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	HSC's 10th Annual Wall Street Comes to Washington Conference

10th Annual Wall Street Comes to Washington Conference

Conference Transcript
July 13, 2005

Paul Ginsburg: I would like to welcome you to HSC’s 10th Annual Wall Street Comes to Washington Conference. The purpose of the conference is to give the Washington health policy community better insights into market developments in healthcare that are relevant to policy. Discussing market developments and their implications for people’s healthcare is what I would call a core activity of HSC.

Last month we completed interviews for our fifth round of site visits, and both HSC publications and peer reviewed journal articles will begin appearing next month. The information obtained from these visits has inspired many of my questions to the analysts on today’s panels. This is an opportunity for all of us to tap a different source of information on healthcare markets, specifically what equity and bond analysts can provide on this topic.

Equity analysts advise investors about which publicly traded companies will do well and which ones will not, and bond analysts advise on the likelihood of debt repayments. The very best analysts develop a thorough understanding of the markets that the companies they follow operate in. They also follow public policy which often has important implications for these companies. Some analysts work for brokerage companies and advise the clients of these firms and others work for institutional investors such as mutual funds, and they are called sell-side and buy-side analysts respectively.

Since the sell-side analysts in healthcare tend to specialize in either managed care or the providers of health services we have organized two separate panels for this meeting. Buy-side analysts tend to cover both areas so our buy-side analysts will participate in both panels. And, we have an analyst from one of the companies whose business is to rate hospital debt. This analyst will participate on the panel on provider issues to make sure that we can bring in the developments from the non-profit hospital sector.

Today’s meeting is, the way I see it, an opportunity for the equity and bond analysts to take a break from their day jobs of assessing the outlook of profitability of companies and their solvency and to bring their understanding of market forces to bear on questions that those involved in health policy have on their minds. We also include on each panel a Washington-based health policy analyst, and these people have made valuable contributions to these sessions by tying the market developments more closely to health policy.

The format is what we have done most times in the past of not having presentations by the panelists and basically just having a roundtable discussion of a series of questions that have been shared with the panelists in advance. We are going to have two sessions today, one on healthcare cost and premium trends and various issues connected with managed care or health insurance; and the second one on hospital and physician issues. There will be opportunities for Q&A from the audience after each panel. There are question cards in your packet and, please, fill them out and give them to an HSC staff members, or you can go to one of the microphones to ask your question and we will take questions both ways. Note that the analysts are not permitted by their employers to answer questions about the outlook for specific companies.

I want to thank the Robert Wood Johnson Foundation who funds this conference and is the principal funder of HSC, and also thank the people at the kaisernetwork.org for web-casting this conference. The web cast will be available tomorrow after three o’clock at the kaisernetwork.org web sites. HSC will post a transcript of this conference by early next week.

Before you leave the conference, we would appreciate it if you would take a moment to fill out the evaluation form--it is purple this year so that you won’t miss it--and leave it on the registration table.

I would like to say a few things about the panelists. We have two terrific panels today. The panels as a whole comprise three analysts who participated in last year’s meeting, Roberta Goodman, a veteran of numerous conferences in this series; Bob Reischauer, who has participated three or four times; and Bob Laszewski, who has participated in a second meeting. We also have three analysts who are new to the meeting, Christine Arnold, from Morgan Stanley; Fred Martucci, from Fitch Ratings; and Ted Shannon, from Janus Capital Management. I am not going to go through their bios which are in the book, and I hope you do read them to get a sense of their experience in Wall Street and related environments.

We are going to begin our discussion with cost and premium trends. Since Brad Strunk and I published our annual synthesis on this issue just a few weeks ago, I want to mention a few key findings to set the stage for the first part of the discussion. We concluded that in 2004 the slow-down in spending growth that we had seen for the previous two years appeared to level off, but the rate of increase in 2004 was well above trends in either gross domestic product or the earnings of employees so that affordability problems continue to increase.

The premium trend, which usually lags the spending trend, is continuing to slow and we saw the possibility of a slowing in the rate at which patient cost sharing is being increased by employers. We saw a continued slowing in the rate of growth of spending on prescription drugs with the one exception from the rock-solid stability in trends in the other sectors. And, for hospitals we saw that price increases continue to be much more important than utilization increases.

So, let me begin the discussion with the first question of asking the panelists about costs and premiums and their sense of the outlook for 2006 and beyond. First let’s talk about the trend in underlying costs. Do you see that the trend is going to continue to fall or pick up again, Christine?

Christine Arnold: Well, contrary to our expectations, we are seeing a continued deceleration in medical trend within the commercial books of business. What is puzzling though is that different sources of data are giving us different reasons for the deceleration in medical trend. Publicly traded companies reported a first quarter trend of about 8.3 percent. That is versus 9.8 percent in 2004. So we are seeing better than 150 basis points of medical trend deceleration. In addition, prior period positive development, which is having guessed the medical trend was higher than it actually was in 2004, has accelerated with a lot of the companies so it looks like 2004’s medical trend was actually lower than initially reported.

We are expecting patent expirations in 2006 to shave perhaps 65 basis points off the medical trend, but the key here for us is we are not quite sure where this year’s medical trend deceleration is because Milliman says it is coming from drugs, yet, the companies say it is coming from inpatient and physician costs.

