Why HMOs Could Thrive In the Economic Downturn

It happened in the slump of the early 1990s, and it could very well happen again. Managed care feasts while other industries starve. People will still get sick, even in bad times.

By Frank Diamond

Senior Editor

Whenever Alan Greenspan makes a pronouncement, lawmakers, pundits, and reporters parse the tortured syntax of the Fed chairman’s statements for any kind of understandable clues as to just what in tarnation’s going on here. Coyness and a keen awareness of how much weight his words carry may not be the only reasons for Greenspan’s prestidigitation. Like nuclear physics and modern poetry, the American economy — when you get right down to it — is one complex little doodle. We watch pink slips float through our lives in much the same way ancients viewed snow falling on crops: We know trouble’s coming down, but we don’t know exactly why.

There’s an adage that says that the food industry is recession-proof because people have to eat. Likewise, it’s been said that managed care survives downturns because people will always need health services. In fact, it’s been argued that managed care does well in recessions — as was demonstrated in the downturn of the early 1990s when traditional health insurance took a beating, points out Peter Kongstvedt, M.D., a partner at Ernst & Young.

“Employers were faced with the choices of maintaining skyrocketing premiums in an unmanaged system, dropping coverage entirely — which is pretty draconian — or using managed care, which might include an increase in premiums, but not nearly as much,” says Kongstvedt. “I think that a lot of the growth in managed care took place under those kinds of circumstances. There was a lot of negative pressure on the economy, and managed care helped provide an outlet.”

Uwe Reinhardt, Ph.D., a professor of health economics at Princeton University, has long maintained that managed care is recession-proof simply because health services take up such a huge portion of our economy — nearly 14 percent.

“If you look at health spending, it doesn’t decline as a percentage of GDP during recessions,” says Reinhardt. “In fact, it increases as a percentage of GDP because GDP goes down. It marches to its own drummer. It has its own cycles that seem to be impervious to outside economic conditions.”

Rich Sinni, M.H.A., director of Unifi Network, a subsidiary of PriceWaterhouseCoopers, agrees. “Health care is one of the few sectors that’s maintaining its value. Why is it maintaining its value? Because HMOs are staying ahead of inflation, and their profits are rising.”

Managed care, locked out of that booming party that was the late 1990s, now seems to be emerging from the fiscal doldrums — just as many former revelers slide.

“HMOs make money not necessarily by selling lots of policies but by selling profitable policies,” says Mark Pauly, Ph.D., a professor of economics at the Wharton School of the University of Pennsylvania. “Since the mid-’90s, their market share increased enormously, but they lost a lot of money because they were losing money on every person, but were trying to make it up on volume.”

They were apparently following the wisdom that even if the market won’t let you profit, if you build up market share, you will still be in a great position when the market becomes profitable.

Vital signs

Recent data on the industry look good, says Donna O’Rourke, a financial analyst with Weiss Ratings.

“The total industry — and we’re looking at over 500 HMOs — had a profitability of $91 million through the second quarter of 1999, versus $370 million through the second quarter of 2000,” says O’Rourke. “That’s a significant improvement.”

Looking forward

Pauly says that HMOs can look forward to two positives in any negative growth period.

“If the economy heads into recession, that will put downward pressure on rates of increases on things like physician fees and hospital charges,” says Pauly. “HMOs may actually find that their claims are growing at a slower rate and that may make selling insurance more profitable. The other thing, which is a little more subtle but I think is true — in fact, we’ve seen a lot of evidence for it — is that when the labor market is tight, employees don’t want to put up with any hassle with their health insurance policy, because they could just as well quit and take a job that gives them a good health insurance policy. But when the economy softens and they need to hold on to that job, I think they’re more likely to put up with things that managed care plans are doing.”

Pauly believes that this was partly the reason “the more aggressive HMOs,” like Kaiser Permanente and Aetna U.S. Healthcare, suffered at the end of the last decade.

Dean G. Smith, Ph.D., who is in the department of health management and policy at the University of Michigan in Ann Arbor and who also sits on the board of directors of Molina Health Centers, says he’s seen this pattern at work nearby.

“We observe this in Detroit with the auto industry talks,” he says. “The autos haven’t been able to talk about cost controls because they’re making so much money. The unions say we’re not going to pay copay when you’re making billions of dollars. If the autos are losing money, then they can say to the unions: Look, we need to put more people in the HMOs to start saving money on health care or else we’re going to have to lower wages.”

That is what’s being described when experts call managed care countercyclical.

“The recession and contraction in the economy are sort of opposite what occurs for managed care,” he says.

This is not to say that HMOs are recession-proof — only that the industry’s recession may not occur at the same time as everyone else’s.

“Price increases are good for HMOs,” Smith points out. “HMOs, over the past two years, have had pretty substantial price increases. The rate of price change is what the underwriting cycle is all about. You have basically anywhere from two to five years of big increases in prices, and then two to five years of zero or, at least, low price increases.”

This underwriting cycle, Smith hastens to add, is a phenomenon that has yet to be explained well.

Underwriting cycle

“Years of research on interest-rate fluctuations, loss shocks, and overall economic cycles have yielded little in terms of our understanding of the two- to five-year up-down pattern of insurance prices,” says Smith. “Some people thought that the underwriting cycle might be broken when managed care entered the picture, with a more narrow geographic focus and closer relationships between insurers and providers. This did not happen.”

L. Dale Crandall, M.B.A., president and COO of Kaiser Foundation Health Plan and Kaiser Foundation Hospitals, believes that the underwriting cycle is typical for nearly all insurance — except life.

“Life insurance is the one part of the insurance industry where you make an actuarial guess at the beginning and the contract has the same price for its entire life,” says Crandall. “If you look at the property and casualty business, the health care business, or most other kinds of insurance activities, there is an underwriting cycle.”

