Eighth Annual Wall Street Comes to Washington

Where is the U.S. Health Care System Headed?

Conference Transcript
June 18, 2003

P R O C E E D I N G S

Paul Ginsburg: I would like to welcome you. I’m Paul Ginsburg, and I welcome you to the Eighth Annual Wall Street Comes to Washington Conference, and this conference, put on by the Center for Studying Health System Change, is intended to give an audience of health policy analysts and health policymakers a better sense of the market developers out there that are relevant to public policy in this area.

We have invited a variety of Wall Street analysts to discuss the marketing.

Let me begin by (?) and why they are relevant for the meeting. Basically, analysts are researchers--

[Technical sound problem.]

Paul Ginsburg: So instead of discussing what Aetna’s profits are likely to be, they will be discussing the implications of market changes for costs, quality, access to care, things that policymakers worry about.

Now, HSC research also focuses on markets, and we conduct site visits, as many of you know, to 12 representative metropolitan areas. We conduct surveys of physicians, households, and insurers, and we synthesize secondary data.

At this point we have just completed the fourth round of the Community Tracking Study site visits, and publications are starting to come out from that round. We also just issued the annual Analysis of Cost Trends that was published in Health Affairs last week as a Web exclusive.

So to bring HSC research into this discussion, Joy Grossman will make a brief presentation on the most recent findings from the site visits and from the cost-tracking analysis.

We are trying out a new format today. It really was inspired by the format that we used in our specialty hospital conference back in April, where instead of previous Wall Street conferences where I just ask the panelists a bunch of questions, today we’re asking analysts to make short presentations which will kick off our discussion.

We’ve organized the day, as you can see, into two sessions, and the first session is going to cover costs, prescription drugs, and managed care, and the second session will cover hospitals and other facilities. And after the brief presentations from each analyst, I will ask them some questions, and then once both are finished, we’ll have some general discussion on the panel and then questions from you, the audience.

This is a part of my presentation that has been changing by the hour as to who we have as far as policy analysts. You know, it’s hard to imagine back in March when we chose this date that we would be competing with the Senate floor action on Medicare prescription drugs and House Energy and Commerce Committee markup on the same legislation. This has caused a problem. Liz Fowler is not going to be able to make it. Tom Scully will be able to be here, I am told, for the second panel, and he will join the panel. He will react to what the analysts say and then participate in our discussion.

Let me say something about questions for the audience. You have yellow cards in your kits at your place, and we are going to do a mixture of people writing out questions, which will be collected, and I will ask some of the questions from the yellow cards. But also there will be opportunities for people to come up to the microphones. And, in a sense, after the second analysts presentation, at least the first session, after Mr. Scully at the second session, this would be a good time to finish up your card for that session and to be collected so that we can get ourselves ready for some of the audience questions and answers.

So, with that, let me turn to Joy Grossman, who is the Associate Director of HSC, and she has been a partner of mine in putting these Wall Street conferences on ever since 1996, I guess was the first one. Joy?

Joy Grossman: Thanks. Good morning, everybody. We thought it would be helpful to kick off the conference by highlighting some of the major changes that are taking place in health care markets today. And as Paul mentioned, I am going to draw from some of the recent HSC studies, and I just wanted to point out some of the specific studies that I’ll be talking about and acknowledge my colleagues who authored those studies. And I will also point out to you that you have copies of them in your conference packet and also available on our website.

Usually when I prepare for this conference, I like to go back and look at the old issue briefs from the prior conferences, and I will confess I do not go back to 1996 to see how well we did in predicting where we would be today in the health care system. I am not sure how well we would have done. But I did go back to last year, and over one year analysts did a good job in predicting where we’d be, unfortunately.

While the rate of growth in health care costs declined slightly in 2002, it is still very high, and the rate of growth in premiums is continuing to accelerate. With the retreat from managed care, there are really few viable tools for controlling health care costs, and with three consecutive years of double-digit premium increases in the soft labor market, employers have gotten much more aggressive about shifting more of the health care costs on to employees. As a result, consumers are having to pay more out-of-pocket at a time when they are beginning to face declining or stagnant wages.

And at the same time, provider leverage in rate negotiations and the ramping up of competition for specialty services are threatening to increase cost pressures.

Although the economic downturn has focused attention on cost control again, we really see few strategies being developed in local markets that promise significant relief. Oops, sorry about that. And, therefore, we expect that consumers’ financial burden is going to continue to rise and that we’re likely to see an increase in the number of people who are uninsured. And for the rest of the talk, I’m going to discuss each of these points in a bit more detail.

The rate of growth in underlying health care costs jumped 9.6 percent in 2002, growing almost four times faster than the economy overall. While the cost trend remains very high, spending growth did slow for the first time since the mid-1990s, dropping slightly from 10 percent in 2001.

You are going to hear more about the components of the cost trends today, so I just wanted to make a couple of key points.

Health care hospital costs continue to account for about half of the overall growth in costs, and looking more specifically at hospital spending, there is good news in that the trend in hospital utilization that spiked up in 2001 slowed somewhat in 2002. However, this decline is partially offset by accelerating price trends. Hospital prices had the largest annual increase since 1994.

Again, there is good news on the prescription drug spending front. For the third year in a row, spending increased at a slower pace, although the trend is still very high.

I think most of you are familiar with the major drivers that are affecting cost trends. Oops, it keeps skipping here. Sorry. So I am not going to go into a lot of detail about these because we will be discussing them more throughout the morning.

While the cost trend has stabilized, this was not reflected in private health insurance premium trends for 2003. Premiums continue to turn upward, increasing an average of around 15 percent, outpacing underlying health care cost trends.

Premium increases would have been 3 percentage point higher, but employers were able to buy down their premiums by increasing cost sharing and other changes in benefits. This comes on the heels of the 2.5-percent buydown in 2002.

Employers’ move to aggressively shift more of the costs of health care costs onto their employees is probably the most significant development in the health care system for consumers over the past two years. While some employers started down this path two years ago, with increased copays for brand name drugs and for physician office visits, many more employers have jumped on the bandwagon today, and they’re beginning to apply this strategy to a much broader range of services.

In some markets, we are beginning to see unionized firms and public sector employers requiring premium contributions from employees for the first time. Private sector firms that already had premium sharing in place are increasing copays and deductibles, and many are replacing flat copays with often high coinsurance amounts that vary with the price of services.

While higher cost sharing may help reduce inappropriate care by making consumers more price sensitive, it may also cause people to delay needed care, and there are limits to the level of cost sharings that can be imposed. So it is unclear what the effect will be on long-term trends.

Mostly what we have been seeing is a trend towards increased consumer cost sharing rather than dropping coverage altogether. But we did hear some reports that coverage was beginning to erode, particularly in some of our smaller sites, like Little Rock. And we have also heard about employers of all sizes experimenting with incentives for employees to drop dependent coverage or to switch to a spouse’s plan.

In Miami, we saw an interesting example. In this market, employers don’t generally contribute to family coverage. But given the large premium increases, we saw a number of efforts by employers, for example, the school districts, and others such as the Chamber of Commerce, to help their workers get coverage for their children through Florida’s SCHIP program.

Health plans’ financial performance improved considerably over the past two years as premium trends have exceeded medical cost trends. While plans are doing better at pricing their business, they have few tools to address medical costs. While we did some new care management strategies and payment strategies being developed, most of the focus has been on designing new types of products that are responsive to purchasers’ demands for greater price transparency for consumers.

Plans in all markets were busy developing tiered network products and consumer-directed health plans, but to date, few of these products of either type have been launched, and enrollment was extremely limited.

In tiered provider network products, employers or consumers pay more for providers in higher tiers. Most of these to date have focused on hospitals, although we had a couple of examples where physicians were included in the tiers. And the tiers are based primarily on costs, although, again, plans were working to try to incorporate quality and efficiency measures as well.

In general, these products have met with a great deal of resistance from providers who have used their leverage and political influence to try to avoid placement in the high-cost tiers.

Consumer-directed health plans are typically high-deductible plans with a personal spending account associated with them. While compared to two years ago employers seem to know more about them, very few employers have adopted them, and those that have, A, find generally there’s limited take-up by their employees, and also they tend to include this as part of a number of options rather than this being a total replacement strategy.

With managed care still firmly in retreat and with providers facing continuing cost pressures, they’re really focusing on two strategies to bolster their financial positions: first, they’re negotiating better payment rates and contract terms with plans; and, second, they’re investing in profitable specialty and ancillary services.

Over the past two years, we’ve seen that hospitals have managed to maintain the upper hand in contract negotiations with plans, in particular, large hospital systems that have brand name recognition in their local communities. We’re continuing to see the same type of contract showdowns between plans and providers that we saw two years ago. But, in general, these negotiations these days are being worked out more in private than they were two years ago, so it is a little hard to tell exactly who’s winning. And the cases that we have seen a few examples in some of our markets, such as Lansing, where plans have been able to do better at holding the line on rate increases, in part because employers have switched allegiance from providers to plans as costs have continued to rise.

We’re seeing a continuation of the competition that we saw two years ago for lucrative specialty services such as cardiac and orthopedic care and for ancillary services, in particular, imaging and other diagnostic services. And we really see this in all of our markets, and one of the most notable examples, which some of you may be familiar with, is in Indianapolis where we have seen six new specialty hospitals open recently or that are under construction. And, clearly, this duplication of capacity threatens to drive up health care costs. And it’s ironic that we see this at a time where we’re continuing to see capacity constraints across our markets that are affecting to care, and Phoenix is a really good example of that.

So what’s the outlook for the near term? The cost trend outlook is mixed. Some forces, such as increased cost sharing, may slow spending in the short term, but countervailing pressures such as this continued build-up of provider specialty capacity could accelerate the cost trend. It’s possible that we could see a turn in underwriting cycle with insurance premium trends dipping below health care cost trends, and that would help slow premiums a bit. We haven’t seen this yet in any of our markets, so we’re really basing this on the historical perspective that when there is strong profitability in the health insurance market, it generally triggers a new round of price competition as plans enter new markets and turn their focus from increasing profits to expanding market share. But that would only have a modest effect on premiums, and without something to slow down health care cost trends in a major way, premiums are likely to continue to rise rapidly, and consumers are likely to become responsible for an even larger share of their medical expenses, and more people are likely to lose coverage altogether.

Paul Ginsburg: Thanks, Joy.

I’d now like to introduce Norm Fidel, who is a senior vice president with Alliance Capital Management, where he is both an analyst, a buy-side analyst, and a portfolio manager of a number of health care mutual funds. Norm is a veteran of many Wall Street Comes to Washington Conferences, and we are really pleased to have him back this year.

Norm Fidel: Well, good morning, everyone, and I am going to try and look at premium and health care trends, and even attempt the impossible task of looking out to 2005 and making some predictions.

As you can see, in 2002 my estimate of medical cost trends was 11.2 percent, and these numbers are going to change by the source. So take them with a grain of salt, but, generally, they’re within 100 bass points of each other.

I do see these cost trends decelerating to 10.4 percent in 2003 and down to 8.5 percent by 2005, and I will go through the reasons for that. But first I just want to mention on the premium rate increase side, I believe the average in the commercial under-65 market, the average rate increase was between 13 and 14 percent--I’m sorry, in 2002. Let me get back to the original slide.

Okay. I think that that rate increase will be about 13 percent on average in 2003, trending down to 9.5 percent in 2005.

If you look at the spread between pricing and cost, it was quite wide in 2002 and we think will remain quite wide in 2003. And the actual spread appears to be as much as 250 to 300 basis points in 2002 and 2003, trailing down to about 100 basis points in 2005. And one might wonder why are insurers pricing ahead of cost trends in the commercial market to the extent that they are, and I think there are two reasons for that:

Number one, they are all afraid of getting behind the eight ball, which has happened periodically in the past. If health care trends particularly start to accelerate, they can be caught flat-footed.

But I think the other significant factor is that the private health care market continues to subsidize the government-sponsored programs. And if you look at Medicare, the average health insurer is getting only a 2- to 4-percent rate increase while their costs are going up 8 to 10 percent. And in the Medicaid market, they’ll be lucky if they get zero rate increases this year and next. So there has to be some subsidization for that, and so we see prices ahead of costs in the commercial market, but it is just the opposite in the government-sponsored programs.

Now, if we turn to different segments, I do see deceleration in each of the four major segments, and let me just mention in the recent two years there has been a significant societal shift for choice. We had a big movement from HMOs to PPOs. Many health plans no longer require certification for entering hospitals. They no longer require referrals to see a specialist. All of these factors were demanded by society, and managed care companies especially were tired of getting hammered daily in the press for being the bad guys, and essentially they decided if this is what society wants, this is what we’ll give them. But there’s a cost to all of these things, and that has been a significant push behind the higher cost trends that we’ve seen in recent years.

Now, I do think that will begin to trail off because I think for the most part people who are still in HMOs and not PPOs are there because of the lower costs, and so each year we’ll tend to maybe see fewer shifting into PPOs from HMOs. And so I think there will be less of an upward push on costs in future years than what we’ve seen in recent years. Plus, so many plans have now eliminated primary care referrals for specialists or certification of hospitals that we’ve already seen the year-to-year change as far as the impact on costs, and in future years that may moderate. So I do think that there was a head wind increasing costs for the last couple of years because of those shifts in where people were moving in their plans and the plans they were choosing, and that will become less significant in future years.

Now, if we look at the contribution to the actual cost increase--and on the far right I’ve highlight 2003--we can see that, in my opinion, the largest contributor to cost increases are actually all of the outpatient market, which includes hospital outpatient. And this, if you look at the size it is of the total health care spending and the rate that it’s increasing, it actually is contributing about 380 basis points to cost increases per year.

The physician, the rates are not increasing that much, but it is 35 percent of total health care costs, and that has an effect of increasing health care costs by about 250 basis points on an annualized basis.

Hospital inpatient has shrunk in recent years. It is now maybe only 20 to 25 percent of total health care costs, and the rates have been approaching double digits. So it is contributing 230 basis points.

And pharmaceuticals, even though by reading the newspapers each day you’d think they’ve been biggest villain behind health increased costs, actually come in fourth place out of these four segments. Not only are they only about 15 percent of health care costs, but for reasons that we’ll go through in a minute, the cost increases for society have slowed significantly in recent years.

So let’s go into each of these segments and try and explain what’s happening behind the scenes in these decelerating trends, not all of which have happened yet but which I think we’ll start to see in the future. And let’s look at pharmaceuticals first, and there’s a various number of reasons why total sales of pharmaceuticals were up almost 18 percent in the U.S. in 2001, and in 2002 they were up around 12 percent. So there was a 500-basis-point reduction in growth on a year-to-year basis. And about 300 basis points of that were due to the significant patent expirations that occurred in many of the blockbuster products, from Prozac to Glucophage to various numbers of products. And that had a significant shift going from the higher-priced brand name to the generic product.

In 2002 and early 2003, there has also been the effect of the hormone replacement therapy, which has reduced growth in the total market by about 75 basis points because that is a fairly large segment, and the use of those products is down around 60 percent year-to-year because of the NIH studies and the side effects that were seen in those studies.

And in early 2003, the Claritin switch to over-the-counter is causing another 50-basis-point drop in the market. We have rising copays, which is probably having some effect on unit growth. And we have had a sharp reduction in the number of significant new products that have come to market.

If we look at the years 1999 through 2001, there were 17 to 19 products that were approved in the U.S. that we think will have sales eventually of over $500 million, and it was very consistent over those years, 17 to 19 products. In 2002, only 10 of those products were approved, and new products do have an impact on growth for the market, and so the market slowed because the FDA did take a longer time to approve drugs, and a lot of drugs were not approved, or at least have been delayed in their approval.

Now, we do see signs that things are picking up at the FDA again, and we think there are going to be 17 to 18 of those potential $500 million drugs approved this year and next year, so we are getting back to that. So I think, you know, as the year progresses, we’ll start to see a larger impact from the introduction of new products, and many of them are the large-molecule biotechnology-based products, particularly in cancer, which are very expensive and which will really have an impact on drug costs. So that is one fact that I see reversing in the other direction from what we’ve seen over the last year.

So I do think that the medical costs trend for pharmaceuticals slowing from 14 percent in ’02 to about 12 percent this year, and slowing further to about 2005 to 11 percent, even though I think pharmaceutical sales growth in the total market will actually be accelerating in the ’04 and ’05 period, which we’ll get into lately. But I think the things that managed care is doing in the drug benefit is having an effect on utilization. And I think we’ll soon begin to see the pharmaceutical cost trend in health plans start to be less than the overall sales growth in the country.

For example, in recent years the cost trends among health care companies for drugs were higher than what actual sales growth was in the country, primarily because people in health plans have drug coverage and not everyone in the country has drug coverage. So the health plan is providing a benefit to all those people. But the changes in the benefit structure is reducing, I think, utilization, and more shift to generics, which we’ll get into.