Robert Laszewski: I think it is important. You made a point a minute ago, Paul, that I really want to underscore, and that is the difference between insurance pricing trend and actual cost. More and more the scenario we are looking at now looks to me like the traditional insurance underwriting cycle. Trend was very high going back three, four years and we continually saw the insurance industry pricing very high numbers and getting what I call a trend windfall. As we saw the deceleration in trend that Paul’s report points to going back to 2001, 2002, 2003, the pricing trend stayed high and that is characteristic of the insurance cycle. That is, the insurance company or the managed care company is able to price a number that is always higher than the actual when trend is falling so you get a trend fall profit.

It takes a few years for the benefit management community to kind of catch onto that and, with their negotiations expect that their actual numbers will be better than that. And, I think that is what we are seeing. Tougher negotiation now is bringing that number down.

I think the most significant thing though in Paul’s data is that the underlying number really hasn’t changed for the last couple of years. So, we are still getting this catch-up as the pricing trend is coming down. What is happening is that the underlying number has been flat now for a couple of years and we are starting to get more negotiating pressure that may, in fact, take us below the actual trend. If we look at the so-called stop-loss or self-insured market we are already seeing signs that the insurance companies are collecting less in trend than the actual number, and that is the most price sensitive part of the market and it is always the first one to show the evidence of the cycle, if you will, or the evidence of the market demanding something less than the actual numbers.

So, I think what is important here is, yes, the insurance company pricing trend is always on a one- or two-year delay but what is important is that the underlying numbers are flattening out, and I don’t see any evidence that that is going to change in the next year or two.

Paul Ginsburg: Go ahead, Ted.

Ted Shannon: I just want to interject something. I think one of the things that the data is confusing analysts, like people up here, is that we are all assuming that the data is based on the assumption that the products being sold this year are the same as the products being sold last year and products being sold the year before that. What I actually believe is going on, based on our research, is that we are actually in the middle of a product cycle in the industry. So, as a result, year over year trend comparisons for premiums versus costs aren’t really on an apples-apples comparison. When employers shift more of the cost of healthcare onto the cnonsumers and as we move into more consumer-based products, consumer-designed products such as HRAs, HSAs or other derivatives of that same account-based thesis, what you are actually seeing is a beginning of a product cycle that looks much more like 1988 in the industries from a cycle perspective when we saw the movement from indemnity-based insurance products to managed care-based insurance products. So, I think a lot of the comparative data that people like us talk about is somewhat skewed because of that underlying dynamic going on in the change of the products.

Paul Ginsburg: Go ahead.

Christine Arnold: I would also add that as we look at this there is a big difference between what is a paid claim that gets kind of into the data and what is actually an allowed claim. Different companies, as they talk about their trends, talk about these things in very different ways but from an actuarial standpoint you really have to look at the allowed claims to judge what is happening with the underlying cost because that does capture what not only the employer is paying through the premium but also what the individual is paying out of pocket. That data, unfortunately, is not that readily available.

Paul Ginsburg: So, if I can point out what I think it is that we really have three types of data. You know, we all know what premiums are, and the underlying costs that I report, which are from the Milliman Health Cost Index, are based on reports from providers about the revenues. But, in a sense, the point that Ted and Roberta bring out, is that a lot of the numbers that insurers point at are the claims that are allowed or paid, which are influenced by product design. Whereas, the Milliman numbers presumably are not influenced by product design. In a sense, if a product has changed their numbers are only influenced if doctors or consumers are behaviorally responding to that.

Christine Arnold: I am not sure I agree that we have seen a shift in product design. We have seen a major hiatus in benefit design changes in 2005. The Hewitt large employer data suggests that; our broker surveys suggest it; the large employer surveys suggest it; and the employer forms suggest it. In addition, less than five percent of any HMO’s total book of business is right now in any form of consumer directed. Less than five percent. And, less than half of that is actually in at-risk business. So, I think we may be on the cusp of a product revolution, which I have been hoping for but I don’t think it is here yet. So, I don’t believe it is skewing the data yet.

Ted Shannon: But I think the precursors to that with the increasing cost share are the member--I mean, if you assume that that is a precursor and that the cost-sharing levels are changing significantly year over year, that definitionally will skew the trend analysis that we are talking about.

Christine Arnold: I think we could see that over time.

Christine Arnold: I think we clearly have seen it with drugs. I think in addition to the patent expiration and some of the changes in major categories, clearly one of the things that has had huge a impact has been the implementation of three-tier formularies because people have, in fact, responded very dramatically to those formularies in their consumption decisions. There has been a big shift to generics and a big shift away from some of the higher cost brand products when you look at those products being introduced into the market, and it does show that there is a great deal of flexibility in the demand curve when you have alternative products and when there really is an economic incentive to look for them.

Ted Shannon: And you are seeing on the hospital side that admission growth has fallen down to the 50-year average after working well above that from 2000 to 2003. ER visits are actually not growing as fast as they have historically and the hospitals are having difficulty actually collecting cash, which really is another way of saying the hospital isn’t really in the business of collecting money or doesn’t know how to collect money in the first place but if the consumer has more money coming out of their own pocket, in addition to the trends of the uninsured, the commercial-based portion of their collections out of consumers are rising significantly. So, you are seeing it across the board.