Smith theorizes that insurance prices are subject to actuarial-company control.

“There are a small number of national actuarial consulting firms, such as Milliman & Robertson or Watson Wyatt Worldwide, that produce predictions of prices. These companies sign off on insurance price increases,” says Smith. “That is, when insurance companies submit price changes, they are required to have actuarial attestations saying that the changes are appropriate. The predictions these companies make become self-fulfilling prophesies.”

These actuarial attestations are required by law.

“Each state insurance commission says that you have to do that,” says Smith. “Banks and insurance companies are regulated more intensely. It’s really part of a good business practice. Even if the state didn’t require it, you probably would do it anyway.”

Confirming solvency

“The interesting thing is that what HMOs and insurance companies have to show the insurance commissioners is that they’re increasing their prices enough,” continues Smith. “They don’t have to prove that their increases are justified. The insurance commissioners are actually worried about HMOs and insurance companies not charging enough rather than charging too much. They do the same thing with banks and the rates that banks charge. They’re really concerned about banks undercutting each other too much and therefore going out of business, more so than they are about banks gouging consumers.”

Common economic wisdom holds that recessions mean higher unemployment rates that translate to fewer employees for employers to cover. Bad for HMOs.

Remember stagflation?

Pauly, for one, says that it would be “bizarre” if the current slowdown — whether it’s a recession or not — doesn’t spur unemployment. Bizarre things have been known to happen in economics, however. In the late 1970s, for instance, there was something called stagflation.

“It was supposed to be that high inflation would reduce unemployment,” says Pauly.

As inflation rose, more jobs would appear. If there were fewer jobs, inflation would drop. There seemed to be a choice: “Which would you rather have inflation or unemployment?” until stagflation — high unemployment and high inflation — came along.

“We’ve seen that we can have both and we can have neither and we don’t quite know why,” says Pauly.

Other experts contend that even if big layoffs come, they will have a negligible effect on the managed care industry.

For one thing, the starting point is a 30-year low in unemployment.

Bob McElearney, formerly of KPMG and currently senior vice president at the international investment banking firm of Houlihan Lokey Howard & Zukin, says that unemployment may not be so fierce this time around.

“Despite the recent and frequent layoff announcements, we are still experiencing a good employment market,” says McElearney. “Because we were at such a full employment situation before, these recent layoffs have had a minimal impact on our overall employment. Relatively speaking, this downturn will still find us with a good level of employment.”

It may not even matter that much for, as Sinni points out, people who are laid off frequently keep their benefits for a while.

“They are usually given COBRA (Consolidated Omnibus Budget Reconciliation Act) coverage and most people select it,” says Sinni. “Also many employers, when they lay people off, give them a severance package, and benefits are often covered in that. So they’ll have that for a period, and they have COBRA coverage afterward.”

COBRA is a choice often taken, even though it means a laid-off worker must pay all of the premium at a time when he can least afford it.

“COBRA’s charged to an employee at about 102 percent of premium,” says Sinni. “The employer charges 2 percent for administrative and other services associated with it.” That, believe it or not, is a bargain for the employee. “It probably costs an employer about 130 percent of the premium to provide that benefit.”

Another reason money may continue to flow to HMO coffers has to do with demographics. Providing care for older employees or retirees is more costly than providing it for younger workers and is the main reason for the recent spike in premiums. In a Towers Perrin survey, employers cited the cost of prescription drugs for those over age 65 as being the main driver of higher premiums and add that Medicare HMO rates have climbed faster than those for any other kind of plan (see charts).

It could be argued that this is a small slice of the premium pie. Premiums are not the only source of revenue for many HMOs, however, especially the big players.

David L. Terry Jr., a senior consultant with Reden & Anders, an actuarial, financial, and clinical consulting company, points out that some of the larger health plans are also administrators for large employers’ self-insured plans.

“During the health care ‘down’ cycles, these programs still generate administrative profits that can help minimize the effect from their insured lines of business,” says Terry.

In a good position

Crandall believes that HMOs are in a far better position to weather downturns than, for instance, a high-tech company that sells personal computers. Consumers will put off buying the computer.

“I think of the health care industry as being more like a defensive industry — similar to food,” says Crandall. “Good times or bad times, people have to eat. Good times or bad times, people get sick. In any kind of recession, I expect health care companies to be less affected than folks who are making semiconductors or automobiles or those kinds of things.”

In any event, as Reinhardt of Princeton says, “There’s no particular reason this recession should be very deep.” Even if it is, there’s no reason that it should affect managed care in a bad way. Reinhardt points to the “enormous stability of the health sector compared to the rest of the economy.”

Provide variety

Of course the ability to weather a recession should never be taken for granted. O’Rourke believes that HMOs should diversify to survive.

“If they offer a variety of products, they at least wouldn’t get dropped for the types of policies or plans that they have that have high premiums,” she says. “If they offer a choice of something where there might be a lower premium and the consumer actually takes on more of the cost — those options may allow them to continue to hold the contract longer during an off cycle.”

Crandall uses the term “team-based care,” when discussing Kaiser’s focus as well as what he sees as the best survival mechanism for health plans. However, for-profit HMOs may have more of a problem instilling such a system because of the way they’ve historically contracted, he believes.

Ultimately, the reason why managed care may be recession-proof is that health care is so fundamental. It is not an impulse purchase, and confirmation of this can be found in the fact that total spending on health mounts in good and bad times.

Reinhardt refers to a chart he uses in his Princeton classes in which he tracks the steady rise in total spending for health care.

Despite a few bumps along the way — bumps that noticeably do not occur during recessions — spending goes up, up, up. “It never really goes down,” he points out. “It’s a really smooth, upward-sloping line.”