So I do think we’ll start to see the sales growth in the U.S. nationally start to parallel to cost trends that health plans see in pharmaceuticals.

As we look to hospital inpatient, we still have close to a high-single-digit to double-digit cost trend, mainly because costs in the health plans is primarily influenced by price and many hospitals are getting high-single-digit rate increases now. Utilization has slowed dramatically this year so far in the first five months of the year. Admissions have been flatish, whereas they were growing 2 percent in previous years. And I think there are a number of reasons for that, and many of which I see continuing for quite some time.

First of all, we’ve had a very low flu season and weather patterns in the first quarter, which is obviously not going to be sustained for the rest of the year. But that did have an impact in the first quarter. One of the reasons that outpatient costs are growing so fast is that we have a whole movement among physician-owned facilities that are negatively impacting volumes in hospitals. We have physician-owned diagnostic centers, we have physician-owned specialty hospitals, and we have physicians doing procedures in their office that they were doing in the hospital before, and we have physician-owned ambulatory surgical centers. And these are mushrooming around the country.

So a lot of the volumes are being drawn out of the hospital into these physician-owned facilities. And one can make their own judgment as to why those procedures are flowing to the physician-owned facilities, but I don’t think doctors are any different than everyone else. Money is an influence on their behavior. And the reality is that I think this tremendous shift is causing a moderation in hospital trend. Now, to some extent, that’s going to be picked up in the outpatient market, so it doesn’t mean it’s lowering overall costs. But typically, things are more expensive when they’re done in the hospital than in an outpatient or ambulatory surgical center.

For example, there are hundreds of thousands of cataract procedures that two, three years ago were done hospitals, that are now being done in physician’s office because it’s more profitable for the doctor to do it in that office. And they’re using $30 lenses instead of $300 lenses that they ordered when it was being done in the hospital. Gastroenterologists are doing most of their scoping in their offices now. That used to be a procedure done in the hospital. And one can look at any city in the country and read about hospitals closing OB wards. Not only is the malpractice situation affecting the delivery of babies and how they’re being done, but it’s just been a loss leader for hospitals for a long time. And that, combined with the malpractice situation, means that hospitals have been closing down OB wards. A lot more of the births are being concentrated in the inner-city hospitals. Birthing centers have emerged in the last two years.

So all these trends, I think, mean that we’ll somewhat of a slowdown. Even if the rate increases stay fairly strong for hospitals, we will see a slowdown in the hospital cost trend in total.

The outpatient market, we can see the cost increases in 2002, and I think again in 2002, are 15 percent, which is the highest of all the segments. And it is due partially to all the factors I mentioned before, so many of these procedures going from the hospital into the outpatient center. And the media always has to have a villain. Five years ago it was managed care; the last couple of years it was the pharmaceutical companies. Now we’re starting to see the hospitals coming under a greater glance. But it’s really this outpatient setting and, I think, physician-owned facilities that are causing a big shift, and maybe they should be the villain. I’m not making any judgments on that, but the media always has to have a villain to bang on.

The physician segment, we can see that the rate increases have been more moderate. The physician is in less of a bargaining position in negotiations for rate increases than the other larger providers of health care on a consolidated basis. Even a physician group doesn’t have much bargaining power, let alone a stand-alone physician or a five-physician office. So in a way, the physician has gotten the short end of the stick in terms of the whole negotiating process in recent years, and has been at the low end of the totem pole as far as rate increases, and that’s contributed, I think, to their action to take a lot of these procedures into settings where they themselves can make more money in the process.

So when we add these all up, I do think there will be a moderation in trend and that the double-digit cost increases that we’ve seen in recent years not necessarily will have to continue all the way into the future. But again, none of us can really predict with certainty more than six months to a year ahead, and even then, certainly not with certainty.

Now, here’s what the U.S. pharmaceutical total market has looked at, and this is all drugs for all people in the U.S., not just the insurer. And we can see that actual drugs sales are up about 16-1/2 percent in ’01 and they fell to about 12 percent in 2002 for the reasons I mentioned before. And they further decelerated in 2003. And I think for the full year we may see drug sales as low as 10 percent. That’s a carryover effect from the patent expirations, carryover effect from hormone replacement therapy, Claritin going over the counter, higher co-pays, et cetera. And also, the lack of new product introductions.

But I think 2003 will be a low point for drug sales’ growth. I think things will get better into ’03 and ’04. As I’ll show you later, the amount of patent expirations moderates considerably in the next three years. I do think we’ll get more products approved. So the trend should improve, although I do not think it will return back to the heady days, back into the late ’90s.

This shows actual sales growth by the month, and you can see this deceleration that occurred in the early months of ’03, although it has shown somewhat of a recovery in April. And so when you average it out, it’s averaging out about 10 percent so far this year, in ’03.

And this is drug price inflation. You can see that it has increased in recent years. And looking forward, I think a lot will depend on the amount of patent expiration. Drug companies are just like everyone else--if they’re feeling pressure in one area, they’re going to--you know, the bubble will push, or the balloon will push, and so they’ll increase prices more to the private market to offset that. And that’s been a big factor behind the accelerating price increases in recent years, and I think will sort of stabilize in this 5 to 6 percent rate in the next couple of years.

And if we look at prescription growth, if you look at the early months of ’03 there’s been a very sharp deceleration. We’re kind of averaging 4-1/2 to 5 percent unit growth for a couple of years, and now up only 1 percent so far this year. And everyone is trying to figure out whether that’s real or not, whether there’s just more drugs going mail order, which the IMS audit data does not pick up as well.

So there has been a moderation. It’s probably not as severe as what IMS is showing. But in ’03 there certainly has been a sharp deceleration in unit growth, although when you look back at the sales growth for the market, on this chart you can see that the deceleration is not as dramatic.

And the next chart shows just what’s happening with generics. Despite all the talk, their share of the total market has increased, going from about 50 percent to 51 percent over the last five years, but we do think that that will increase more significantly because of all the patent expirations that have happened in recent years. You can see that actual generics are only about 8 percent of the sales dollar. If you included branded generics, in most cases only one branded generic, it’s 17 percent of sales because prices are so much lower for generics.

And the last chart does show the effect of patent expirations. To some extent, each year is influenced greatly by litigation and when generics are allowed in the market. But you can see that almost $16 billion of drugs went off patent in 2002. That will fall to about $6 to $7 billion in ’03, ’04, and even less in ’05. And then ’06, we get another round of significant patent expirations.

And I will end there. Thank you.

[Applause.]

Paul Ginsburg: Thank you for covering such a broad area. I’ve got a few questions for you, Norm. You mentioned that the shift of a lot of services out of hospitals into physician offices or physician-owned facilities would be something that tends to slow the cost trends, I guess because the prices were lower. But what about the effect on volume? I mean, aren’t there studies that when things are done in physician facilities that volume tends to be much higher?

Norm Fidel: You know, I can’t give you a--you can look at different studies and get different conclusions on that. If, to the extent that procedures are done because they’re not medically necessarily, but to put money in the pocket of the physician, I would think that that’s the case. I don’t believe that that’s a significant amount. I do think, though, that--you know, the point I was trying to make was that the lowering of the hospital cost trend that I see in coming years is mainly due to this effect. It doesn’t necessarily mean that much of a lowering of cost in the total system.

Paul Ginsburg: Oh, I see. Sure. Another question. You had mentioned that you thought that one of the reasons for the very large spread between premium trends and cost trends is because insurers are not doing well in government Medicare and Medicaid markets. In a sense, you’re really positing a cost-shift mechanism. You’re saying that--and let me just challenge that in two ways.

You know, one thing is that to say that insurers are keeping their premiums high in commercial markets because they’re not doing well in other markets presumes implicitly that they would have had lower premiums, perhaps less than profit-maximizing premiums, in the commercial market if they were doing better in the government markets.

And the other point is that I always thought that insurers were at very different proportions of Medicare and Medicaid business in relation to commercial business. So wouldn’t the insurers that don’t have much Medicare business, such as Wellpoint--you know, why would they be pursuing this?

Norm Fidel: Well, if you look at Wellpoint, their price increases have been at the very low end of the entire industry. Last year their rate increases were about 9-1/2 to 10 percent, whereas the average was 13 percent. But actually, Wellpoint does participate in a lot of the MediCAL and Healthy Children program in California. They have a total of hundreds of thousands of individuals in that program. So they have not entered the Medicare risk business and they’re not very prominent in the Medicaid businesses in other states, where there’s a different setup for price increases. In California, they’re a significant participant in the Medicaid business.

Paul Ginsburg: Okay. Finally, on the outlook for pharmaceutical spending, we often hear about both genomics and also remarkable advances in the technology of drug developments, making it less expensive to develop drugs. At what point do you think this will start showing up as far as the--you know, with new drugs introduced; and what effect will that have on costs?

Norm Fidel: Well, I certainly think there will be an impact. I think that the sequencing of the human genome is just a remarkable accomplishment, and we will see the impact of that not only for large molecule, protein-based drugs, but also for small molecule, orally-taken drugs. It’s just that drug development takes a long time. And if on average it takes 10 to 13 years to develop the drug, even if you can cut that down by a year, it still takes 10 to 11 years.

So I think we will see a ballooning in the number of products in clinical trials that have been developed from all of this knowledge. But those products won’t be entering the market for another 8 to 10 years. And so sometimes our, you know, joy and wonderment over science immediately, you know, has an impact on us, but you just can only move drug development so far.

So I do think, looking out 10, 20 years, it will have a significant impact on the market. And I think we’ll first see it in the large molecule, biotechnology-derived drugs. Right now they represent about 10 percent of all drugs. And I think 25 to 30 percent of all new drugs that are being developed will be in the large molecule space in the next 5 to 10 years.

So we will see the biotechnology-type drugs increase their percentage of the total drug spending. And it’s much harder to control the spending for those types of drugs. Usually they are the only drug in town. You can’t pit them up against another one. And so it’s going to be a real issue for cost containment in drugs in the future, but I don’t think we’ll really see the fruits of that for another 8 to 10 years.

Paul Ginsburg: Good. And just one more thought. This is more of a comment. Something you said was very interesting, and if I understand it right, it sounds like the things that dominate cost trends being unusual, either being unusually low or unusually high, may not be the different regimes--like, you know, what happened before managed care or managed care or what’s going to happen after the managed care--but the transition from one regime to another one. And if I understand you, in a sense saying that because the transition from the tight to the loose managed care is pretty much over, that’s one of the reasons you’re expecting a lower cost trend in the next few years than we’ve experienced in the previous couple of years.

Norm Fidel: You know, over time the cost trends don’t change that much. But when you get sharp changes in reimbursement it can destroy profitability for an industry, and it takes a while to recover from that. And so one bad year of pricing can then result in three or four years of catch-up, where pricing has to be ahead of cost trends. If you could find a way to smooth this all so it will be more consistent year-to-year, it will be a lot less disruptive to us all. But the markets don’t work that way. And typically you get, you know, just the pendulum shifts too far in both directions and it takes a while to recover from the extreme.

Paul Ginsburg: That’s right. Roberta, you may have some comments on what Norm said or what I’ve said. I leave it to you whether you want to do your presentation first or make your comments first.

Roberta Walter Goodman: I think I’ll do the presentation.

Paul Ginsburg: Great, okay. Well, let me introduce Roberta Goodman, who is the first vice president at Merrill Lynch. And the thing I really want to mention is that Roberta has been at many Wall Street Comes To Washington conferences, including the first one, which didn’t come to Washington. It was in New York at the Merrill Lynch office. And I’m very delighted that she has been able to come so many times, and delighted that she’ll speak today on managed care.

Roberta Walter Goodman: Actually, I’ve just missed one. I missed the one in 1999, when I was on my honeymoon. So that’s an excused absence.

I’m going to talk about five topics that Paul had asked me to address, first to go through some issues on the premium and cost fundamentals, and I’ll just sort of add on to what Joy and Norm said; second, to talk about product design issues; third, to talk about efficiency gains within the managed care industry; fourth to talk about capital deployment, which I will do in the context of the underwriting cycle; and then finally, to touch on the public policy environment.

First, the premium and cost fundamentals. Let me make a few observations here. This graph is looking directionally at the same kinds of data that Norm was showing you, but it does put it in a historical context. So there are several observations that I think are important to make here.

First, we’ve seen six years of premium acceleration which follows on to a number of years of cost acceleration. We do see pricing flattening in 2003, at least for the publicly traded companies. We’re using a 13 percent trend, which is, I think, consistent with what Norm is also seeing.

Secondly, what we’re seeing in terms of how the companies are approaching the pricing process is that the pricing is lagging rather than anticipating the moderation in the cost environment. And if you look to that ’95 to ’99 period during which the companies were playing catch-up on the pricing, it’s pretty clear to see why they would be doing that.

Third, looking at the cost trends, I would agree with the comments that the costs did inflect in mid-2002. My view is that a large part of that inflection point was in fact due to the weakness in the economy and the impact that it would have on behavior. As well as some things that are happening at a granual level within various components of costs. That said, I think that it’s important to recognize that cost issues in health care are non-trivial and they do represent fairly major challenges for managed care companies or others who are pricing health care benefits.

One thing I think that’s important to remember and that sometimes gets lost is that, at the end of the day, pricing has to reflect the underlying cost of services. And not only is that true when plan sponsors approach the negotiation with the insurer, but also when the insurer approaches the negotiations with the various providers of goods and services to them. So if you look at the hospital trend during the mid-1990s, those were clearly unsustainable because pricing was not commensurate with cost, and I think that’s part of the catch-up that we have seen.

The key challenge, accordingly, for the managed care companies has been to understand not only what has been the case with their cost trends, but also what will be the cost issues in the future, and then to price to those so that, as Norm was indicating, they can achieve stability and predictability in the costs that they present to their customers, rather than underpricing them one year and trying to catch up with dramatic cost increases in the following years.

Our expectations are consistent with norms. We think that the cost trends will continue to moderate. The exact magnitude of that I think is somewhat unclear and depends upon a lot of external factors, and I think that the premium trends will also moderate, but they will likely track the improvement in the cost trend, and I would think will probably still be at a slight positive spread to what we see for the current year’s cost trend. So we look for, if the current year is, we’re using 11 to 12 percent as a range, which is a little bit more conservative than where norm is, that the pricing would be somewhere in the 11.5- to 12.5-, 12- to 13-percent range rather than trying to track that exactly.

Looking at the components of trend maybe a little bit differently than the way that norm was and getting a little bit of a perspective. You do see that the hospital portion of the equation has increased pretty substantially. It was pretty much a neutral to positive in ’96-’97. It is now 50 percent or so of the aggregate cost increases that we’re seeing.

I would agree with a lot of the issues that were raised in terms of the reasons for this. I think that we’ve seen a bolus effect on utilization as capitation has rolled off and as some of the very intrusive precertification programs went away.

Outpatient I think has had a technological boost. It also I think is one of the areas that is somewhat more difficult to control pricing and volume from the standpoint of managed care because you’re dealing with a lot of units of service, and so it’s hard to control volume in that context. It’s costly to do it.

One comment I would make that we would see somewhat differently from what Joy was indicating on the cost environment, though. I do think that we are seeing an inflection point on the hospitals from a pricing and terms standpoint, which may not be captured yet at the market level.

I think that there are a lot of issues that are contributing to this. Clearly, the hospital industry was the recipient of a lot of avarice publicity in the aftermath of the Tenet discussions last fall about their stop-loss coverage and their Medicare outlier payments, and I think that that has focused attention in on what the hospitals are doing from a charging standpoint. I also think some of the FTC issues, as we talked about last year, are coming to bear as well, and we are seeing a bit of a shift in terms of the health plans’ willingness to be a little bit tougher in the negotiation, not only on pricing, but I think more especially on terms, and particularly those that relate to stop-loss coverage.

So, in my home state of Tennessee, we’ve seen Blue Cross/Blue Shield of Tennessee terminate its relationship with HCA or HCA terminating its relationship with Blue Cross/Blue Shield. It doesn’t much matter which way because Blue Cross/Blue Shield of Tennessee did not capitulate to contract terms that they felt were unacceptable.

What’s happened in the aftermath of that I think is somewhat interesting because the view was that you’ve got the franchise hospital, and the insurer would have to come to heel. Not only have they not done that, but they’ve actually picked up close to 200,000 members over the course of 2003, and I think what that points out is that the key relationship that most people have with the health care system is with their physician. And as long as their physician relationship is not imperiled, they will tend to ignore what happens with other components of the network.

We’ve also seen United terminate with the University of Utah hospitals and clinics, and of course HealthNet was successful in negotiating much tighter contract with Tenet in the aftermath of that company’s problems.

Looking at the future, I think that it is important to recognize that the challenges associated with costs are very real, and those would include a variety of factors. Obviously, the demographics in this country, with the aging of the population, will point to higher costs and higher utilization. This is a wealthy country, and health care consumption is well-correlated with disposable personal income per capita, and you can see that both within the trend factors historically in this country and also looking at the OECD data.