Robert Laszewski: I think it is important--we get into all this data and market pricing and insurance cycles, and all of the rest of it and I think the most important thing is to keep an eye on the fundamentals. The marketplace, on a year-to-year basis, is never going to actually reflect the true number. If it ever does, it will be an accident because what happens is people look sort of through the rear-view mirror and they look at the experience and they price prospectively.

The trend healthcare number has been coming down over the last three or four years faster than any one expected it to for buyers or sellers of health insurance. People talk about the fact that prescription drugs trend has moderated; utilization is down but drug prices are up. So, it is always a mixed bag. And, I think it is important not to focus too much on how much these insurance prices are coming down because it looks like we are getting a real deceleration. Well, what they are reflecting is what was really going on in the market two, three, four years ago.

What is important to do, and where I think the HSC data is always so valuable for me and the way I advise my clients, is that it puts a lot of emphasis on the underlying numbers. And, the underlying numbers, while they are somewhat of a mixed bag--some are up a little; some are down a little--indicate that for the last two years we have sort of hit a plateau, and we have hit a plateau in fundamental healthcare inflation that is about four times the wage rate. It is in that eight percent kind of range and that is what is going to drive prospective pricing.

Then you have the vagaries of the market. What the insurance company thinks it ought to price or what it can price; benefit managers, what they want to negotiate, what they want to do in terms of buy-downs and what they can negotiate in terms of the renewals and so forth. That is just going to make the numbers look screwy in all kinds of ways.

I think the most important couple of lines in the Hewitt study on numbers was when Hewitt said that the most effective tools that benefit managers have today to control costs are, number one, negotiating a lower rate with the insurance company and basically cost shifting. Those are the two things you can do. Well, neither of those get at the fundamental issues. You know, negotiating with the insurance company is an artificial lowering of cost and buy-downs are a shifting of cost. So, when you see the benefits consultant community saying these are the two things you can do to control costs, it says there isn’t a lot going on out there to control costs; we are just along for the ride.

So, I think it is fundamentally important to look at the underlying numbers and all the gyrations that go in the market are interesting--they are interesting for the profitability of the industry quarter to quarter, but from a policy perspective there really aren’t any significant shifts going on here or changes.

Christine Arnold: I think one of the major problems if you look at the underlying issues driving true costs is costs above the rate of GDP growth. The fact of the matter is that over half of that is attributable to advances in medical technology. You can dance around that issue all you like but at the end of the day, unless you confront that issue, we have to accept that the costs will increase at a rate that is substantially greater than the rate of growth of wages because people want the technological advances that give them greater likelihood of ameliorating disease and there is no one in this country really who has said or is willing to say that we need to ration that. And, I think that is really not an economics debate; that is really an ethical debate and societal debate.

So, I would agree with Bob that there is not a lot that happens underneath that that you can get that unless you really start dealing with fundamental causes, which is not something that a benefits manager is going to do and it is not really something that an insurance company is going to do either.

Paul Ginsburg: You know, I have been waiting for 35 years to hear public officials discuss this but I am still waiting! I don’t know if it will happen soon.

Let me transition to the underwriting cycle questions. Realizing that in a sense the underwriting cycle is probably of greatest interest to the investors and health insurers, it is of some short-term interest to the purchasers of healthcare because if the cycle turns it means that their premium increases will be small but probably not relevant for the long-term decision issues that Bob and Roberta were talking about. Do you see signs now that the underwriting cycle is turning? From my recollections of watching the last big turn of the underwriting cycle, I guess in the mid ’90s, I saw enormous interest of insurers into markets that were new to them. Are we starting to see that now or not?

Robert Laszewski: Absolutely. I did an analysis for my clients in the last quarter and I looked at the results of each of the major managed care companies. First of all, their trend rates were almost identical. Their loss ratios moved in an almost identical way. Their revenue numbers were almost identical in terms of growth. You have the big managed care companies out there that are growing in revenue by eight, nine, ten percent when trend is eight, nine, ten percent. Their commercial enrollment, that is, the under 65 basic business that they have been in over the years, is flat, flat as a board. The marketplace, the number of people who are out there as a market to be insured is flat as a board, and has been for a couple of years because we haven’t had a lot of job growth. We have about as many people insured as this system is going to be able to insure.

So, everybody, to grow, is doing two things. One is mergers. You have seen that. The reason for all these mergers is that it is the only way they can show Wall Street that they can grow because they can’t grow organically. There is no organic growth. They have to steal from the other guy if they are going to do it. The second thing is entry into new products. It is one of the reasons why we have had so many people aggressively interested in Part D. Medicare advantages, you have seen, is a real shining light because of the way folks in Washington have--I mean, you know, Medicare advantages is like the Oklahoma gold rush for the managed care industry. And, Medicaid is suddenly a very good market. So, what you are seeing is people moving into markets they haven’t been in before because they are desperate to be able to show growth, and I think that is characteristic of the cycle, as Paul has pointed out.

Paul Ginsburg: Christine?

Christine Arnold: I had feared that this cycle would end this year given the dramatic deceleration in premium yields, coupled with the lack of benefit design changes and the product shift to innovative plan designs being a little slower to take off than I had hoped. Now, certainly, we are seeing shifts to consumer-directed products but it is a little bit slower than certainly I had hoped for. Things tend to move more glacially in healthcare. So, commercial yields in the first quarter are about 8 percent, first quarter 2005, versus about 9.7 percent a year ago. Now, that is what the companies say they are getting. On a calculated yield basis, which is what are you getting per member per month, we are down to about a 7.3 percent yield versus about 10 percent a year ago.

