibility, and one with such major consequences for the general public that maximizing shareholder value cannot be the endgame. "It doesn't fit into any of the traditional business models," says McNulty.

As in any sector with such profound implications for society, government regulation is a fact of life. But decades of intermittent periods of heavy-handedness and laissez-faire policy have produced a matrix of complex regulations and entities. It's often not clear where the public sector leaves off and the private sector begins. "If someone could plan a whole new system, it would make much more sense," says Kerns. "The problem with what we have is that the shareholders want profits, the patients want care, the payers want low costs," she says. "And the CFOs get stuck in the middle."

Pricing Pressures at Kaiser
Operating on high volume and slim margins, accurate cost projections are critical to the financial health of an HMO. Kaiser Permanente's CFO, Dale Crandall, who replaced Porth last year, learned about unanticipated costs when the longtime trend of hospital utilization declines suddenly reversed, putting a strain on Kaiser's cost structure. "It doesn't take that much to have a dramatic increase on the cost side," says Crandall. He contends that nobody has been able to explain the increase. "Most people thought costs would continue to decline," he says. "It was a surprise that was not reflected in our pricing decision."


It was also a problem that Kaiser couldn't immediately fix. The HMO enters into contracts more than a year in advance. For example, pricing for the start of this year was done in spring 1998, using data from 1997. "A very small error in estimates has the potential for very large changes in margin performance," says Crandall. "If you make mistakes, it can have very dramatic consequences."

Even now that Kaiser is more cognizant of rising costs, passing them on to members in the form of higher premiums has been difficult. Last year, one of Kaiser's large customers, the California Public Employees Retirement System (Calpers), decided to fight Kaiser's proposed rate hike of 12 percent for 1999. Kaiser insisted on the increase despite the fact that nine other HMOs had agreed to 5 percent hikes for Calpers employees. The agency threatened to freeze Kaiser's enrollment, a tactic it employed in 1992 when Kaiser sought to raise Calpers's premiums by 10.5 percent. Eventually, the two settled on a rate increase of 10.75 percent for 1999, still well above competitors', al-though Kaiser's rates were lower to begin with.

Like many HMOs, Aetna US Healthcare found itself facing bottom-line problems as it pursued market share at the expense of profits. The idea was that only the biggest would survive, and to compete for patients, they kept premiums low while costs spiked. "They competed to see who could offer the lowest premiums, to the point where the marketing people set the rates and the actuaries were sent on vacation," says Uwe Reinhardt, a health economics professor at Princeton University, of the pricing strategy many HMOs followed.

When the numbers started coming in, managers realized that they had a serious problem. Their medical loss ratio--how much the company actually spends on medical costs from each $1 in premiums--started to approach 85 cents, well past what the company predicted. When the news hit the street, Aetna went into damage-control mode, ultimately firing US Healthcare CFO James Dickerson. CEO Richard Huber told Business Week, "It was a painful way to learn."

Now, having been burned, Aetna US Healthcare, like Kaiser, is trying to reverse course and ratchet up premiums to restore profit margins. "We are pursuing a price structure that is set up to improve margins, or at the very least, to make sure they don't go down," maintains Aetna US Healthcare CFO Daniel Messina, who was promoted from the company's business strategy group to CFO in 1997. But that is easier said than done. For one thing, Aetna signs contracts that set its rates out a year in advance in most cases. And employers, having now enjoyed a sustained period of low health-care inflation, are wary of returning to the days of spiraling health care costs, and are willing to fight increases every step of the way. Still Messina says the company intends to raise overall rates by 7-plus percent. He says the company expects commercial HMO medical costs to increase 4 to 6 percent this year.

Kaiser is not only raising rates, it's also taking a hard look at labor costs. The company has launched an effort to bring wages in line with other hospital systems. Part of the problem lies in the higher labor cost in general in one of Kaiser's key areas, northern California. The HMO is taking the hard line in a difficult collective-bargaining agreement with the California Nurses Association, and has been reluctant to make any concessions. The organization is also providing incentives for its doctors to retire early.

45,000 Pages of Code
While managed care companies wrestle with employers for premium hikes, many health care providers have to contend with Uncle Sam. Tenet Healthcare, the second-largest health- care provider, with 128 hospitals in 18 states, for example, is concerned about the high proportion of earnings that come from government programs. Roughly 40 percent of Tenet's net patient revenue comes from Medicare and Medicaid alone. "This adds a tremendous obligation to be accurate and not have fraud. We have a very extensive ethics training program," says Tenet CFO Trevor Fetter. "We don't tolerate a lack of compliance."

And navigating the treacherous waters of compliance with the Medicare and Medicaid system is not easy. The code that regulates the programs is 45,000 pages long. "It's tough to have a good track record," says Fetter. "In other businesses, if one side doesn't live up to its end of the agreement, they sue each other. But if we don't live up to our end, they send in the FBI." As part of Tenet's extensive ethics and compliance program, all new employees are subjected to a background check, a drug test, and extensive ethics training. Tenet spends millions of dollars annually on the program.