I think that the third-party payment system has tended to insulate people from the true economic cost of the care that they receive, and that does tend to spur demand. We have seen tremendous changes in technology over the past, and as Norm indicated, those will continue.

I think the societal attitudes that we have towards health care are different and do promote higher usage, and I think that there also has been a pervasive failure in this country to follow evidence-based medicine, and that also has tended to increase cost.

Turning to issues of product design, which I was asked to address. There is a perception that consumers are being asked to bear so much of the health care costs and that this is just so unreasonable. The reality is that there has been a steady downward trend that has somewhat abated in the recent years, but that is substantially below where we were 10 years ago, 12 years ago, 20 years ago, 30 years ago.

But I think that what happens is when we become exposed more in the media and also when you have a weak economic climate, the health care costs become much more apparent to people. And so as you can see from this chart, when you go into recession, all of a sudden health care spending as a percentage of GDP goes up dramatically because you have health care spending continuing to grow, but GDP not, and so you end up with a much greater visibility, both in the press and on the part of consumers.

Looking at what we’re seeing on product design, we said last year that we thought that employers would be mostly tweaking their benefit designs, and I think that’s what is continuing to happen. There has been a continued shift to self-funding, as employers try to get out from under the burden of costly state benefit mandates. We are seeing increases in cost sharing, in co-payments, co-insurance, deductibles, et cetera, and I think that that does tend to impact demand at the margin, which is consistent with the Rand Corporation studies.

As Joy indicated, we are seeing some moves on the tiering front to try and steer customers/patients into the less-costly/higher quality providers. I can tell you that my insurer, my plan did exactly that, but not tiering hospitals, tiering the physicians in the network. But I think that this is a relatively narrowly adopted kind of structure for the reasons that Joy indicated, and I think what we’ll see is that it will end up being more a geographic strategy that a market like California, in which there are a lot of issues with provider pricing, that there will be an emphasis on these kinds of structures. Whereas, in smaller markets, where you don’t have as many providers from whom to choose, that there will probably be less interest in the structure.

Consumer-directed health plans I think do take advantage of the idea that consumers should be engaged and should be spending their own money and acting more as consumers, but I don’t see it as a panacea, and I do think that there are real issues.

In particular, I think that employers have proven to be somewhat skeptical that this is, in fact, the silver bullet to address health care costs. For one thing, I think that they are sort of smarting from the HMO experience of the early ’90s because that was the panacea, and instead what happened was that for a lot of employers, there was an adverse selection against the other plans that they offered, and so their aggregate costs actually did not benefit that much.

And I think that there is the concern that if you start segmenting the risk pool with these kinds of structures that you’re going to pull the 25-year-old single guys in, and you’re going to be left in the rest of the plans with 55-year-olds with diabetes and hypertension, and I think that’s a real issue.

I think the other issue, which is a more fundamental one, is that, by itself, consumer-directed health plans do not really address the truly high-cost aspects of health care delivery. And I’m going to sort of flip forward to the slide. And what we know is that a small percentage of the population consumes most of the dollars.

And if you have a child that’s born two months prematurely, you’re not going to go and be a cost consumer when you’re looking at NICUs. You’re going to find, hopefully your child is delivered at a hospital with a really top-flight NICU, but you’re going to care about can I bring my baby home well two or three months from now, not what does it cost me today. People do not think about cost at all when confronted with serious illness.

And so the notion that a consumer-directed health plan is going to address that small portion of the population that actually generates most of the costs I think is not realistic. I think that there are ways of approaching those portions of the population through better care coordination, identifying them prospectively, trying to work through the gaps in treatment.

And clearly there are a lot of companies focusing in on these kinds of approaches, but at the end of the day, I don’t think it matters what kind of a plan you’re in. It matters what data you have, what kind of clinical programs you have and whether or not the interactions with the consumer and with the provider are constructive and help them to care more effectively for the population and motivate changes in behavior on both sides. And I don’t think that that is a financing structure issue. I think that that is a clinical issue.

I’m going to try and go back, if I can do this, and just talk a little bit about elasticity of demand. I think that there is a view--you can’t see this in the handout because it’s yellow, so I apologize for that--but I think there is a point of view that health care demand is immutable and unchangeable.

I think, as Joy indicated and Norm indicated, there clearly is some elasticity of demand, particularly for the noninpatient services. And what we’ve done here is we have extracted some information from the Rand study that was published in JAMA last fall. And what you can see is that as you have increased cost sharing and as you move from 1- to 2- to 3-tier drug benefit structures, the consumer will try and maintain a certain level of out-of-pocket spend, and that effort then impacts their consumption of drugs and the types of drugs that they consume.

I didn’t put it here, but they will tend to consume more generics. They’ll tend to look a little bit more carefully at what they’re doing, and the result is a reduction in cost to the plan.

Turning to efficiency gains, what we can see is that over time, and particularly over the recent past, there has been an improvement in the administrative expense ratio that the industry produces.

Now, this is not a really good metric in a lot of ways because you are measuring a lot of apples and oranges. There are a lot of companies that are built into this calculation that have a lot of fee-based business, and so therefore they will tend to generate lower revenue per member, but there is no medical cost associated, and therefore there is a higher expense, but clearly we are seeing improvements, and I think that those improvements actually, to some degree, are understated in this chart.

So we see the primary factor is the substitution of capital for labor. This is a very transaction intensive industry. And to the extent that you can automate those transactions and remove them from human hands, get things right the first time so you don’t have irate calls coming in from physicians or patients saying that the claim wasn’t paid or was paid wrong or something of that nature, you can reduce the cost very substantially.

But beyond that, I think you can achieve some economies of scale on the capital particularly for companies that have been able to pull out labor or pull out service centers as a result of putting in good operating infrastructure. We also see better visibility on data needed for decision support. So to the extent that you can process your claims faster and more accurately, you have a better sense of what your cost trends are actually doing and you can price accordingly, rather than getting surprised six months into the fiscal year that, oops, you’ve priced 100 basis points lower than your costs were.

I also see that there is the opportunity to reduce the friction in the system. And I think all of that provides the opportunity for companies to differentiate themselves favorably on non-priced dimensions which, again, should contribute to a more stable and predictable pricing environment.

That said, I think that it is necessary to invest in stronger operating and systems infrastructure because the industry is becoming increasingly complex from both a competitive and a regulatory perspective.

Turning to the issue of capital. What we’re seeing is that the companies had been focused in this era of improving profitability on improving their balance sheet, rather than going out and doing lots of expansion. Companies have been using excess cash to repurchase shares and to reduce debt. As a result they have been seeing improved return on equity and return on invested capital. We’re also seeing that in the Blues environment, the national association has put tighter requirements on the plans that bear the trademark because they, again, want a more stable and predictable environment. And so we don’t see the three year up three year down traditional blue underwriting cycle.

We’re not seeing companies taking excess cash to any meaningful degree and plowing it into iffy acquisitions. We’re not seeing them taking excess cash and going in and doing de nova start up activity, all of which were contributors to the poor performance in the mid 1990s. And so for those reasons we think that in the near term the companies are likely to remain concerned about matching or exceeding their costs with their pricing, continuing to improve their capital returns. And so we don’t see the conditions being right for a down turn in the underwriting cycle.

Finally on policy issues, I mean we are obviously in the midst of a fairly significant debate down the street here on Medicare drug benefits and reform. And obviously that’s going to be a moving target over the next few months. So rather than prognosticate on al of that, I think what I would rather do is just share with you the issues that I think that the market will ultimately care about.

Most importantly the market wants to know is this going to be an actuarially sound structure to the extent that private plans and private organizations participate in it. And so to be actuarially sound I think you have to have payment levels that are not only adequate at the beginning, but also are able to increase predictably to match underlying costs. Over time you cannot price your products below your costs. It just does not work. I think it’s also important that whatever structure is derived avoids adverse selection problems. That the people who go into the benefit are not all the folks like my grandfather who had $1,000 a month worth of Parkinson’s drug needs at to the exclusion of people like my father who takes 19 cents worth of beta blockers a day.

And I think it’s also important that the service areas provide for predictability and integrity to the risk pool that various companies would be taking in. You know, if you look at a state like California, there are big cost differences from the rural areas to the urban areas between San Francisco and Los Angeles, Los Angeles and San Diego. And so the--anybody who would be looking at underwriting risk in the context of California would have to be concerned not only is the aggregate okay, but what particular parts of that population will you attract.

I think it’s also important that plans be allowed benefit flexibility in order to position themselves to compete. And I think that the competitive bid structure that is contemplated for the private market plans, the Medicare Advantage Program, is going to be very important. Because a competitive bid structures tend to have the effect over time of driving pricing down to unsustainable levels because of the risk of being excluded from a market place, which is particularly troublesome if the company has invested in infrastructure to establish that market place.

So I think there are some big issues here. And we’ll see how it all pans out. Right now the street is in a sense of euphoria about the Medicare reform and drug benefit representing an opportunity for everybody throughout health care. And I personally think that will be unrealistic.

I just wanted to sort of touch on some of the sources that we use for research purposes. I am required under various regulatory and company rule to make this disclosure that I actually think and believe what I told you to be true. And as anybody who knows me over time will tell you, I pretty much speak my mind. So that’s not an issue.

And these are the Merrill Lynch mandated disclosures, which I can’t even read on the screen.

[Applause.]

Paul Ginsburg: That was a really good presentation, Roberta. One of the things you said was really important. In a sense you were saying, and I want to translate this for the audience, that the, you know, that the trend of sharply rising hospital prices you’re thinking might very well likely slow down. And when we met a few days ago, you had explained to me this issue of stop loss. And I was wondering if you could elaborate on that for the audience?

Roberta Walter Goodman: Is this mike on?

Paul Ginsburg: It will be on in a second.

Roberta Walter Goodman: Okay. Stop loss provisions were established in most managed care contracts so that the hospitals would be protected against a patient that became much higher cost for various reasons than the--

Paul Ginsburg: In the per diem reimbursement.

Roberta Walter Goodman: Than the per diem reimbursement, or even a case rate that would have been negotiated. And how those are calculated typically, and I’m going to simplify this because it’s pretty elaborate, but the hospital will submit a bill with bill charges, and then the plan will look at those billed charges relative to the stop loss level. And if it exceeds it, then they calculate payment that is based not on the per diem or case rate that they have negotiated, but on some kind of a discount off of those billed charges.

What we’ve seen happening over the last few years is that as hospitals have raised their billed charges, more cases will fall into the stop loss provision rather than into the case rate or the per diem, or whatever typical reimbursement will be applied. And then the calculation would be off of a higher number. So you get not only more volume, but you get more price per unit. And so that has been a fairly significant driver.

One of the things that Blue Cross/Blue Shield of Tennessee cited in the termination of the contract with HCA was that one hospital in Chattanooga last year had a 62 percent increase in the cost per case that they incurred because of the stop loss provision. So these are actually fairly important as you look at the contract structure. It’s not just, you know, do you negotiate an 8 percent rate increase on the per diem. But what kind of protection does the health plan and indirectly the plan sponsor have that the cost of that contract will be predictable and reasonable.

Paul Ginsburg: So is this an analog to the Tenet problem with Medicare?

Roberta Walter Goodman: Yeah. And one is a derivative of the other. If you raise your charge masters in order to generate higher payment from HealthNet or Wellpoint, you will have the residual effect of also pushing more of the cases into the Medicare outlier payment structure.

Norm Fidel: However, if I could add a thought there, before you start taking down all the assumptions on what hospitals receive. In these cases where stop loss has been renegotiated, for example Roberta raised the issue of HealthNet and Tenet, HealthNet had an unusually large number of stop losses with Tenet, very low per diem. Now the new contract is a raised per diem, less stop loss. And even HealthNet will admit that the economic value of the contract is the same. It doesn’t mean that Tenet will necessarily be getting less money from HealthNet. It’s just that what was driving the system before has changed. Now per diems are higher and stop loss will be much lower.

Roberta Walter Goodman: What they’re looking for is predictability and sustainability and I think also protection against a contract that they thought was going to generate an 8 percent increase in cost actually generating a 12 or a 15 percent increase in cost.

Paul Ginsburg: Okay. I should like to invite Bruce Gordon into this discussion. Bruce is Senior Vice President at Moody’s. He’s going to be presenting on the second panel. But he may have some perspective on this issue.

Bruce Gordon: Actually the thing that comes to mind as I listen to these two folks talk about their for-profit organizations is the fact that all of my issuers, hospital issuers are nonprofits. Not only that, but they all operate in very local markets. So from a cost and a pricing standpoint, I think one of the biggest differences is the fact that they are not necessarily looking to maximize profits. These are community assets. They are dealing with typically nonprofit board who represent maybe the largest employers in their communities. And so there’s probably a limit on how high they can sort of raise fees, if you will. I find a whole variety of pricing strategies with issuers in our portfolio from maybe setting a bottom line target for an operating margin of, say, 3 percent in order to generate sufficient profit and cash flow to, to embark on the kind of capital programs they have to those that may be a little more sort of profit oriented and going for whatever the market will bear. If they’re the 800 pound gorilla in the market they know they can get, say, get a 10 percent rate increase. And if the Blue Cross plan has been increasing premiums by double digits themselves, then there’s, there’s less reluctance, I guess, on the part of the hospital to go, to go for the gold as it were.

So I think, I think though that in the context of nonprofit operators, and again, roughly 85 percent of the hospitals in the U.S. are nonprofits, they’re not Tenet or HCA. So they’re really sort of operating within that local community. And they sort of have to live with, with the participants in that community.

Paul Ginsburg: We’ve got some more discussion up here, but this might be a good time for people to finish filling out their question cards, if they have questions and stuff. We’ll be picking them up.

Roberta, you in a sense were saying, as far as the underwriting cycle, that from what you see now there won’t be an underwriting cycle going forward, presumably, unless there’s some major unanticipated shock to the system that causes it.

Roberta Walter Goodman: I actually would look at it more as a business cycle, that in any industry, in any set of companies, you’ll have periods of fear and periods of greed--just the reality of things. And I think the things that would lead to a deterioration in financial results in this sector would be one of several things happening.

One would be a complacency about costs and, you know, particularly if we have several years of cost moderation and companies then pricing in anticipation of cost moderation that in fact does not occur--which is what, really, to a large extent happened in the mid-1990s. And I think, similarly, if times get good and even bad companies are finding it easy to make money, that they will start making bad capital decisions. And I think that that can also lead to a deterioration in financial results.

But I think it’s important to also recognize at the same time that it’s not an inevitable cycle. If you look, for example, at Wellpoint during the mid-1990s, they as a company did not fall into the idea that cost trends, which were decelerating in the period ’91 through ’94, would continue to decelerate in ’95, and so they did not actually end up missing their financial projections during that period. And actually, if you look from the end of ’94 to yesterday, the best-performing stock in the group was in fact Wellpoint. So they did get rewarded for the discipline that they showed.

That’s number one. I think number two, we’ve seen over the last few years various companies from time to time doing things that were ill-disciplined in terms of their pricing, in terms of M&A activity, et cetera. But as long as you didn’t see a wholesale move to follow them, that you didn’t have the lemming impulse taking over, other companies were able to produce very solid financial results and it did not result--a few companies doing things that were silly did not result in a deterioration of the overall business environment.

Paul Ginsburg: Thanks. Norm, did you have a comment on that? Okay.

Another thing is that graph you put up about the administrative expense ratio, when I first saw that in your notes, I reacted that, you know, could a large part of it be the differing trends in medical costs, in the sense that if an insurer’s going to be doing the same thing each year, that its administrative costs would probably increase a little bit less than the rate of increase in wage rates that pays personnel. So that, in a sense, if medical trends went up, then administrative costs would seem to be declining as a share of it, and vice versa.

Roberta Walter Goodman: You’re probably--there clearly is some leverage from a higher revenue per capita, but I think if you look at a number of the companies, they have actually been pulling administrative costs out of the system. So it’s not just a question of the top line growing, it’s also a question of the administrative expenses shrinking.

Norm Fidel: I’ll add another point. I think Roberta’s slide actually understates the amount of SG&A leverage that’s gone on. Because there has been a shift from fully insured to self-insured in the marketplace, particularly among the largest health insurers, and the SG&A ratios are much higher, obviously, for ASO or self-funded business than-- So if it were apples-to-apples, you would probably see a much more dramatic improvement in the SG&A ratio as a percent of revenue.

Roberta Walter Goodman: If you look at Anthem, for example, that is a company that has historically disclosed premium and equivalence, so they translate the self-funded business into a premium equivalence so that they can get a measure of what the administrative load is doing relative to the aggregate book of business. And that has been improving north of 100 basis points a year. So there are some fairly substantial improvements taking place when you take the business and you make it apples-to-apples.