So, we are starting to see a divergence between what the companies are saying they are getting and what they are actually getting on a calculated basis. We haven’t seen that since 1995 which, of course, was the turn in the cycle. So, the key question is, since we know rates are decelerating, what are medical trends doing? There are two reasons to think that medical trends might be okay for at least another year. The first is the drug cost deceleration from patent expirations which we talked about earlier. The second is that Medicare is still a good payer. It is a good payer for providers; it is a good payer for managed care. And, I happen to believe that we are in a cyclical upturn for Medicare with the MMA reversing the damage done with the BBA. So, I think there is a secular growth opportunity with Medicare.

Christine Arnold: You know, as I look at the "underwriting cycle" the issue historically has been, to me as I follow the industry, not so much what was happening with pricing per se but the ability of the companies to forecast inflection points in the medical cost trend. As Bob pointed out, there is a lag effect between the time that the costs are incurred and the time that the costs are fully recognized which gives rise to prior period development. That has continued to be favorable, as Christine pointed out, and I think that that indicates that there has been a degree of conservatism both in how the medical cost trends have been reported and the data that is being used on an underwriting basis to set pricing.

We haven’t seen, as we did in the early 1990s, a lot of new entry into the commercial business per se. In the ’90s you had a lot of providers getting into the business. You had a lot of physician groups that decided they could go out and do various capitation arrangements, and so on. And, I think that that did tend to make a proliferation of capacity which we are not seeing now. We are seeing companies developing new products. They have branched into the consumer-driven products. They are diversifying away from just doing HMO and PPO to doing a lot of hybrids, and that has been a process under way for many years. But I don’t see at this point that you have a contraction in profitability unless and until you have an inflection point in the cost trends and cost trends starting to rise and not being recognized by the companies in terms of the underwriting discipline that they apply to that.

So, what I would think would be a dangerous sign is if you start seeing a reduction in the prior period development, companies starting to report negative development, because that would indicate that they are not giving themselves as much cushion in either the cost estimates used for reporting or the cost estimates used for the pricing on a prospective basis.

Ted Shannon: Yes, I think one of the things that is key is to realize that--Roberta is right--there are no real new entrants into this marketplace, unlike the late ’80s and early ’90s. Remember, matched care really started going through a gross cycle in the late ’80s because it was an arbitrage against indemnity insurance companies, and it was pretty easy to have a slightly lower cost structure business and a lower cost product that you could then shadow price to a higher price, higher cost trend product and then, as they pushed the indemnity guys out of the business they, instead of, you know, trying to control their costs, they used the same pricing tools and tried to use the same arbitrage tools against themselves. Well, it didn’t work; it blew up on them.

Today you have no real new entrants coming in underneath the matched care plans trying to play that same arbitrage game and the industry today--you mentioned consolidation--the industry is going through the same thing the banking industry did in the mid ’80s. It is going to consolidate down fairly aggressively. I mean, the top ten plans control something like 50 percent of the commercial lives in the country. Compare that to the banking industry where the top ten banks control something like--what?--80 percent of the consumer assets. You are going to see something like that emerge I think over time in the industry. As a result, because there are no real new entrants into the business, the companies now focused on actually maintaining the spread between their cost and their pricing. So far, by all indications we have seen, that spread has actually been stable. It might have compressed. I will give you that, but it is not negative and it seems to have been fairly stable, like 50 basis points or something like that.

Paul Ginsburg: Yes, I think what we can probably conclude from this discussion is whether the underwriting cycle is turning or not it is a much less dramatic and important phenomenon than the experience in the 1990s because just the forces are much more modest in doing that which means, as far as the policy agenda, it is probably of less interest, and even of less interest for those that follow insurance managed care stocks because it is not going to have a dramatic effect. So, in a sense it may be there but much more muted.

Let me go on to the next area. Actually, let me just ask if anyone has anything they want to say about directions of benefit design before I go into network design issues. Is there anyone?

Christine Arnold: There was data out last night from the consulting community and it is inconclusive. It is the Hewitt database. What we are seeing in terms of the benefit design changes is an increase in interest in hospital co-insurance. We had been in a very co-pay oriented benefit design structure that was kind of the advent and the growth of the HMOs and, as part of the evolution of the marketplace towards PPOs kind of back to the indemnity kind of plans, we are seeing more interest in co-insurance. About 39 percent of those employers seeking benefit design changes on the hospital side are looking at co-insurance versus 19 percent a year ago. So, 39 versus 19 more interest in co-insurance on the hospital side of the equation are likely to stem both utilization and pricing, giving managed care companies more leverage with providers on the pricing side since the consumers are going to be paying a percent of that hospital bill and not just a co-payment.

That was the one area where we are seeing a little bit of a tick up in potential benefit design changes. In all other cost categories, like we said, in 2005 we saw deceleration in the shift of cost to consumers both in small group and large group. There are three reasons for that. One, rates are below 10 percent. All of our survey work suggests that employers will take a 10 percent rate increase and not pursue aggressive benefit design changes, and they can get less than that now. We are looking at 8 percent rate increases max.