Government intervention is more than just a compliance hassle; at times, it can have a profound impact on how companies do business. "The political environment is always a big variable," says Aetna US Healthcare's Messina. He says the company learned firsthand when new regulations cut back the reimbursement rates for Medicare HMOs.

These programs were set up to give Medicare recipients an incentive to join the ranks of those in managed care. The federal government reimburses managed-care companies a certain percentage of the average cost of care for Medicare recipients based on such criteria as age, gender, and region. But recently, the government scaled back the amount it paid to Medicare HMOs based on fears that the programs attracted healthier subjects, who required less care.


As it turns out, the reimbursements were set too low, and many Medicare HMOs were forced to close their doors, forcing Medicare recipients to give up some of the services they had become used to, and, in some cases, to switch doctors.

Consolidation Breakdown
If free-market forces on pricing and government regulation have not worked to craft a better system, neither has the health care industry's own solution: consolidate to capitalize on economies of scale. The great wave of consolidation promised more efficiency and greater bargaining power with purchasers, but integration has been difficult for nearly every health care company. "Consolidation went too far, too fast," says David Friend, managing director at Watson Wyatt Worldwide. He adds that health care companies are still incredibly inefficient. "It doesn't help to tie sinking ships together."

The problems related to consolidation at US Healthcare have been legion. Promised cost savings from acquisitions have yet to materialize. Cost-cutting measures in the back office, such as consolidation of claims-processing centers, along with computer snafus, have touched off long delays in payments. This has not gone over well with customers or providers.

Undeterred, Aetna US Healthcare announced last month the $1 billion acquisition of Prudential HealthCare, presenting another massive consolidation project for the company. Aetna's health-care customer base will expand to 22.4 million customers, making it the largest health insurance company in the country.

It remains to be seen whether Aetna can capitalize on its size. But for the big and small in managed care, difficult problems loom, including soaring drug costs, the aging population, and the growing ranks of the uninsured. Kaiser's Crandall admits the biggest challenge is keeping up with the rapid pace of change in the industry. "The whole industry is in turmoil, and I don't think any of us knows where this is going," says Crandall. "We have a lot of options and I'm not sure any one is the right one, but decisions have to get made."

And those decisions have an impact on more than just the bottom line. "It's not just a business; there are enormous social considerations," says Tenet's Fetter. "Every day we have to consider that the consequences of not doing a good job are just terrible. We take it very, very seriously."

Joseph McCafferty is an associate editor at CFO.

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Say Goodbye to Low Premiums?
Significant price hikes for HMOs and other health care providers may be just what the doctor ordered for ailing balance sheets, but it is bad news for many employers, who have grown comfortable with relatively flat premiums over the past five years.

"The insurers are willing to take a chance that they might lose some market share," says Paul B. Ginsburg, president of the Center for Studying Health System Change, in Washington, D.C. Ginsburg sees premium increases averaging in the 5-to-8 percent range for 1999.

A Watson Wyatt Worldwide study of 445 executives who buy health care services reports HMO increases for 1999 between 5 and 7 percent. Point of service plans have fallen between 7 and 9 percent; preferred provider organizations, 9 to 11 percent; and basic indemnity plans, 12 to 15 percent.

Indeed, the specter of double-digit health care inflation looms. Premiums for the Federal Employees Health Benefits Program, which covers some 9 million Americans, will increase by an average of 10.2 percent next year, according to the federal Office of Personnel Management. And Kaiser Permanente, the nation's largest not-for-profit HMO, with 8.6 million members, is asking for "double-digit rate increases in a general sense," says Beverly Hayon, a Kaiser spokesperson, adding that there will be a "wide variation, but fairly high increases."

But there are more targets for blame than the health insurance industry. There is the drug revolution, for example. New, more- expensive, and wider use of pharmaceuticals is inflating health care costs. The Office of Personnel Management reported the costs of prescription drugs increased by 22 percent in 1998; one in five dollars spent on health care goes to pay for prescription medicine in the federal health program.

Employers should be ready to shop around for new health plans. "You have to be ready to move the business," says Helen Darling of Watson Wyatt. If an employer is big enough, she says, it can convince a new plan to expand its network so disruption to employees is minimal.

Darling, for one, sees a return to an "explosion of costs. We've conditioned the American people to generous first-dollar coverage at essentially no cost," she says. "They have developed a new level of entitlement they have never had. I think collectively as a country we're in for a shock."

Not everyone agrees we're headed for a new era of sharp price spikes. "We've had a remarkable last four years, better than anybody imagined," says Jon Gabel, director of the Center for Survey Research at KPMG Peat Marwick LLP. Gabel, who notes that recent predictions of cost surges have not materialized, predicts an average increase in the neighborhood of 5 to 7 percent. "I'm the optimist," he says. "I consider this a correction." -George Donnelly




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