Paul Ginsburg: You were talking about disease management at one point. And this is a question I think I asked last year and I want to ask again, which is are we at the point where disease management is done enough and maybe has enough impact that it actually has an effect on cost trends?

Roberta Walter Goodman: I think it would be very hard to split out and measure. I don’t think that there’s really a good methodology for doing that. Companies will say, you know, gee, when these people went into our congestive heart programs their use rates went down by 40 percent. But they don’t really measure what would happen to a comparable population identified at the same point in the disease process that were not in a disease management program, number one. And number two, I think also that there is a voluntary aspect to disease management, so you will tend to get the more motivated patients going in, and those are people who would probably follow their doctor’s orders better in any event.

I’ll use my father as an example. He had a heart attack in 2000. He had an emergency quintuple bypass. He was discharged. He takes his beta blocker, he goes to cardiac rehab, he maintains his diet, his cholesterol’s lower than mine. He’s not in a disease management program; he’s just a really good patient and a very disciplined human being. And I’m very proud of him, obviously. But somebody like that, you know, if you put them in a disease management program--was it the person or was it the disease management program? I think it’s really hard to split out.

Where I do think that there’s a lot of opportunity is for the patients with multiple morbidities that have very complex conditions that need to be managed more effectively than they may be in the existing very fragmented system. And I think that to the extent you can identify those patients, identify what the gaps in treatment are, work with the physician, work with the patient, work with the family to remedy some of those issues, that there can be some real benefit. But I don’t think you can quantify it down--you know, that it’s going to be 300 basis points or 400 or 100 or 50 off the cost trend.

Norm Fidel: Several of the companies don’t use the word "disease management," they use "care management" because patients don’t like to think that they’re part of a disease management program. And patient cooperation is so important in these programs and, you know, the 20 percent of the people that are responsible for 80 percent of the costs, if you don’t get them participating in the program, it doesn’t do much good. And so that’s part of the problem.

The other thing, and I thought it was a classic case--I think it was two days ago in the Wall Street Journal, there was an article about disease management. And the headline was--I forgot exactly what it was, but it was something like "Big Brother Is Watching You." So here is disease management, which I think intuitively everyone would feel is a great effort, but the media posing as a negative, saying that, you know, the health plan has knowledge of your health care and do people really want to have this intrusion on their privacy.

So it just seems that all these efforts, even if they’re well designed and well thought of, there’s barriers to them being accepted.

Paul Ginsburg: Thanks. Joy.

Joy Grossman: Yeah, I just wanted to mention, in our site visits we continue to find--every round, we ask the same questions about the impact of disease management, care management on costs. And we still don’t really get an answer. The plans can’t really tell us what the impact is overall on cost effectiveness in most cases.

But we are seeing a movement away from, sort of, more general population-based strategies, like dealing with everybody with asthma or everybody with diabetes, to focusing on these high-cost cases that Roberta mentioned and using predictive modeling to try to identify those cases and to try to target them in terms of high-cost case management once they enter into the system.

And that applies to the local plans as well as the more national companies.

Paul Ginsburg: Yeah, thanks. I also want to say there’s going to be a HSC study on disease management coming at probably in July sometime, reflecting what Joy said.

Bruce Gordon: Let me just add we have been hearing it a whole lot more frequently from our hospital issuers, particularly when we do sit down with the chief medical officers--which is not all that frequent; we tend to be meeting mostly with the financial people. But as you speak to the physicians that are overseeing the nexus between the management and the physician staff, you hear time and again the chief medical officers commenting about, what Norm just said, the 80-20 rule, and I think it’s even more extreme than that.

I was at a conference last week and there was a very high-end academic medical center that showed an array by percentile of their patient base, and they broke it down in 1 percent units. And basically what the graph showed as that the top 1 percent of their business was accounting for probably twice their total bottom line, and that almost everything in-between was basically break-even, except for the far 1 percent and which consumed an inordinate amount of resources. And so they were focusing basically at the tails there. And it wasn’t quite disease management, but I think it just sort of shows the potential financial impact that you can have by really focusing on that couple of percent at both high-end winners and losers.

Paul Ginsburg: Good. I have just a couple more things to do, but could I ask the people on the HSC staff who are sorting through the question cards to bring them up, because we’re just about ready.

Yeah, I had an observation about a comment Roberta made about whether a Medicare prescription drug benefit is going to be a business that health insurers are going to want to get into. And, really, the observation is, oh, how far we’ve come in, say, five years; that the notion of whether in fact the private sector will do business with a government program. I doubt policy makers ever thought about it that much until they experienced the withdrawal from the Medicare Plus Choice Program. And so in a sense today, I don’t think your comments will surprise anyone in the policy area, whereas five years ago I think they really would have.

Okay, we’ll go to some questions unless any of you have something else you want to bring up.

Here’s one for Norm Fidel. Do you see the proposed drug bills as a primarily good or bad thing for pharmaceutical manufacturers?

Norm Fidel: A good. I think we’ve reached a point where the political pressure on the industry, as manifested by the Medicaid--what the states are doing for Medicaid and the pressure that they’re bringing on that has reached a point where it’s ridiculous to think that 40 percent of people over 65 do not have a drug benefit in this program and are paying top dollar for drugs, they’re not getting the drugs they need. So the industry does want a Medicare drug benefit, and I think it will be good for the industry. And I do think it will be in the form where a lot of the burden that’s put on the states for dual-eligibles will shift to Medicare.

The big question will be how long do market forces control it, or when do we get into a situation when costs are accelerating and the government sort of reneges on what they agreed to. And that’s the ultimate fear. Right now, I think that the Senate proposal has the PBMs in the role of taking on risk. I doubt that there is a PBM that would accept risk in a stand-alone drug benefit as part of a Medicare program.

So there’s a lot of issues that have to be resolved, and, you know, we’ll see what happens. But I do think that there would be an increase in unit demand for drugs, I think on the order of 4 to 6 percent if you were to look at the number of elderly that do not have drug coverage and try and look at cannibalization from people who do have it, that would shift into a Medicare drug benefit from a retiree drug benefit. And as long as it’s market forces with PBMs involved, the drug industry, I think, will do very well because they can handle 20-25 percent discounts. The 80 percent gross margins to 90 percent gross margins on drugs can well cover 20-25 percent price discounts. It’s when we get into administered pricing that, you know, the situation will become very negative for the drug industry.

Paul Ginsburg: Thanks. Roberta, a question for you. You note that despite the cost of increased consumer cost-sharing, it is low by historical standards when compared to national health expenditures. Perhaps this is a misleading measure. What are the trends when compared to income and differing levels of income, or by major disease categories?

Roberta Walter Goodman: I haven’t really seen good data on the income levels. I would say that the national percentage is, when you talk to the companies and get a sense as to what percentage of the premium and the total cost is actually being borne by the individual, it’s still less than 20 percent, even with the recent increases. You know, the companies do take a pretty hard look at this because it is something that they consider to be an important metric. And there has been a move up. But it’s still low relative to historic standards. When you think about a, you know, $200, $250 deductible with a 20 percent co-insurance package, you’re paying more than 20 percent.

And again, I haven’t seen it by disease category. I don’t know if maybe Norm has, but I haven’t.

Paul Ginsburg: Okay. What is your view of association health plans? This is for Roberta. And how do you think passage of this bill would affect employers both large and small?

Roberta Walter Goodman: I think the association health plan structure carries with it the kind of risk that we’ve seen with CalPERS, which is that participation, obviously, is optional, so you end up with a very high likelihood of adverse selection of the pool that actually, you know, comes into the association health plan. So I think that the employer that has a better population would be able to find better coverage on their own. Those that do not, would not. And so I think it would be not necessarily a program in which a lot of companies would choose to participate even if there were theoretically a large number of lives and accounts available.

Paul Ginsburg: Joy, there’s a question for you. If there is that much supposed duplication or overcapacity, why are we seeing so many signs or indicators of capacity constraints? If use rates have, in fact, moderated, and there are still symptoms of capacity constraints, why do we continue to maintain that there is overcapacity?

Joy Grossman: I guess maybe I wasn’t clear in the presentation, I guess. There is an issue between general capacity issues, and this focus on specialty services and ancillary services like diagnostic imaging.

So I think in our sites we are continuing to see pressure on capacity, overall general capacity. For example, it is in part physical plant, but it is also labor shortages and the like, so we are continuing to see backups from the OR and like into the emergency room. We are also seeing, for various reasons, like malpractice pressures in markets and other things that there is more business in the emergency room department, as well as sometimes shortages of physicians who treat them.

There is a whole host of factors that are causing capacity constraints in general acute care services. I think what we are also seeing, though, is increased competition for these lucrative services, in part, because reimbursement, for some services, is much higher relative to costs than for other services. So, for example, in orthopaedics, in cardiac services, we are seeing this expansion of capacity, presumably we will also see an expansion of admissions as more people get these services. So that is where the imbalance comes into play.

Paul Ginsburg: Thank you.

If some people have questions they would like to ask from the microphones, this would be a good time to come up, maybe after this next question, and turn to you.

Roberta, do you think that negotiated leverages will swing back to managed care from the hospitals, and what do you see as the primary driver?

Roberta Walter Goodman: I think that there is always a tension between a buyer and a seller of services, between the bid and the ask for the services, and I would say that over the period of ’99-2002ish that the balance was very heavily weighted towards the hospitals. There clearly have been some very high-profile conflicts; the Blue Cross of California-Sutter contract negotiations of ’98, for example. And I think what we are seeing is that the pendulum is swinging back a little bit, and I don’t think that it swings all the way back to where we were in 1994, in which hospitals were falling all over themselves to price below cost because they thought they were going to get incremental volume. But I do think that some of the more problematic aspects of the contracting will be less so over the next few years.

Paul Ginsburg: Yes? Could you identify yourself, please.

QUESTION: Ellen Beck with UPI in Washington.

Could you go into a little bit more detail about the PBMs and how they might participate in the Medicare drug benefit, specifically breaking out the stand-alone plans that are supposed to develop and attaching themselves like to a PPO?

Norm Fidel: Right. Well, there are two aspects of this. Do they do it alone or do they do it in collaboration with a health plan? As I mentioned before, I do not see any of the PBMs absorbing the risk part of this, and so it would have to be in an association with a health plan or a collaboration.

Medco, if it was still part of Merck, may have entered into risk contracts because it would have had the deep pockets of Merck to protect them, but now that Medco is going to be a stand-alone operation, I doubt that they will take on that risk.

So PBMs now do carve-outs with health plans, and in almost all cases, they are earning money based on administration fees and keeping a portion of the rebates, and I assume that would be the way that they would participate in a Medicare drug benefit, also, but I do see a health plan taking on the risk, not the PBM, for the total drug spending.

Roberta Walter Goodman: Well, I personally do not think that health plans are going to be lining up to want to take that carve-out risk, so I think it could be a party that gets thrown to which hardly anybody comes.

[Laughter.]

Paul Ginsburg: I think it is probably something that policymakers have to factor into their calculations as to the scenario that nobody comes, and then how does the system run without the plans.

This would be a good time to take a break. Actually, some of the questions I got I thought were more suitable for the second session, so I saved them. So let’s get started at around 10:35.

[Recess from 10:18 a.m. to 10:35 a.m.]

Paul Ginsburg: I’d appreciate it if people could come to their seats. We’re about to begin the second panel, and this panel is going to be focusing on topics related to hospitals and specialty facilities. Please come to your seats and cut the conversations.

How we are going to organize this is Bruce Gordon, from Moody’s Investor Service, is going to speak first about nonprofit hospitals. And then Gary Taylor, from Bank of America Securities, is going to speak about for-profit hospitals and other for-profit specialty facilities, such as specialty hospitals. And I am told that Tom Scully is going to be here imminently, and he will react to the presentations. And then we’ll have discussion throughout the panel and then finally another session of questions from you.

So let me introduce, again, Bruce Gordon, Senior Vice President of Moody’s Investors Service.

Bruce Gordon: Good morning, everyone, and thanks very much, Paul.

My presentation will probably be a little less quantitative than the other two, focusing a little more on sort of qualitative issues that drive our assessment of both individual providers and then sort of rolling all of that up into our industry outlook, short term and longer term.

I just wanted to start off putting in perspective kind of how we assess the fiscal health of the issuers that we look at. And what you are looking at here is a distribution of ratings.

The shaded area under the curve actually represents the health care portfolio--roughly, 550 published ratings. The dark line represents the totality of public finance ratings. Again, as I mentioned earlier, all of the issuers that we rate on my side of the ledger are nonprofits, 501(c)(3) hospitals and, as such, we are part of the Public Finance Group at Moody’s, and so the dark-black line represents sort of the risk portfolio of the entirety of Public Finance, which includes ratings for states, and cities, and counties, and water and sewer authorities.

And the point I wanted to make here really was the fact that the health care ratings reflect sort of a shift to the right, which means a higher risk or lower-rating profile. What I would further like to point out is, on the tail towards the right, anything that is what we call BA1 or speculative grade really represents an inability, for the most part, to access debt, to issue public debt in the public debt markets.

In municipal finance, once you fall below investment grade, it makes it very difficult, and roughly 10 percent of the portfolio is noninvestment grade, probably have very limited access. In fact, that tail end is growing most recently in the last six months actually. Very different from the for-profit markets, where issuers that are not investment grade or spec grade have wide access to the capital markets. Again, just to put this in perspective that health care is construed to be a much riskier industry sector than the rest of public finance.

About five months ago, we published our industry outlook. The year ’03 really represents the third year of what we would consider to be relatively stable industry outlook. And in January I think we felt pretty comfortable with the coming 12 months. Contract rates had been locked in, volumes were looking good, and we thought that ’03 would probably be a pretty good year for most of our hospital issuers.

We cautioned, though, that the magnitude of sort of the pressure points had been building, and we felt that beyond ’03 we were going to be looking at some potentially major changes. In fact, as I go through some of the points, we may be a little sooner in possibly peaking and turning south than we might have thought back in January, based on some recent evidence.

These were the major items that we cited in January for a stable industry outlook. Again, in a sense, what is sort of "good" for our issuers may be bad from a public policy standpoint. The fact that the top-line revenue is growing and growing faster than the expense line may suggest that overall health care costs are rising from a societal standpoint.

But, nonetheless, these were factors that we saw at the beginning of the year, to some extent, are still continuing, although there has been a little softness, actually, that I think Norm mentioned earlier on hospital volumes that we have seen and are hearing from a number of our issuers.

At some point, when enough people talk about a weak or a mild flu season, you start believing maybe where there is smoke there is fire, and it has been across the board almost that people have been sort of citing the weather as a reason for declines in utilization.

Nonetheless though, I think we think longer term sort of with the baby boom, the front end of the baby boom generation, kind of hitting that mid-’50s age grouping that notwithstanding some of the other factors that might limit hospital utilization, that just the population demographics are going to probably swamp most of the other factors. In the longer term, I think we expect to continue seeing fairly solid volume growth in the hospitals.

Some of the other speakers have talked about commercial rate reimbursement and the insurance cycle. I think a year ago we were debating whether or not we had sort of seen the end of the good times, and we’re hearing I think late in the season that CalPERS, which tends to be one of the bellwether sort of purchasers of health care had sort of upped for another double-digit premium increase.

And so at that point we felt that ’03 was probably going to be fairly solid reimbursement climate for most hospitals. And, in fact, I think the data suggests that ’03 is looking like at about a 15-percent premium increase, and again much of that does trickle down to the hospital providers.

Medicare, again, kind of all relative. 1998-1999 were, by far, the worst years for hospitals the first couple years of the BBA, particularly ’98 with the freeze. Again, we’re talking about 40 percent of the typical revenue stream of most of our providers, but again, ’03, first year outside of BBA, in-patient rates of market basket minus a half. If you go back 10 years and look, it is not a bad rate of reimbursement, relatively speaking.

Again, if you had nothing but Medicare business in your entire hospital, you would not be able to make a positive bottom line, in all likelihood, but from a relative standpoint, you are getting a good enough rate of return on that so that you can "cost shift" to some of the commercial areas to sort of make up the difference, and most of our issuers have done so.

We have talked about sort of some of the niche providers, some of the better-paying services. And, again, we are seeing this in many community hospitals throughout the country. It has been mentioned already on the orthopaedic and cardiac side.

These are areas that many of the hospitals are deciding to get into. In fact, we have seen this in hospitals as small as, say, 6,000 admissions, which we would consider to be a very modest-size hospital, starting its own heart program. And that is kind of on the extreme, but it just sort of does speak to the profit motive or the bottom-line dollar greed factor that was referenced earlier.

Finally, M&A activity, actually, the absence of it, has resulted in improved financial performance for most of our issuers. I think a lot of the push to merge, sort of the "lemming effect" that Roberta was referring to earlier, actually did take place on the nonprofit hospital side. There were a lot of hospitals that got into horizontal integration, figuring that there would be synergies, figuring that there would be contracting benefits.