Second, there were big changes in 2003 and 2004 to benefits. They took a break, ’03 and ’04 were huge benefit design change years. Third, employers are waiting on HRAs and HSAs. So, they are looking for experience to suggest that the risk profile, the selection and the medical trend deceleration that earlier doctors have seen is sustainable so if you are going to make a benefit design change, let’s move towards consumerism which is where a lot of employers are looking. So, that is what we are seeing on the benefit front.

Robert Laszewski: I would add one thing, Paul, that is of interest, especially from a policy standpoint, and that is that there is a lot of emphasis this season, if you will, on limited benefits plans. What that comes down to is insurers are recognizing that the 45 million people who are uninsured are a market. Now, they are not a market for comprehensive major medical insurance but they are a market for very limited benefit programs, benefit programs that perhaps cost $50 to $100 per month and I think are very interesting because they start to focus on being able to deliver certain primary care benefits to those people who are uninsured. For example, a package that provides a wellness visit, a wellness checkup maybe once every two years, of a couple of visits to a primary care physician, or a drug benefit that is based upon generic drugs.

Now, a lot of people have criticized these things because they aren’t going to solve the problem of the uninsured. I think that is sort of a false set of arguments. Of course, they are not going to solve the problems of the uninsured but there are some very interesting products that do respond to the needs of people who cannot afford health insurance and have to pay retail.

One of the really goofy parts of our healthcare system is that the only people we charge retail to are the uninsured whether it is drugs or visits to the doctor. So, these products are starting to focus on that, trying to get the managed care discounts, if you will, for prepaid care for the uninsured. So, they are going to be interesting and I almost think that over the next year they are going to be receiving a lot of the same attention that consumer-driven did over the last couple of years in terms of people looking at these things.

Ted Shannon: I think that is completely right and also, from a policy perspective, it might actually get some larger players who basically insure their populations through Medicaid to actually, you know, provide some sort of opportunity for their employees, typically low income, low wage earners, to have a chance for healthcare coverage. You mentioned earlier that the commercial market overall is flat and that is clearly the case but, you know, as we continue to find new ways to expand the definition of the commercial market--

Robert Laszewski: Thirty million of the forty-five million uninsured I think are--what?--over $25,000 of income families. So, these price points of $50 to $100 a month make a lot of sense.

Ted Shannon: Absolutely.

Paul Ginsburg: Especially if this gets you into network prices--

Ted Shannon: Exactly.

Paul Ginsburg: --it will be worth far more than the insurance benefits.

Christine Arnold: There are actually products being sold that are not insurance per se but do give individuals access to network pricing and to drug discounts. So, that is another avenue, although not something that is going to show up in premium.

Paul Ginsburg: Have they been very successful in selling those products, or would coupling them with some limited insurance benefits make a big difference in their attractiveness?

Christine Arnold: I think that they are relatively young products and there are probably not enough to move the needle sufficiently on any of the large public companies for people to spend a tremendous amount of time looking at it, but I do think that it is something that at the margin is helpful.

Christine Arnold: My sense is you are dealing with about $9 per member per month versus anywhere between $15 and $25 for a self-insured product which will give the employer kind of claims processing and some stop-loss and some other products, and we are dealing with in excess of $200 for your average commercial product. So, that gives you some sense for kind of orders of magnitude where these products lay.

Ted Shannon: When you say $9, that is for the non-insured.

Christine Arnold: Right.

Ted Shannon: That is just for like an access card.

Christine Arnold: Right. That is the discount so, for example, a large insurer has a network so if you were uninsured and went into a hospital you would get charged bill charges. This would instead give you XYZ company’s negotiated rate with that hospital or doctor or with that drug.

Robert Laszewski: Where I think this new generation of product differs from the discount card and is really important is if you go to someone who is making $25,000 a year, maybe a single mother making $25,000 or $30,000 a year working for Wallmart and no insurance, you tell them I am going to give you a discount card so instead of the doctor visit costing you $125 it is going to cost you $75. It doesn’t do them a lot of good but, most importantly, they still see access to healthcare as this expensive thing they can’t afford.

What is different about these products and what I think is really valuable is that you go to that same person making $25,000 or $30,000 a year--maybe the single mother with one child--and you say for $50 a month I will give you one wellness visit for you and your child every couple of years, which under the age of 50 is what they should have; I will give you two visits to the doctor; I will give you one emergency room visit; and I will give you a $500 generic drug benefit with a $15 co-pay, and maybe a couple of other things. And, it is an entirely different mind set because now you have gone to this person who doesn’t think they could ever afford to access the healthcare system and you have said for this 50 bucks a month payroll deduction you have the following services. Then you go to the employer and you say, well, it is $50 a month. You wouldn’t contribute to the health insurance plan because family health insurance costs an average of $10,900 a year, or whatever; you can’t afford to pay $2,000, $3,000, $4,000, $5,000 for that person but, Walmart, could you afford to pay $25 a month and this person also pays $25 a month?

So, what you have done is you have completely restructured access to the system. It is sort of a prepaid system. It is really not insurance. You price this thing presuming almost 100 percent utilization. So, what you have said to this person that didn’t think they could afford access to primary care here is a package--here is your ticket book. You have access to the doctor three or four times and it doesn’t cost you anymore money or it costs you a $10 co-pay. So, that restructuring is I think really innovative.