And what really turned out to be the case was that a lot of these, in fact, probably three-quarters of the ones we rated, stumbled coming out of the blocks. So there have been a lot that have just sort of remained on the sidelines as stand-alone providers. Again, it’s a very local business, very different I think from the pharmaceutical or managed care side. Most of our issuers basically occupy a universe that may go at 30-mile radius from where the hospital stands. That is really what matters to them.

The downside, and this list has been growing over the last couple of years, and I think it got to the point where we just felt there were too many unknowns on the negative side where we put out sort of this outlook that, come ’04, the good times might be ending.

Again, as I mentioned, Medicare is the single largest payer for the average hospital that we rate. Gross revenue is probably about 40 percent from Medicare, net maybe 35 percent. Interestingly, with all of the talk about Medicare drug benefit, hardly any of our hospital issuers have mentioned it. It has virtually no direct impact on the hospital issuers that we rate.

The only thing that people are saying is that if the federal government looks to save $400 billion somewhere else in the program, and I think I read just this morning under the House plan that was passed that they may be looking for hospital savings, that is where hospitals are really concerned, and that is where we are concerned.

Again, I think, when we hear the word "reform" in Washington, our automatic response is cost cutting, and so we’re figuring that many of our issuers are going to get potentially hammered by this.

State budget deficits already here. It’s only about 8 percent of the revenue stream of most of our providers: On the long-term care side, much larger impact, but on the hospital side, modest on the fringes I would say. Again, it depends on the state that you might be operating in.

A number of states have sort of dodged a bullet. New York recently, with its budget, sort of didn’t cut the Medicaid program dramatically. Next year is probably a much different story, so I think the jury is still out here.

Again, commercial rate increase is peaking. I don’t have a crystal ball. I talked to my own insurance guy at Moody’s. There was sort of mixed evidence as to whether or not we sort of reached the peak of the underwriting cycle. I think, though, given the economy, I think most employers are at the point where not only are they cost shifting, but I think they are taking a harder line with the kind of rate increases that they have seen, and that likely will funnel its way back down to lower reimbursement on the hospital side.

Joy and I were just talking about capital needs. Ten years ago, there was basically an oversupply in most marketplaces. There was a hew and cry of too many beds in most urban areas, and a lot of the M&A activity that occurred took out a lot of what was excess capacity at the time.

It looks like, in many, many markets, they have overshot the mark. We are seeing an awful lot of brick and mortar construction. Almost universally it is ERs being doubled in size, it’s parking facilities being doubled, it’s additional ORs, it is outpatient surgery capacity, and it is almost throughout the country that we are seeing this.

The stock market I think is more of a historical issue than it is a go forward. Now, not that any of us can predict. It has resulted in a lot of rating downgrades because a lot of hospitals got into fairly heavy equity positions in their own investment portfolios, but I think going forward it is hard for us to assume that the bottom is going to drop out again.

During the go-go years of the ’90s, we assumed sort of a relatively, at the time, modest 8-percent rate of return assumed for most of our issuers. We are now assuming about a 6-percent rate of return.

Future bioterrorism, more of an event risk. It is not directly factored into our risk assessment for an individual hospital, but clearly those operators in urban areas are going to be more susceptible.

Finally, there has been a lot of talk already this morning about kind of skimming the cream on the orthopaedics and the cardiac physician reimbursement, I think Norm mentioned, sort of at the bottom of the food chain, and they are clearly looking to sort of supplement declining income that they are receiving, particularly under Medicare by going into some of these ventures and clearly taking a lot of the high-profit/high-margin business out of the hospitals.

Fifteen years’ worth of rating history here. This is kind of how we view sort of the success or failures of our individual hospitals within the portfolio. Over this 15-year period, you will find there are only three years where upgrades, rating upgrades, outpaced downgrades. Two of those years were just prior to BBA. I think that people sort of knew it was coming, and they were sort of getting their financial performance intact. The year 1997 was a clear high-water mark for financial performance for hospitals.

You can see ’98, ’99, 2000, even into 2001, most of this is BBA-related. Revenue growth was cut dramatically under the Medicare program, and while there were a lot of other things happening during this time frame, that was probably the single largest impact on hospital performance during that time period.

You can see, as we sort of got through the worst years of reimbursement under BBA on the inpatient side, that the number sort of got better relatively speaking, but clearly not to the point where upgrades were exceeding downgrades.

This has kind of got our attention most recently, and in particular the second quarter of 2003. What you see here is the ratio of downgrades to upgrades in the first half of ’02 versus the first half of ’03, at least through, as it says here, June 10th. There have been a few more downgrades in the second quarter. We are still not done the second quarter yet.

But what we have seen for the first time is that in the first six months of the year we are starting to see some revenue pressure. Up to this point, much of the downgrade activity was related to cost pressure and balance sheet pressure. So the problems that we were seeing were issues like wages going up because of nursing shortages, malpractice expenses, pension expenses, so things on the expense side of the income statement.

But more recently we have started to see the beginnings of the impact from a slowdown in volume, from some indications that rates are not growing as rapidly as one might expect, and so we are sort of contemplating now whether we have reached a point with the industry outlook that we may need to sort of change it prematurely, whether we’re going to sort of see ’03 contract, and I think the jury is still out.

One thing that really dramatically occurred with the downgrade activity in the first six months was at the lower end of the rating scales, that sort of the just-above-investment-grade levels we had a considerable number of issuers go from investment grade status to noninvestment grade status, which is a fairly dramatic move from a fiscal standpoint.

And so I think, in our minds, it may be signalling that the nature of the problems are more widespread, at least at the lower end of the financial scale.

The next number of slides were basically reasons surrounding our downgrade activity, and I basically grouped them into three categories. Strategic issues really were things within the capacity of a management team to either improve or not, and much of the downgrade activity was self-inflected, again, the "lemming effect." There were a lot of hospitals that got into sort of the horizontal and vertical integration, the acquisition of employed physicians, HMO purchases. None of these worked, by and large. And so hospitals have sort of gotten back to the basics and sort of focused on providing health care.

Similarly, capitation is pretty much dead for most hospitals. And, again, we are seeing some actual dissolution, mergers breaking up and causing even more problems on the back end.

These are really very market specific. As I mentioned earlier, a lot of this is location, and depending on the market that you’re in, if you’re in a nice, growing, affluent suburban area, you can almost do no wrong. You are still going to perform well. The demographics will sort of raise all boats in the area.

On the other hand, if you’re in the urban inner city, and you’ve got a high indigent care in an academic medical center with teaching and research costs, you’re going to find yourself under a lot more fiscal pressure.

Finally, just pure financial issues. I think I mentioned most of these. Many of these are really an outgrowth of the prior two slides. And then on the positive side, and there has been a lot less of this, but again what we have found, in large part, is that it does seem to be within the scope of management teams to improve their situation, and I think the top one here probably has been the driving positive aspect for those upgrades, really sitting down at the table and negotiating better rates with commercial payers.

I think it took a long time for nonprofit hospitals to realize that they could sit down and demand higher rates of reimbursement from these for-profit nationally spread companies, and they’ve had a lot of success. But as I said, again, if you’re in a good demographic area, you’re going to have a pretty good financial performance.

Paul Ginsburg: Thank you.

Bruce, hold on a second. I’ve got a couple of questions for you. You had mentioned the decline in the merger and acquisition activity, and in a sense you attributed it to that mergers were too much of a fad, a lot of them didn’t work out. And the perspective I’ve had is that no matter what hospitals said, I think a principal reason for mergers throughout the 1990s was to increase leverage with managed care plans. Actually, my sense is that hospitals have had a lot of success, that we have examples in our last round of site visits where, in a sense, a system that has a very prominent hospital and a bunch of ordinary hospitals, that the dominant hospital has been able to transfer, by tying the agreements to transfer its strength to some of the ordinary hospitals.

Are these just more isolated things?

Bruce Gordon: To some extent. It’s a mixed bag depending on where you’re operating.

We have found some cases where that eight-hospital system that was the result of a merger has been able to negotiate sort of what they call a single signature contract with the payer and leverage generally sort of the flagship hospital that may have a very large market share, sort of a "must have" provider in any local network. And they’ve been able to sort of bring maybe the smaller outliers that had less leverage into that single signature contracting.

But in many other areas we have found, as I said, it is very much a local market game, and, of course, I think the payers are going to try to divide and conquer; and where they can, they may, you know, award the flagship better rates. But, you know, when it comes to the smaller facilities in other demographic areas, they may basically say, uh-uh, it’s not a keeper, we don’t need that one in the provider panel.

And so it really has been a mixed blessing. A good market example is Chicago where you had a rush to sort of merge to create networks to leverage managed care. Most of those, with one or two exceptions, failed miserably. They did not get the contracting leverage, and we find that we have a lot of fairly strong stand-alones, particularly in the western suburbs, that can do very well negotiating in their little local market where they are a provider of choice and they can go to the table and sit down and negotiate pretty good rates.

Paul Ginsburg: Thanks. The other question I had was: You mentioned the increased volume of brick and mortar construction, and when I think of that and I think of some of the things Norm Fidel said about how he is expecting utilization trends to be fairly slow, that hospitals are going to lose patients to physician-owned facilities, whether it’s in their office or some outpatient facility. Do you think there’s a chance that there could be a major error, in a sense an overshooting on some of the hospital construction that’s planned?

Bruce Gordon: Right now I wouldn’t predict it. I mean, obviously, I mentioned, you know, 10 years ago it was just the reverse, and they overshot the market on the supply side.

It has become so universal--and, in fact, you can see it visually. When we go visit a hospital, trying to find a parking place on campus is very difficult. And as I mentioned earlier, so many of these projects are just pure parking. There is clearly the demand today and the need today for the brick and mortar. Almost universally every ER we go through, you can see patients waiting in chairs to be seen because there are not enough bays, in fact, probably a more acute problem in the ERs than, say, for licensed directing staff to inpatient beds.

But even so, there is a lot of brick and mortar extra wings, extra inpatient beds, which is something we didn’t see five years ago. Nobody was adding sort of inpatient capacity.

So I think the demand there right now exists, and, again, I think long term because of the demographics, I don’t think that we’re going to find we have a lot of unused capacity.

Paul Ginsburg: Good. Okay. I’d like to introduce Gary Taylor. Gary is principal of Equity Research at Banc of America Securities. This is Gary’s first Wall Street Comes to Washington Conference, but he is familiar with HSC in Washington by being a very valuable panelist on our specialty hospital conference back in April.

Gary Taylor: Thank you. Good to be here. You saw me chomping at the bit to get to the mike over there. It’s so rare that Wall Street analysts are invited to anything anymore without a court subpoena attached to it--

[Laughter.]

Gary Taylor: --that I was only too willing to jump on the Acela and to come down. We tried to pass that mantle to the auditors, but it didn’t take, and it’s kind of still stuck with us.

I want to spend a little time and talk about a few issues that Paul asked me to talk about: pricing power, capacity, the fallout from Tenet’s behavior, and then also what’s fueling some of the growth in the specialty hospitals. And as Bruce mentioned, 85 percent of the industry is nonprofit; only 15 percent is for-profit. But, nevertheless, I do have to--it looks like I messed up the slide. Sorry. I do have to talk about--AV help, anyone?

Paul Ginsburg: I think I can do it.

[Pause.]

Gary Taylor: So, nevertheless, it is important to talk about what we’re seeing overall in the hospital industry. A lot of competition for the for-profit providers comes from the nonprofit hospitals, and a lot of this--I have sat through this morning. A lot of these points have been touched on, so I will be very brief.

But, you know, I would argue the last few years in the hospital industry are probably the best we’ve seen in 20 years. You really go back to the early ’80s to find the last time you had rising inpatient admission trends and positive commercial pricing trends. So it’s been a very great time to be a hospital analyst, and only in the recent history has that changed a little bit. But this just shows you how over the last few years we’ve seen a slow acceleration of inpatient trends, and the blue line there is outpatient growth, well-documented shift in the U.S. from inpatient to outpatient services, and technology has enabled a lot of that.

This slide is a little more interesting. This slide goes back to 1946, actually, and shows you what inpatient admission trends look like in the U.S. as well as our forecast of where inpatient admission trends could go out over the next 40 years. You’ll see that blip, that period of time in the interim where I would argue the introduction of financial risk into this industry caused a massive movement of subacute patients out of the inpatient setting. And I believe generally we’ve really bottomed that trend, and we’re back to seeing pretty high acuity levels in the inpatient setting and underlying demographics again in the future beginning to drive where inpatient admission growth goes. Historically, those inpatient trends have been fairly immune to various economic cycles.

This slide has almost been touched on. It tells a real story in and of itself. The blue line there is total inpatient beds in the U.S. going back to 1975, and you can see, not coincidentally, with the introduction of DRGs in ’83 and the introduction of financial risk, you begin to see real capacity decline in the industry.

Now, this slide really is capacity decline. This isn’t representing just consolidation. This is actually hospitals that have exited the market either through bankruptcy or some other means. And then off of that are occupancy rates for U.S. hospitals, and we began to see a real dichotomy between occupancy on the basis of licensed beds and what I would characterize as staffed occupancy because in 1983, once the government changed its reimbursement system, we began to see a real accelerated shift to outpatient. We began to see lots of hospitals converting inpatient square footage to outpatient, to subacute, to home health, to nursing home. And so licensed bed count isn’t a great measure of actual hospital capacity.

We actually conduct a couple surveys a year, and one of the things we look at is what is actual staffed and available occupancy. So that’s the red line, and you can see that in the last few years, with capacity down yet admissions starting to rise again, that we’ve had a rebound in occupancy rates in the U.S., kind of in the 68- to 69-percent range. And I would argue that this occupancy line is absolutely the most critical factor for hospital pricing power. When hospitals are full, they have a lot of negotiating leverage. When they’re not full, they don’t have a lot of negotiating leverage.

And so when we look at the pricing charts in a couple slides, actually, you’ll see the same sort of correlation and pricing trends.

I would also argue the fact that--and Roberta mentioned this, but, you know, back in the late ’80s, early ’90s, hospitals were stumbling to negotiate pricing discounts with the managed care players, largely because if you go back to 1985, I want to say, HMOs had 15 percent of the total commercial market, but every industry analyst and every trade rag said by the year 2000, 80 percent of us were going to be in an HMO. And if you were a hospital and you weren’t discounting your rates to get into those contracts, you were going to be left out of a heck of a lot of business.

Well, that 15 percent peaked at roughly 31--various sources differed--according to Kaiser, and we’ve actually seen HMO share at best case, stagnant, if not slipping a little bit, and PPO growth much more popular and much faster and with much broader networks, much less negotiating power for the insurance companies.

So if you can remember what that occupancy chart looked like for the hospitals, you’ll see a real correlation to what this pricing graph looks like, and I would argue this is a classic case of an industry that built itself to excess capacity, pricing comes down, and we saw pricing trends descend all through the ’90s. Only with the rebound of occupancy rates has commercial pricing power increased.

And then I would argue as well the Balanced Budget Act of ’97 perhaps prompted some of this behavior on behalf of hospitals, very, very material Medicare reimbursement cuts in ’98, as Bruce also mentioned, for the hospitals. And the reaction to that was to go to the private sector and to raise pricing. And we’ve seen that in dramatic fashion over the last few years.

And I would argue that with most things the for-profit companies are on the real forefront of this. They began aggressively raising prices a few years ago, and when you look at total hospital PPI, which is the bottom line there, that’s a measure of nonprofit hospital pricing only. Even though it’s come up dramatically, it still lags significantly the type of price increases we’re seeing in the for-profit sector.

So I’m going back to this slide again because one of the questions I was asked to respond to was what we anticipate in terms of capacity, and one of the great things about this chart is, if you remember my admissions forecasts of modestly accelerating U.S. admission trends in the context of flatter, declining capacity, that means occupancy goes up. That means pricing power improves. That means operating margins improve. Great, great outlook for the industry. And I would argue that peak operational capacity for individual hospitals is somewhere between 75 and 80, and in five or seven years we could be there.

If you look at the blue line there, which is that capacity line, you’ll see we just saw a little uptick; 2001 was the first year total licensed bed capacity increased since 1983. And I would argue over the next five to seven years pretty significant capacity growth is going to be a characteristic of the industry. And it’s a little too early to be worried at this point, but I am worried as an analyst that we may see the nonprofit hospitals overshoot the mark in terms of capacity adds. They’ve done that historically. Capital spending is how you drive market share in this business, and I think we’re returning to that environment.

This slide shows you total industry margins. According to the AHA, total industry hospital margins were up in 2002 for the first time since ’96. So my belief is even though those margins are still well below where they were in the mid-’90s, you have seen a stabilization of nonprofit hospital margins, and, therefore, you’re now seeing the willingness to spend capital and to seek capacity growth.

This slide actually shows you the same blue line, which is total inpatient licensed beds going back to 1960 versus total hospital construction spending, and that’s on an inflation-adjusted basis. So obviously the leading indicators of capacity growth are construction spending, and you can see in 2002 hospital construction spending jumped 20 percent and in 2003 year-to-date we’re up another 20 percent.

So if I had to forecast where that blue line was going, I would argue that we’re going to continue to see an up trend there. As I mentioned, we do a couple surveys a year, and the results of our latest survey of nonprofit hospitals was pretty intriguing: 86 percent of the nonprofit hospitals we surveyed suggested they would be adding capacity, either inpatient or outpatient, over the next two years. And these are their forecasted growth rates in terms of capital spending, and those growth rates basically tripled over our survey last year. So I very much believe that we’re at an inflexion point where we’re going to see real capacity growth in the industry.

Now, from a policy perspective, you’ll note that in the rural markets it’s kind of the laggard. And I don’t necessarily suggest that this capacity growth is going to be implemented in the most rationalized way in rural areas, for example, or for urban safety net hospitals. It’s probably unlikely we’re going to see a lot of capacity growth there. But in suburban markets with pretty affluent demographics and payer mix, that’s where I think we’re going to see the construction growth.

The last few things I just want to mention very important to the hospital sector, outlook for Medicare spending given that it could be a third to half to 60 percent of hospitals’ total revenues. I have another Medicare slide--I should have brought it--which shows that fiscal 2004 update from Medicare will actually be one of the best increases in the last six years, because for most of the last five years we’ve lived under the regulatory impact of the BBA on a continuing basis. So the increase is actually pretty good. And from Wall Street’s perspective, going into next year as an election year, pretty unlikely, we believe, that you’ll see material reductions to Medicare in an election year. So we actually have a pretty good outlook.

This slide just happens to show Medicare spending going back to 1968 versus total budget deficits, so we haven’t been too concerned that the new forecasted budget deficits were going to materially change the trajectory of Medicare spending. That never seems to have been the case, and Medicare has lived pretty well off the backs of the federal treasury.

Then, finally, the one issue I would argue is absolutely most important in terms of hospital margins is where labor costs are going. The blue line is the hospital employment cost index. You’ve seen a pretty dramatic upswing in the last few years driven by what’s going on in the overall economy in terms of employment costs, also driven by a very real nursing shortage that we’re seeing primarily in urban markets.

As the economy has slowed the last couple years, we’ve seen that hospital employment cost index roll over. That’s helped hospitals, that’s helped the stabilization of margins, and I would suggest under any sort of forecasted economic recovery, we’re probably going to see the hospital labor costs at some point in the future begin to pick up as well.

I also have all my own certifications and everything, and I would just tell Roberta that my analyst certifications are bigger than yours because mine are--

[Laughter.]

Gary Taylor: --four pages. I think hers were only two.

One last thing I want to touch on--what?

Paul Ginsburg: I guess your lawyer is more cautious than hers is.

Gary Taylor: The one other thing I want to touch on is just specialty facilities and what we’re seeing there and what the street scene is there. I think we have seen pretty aggressive growth in terms of surgery centers and specialty hospitals. You do have to remember at this point this is still a very small segment of the industry. There’s 5,000 hospitals in the U.S. I think there’s maybe 100 specialty hospitals. There are about 4,000 surgery centers in the U.S. But a couple things we think driving that growth. One is on an inflation-adjusted basis, physician incomes have been declining, and we’re seeing more appetite from physicians to enter into these types of arrangements. Of course, physicians have ownership interests in these hospitals, and there are some financial incentives there.

But, also, in a period where the economy hasn’t been doing that well, there’s some pretty attractive services that these types of facilities have looked at. For example, cardiovascular services is a $140 billion market in the U.S., is growing 8 or 9 percent a year. Orthopedics is almost a $100 billion market, growing 7 to 8 percent a year. These services have 20 to 30 percent operating margins, so if you are a private investor or private equity firm looking for a place to start a business, these look pretty attractive.

In terms of physician ownership, I think it’s absolutely critical to the growth of this industry, and what I may say as a capitalist or from a Wall Street perspective is probably very different from what I would say if I put on my policy hat. But I absolutely believe if you take away the physician ownership or the ability or the exemption to allow physician ownership in this industry, this industry goes away overnight, or certainly the growth will.

Depending on what happens, in the Senate bill, the Senate Medicare reform bill, there is an amendment to that that would take away one of the exemptions that adds physician ownership. We haven’t necessarily seen that coming out of the House yet. I think Wall Street is pretty split on whether or not we’re actually going to see Congress able to push that through or not for the specialty hospitals, but it is definitely a concern that’s being reflected in some of the stock prices.

From the surgery center perspective, I think Wall Street largely believes that from a policy perspective nothing is going to happen there. This industry is 20 years old. There’s 4,000 of them. Physicians have long had an ability to have ownership interest there, and we haven’t really seen anything developing that suggests that there may be a reason that that goes away. So, absent that, I still think you’re going to see pretty tremendous growth in the specialty business, especially in the surgery centers, and at the margin that’s a real risk factor, especially for urban nonprofit hospitals.

With that, I think I will stop. Thanks. [Applause.]

Paul Ginsburg: I have one or two questions for you, Gary. What’s your perspective on what we call hospital cost shifting? For example, we’re seeing Medicaid cuts in payment rates in some states, and we never know what the Medicare perspective is going to be too far in advance. To what extent are hospitals able to easily shift this to commercial payers?

Gary Taylor: Well, I don’t know how it’s been, but clearly--and evenly, as I mentioned, when you had pretty significant Medicare cuts in ’98, was exactly when you began to see a real acceleration in terms of hospitals negotiating higher commercial rates with the insurance companies. I think historically it’s pretty well documented that commercial payers really subsidize Medicaid in particular, and some service lines, even Medicare.

And on a forward basis, you know, we’re looking at a Medicare increase all in the 2-1/2 to 3 percent range, which I mentioned is one of the best increases in 6 years. That hospital employment cost index was running 6 percent or a little better, so you’re not necessarily seeing the rate increases out of government agencies that are completely covering the costs hospitals are facing. And so they’ve gone to the commercial payers where they actually have some negotiating power to offset that. And I think barring any significant near-term capacity growth, hospitals are still going to be very aggressive in terms of raising prices.

Paul Ginsburg: And one other thing. As far as the outlook for construction, and we’ve talked mostly about demand for services and capacity constraints, but is the changing cost of capital an important factor that in a sense determines hospital construction activity? And what is the cost of capital today?

Gary Taylor: Sure. Well, I think I’ll let Bruce chime in on this as well, because a huge amount of the industry is nonprofit. I think everyone has benefited pretty substantially from a 40-year low interest rate environment. The nonprofits have an issue that bond insurance and availability of that capital isn’t necessarily incurring the same benefits to them, but for the for-profit hospital companies, you’ve seen massive capital spending over the last few years. Interest rates are historic lows. The health care high yield bond market is the hottest thing going. The convertible bond market is free paper, so I think that’s certainly played a role. And in the last few years with stock pricing having accelerated, whether you look at equity cost to capital on an earnings yield basis or you look at a beta, in either case, equity cost capital has fallen as well.

Now, that’s changed in the last few months after the Tenet debacle, but over the last few years, the cost of capital has come down pretty substantially.

Paul Ginsburg: Good.

Now I would like to introduce Tom Scully, the administrator of CMS. The reason that I asked Tom to do this is one of the innovations he’s put forward at CMS is by hiring a small staff of people who have backgrounds on Wall Street in order to give him and perhaps the congress a perspective on what is happening in the industry that hasn’t been available before.

So, Tom?

Tom Scully: I wasn’t prepared to give a long speech, but I will anyway if you want.

[Laughter.]

Paul Ginsburg: Actually, what I though we would do is just if you had any reactions to what you’ve heard.

Tom Scully: No. Lambert van der Walde I think is here someplace. Lambert used to work for Salomon and I hired him about a year and a half ago, and he does the small staff, and he’s about to put out a hospital report I think in the next week. We’ve put out a whole series of them in the last two years that try to condense the analysis that these folks do, and basically put it one place and send it around to the CMS staff and congressmen, senators and people in Washington.

As I always semi-jokingly say, when I ran the Industrial and Hospital Association, I used to go up to the Hill and whine about not getting enough money, and then I’d hope on a shuttle and go to New York and say things are great. Buy our stocks and bonds.

[Laughter.]

Tom Scully: And I don’t think people should get away with that now that I’m a regulator.

[Laughter.]

Tom Scully: So we’re trying to connect the dots on a more regular basis than your extremely helpful periodic conferences. So I think that’s basically the goal.

And now that I’ve heard what Gary has to say, I guess we’re going to have to back and be for market basket minus 10.

[Laughter.]

Tom Scully: Just kidding. But I think there is a disconnect, and it’s just a fact of life. I was an advocate in a prior life, and I think, you know, that the Blue Cross Association or the AHP or the AHA, your job’s to advocate for more funds, and my view is that we ought to--one of the reasons I think Lambert’s work is helpful is I think if you want to be a government contractor, which is effectively what you are, if you’re a nursing home you’re getting 85 percent of your revenues from Medicare and Medicaid. If you’re a hospital you said, probably 50 to 60 percent from Medicare and Medicaid. Our goal ought to be--you know, we want hospitals to do well, but not too well, and we want--

[Laughter.]

Tom Scully: That’s just a fact. Our goal as regulators is to pay people a reasonable return. They ought to be boring government contract returns. Some of my for-profit hospital friends don’t like that, but I think even as I’m sure Norm would say, people that are buying even hospital stocks or HMO stocks, that health care is perceived to be relatively low risk, or supposed to be In the last 15, 20 years I think it’s been extremely volatile largely due to government policies. You’ve had these huge roller coasters. If you look what happened to home health or nursing homes in the ’90s, had these huge margins and then these giant cliffs, the same thing with hospitals all across the board.

This is a government contracts business. I think it should be boring and predictable. Instead it’s been unbelievably volatile, which is not what people expect from a government contracts business, which is what health care largely is. So my hope is to get to the point where we have less volatility and more predictability and more boring stable margins, which as an investor I think it probably a good thing. People don’t buy health care stocks or bonds expecting massive returns. They generally expect predictability. The last 15 years has been pretty unpredictable.

So one of the goals I think Lambert out there is having is that people in Washington understand this better, so that they understand that when they do a reconciliation bill like in 1997, that you may get huge cratering in the nursing homes, and I mean I think that policy was right. The nursing homes were out of control in ’94, ’95 and ’96, but none of them saw what was coming in ’97 and I don’t think Congress understood how hard they were going to hammer them. The hospital cuts were probably bigger than everybody expected, and I don’t think anybody projected that. So one of my goals is to have more stability and predictability.

I can tell you one thing about this bill, despite the nervousness of the hospitals and others, that prescription drug spending last year in Medicare went up 30 percent. Physician spending, despite the negative 5.4 percent update--I’m still trying to figure out how you can have a negative update.

[Laughter.]

Tom Scully: But physician spending went up 8 percent last year. Hospital spending went up 9 percent, was supposed to go up 6 percent, and a part of that is the fact that the outliers, we overpaid $2 billion for outliers last year, and it wasn’t just Tenet, it was lots of other people. And just to show how brilliant we structured our program, we overpaid by $2 billion a year for hospital outliers four years in a row, and we only figured it out when some of the hospitals started ratting each other.

[Laughter.]

Tom Scully: So it’s not exactly a efficiency machine, despite the fact that some people argue that. But the one thing that worries me, I, obviously didn’t talk about reform. I think these reforms make a lot of sense. I do think you get a much more rational behavior when you get people paying hopefully in a more PPO structure, which is a much looser structure, and you have people making more efficient--I don’t think any insurance company in the world would have ever paid $2 billion for outliers four years in a row, would not have understood that. It just would never happen.

I think when you get into a PPO structure, you’ll get the kind of--some utilization control as you get much less from HMOs, much more rational decision making, but it’s only going to be a lot looser and it is not going to have the cost containment that some people were clamoring for 10 years ago.

But I think you’re going to see a big move towards that, but the bottom line this year is we’re spending $400 billion. There aren’t any cuts. It’s extremely. I mean you can call it a cut. The only, quote, cut on the horizon is market basket minus 4 in the House bill, which for those of you who follow the current law is market basket minus .55, which is the best the hospitals had in 30 years. So you can call it a cut. It’s actually an increase over current law. And there’s nothing in the Senate bill. There’s just a lot more money. So if you’re looking for the next few years, my view is this bill is going to have--lead towards more rational behavior and more stability in the long run. In the short run it’s a giant gravy train, and for the next few years, if I worry about anything, we’re going to overcompensate some of the traditional programs, and we may get congress to come back in two or three years--I think you’ll be fine, as you said, for the next three or four years, but if you overcompensate all these providers, which is going to happen in this bill, congress abruptly overreacts every three or four years, and I think that’s a concern, and that’s one of my--

Paul Ginsburg: I just want to interrupt you for a second time to ask people that this is the time to pass your question cards to the side I guess, so the staff can pick them up.

And you can continue now, Tom.

Tom Scully: But I think when you look at just some of the--you know, one of the reasons I’m such a strong advocate for some of these market-based reforms, which will happen very slowly and very gradually, is one thing I’ve learned from being on the policy side and the provider side for many years is people follow the money incredibly rapidly. And where we’re overpaying for ancillary care, we had a hell of a lot of ancillary care, and where were overpaying for home health, we got a hell of a lot of home health. I won’t pick on ASCs, but ASCs are growing rapidly because that’s where the Medicare incentives go.

Specialty hospitals are growing rapidly because the docs can get a piece of the payments. When you’re in a MedCath hospital, you get half of the hospital profit too. It’s not real hard to figure that one out. I happen to think specialty hospitals are fine as long as they have equal incentives.

DMA providers are doing great because they’re locked into the 1984 fee schedule that’s inflated by CPI or MCPI, which is nuts.

Then when you look across the place where you have these explosive payments, it’s all driven by unbelievably stupid Medicare policy, which, you know, outliers being a great example.

I think in the long run the health system’s going to be better off when you have people dealing more rational local decisions through a local Blue Cross plan, through a PPO. People don’t like HMOs. As your chart showed, 70 percent of the population under 65 is in a PPO. I think that has a fairly rational balance between some utilization oversight and not too much. We think it’s going to lead to a lot more rational behavior in the Medicare program. It’s going to happen very slowly. It’s not going to happen overnight.

But when you look at the Medicare program all across the board, look at doctors’ offices, I mean just for example, look at a doctor who is in a ASC versus his office versus an outpatient facility, and look at what the different payments are for a colonoscopy, and in about 3 seconds you can figure out where the volume is going to go. That’s all driven by outrageously dumb Medicare policy. That doesn’t make a lot of sense.

We think getting away from that, the local Blue Cross plan, can figure out pretty quickly where the best site of service is and what’s more rational. That doesn’t happen in Medicare.

So I guess in summary what I would say is, in the short term this bill’s about doing long-term reform, putting a hell of a lot of money into prescription drugs, very little pain for anybody, and it’s probably going to be a short-term gravy train. My concern is, when you see gravy train bills go through congress, they’re usually three or four years later followed by overreactions. And one of the goals of your conference, and hiring Lambert and other things, is to hopefully identify those and get rid of these big ups and downs.

I believe--and I’ve made this argument to, I hope my still friend in the hospital business but my former friends--that in the long run, you’re better off having your margins. Hospital margins are exactly at the historical average for 35 years. If you look at the best margins in the history of the hospital business, they were 1995 and ’96. 1997 congress saw that and creamed them. I believe in the long run, every sector of health care is better served by sticking to the basic boring margins. I think, for instance, market basket minus .4, you can argue about it. I think if hospitals get a full market basket update and a whole bunch of money, I’d probably be advocating for that if I were still a hospital lobbyist. That’s what they get paid to do. It’s very smart. I wouldn’t argue we should do market basket minus--even though I was joking--1.5, because that’s probably too harsh. But I think if you’re in a regulated you should look for boring, predictability and stability, and I think I worry about too much give-backs too fast because there will be a backlash in two to three years inevitably.

I didn’t see Roberta’s provision, but let me say on the provider side, I think this bill--the biggest thing you’re going to see out of it, it’s going to massively change the dynamics of not just Medicare PPOs but HMOs. If you look at where the money’s going and where the incentives are going, it is going to significantly refinance the private side of Medicare, which I obviously think is good. Medicare HMOs have been starved on the vine by a flawed payment policy the last few years. And that’s going to be significantly reversed, as will the PPO payment policy.

I think that obviously we have a health debate between my actuaries and CBO’s, but obviously we think we’re right. But I think what people are going to see is Medicare HMOs were unbelievably popular, especially with poor people in inner cities when they were properly financed. They haven’t been properly financed in the last 5 years, and the economic reality was that the finances got squeezed and people dropped out. And HMOs follow the money just like everybody else, so when there’s not enough money in the pot, they bail out. When there’s enough money in the pot, they’ll get back in.