Now, is that dealing with the uninsured? Of course, not. It is not catastrophic. It doesn’t go beyond a couple of primary care visits; it doesn’t go beyond a few generic drugs. But it is a start and at least it is giving some people the confidence that they can access the primary healthcare system.

Ted Shannon: I think one of the things that you are hearing from all the people up here is that if you step back and you look at it, what we are really going through is a cycle that ends first dollar coverage of healthcare in the commercial marketplace. With the exception of primary care visits, which I think everyone acknowledges do ultimately lead to lower cost care if we can actually get people to take care of themselves and go in for their checkups--people get oil changes more frequently than they go to their primary care physician--but first dollar coverage in this country is slowly and surely, outside of the primary care market, coming to an end. Account-based products are a precursor to that. These prepaid products are a good example of that. Either the employer, plan sponsor or the insurer is capping their liability at some fixed level, and more and more of the money, more and more of the responsibility for healthcare and the decisions individuals make about their lifestyle choices and how well they take care of themselves is going to fall back onto them.

Paul Ginsburg: I would like to move on to network design. In our site visits we saw that tiered hospital networks aren’t really progressing very much. In a number of sites we saw products from Aetna or from United that seem to be a lot more attractive to employers. I call them high performing networks. They tend to go by speciality of identifying who are the value providers, somehow measuring costs and quality and steering people to them. I want to ask the panelists if they see this becoming an important product.

Ted Shannon: That is part of the movement. I mean, as you move to account-based products and as you put more of the responsibility onto the consumer, the consumer is going to need basically a report card for the local market that says, by cost and by quality, who are the best doctors; who are the best hospitals; where should I go to take my child for some sort of pediatric work; where should I go to take my grandmother for congestive heart failure. The provider community is going to have to accept that they are going to be rated; there are going to be scores; and there are going to be prices associated with that scoring accordingly.

Christine Arnold: I think there is a tremendous amount of resistance by both the health plans and the providers to this trend. So, if you attempt to, say, rate an oncologist, this oncologist will insist that he has taken the worst risk; that he has taken people for whom he is their last hope and, therefore, your quality score can’t possibly assess the good that he is doing in the world and that efficiency is more than just price, and that we don’t have good quality metrics.

So, I am watching a couple of initiatives to see if this will take off in earnest because I think overcoming natural provider resistance, coupled with resistance that I think you might see among the health plans--think about it, if there is an independent entity that says here are the best providers, the health plans each have their own networks. What happens to the value of their network creation if suddenly someone else has said here are the providers you should be going to? What is the negotiating leverage that all the managed care companies now have with XYZ hospital which is the best in the area for oncology, or ABC physician who does the best cardiac work?

So, I am watching two initiatives in order to assess whether or not this will move forward. I think it could be a tremendous help to consumers, employers, to mitigating medical trend because there is a lot of data to suggest that cost can be reduced by up to 40 percent by making sure that people wind up in the best place--the right care at the right time and the right practice pattern. So, I am watching the Ambulatory Care Quality Alliance. This is an alliance between the American Academy of Family Physicians and AHIP which represents the health insurers, the Agency for Healthcare Research and Quality, and they are trying to put together an objective list of measures.

So, the first thing we have to agree on is how do we measure who is a good provider. Clearly, it can’t just be what their bill charges are. We have to incorporate how good a job they do in making sure that you don’t wind up back in the hospital with an infection or we didn’t leave the sponge in your belly. So, as we think about the ways to assess quality, I think we need a standard but, again, that is going to be resisted by I think providers and health plans and I am hoping that this can overcome that resistance.

The second thing I am watching is care focus purchasing. It is an initiative by employers. There is a bunch of employers getting together with the consulting community to attempt to make care focused purchasing the way that they sign up for health plans and providers. So, if a health plan participates in submitting their data to be aggregated so we can actually determine who is good and who is not, because any one health plan can’t give you a full picture of this oncologist--right? If he is dealing with complex cases it is not, you know, an OB/GYN with 30 deliveries a week; it is a guy that is dealing with five people a week and a health plan that only sees one of them, even if he has 20 percent market share, can’t assess how good he is. So, we need to pool the data and the care focus purchasing initiative is an effort by employers to get together to pull the providers and the health plans in. So, those are the two things I will be watching to see if this takes off.

Christine Arnold: There are a lot of technical issues in doing this though because, you know, I think a lot of what we have been looking at in terms of measuring quality is process oriented--what did the provider do? Ultimately, outcome is a more complicated process because it is not only what the provider did but it is also what the individual patient does in response to that provider and there are going to be big differences in how compliant different patients will be based on their educational levels, based on their economic wherewithal, based on their family support systems, based on race and national origin. So, you can have, for example, somebody with coverage, with access to the system but who comes from a cultural background that is not particularly receptive to a change to a low fat diet. The doctor can say anything he wants to that person who has had a heart attack and they are not necessarily going to understand what he is saying, let alone make changes.

So, I think that there are some significant issues that way. I think that there are also real issues in terms of how do you go about taking enough data, getting the N big enough so that what you are measuring--you know, assuming you get to the point of doing risk adjustment, this is going to reflect all of the complexity dealing with these patients. I think until you get there, there are a lot of vested interests in the provider community in not being subject to this because, by definition, half of them are going to be below average. This is not like woebegone. They are going to resist it. They are going to point out all of the methodological failings around any of the methods of risk adjustment to say why this is not valid. I also think that in addition to the providers being resistant and the insurers potentially being resistant, although I think a lot of them would like to move to that point, patients will be. If you are told that your family physician where you have gone for the last X number of years is a below average practicing doctor but you trust him and you have a relationship with him, you are going to discount the data rather than discounting your doctor.