Paul Ginsburg: Tom, that’s good. I’ve got two questions for you. Actually, this question is more for Roberta or Norm. That when you’re talking about the dumb things that Medicare has done as far as paying providers, what’s your perspective on, n the commercial insurance market, how sophisticated insurers have been in paying physicians and hospitals?

Norm Fidel: Well, you know you have--that’s a very difficult--I mean you have--

[Laughter.]

Paul Ginsburg: Actually I have a concrete thing in mind. What I was struck by is the degree to which managed care plans have adopted everything and almost everything in the Medicare physician payment system.

Norm Fidel: Yeah. But they haven’t had a whole lot of choice. As you know, I helped design--it’s better than what we used to have, RBRBS in ’89, but one of the frustrations--follow--we live in this capitalist world in which the only place that the government totally dominates is health care. If you’re a hospital and you’re getting 55 percent of your revenue from Medicare and Medicaid, then you’ve got 35 percent coming from your commercial payers who may be splintered unless you’re in Philadelphia with Independence or some very consolidated market or Alabama, Blue Cross of Alabama, you generally have splintered market power. You know, it’s kick the ball and drag the government. When the government’s paying 50 percent of the cost, the leverage of the private insurance plans to drive much is pretty limited.

One of the reasons I feel so strongly about the PPOs is if you take the Medicare population, which is a very high hospital consumption population, and take some of those people and plug them into the Blue Cross network, there’s going to be a hell of a lot more leverage. That’s what the hospital should be worried about and that’s exactly--not going to let that happen. If you take Independence Blue Cross or Blue Cross of Alabama, or Oxford, where I was on the board for 8 years or any other plan, and give them a significant portion of the Medicare population, which is a very high hospital consumption population, and stick them in their networks, their networks are going to be a hell of a lot more powerful to drive change than they are right now. Right now if you’re a provider, so much of your revenues come from the government, the market forces are extremely muted to drive any change at all. So why not piggyback on the RBRBS scheduled, the DRGs?

Paul Ginsburg: Roberta?

Roberta Walter Goodman: I think the amount of leverage, as we’ve been talking about today, is not all that, you know, it’s not all that great to deal with, some of the perceived problems. You know, the effect of the chargemaster behavior was certainly something that companies had identified before October of last year, but they did not have the ability or the leverage to go in and get that behavior to moderate.

I talked to one of the companies two years ago, actually over two years ago now, who knew exactly what was going on with those chargemaster issues, had brought it up to the company in question, and were basically told to take a flying leap, because that company needed those facilities in its networks to deal with the demand from large employers for a very broad and inclusive network. So despite the fact that they knew that there was a problem and despite the fact that they actually had a very large enrollment base, they really did not have a lot of ability to correct an abuse that they had identified until it became a public hot potato.

So I think that Medicare clearly has unilateral pricing ability. I personally don’t think that even with some volume coming in--and I think you’ve got a bit of a chicken and an egg problem there--even with some volume coming in, I don’t think that the health plans are going to be able to drive pricing that will match what the government has be fiat.

And the chicken and the egg problem is that without the pricing, you don’t have the cost structure. Without the cost structure, you don’t get the member. Without the member, you don’t get the pricing. So I think that there is a big issue there.

Norm Fidel: I think pricing for the providers just follows the line with pricing for the whole pie, which is really the private insurers. And for example, Gary mentioned that the pricing leverage for hospitals started to improve in ’99, but so did the pricing leverage for the insurers, so the pie got bigger. Health insurers had greater pricing flexibility in terms of their rate relief. And throughout the whole food chain, whether it be hospitals, or whether it be physicians at the low end of the food chain, their pricing improved.

So I think the pricing strength for hospitals will follow the overall pricing that you find for private insurers, and it’s not that much of a disconnect. The pie gets bigger, and the pie gets better for most of the sectors. Now, doctors have been at the worst bargaining position in that food chain and they have shifted to other methods to try and supplement their income, which includes a lot of physician-owned facilities, but for the most part I think in the other part of the pie, it really does follow what the overall health insurers are getting in terms of rate relief.

Paul Ginsburg: Good. The other thing I wanted to mention to you, Tom, is in the first panel there was significant discussion about whether--if the Medicare drug benefit passes, whether private insurer would be attracted into either providing the drug coverage for those beneficiaries staying in Medicare, or the PPO options. And I reacted to that as that, you know, isn’t this progress, that I think Washington is thinking in a more sophisticated way about we need to make this attractive if we want to rely on private contractors to do things.

Tom Scully: With the usual lobbying cycle from mid legislative process--and I won’t get into which, but lots of insurance companies call me every day and say, "This isn’t going to work. We’re not going to do it unless you fix the following 37 things." If the money is right, I believe they’ll show up. I think you found that in TriCare. You found that in FEHVP. You found it across the board. We very intentionally only pick three providers per region to create exactly--you know, we want to have local providers, and I’ve heard from Oxford and Harvard, Pilgrim and other people worried about, "Are we going to get in for the whole region?" And TriCare you’ve had regional affiliated bids from multiple companies. A couple of the TriCare regions had 6 or 7 companies that affiliated to make a bid, which is what we hope will happen.

But we clearly want Blue Cross an Cigna and other people to say, "Oh, my God, if we don’t--one of those three low bidders, we’re going to lose a giant amount of volume that’s going to affect our commercial network as well, so we’d better bid low." Which is exactly why we did it that way, and that’s one of main reasons our actuary shows us as saving money. It’s the DMAC [ph] that occurs in TriCare and it’s the DMAC we’re looking for. Now, are they going to complain and say, "Oh, you’ve got to let everybody in?" Of course they are. Are they going to say, "We’re not going to show up?" I mean the one thing that a lot of people have missed is that the average beneficiary premium rate, cost for Medicare right now, is 7,000 bucks a year. It goes from 4,000 to 11,000. Here in D.C., the center of waste in the universe, it’s 11,000.

The average is 7,000 bucks per beneficiary. The beneficiary pays 700 and the government pays 6,300. If you go give that to a Medicare HMO--their rates vary, as you know, based on 100 percent of the APCC, but let’s say it’s 100 percent of APCC--they have to carve a drug benefit out of that, and catastrophic stop loss and other things, so they’re basically providing the traditional Medicare benefit for probably 5,700, 5,800 bucks, spends the rest on margin and catastrophic and other supplemental benefits, and probably usually somewhere between 500 and 800 bucks for drug benefit.

We’re now going to give them 7,000 bucks, and on top of that we’re giving them 1,200 bucks to 1,300 bucks, depending on the House or Senate bill, in addition for drug benefits, and if they’re poor, they’re going to get 3,000 bucks. That is completely going to change the financing of Medicare HMOs and PPOs. They’re not going to have to carve a drug benefit and catastrophic out of their base rate any more. They’re going to get a big add on. And somehow people are missing that. That’s the $400 billion. That’s a hell of a lot of money.

Paul Ginsburg: Good. I’ve got some questions from the audience, some good ones. I’ve got a couple that were about hospital investments in information technology. And I want to ask people are they expecting a significant increase in that area? Are hospitals going to accomplish something with their investments in IT?

Gary Taylor: Can I just answer--one of the things that we always ask about in our survey is to have hospitals rank and prioritize where they’re going to spend their capital. Capacity growth continues to be number one. But in our survey this year, we did see information systems move from number two to--or from number three to the second lowest priority. So it seems like as they’ve done a little better, there is a little more focus there. But I think it’s probably been 10 years or 20 years that we’ve talked about this is an antiquated industry needing to update its systems, and I can’t see that we’ve made a heck of a lot of progress so far. So it still remains to be seen, I think, whether that’s just wishful thinking or if we’re actually going to see that accelerate.

Bruce Gordon: I’ll just add I think probably a third of most total capital budgets are an IT component. Electronic medical records seems to be the latest thing in vogue. We’ve got a couple of unsuccessful ventures, high-profile ones, that have come out in the news lately, but I think, by and large, there are significant efficiencies to be reaped here, you know, particularly just--as Tom said, following the dollars. A lot of this stuff is back-office sort of blocking and tackling, and if you’ve got better systems, just even in the billing office, you’ve got a lot of dollars that you can reap to the bottom line.

Tom Scully: I think we’re very big on doing something on electronic health records, but I think it ties in with the whole broader issue and we’re trying to tie it to the whole broader issue. Hospitals are--all health providers are 25 years behind the rest of the world in IT. As Tommy Thompson always says, you know, he can go to Jiffy Lube in Milwaukee and find out what happened to his car last month, but he can’t get his medical records.

We’re trying to modernize that, but our view is we’re interested in funding and hospitals and other providers for IT, but we want to tie it to public information. And we’re happy to finance better electronic health records, but we want to take that data and send it to us so we can put it in the newspaper because we believe that tying this quality in is that nobody in Washington can tell you, if you flew into town today, they could tell you where to go for a heart bypass or a hip replacement or what’s the best nursing home. And we believe if you’re going to start having the payment differentials and driving quality, people have to have information. They have zero in health care.

So we’re very interested in funding electronic health records and funding IT and speeding that up and catching up in the health care system. But we want to tie it to them sending it in to give the public a hell of a lot more information about quality because we think that’s--you know, if you go out right now and say, you know, everybody wants to be in the network and everybody says Blue Cross is going to pay the same thing, you start putting ads in the Washington Post about whose ASC is better than the other one, and all of a sudden they don’t have to be in the network anymore. And that consumer information we think is a huge missing piece of this puzzle.

Paul Ginsburg: There are a couple of questions about physician-owned specialty facilities and hospitals. One of them, maybe for you, Bruce, is: Do you see a significant impact on academic health centers and teaching hospitals of the growth of this competition?

Bruce Gordon: I don’t think it’s limited just to the impact on AMCs. I mean, I think we have seen this in almost every market--I think we have seen this kind of activity in almost every market, including the most rural markets, where we were very surprised to kind of see, you know, the physician sort of leaving the comfort of the hospital. But indeed, as many have said, you know, it’s a dollars-and-cents thing, and they’re going to supplement their income as the law allows it.

I think the academic medical centers may be more fiscally at risk because they’ve got obligations on the teaching and research side that don’t pay for themselves. I think the whole mission that they have, their physical locations typically in urban areas where they’ve got a high Medicaid and indigent mix, you know, they’ve kind of got two strikes against them to start off with fiscally.

Paul Ginsburg: Thanks.

There’s a question for you, Tom, on this about what modifications to the Stark regulations are being considered in CMS on physician ownership, especially hospitals.

Tom Scully: Well, there was something printed, I guess in some rag now, that we’re going to do something on the regulatory--it’s not clear we have the regulatory authority to do this. If we did, I would have already done it. And I have no problem with specialty hospitals. I think specialty hospitals fill a valid spot. If you’re a doctor and you’re in a hospital and they’re not providing for your needs, you have a right to go across the street to another hospital that may have 30 beds and is much more specialized in hearts or hips or whatever else.

My concern about this is not the specialty hospitals. It’s with the whole hospital exemption. The Stark exemption was a special--it was intended originally if you’re a doctor, there was an exemption to the anti-kickback laws on the theory that if you bought into a 500-bed hospital and you were a surgeon or you were a GI guy doing colonoscopies, that you couldn’t possibly steer enough volume to have an effect on the whole hospital. So you could invest in the whole hospital because you couldn’t possibly affect volume.

Well, obviously, if you’re buying shares in a 30-bed hospital and they’re all surgeons that are doing hearts, you can affect volume and that’s the whole design. I don’t think anybody envisioned it, and I think the whole hospital exemption is being abused to give a financing advantage.

If you’re at Bakersfield Hospital, just to give you an example or one particular set of example, and you’re at Bakersfield Community Hospital and somebody opens a heart hospital across the street, I have no problem if they’re opening it because Bakersfield is not doing a good job of taking care of the surgeons. But if we’re paying 3,000 bucks, 4,000 bucks to the surgeon for the procedure and fifteen to the hospital and the surgeon’s going over there because he wants a piece of the fifteen not just the four because he owns 50 percent of the hospital and he’s going to get 50 percent of the profits, that’s not an appropriate incentive. And that’s what’s happening.

So I am very concerned about the perverse incentives created by the whole hospital exemption. I believe surgery hospitals will grow, anyway, just because physicians are looking for better services and better places to go. So if you’re in MedCath or National Surgical, the two biggest, I think this is going to grow, anyway. Should it be artificially fueled by pouring gas on the fire by having the whole hospital exemption? I don’t think it’s good policy, nor is it appropriate. I think Senator Breaux offered an amendment to do something in the Senate. Congressman Thomas has been real interested in this. His views on this have fluctuated back and forth as opposed to doing something, and it depends on the day I talk to him.

So I’m not sure what’s going to happen, but I don’t think anybody should look at this as being anti-specialty hospitals. Specialty hospitals provide positive pressure in the system. If you’re not doing a good job of taking care of your docs and they run across the street, terrific. But they shouldn’t do it because they have an artificial Medicare-induced financing incentive.

Paul Ginsburg: Gary, from your knowledge of these companies, do you have any perspectives on this issue?

Gary Taylor: Well, I still think that carrot that you’re holding out to the physician to have some ownership interest is hugely attractive, and I think you take that away, you cause a significant barrier to entry for both the private and public surgical hospital. So perhaps they may grow, but I would think that the growth rate would be curtailed pretty significantly.

If you look, on the other hand--

Paul Ginsburg: You wouldn’t want to call that a barrier to entry. It’s more of an extra attraction entry?

Gary Taylor: Well, right, it’s an anti-barrier at this--

Tom Scully: Or a kickback.

[Laughter.]

Gary Taylor: These specialty--

Tom Scully: Actually, if I paid you a hundred thousand bucks to come speak today, you’d probably be more likely to come than if I didn’t.

[Laughter.]

Roberta Walter Goodman: We’re not allowed to accept.

Gary Taylor: You know, the one thing to note, though, specialty hospitals isn’t a new concept. It’s the development of surgical hospitals focused primarily on orthopedics and cardiology that I think is a fairly new phenomenon. It’s a very small number of hospitals. But, you know, in the U.S., we have hundreds of women’s hospitals, children’s hospitals, cancer hospitals, and these have been developed to provide specialized care for a singular disease, generally, or a type of patient--

Tom Scully: And that’s fine, but--

Gary Taylor: Right, and that’s been developed, but they don’t have the advantage of offering the same sort of physician enticement. So it’s definitely an uneven playing field that’s played very nicely into the hands of the surgical guys. And, you know, accordingly, they’re going to be quite upset to see millions of dollars of capital potentially being--

Tom Scully: I don’t think anybody’s talking--I mean, most of the proposals, including Breaux’s, I think grandfather in the old--the existing facilities. The issue, as you can see, things are being fielded, and I’ve met with the surgery hospitals, I have no problem with surgery hospitals. I have a problem with an artificial fueling of the incentives. I think they’ll do just fine without it. There are plenty of doctors who don’t like being at a 500-bed hospital and they’re not attentive enough and they’d rather go across the street. And they’d probably go, anyway, to one that provides them better service. The issue is do they have to have an ownership interest or not, and I think that’s the issue.

And in ASC, by the way, nobody’s talking about doing anything in ASCs because ASCs are different. It’s a hybrid. It’s different behavioral incentives, and obviously doctors own their own offices, and ASC is a different setting than--I mean, the ASCs have physician ownership, primarily physician-owned for years, and I don’t think anybody’s look at affecting that.

Paul Ginsburg: I’ve got a question here that in a sense it may be--it was about, you know, the attractions of what today are Medicare-Plus-Choice plans under drug reform. And I remember a few years ago when we were discussing a drug benefit then, people used to say, oh, if Medicare enacts a drug benefit, that’s going to be the end of Medicare-Plus-Choice because so many beneficiaries had joined in order to get drugs, and if they don’t have to join to get drugs, they won’t do it.

What’s the perspective today?

Tom Scully: I couldn’t disagree more with that. I think certainly that was the attraction of drugs. If you look back to ’97, just since everybody argues about who’s right and wrong with CBO and OMB, if you remember ’97 we had 18 percent of the people in Medicare-Plus-Choice plans, and everybody was certain it was going to be 30 percent by 2002, and they were wrong. It was 11 percent.

The reason is they basically disconnected the AAPCC from the rates and the places where it was popular, like Philadelphia, New York, Chicago, Detroit, Miami, L.A., and all the big urban areas, got frozen at 2 percent five years in a row. And all of a sudden if you look at their rates, they’re 88, 89 percent of AAPCC and there’s nobody there.

Look in rural areas, there’s places where you’ve got 140 percent of AAPCC, and nobody’s--you can’t do an HMO there. So we’ve gone from $43 billion a year in spending to about 30 on Medicare-Plus-Choice plans, and it was totally predictable. I mean, everybody says nobody likes HMOs. That’s just garbage. The fact is you screwed up the policy, and it was as predictable as the sun coming up what was going to happen.

Paul Ginsburg: So, in a sense, maybe you’d say it’s really the fixing of the reimbursement mechanism to private plans that’s really the key in addressing that.

Tom Scully: Well, I think what’s going to happen, in my opinion--and I testified to this last week--if you look at a senior right now who’s hitting 65, if they want to stay in Medicare, under both House and Senate bills they can stay in Medicare. They’re going to get a Medicare benefit that’s wonderful, community rated for 60 percent of their costs, and they’re going to keep that.

On top of that, they’re still going to go out and buy Medigap, an average of $2,200 a head that’s not community rated, it’s highly risk selecting, it’s a poorly structured plan. And on top of that, they’re going to get a $1,200--if they’re not poor--drug-only benefit that’s also going to be poorly structured, but will probably exist.

As opposed to going to Empire Blue Cross and getting one package that’s far more efficient, that’s community rated, run by the government that gives them supplemental plus Medicare, plus drugs, in one package that’s much better designed. That was always the appeal of Medicare. The problem with Medicare is some people don’t like the restrictions of HMOs.

But when you look at the benefit package for a 66-year-old in a couple of years and what they’re going to get from going to Empire Blue Cross when they hit 65 and staying in a plan that they’re already in they like versus buying--getting Medicare plus a sloppy supplemental, plus--I believe it will exist, but it will be sloppy and not a particularly pretty package, a $1,200 drug-only plan, I think you’re going to see people in hordes going to the PPOs because it’s going to be--for the reason everybody in this room is in a PPO. It’s a simple, much better structured, community-rated insurance package that is going to have better benefits for less cost.

Paul Ginsburg: Good. One thing I want to ask people is we really do use your evaluations, so if you haven’t filled it out, it would be great to start doing it now before you leave.

If there are people that would like to come up to the mikes and ask questions, this would be a good time for that, and I’m going to keep trying to flip through--actually, I’ve got one, I guess mostly for Gary.

The impact of HealthSouth, please comment on how the HealthSouth investigation is having an impact on investors’ confidence of for-profit specialty centers in general and rehabilitation or orthopedic providers specifically.

Tom Scully: I’ll just say from Moody’s point of view, there’s been a boom in criminal justice construction in Birmingham.

[Laughter.]

Gary Taylor: I’m on the nonprofit side, Tommy. There are probably some very big parking lots down there, too, because they all drive SUVs.

Well, obviously I think, you know, that the HealthSouth issue on the heels only a few months following, you know, Tenet’s issues have dealt a pretty severe blow to investor confidence in the area. I think that goes without saying.

I don’t know that we’ve seen a tremendous amount of behavior change. It’s unclear to me--quite frankly, I think HealthSouth’s issue that they had raised in terms of how they were billing for a group versus individual seems to be certainly a big smoke screen. And so I think at first many people were concerned that what you would call a reiteration of the policy, there was a great debate over whether it was a change in the policy or reiteration and were they going to see changes in physical therapy practices. And I think HealthSouth’s side of that issue is a distraction--

Tom Scully: An intentional distraction to write off earnings--

Gary Taylor: Right. Correct. So, you know, I haven’t seen--you know, I think certainly in the near term there are some other public companies in the sector that do rehab and do orthopedics, and I think those stocks initially followed what you’d expect, a big sell-off, and they’ve recovered. And I think people have, believe it or not, really looked at HealthSouth as a very company-specific, management team-specific issue that wasn’t entirely a surprise to a lot of us, probably.

So I would say the implications there are probably far less reaching than what happened with Tenet in October in terms of really shaking people’s confidence in the sector.

Tom Scully: As you know, many people I used to represent, both in HealthSouth--I happen to be a fan of for-profit medicine. There are some good incentives for shareholders driving better incentives. The bad thing is if you don’t address the board oversight, the money incentives; the bad news is without effective regulation of board oversight, there’s obviously dangers of for-profit medicine. And I think HealthSouth and Tenet--I can tell you I’ve been to a lot of HealthSouth facilities as a--you know, I think HealthSouth is obviously going to be turned upside down, but they do have good hospitals. They provide good care. And I think from Medicare’s point of view, you know, we spent some trying to make sure that new, honest management comes in and we don’t blow up 70,000 employees and hospitals.

Similarly, Tenet, who obviously did some wild stuff in outliers, generally runs bigger hospitals and they’ve done a good job in Philadelphia, for instance, in turning around the Allegheny system. On the other hand, they obviously figured out the outlier game better than anybody else and milked it and they’ve paid a price for that.

I think in both cases, effective board oversight, much more aggressive shareholder oversight to make sure that people understand that if you act irresponsibly, it has inevitable results, would have prevented some of those. But I don’t think either one of those companies run bad facilities. I think they just had extremely bad, irresponsible management, most of which has been changed.

Paul Ginsburg: Let me turn to a couple of audience questions. I think we’ll just do both of you and that’s about all we can do. I think, Marc, were you up first?

QUESTION: Marc Freeman, Public Policy Institute, AARP. I’d like to follow up on some of Tom Scully’s initial remarks and ask the panel if they have any comments on the nursing home industry, particularly since a large portion of it consists of private for-profit chains and there have been a variety of events recently, some that maybe should have been anticipated, some that weren’t, that have led to a series of bankruptcy filings and, as indicated in the most recent CMS market review report, a pretty much complete drying up of the equity financing market for nursing homes.

Norm Fidel: Well, going back to the bankruptcies, I think there was a whole difference in the nursing home industry. I think the individual mom-and-pop nursing homes, you know, there wasn’t much of an issue there. I think the bankruptcies resulted from a lot of the ancillary service activity that a lot of the public nursing homes go into, and it was almost a special situation in that case. I don’t think that the finances of the individual nursing home have been under the pressure that has been perceived that the large for-profit nursing homes which own virtually all but one or two have gone bankrupt.

Roberta Walter Goodman: The other thing you have to look at would be--with the large publicly traded companies that were active in that industry is that, you know, as Tom said, they were taking advantage of the Medicare incentives that were there. Not only were they taking advantage of that, but they were making a lot of acquisitions that were designed to take further advantage of it, and they were financing those acquisitions with debt. At the same time, these companies were not generating cash flow from operations. They have very long receivable cycles, and having to crunch on reimbursement is just unsupportable in those circumstances. And as Norm said, that’s not the same situation that you would see with some of the more traditional and less aggressive companies.

Gary Taylor: I’ll chime in. You know, I cover the nursing home industry as well, and I think what we’ve seen recently, certainly in terms of lack of investor interest and lack of equity financing currently, you certainly can’t blame the balance sheets anymore because they’ve all gone through bankruptcy and the balance sheets look a lot different. But lots of other issues in terms of labor costs, in terms of reliance on Medicaid, in terms of medical malpractice costs being significant issues for investors to overcome. And, you know, following the sector, we were really pleased recently. It seems that CMS has kind of changed the tune a little bit. I think Tom would tell you that Medicare cross-subsidizes Medicaid plans, and CMS has generally been unwilling to continue to try to do that to a greater extent, but has been willing recently to create a fix in the formula, has added some money back to the nursing homes.

So I don’t know that at the end of the day that’s enough to really get these guys stabilized on their feet. I think some of the longer-term issues in terms of tort reform and regulation of medical malpractice rate increases or something you need to see longer term before investors are going to have a real prolonged interest in the sector.

Tom Scully: Let me just add, you know, this is--Roy Lambert’s reports have helped the White House and helped me, and the reading of your analysis. I don’t--we don’t try to pick favorites anyplace. I think hospitals should have (?) margins, HMOs, and the nursing home industry. The bottom line is we’ve got a huge tidal wave of seniors coming, and I don’t know of anybody who wants to be in the nursing home business, and that’s not a good thing. And we’ve got to have capital in the nursing home industry, both equity and debt, and right now they’re limping along, and we’re not excited about massively repaying in Medicare, which we do, but the states are--you know, we’re forced to for now, and in the long run, we’ve got to find a whole bunch of other ways to finance long-term care, like reverse mortgages and other things we’re working on, because ten years from now you’ve got to have nursing homes and assisted living. We’ve got a tidal wave of people coming, and it’s greatly in all of our interest to have talented people interested in going into the nursing home business, not to make a lot of money but to make a respectful margin. And it’s not in anybody’s interest that nobody covers--I mean, I don’t know of anybody. I’ll bet you Norm hasn’t bought a nursing home stock in years. And it’s not that I like for-profit, nonprofit, or anything. The fact is it’s in everybody’s interest to have an infrastructure to take care of seniors as they age, and right now it’s a miserable business, and in the long run I think it’s the government’s responsibility to at least keep it going while we look for answers to make the long-term financing work better, which includes Medicaid, which is extremely tough now with the state problems.

I’m not--believe me, we have 25 to 30 percent margins in Medicare long-term care, but there are negative margins in Medicaid. We’re not at all happy about propping up the system through Medicare. It’s not the right thing to do, but in the short term, I think it’s the only Band-Aid we have.

Paul Ginsburg: Yes, last question.

QUESTION: My name is Lisa Schell (ph), and I’m with AHA News. My question is: Why isn’t CMS going to put out regs in July on the niche issue? I believe that you answered the question, but you said that you had a concern about this, about--

Tom Scully: On specialty hospitals?

QUESTION: Right, about specialty hospitals, and I missed that part.

Tom Scully: I have a little teeny problem called my general counsel.

[Laughter.]

Tom Scully: I’ve beat the drum a lot about it, which is (?) some things. I feel strongly personally that we should close the whole hospital exemption. It’s debatable as to whether we have the legal authority, and we generally--I get sued a lot as it is. We generally try not to put out regulations without clear legal authority. We’ve been encouraging Congress to do it, but it was--it’s not certain--in fact, I would say our lawyers probably think it’s questions that we have the legal authority to fix it in the whole hospital exemption right now. If we could have, I would have.

Paul Ginsburg: Let me just close the conference now. A couple of things that I’ll recall, very selective. The perspective by at least two of the panelists that hospital price trends might be moderating in the future, although I don’t think you would agree with that, Gary, given what you said about occupancy growth.

Gary Taylor: Well, I think increasing capacity could cause occupancy to slow, and that could cause some moderation. I also agree with Roberta’s point that we’ve had a lot of catch-up and stop-loss payments and a lot of things in there. And as you see some of those come out, you could see some moderation.

Paul Ginsburg: Okay. So we’ve got that, hospital price trends moderating, the cost trend projected to slow, and I think the premium trends will follow the slowing in cost trends but will not anticipate it, and also a projection that drug spending, which has come down quite a bit, will pick up in the next few years.

I want to thank the panelists for doing a really good job. They came very well prepared and really brought us very valuable stuff. And the HSC staff, and Richard Sorian was involved in planning this conference with Joy and myself, and Roland Edwards really set up all the arrangements in a great fashion, as he always did, and lots of other staff helped out, especially in the last two days, and we’d like to thank them.

[Applause.]

Paul Ginsburg: And please do fill out your evaluation forms and drop them off.

[Whereupon, at 12:03 p.m., the meeting was adjourned.]

Participant Biographies

NORMAN M. FIDEL, M.B.A., C.F.A. - Senior Vice President, Alliance Capital
Norman M. Fidel is senior vice president of Alliance Capital, where he covers pharmaceuticals and healthcare services. He joined Alliance in 1980 from Eberstadt Asset Management, where he was a senior vice president and director of research. Previously, he was a security analyst with Irving Trust Co. He is a member of the New York Society of Security Analysts and the Health Industries Analyst Growth Group of New York. Fidel manages the Alliance Health Care, ACM International Health Care, the Global Growth Trends, Mackenzie Universal Health Sciences, and AXA Global Equity Healthcare funds and co-manages the Alliance Select Biotechnology Fund. Fidel was named to the Institutional Investor Best of the Buy-Side All Star Team in 1989, 1991, 1996, 1998, 2000 and 2001. He attended Tufts University, received his bachelor’s degree from Babson College and his M.B.A. from New York University. He is a chartered financial analyst.

PAUL B. GINSBURG, Ph.D. - President, Center for Studying Health System Change
Paul Ginsburg, a nationally known economist and health policy expert, is president of HSC, a nonpartisan policy research organization in Washington, D.C., funded exclusively by The Robert Wood Johnson Foundation. Previously, Ginsburg was the founding executive director of the Physician Payment Review Commission (PPRC), created by Congress to provide nonpartisan advice about Medicare and Medicaid payment issues. Under his leadership, the PPRC developed the Medicare physician payment reform proposal that was enacted by Congress in 1989. A highly respected researcher, Ginsburg previously has worked for the RAND Corp. and the Congressional Budget Office. He earned his doctorate in economics from Harvard University.

ROBERTA WALTER GOODMAN, M.B.A. - First Vice President, Merrill Lynch
Roberta Walter Goodman is first vice president of the Merrill Lynch equity research department and has been with Merrill Lynch since September 1997. Previously, she was a vice president at Goldman Sachs, with responsibility for coverage of the health services industry. Goodman also has served as an associate with Donaldson, Lufkin & Jenrette, assistant vice president at Thomson McKinnon Securities and director of strategic planning at Samaritan Health Services in Phoenix. She has been named an institutional investor all-star from 1992 to present. Goodman is a member of the National Health Policy Forum Private Markets Technical Advisory Group. She has an M.B.A. in finance and healthcare administration from the University of Chicago and a bachelor’s degree in economics and history from Cornell University.

BRUCE GORDON, M.B.A. - Senior Vice President, Public Finance Group, Moody’s Investors Service
Bruce Gordon joined the Public Finance Health Care Ratings Group of Moody’s Investors Service in 1993 and is currently a senior vice president. He was named team leader of the Health Care Group in spring 2002. Gordon’s primary geographic responsibilities include assessing credits in New York, Illinois, North Carolina, South Carolina, Maryland and Minnesota. He also handles a number of the large, multi-state hospital systems and long-term care credits, and serves as the primary health care contact for issues surrounding liquidity facilities and legal structures. Prior to joining Moody’s, Gordon spent eight years with The Toronto-Dominion Bank, the last five of which were with the bank’s health care finance group in New York. Gordon earned his M.B.A. from Cornell University and his bachelor’s degree in economics from the University of North Carolina at Chapel Hill.

JOY M. GROSSMAN, Ph.D. - Associate Director, Center for Studying Health System Change
Joy Grossman is associate director, HSC, where she contributes to the development of HSC’s research agenda and oversees data collection activities. Grossman’s research focus is on health plan and provider competition and market variation in managed care. Before joining HSC, Grossman was a health policy analyst with the Prospective Payment Assessment Commission. In this position and in prior research positions, she worked on a variety of issues related to hospital financing and competition. As an investment banker in New York, she arranged tax-exempt financings for non-profit hospitals. Grossman earned her doctorate in economics from the University of California at Berkeley.

TOM SCULLY, J.D. - Administrator, Centers for Medicare & Medicaid Services (CMS)
Tom Scully was appointed by President George W. Bush and confirmed by the U.S. Senate in May 2001 as the administrator of the Centers for Medicare & Medicaid Services (CMS), formerly known as the Health Care Financing Administration. CMS is responsible for the management of Medicare, Medicaid, SCHIP and other national healthcare initiatives. Before joining CMS, Scully served as president and chief executive officer of the Federation of American Hospitals from January 1995 to May 2001. Scully is also a former partner in the Washington, D.C., law firm of Patton Boggs, LLP, where his practice focused on regulatory and legislative work in health care. Before joining the law firm, Scully worked at the White House as deputy assistant to the President and counselor to the director of the Office of Management and Budget (OMB) from 1992-93, and as associate director of OMB for Human Resources, Veterans and Labor from 1989-92. He was an attorney with Akin Gump from 1985-1988, and he worked for U.S. Sen. Slade Gordon from 1980-1985. Scully holds a law degree from Catholic University and a bachelor’s degree from the University of Virginia.

GARY TAYLOR, M.B.A. - Principal of Equity Research, Banc of America Securities
Gary Taylor is a principal and senior research analyst at Banc of America Securities where he focuses on health care facilities and health care REITs. He is responsible for coverage of hospital management companies, long-term-care providers and other health care facilities companies. For the past two years, he received recognition from Institutional Investor as a "Best Up and Comer" for his work on the health care facilities sector. Taylor joined Banc of America Securities in 1999 as a senior associate focusing on health insurance companies. He was promoted to research analyst in 2000. Prior to joining the firm, he worked for A.G. Edwards & Sons, Inc., as an associate vice president in investment banking where he originated and arranged public and private debt financing for hospitals and nursing homes. He also acted as a senior consultant for Ernst & Young, performing operational and financial analysis for hospitals and other health care providers, including feasibility studies and merger analysis. Taylor is a graduate of the University of Missouri, where he received his M.B.A. and Master of Health Administration in 1994 and his Bachelor of Health Science in 1992. He is a member of the American College of Healthcare Executives and the Healthcare Financial Management Association.