Robert Laszewski: The acid test here is what is the discount. You have two parts to the insurance market, the self-insured market and the fully insured market. For HMOs and other fully insured products, the insurance company, the managed care organizations are taking all the risk of the pricing; for the self-insured market, the employer, the sponsor of the plan is taking all the risk.

I was with one of the largest Blue Cross Plans in the country last week and this came up. The reaction to it all was this is this season’s consulting initiative. The consultants are out putting out the RFPs, tiered networks, quality-based networks, and all the rest of it, so we have to play along with it. I mean, the bottom line is we don’t either have the data nor the ability to determine who the really quality and efficient providers are. You know, you do some analysis and there are all kinds of reasons why that provider is where it is.

What it fundamentally comes down to is if the industry believes that they can tier the networks or in other ways segregate quality they should have two products. One product is all the networks, the standard products, and the other is the segregated or quality networks. And, if they believe that it is worth 10 or 15 percent, if the costs are 10 or 15 percent less than the quality networks then that particular product should be priced 10 or 15 percent less. All of this is going on in the self-insured market where the insurance companies are not taking any of the risk; where you are going to the employer or the benefit sponsor and say we think you should embrace this and we think it will lead to lower costs. But in the fully insured market where the insurance companies or the managed care organizations are taking all the risk there is no discount. There is no price offset for any of this.

What does that tell you? It tells you that there is no confidence that there is, in fact, lower cost there. Why isn’t there confidence there is lower cost? Because we don’t have the slightest flipping idea where the efficient providers are or how to calibrate how we are going to find them or how we are going to do it. So, when you see a discount and you see people putting their money where their mouth is, then you know we are onto something.

But we have been talking about data for 20 years. We have to keep going in that direction obviously. You know, Jack Wennberg, up at Dartmouth, told us 15 years ago it was a 40 percent difference for quality. Well, we haven’t figured out how to do it yet. When you see industry putting its money where its mouth is, then it is real.

Ted Shannon: One of the reasons we don’t have good data is because most of the industry hasn’t invested in data. They have invested in pricing systems; they have invested in ways to adjudicate claims more quickly but, with few exceptions, on the insurance side business they don’t invest nearly as much money on the system side as other large industries. It is actually somewhat shocking. I think there is only one health plan that has spent more than a billion dollars over the past several years investing in IT systems. So, I think one of the push-backs that you are seeing in the industry is they just simply don’t have the technology to pull off a lot of this stuff. That doesn’t mean it isn’t coming. I mean, benefit innovation in this industry typically starts in the ASL market, in the large group commercial market. As the GEs, the Chryslers, the General Motors, the Fords, the Xeroxes all push back hard on managed care entities saying help us understand why our costs are going up; don’t just tell me what the inputs are--hospital, specialty, ambulatory, surgical, drug, let me know why it is happening. What is the trend? Why is the trend in this market 200 basis points higher than this market? Why is a utilization score higher here than there? Don’t just give me here is what the data is, find out actually why. As they push down harder on the industry to actually answer those questions you are going to see the creation of these performance-driven networks, as Paul called them.

The interesting thing that has come about is doctors are very competitive animals. This is the ultimate small business man. They went to school. The biggest company that they are going to work for consists of five or six of like-minded individuals, all trying to run a very efficient small business. These guys are competitive. If you give them data that they finally can buy off on--and they are never going to buy off on it, but if you give them data that they are going to be paid on they are going to do everything they can to maximize that payment. You tell them that if you do X, Y, and Z to get back to a standard of care, they are going to do X, Y, and Z to get back to the standard of care to maximize their reimbursement. So, to the extent that you get these types of things out there and you can actually put out some objective scores--and there are technical challenges associated with that--you actually will see that improvement in the system.

The interesting thing that happens with that is the higher quality doctors and provider systems in the country have higher unit costs. That is true. But they have a lower all end cost over the course of a disease. So, what happens is I might be paying more per unit as an insurance company but my total cost across the disease episode will actually be lower and that actually will then translate into--you know, typically what happens on the commercial side is better cost trend gets passed on to the consumer at better prices.

Paul Ginsburg: I would like to move on to consumer-driven healthcare. Because this has been a phenomenal panel from my perspective we are way behind schedule. I have seven questions on consumer-driven healthcare. I would just like to invite the panel to just talk about any of them rather than going through one through seven. We probably should start with Christine Arnold who is the author of a forthcoming book on consumer-driven healthcare.

Christine Arnold: I think from a very philosophical perspective as I look at consumer-driven healthcare, it is really the first time that we have moved away from an attempt to manage healthcare costs and healthcare behavior from the supply side, moving to the demand side because it is seeking to engage consumers, put financial skin in the game, and also give them some of the tools that they need in order to manage their expenditures more effectively.

I think if you look at the failures of managed care, it is that in a sense you put the consumer in the car, you load it up with gas and say, here, drive. You have a $5 co-pay to go to the doctor; you have a zero co-pay to go to the hospital; you have a $5 co-pay for drugs. Then, lo and behold, they demand a lot and what do you try and do? You try and use capitation, utilization management, etc. as a way of slamming on the brakes, which is something that wouldn’t be particularly good for your car and it certainly is not something that is good for the healthcare system.

I think here, by saying you are going to be spending your own money, you have the ability to recapture and reallocate those savings for purposes that you, yourself, want to use. It should have, I think, a beneficial effect on the system.

I think if you look at the advocates, the professional advocates for consumer-driven healthcare, they overstate what it can do. I think you have to look at the inherent limitations of anything you do based on the role that technology plays in rising healthcare costs; the disproportion in the amount of the costs that are consumed by people who have very profound healthcare needs in any given period of time; and the continued presence of information asymmetry in the market that will I think keep healthcare cost trends at a level that is substantially above GDP.

I also think you have to look at where the adoption will be. I think if you look at the market and you sort of broadly segment into individual, small group and large group, clearly HSAs are making big inroads already in the individual market because these people already do have high deductible plans and what the HSAs give them is the ability, on a tax advantage basis, to fund some of the needs that they already have.

I think the small group market probably will take some more time to adopt it because it is complicated. There are a lot of adoption hurdles but, at the same time, it is a much more viable financial mechanism for a lot of small groups, particularly those that are run by the proprietors.

In the large group market I think that we are likely to see consumer-driven healthcare, whether you are talking about HRAs or HSAs or customized design products, being more of a niche product and a niche product that will tend to attract employees that have higher incomes, greater educational attainment and lesser healthcare needs, which is what you tend to see when you adopt any kind of a new benefit plan structure. So, I don’t think it provides a complete answer but I think it does provide a niche product and I think it also provides something which starts to change the way in which people interact with the healthcare system. Down the road I think that that does bring with it some real benefits to the system.

Paul Ginsburg: Thanks. Ted or Christine?

Ted Shannon: I have been following this market for a long time and I have been consistently early in my belief that this product was about to take off.

[Laughter]

But I do believe it is the next product. I keep coming back to the last time we had a major product movement in this marketplace in which, over the span of four years, 60 million Americans were moved from indemnity-based coverage to some sort of managed care-based coverage. As I look at that model, I don’t know what the pick-up curve is going to be in this product. I don’t know if it is, you know, the logarithmic curve we saw then or if it is more of a straight line growth pattern. But this is the product set that is going to dominate the market over the next five, ten years.

It will eventually replace all matched care--not all matched care but the majority of the matched care products that are sold out there today. It is for the first time actually aligning or almost aligning incentives in the system. Instead of having someone control the money, someone determining access and someone determining incentives for utilization, I am now giving one person the ability to say what do I actually want, and if I can educate them and I can give them the data, and I can help guide them through the system--and that is going to be the biggest challenge for the industry; it is not going to be the pick-up of the products, it is going to be the education component--but if I can overcome those hurdles this will basically replace most of the products that are sold out there today.

Paul Ginsburg: Can I ask you a question about that? I have been thinking that as this product evolves and morphs it may wind up with substantial managed care elements to it.

Ted Shannon: Yes.

Paul Ginsburg: Okay.

Ted Shannon: I mean, In believe based on the work we did on the survey work we have done on individuals, members objected to managed care because they didn’t believe that the interest of the health insurer was aligned with their own interest. So, having a health plan and saying, no, you can’t go do this was thought to be "well, of course you don’t want to do this; it’s going to cost you money." Well, if I put up a nurse in front of a member that says, "Mr. Johnson, you should go do this and you shouldn’t go do that; here’s what it’s going to mean for you," and I can educate a consumer about what happens I can actually use some of the tools that actually work, like disease management, directing care to the most appropriate providers and helping to get members to commit to lifestyle changes to actually improve their health.

Paul Ginsburg: Christine?

Christine Arnold: Well, I am a huge fan of product innovation and I view this as a potential starting point for product innovation, but let’s think about it as what it is, it is a tax advantage indemnity product. It is not some major revolution. What it means, I think to Paul’s point, is the introduction of the provider benefits, the network advantages that managed care companies can bring, coupled with information and tools. Remember, our whole discussion on how the data is not yet available to consumers. I think if consumers are in these products, I am hopeful that we will start to not have perfection be the enemy of good with respect to data.

For example, if you look at the large employer market, 40 percent of employees spend less than 500 bucks out of their pocket in the large employer market and 70 percent spend less than 1,000. If you are going to be in an HSA, then the minimum deductible for individuals is $1,000 and the minimum for a family is $2,000. So, it is a very prescriptive plan design that is going to move the large employer market very far along the continuum of increasing cost sharing, which may take some time, but once you get to that point where all these employees are spending out of their pocket I think they will start to demand some of the data, and the fact that it is not perfect will not stay in the way of it flowing from the health plan’s perspective and provider’s perspective.

So, I think it creates an incentive with the data to create a major new product with the potential to really reduce healthcare costs and move us away from tax advantage indemnity, which is what we have I think right now with this plan design. If you think about where we are, half of RFPs entering 2006 are largely employers wanting to seek consumer directed. They are not going to buy it because it usually takes about two years for employers to buy things that they are actually looking at, but it is definitely gaining interest. And, 37 percent of brokers we surveyed in the small group and individual market are actually offering HSAs. That is only 5 percent of their book, and because it is a 20 percent discount off the average product the brokers are thinking, well, I am paid off the premium. Right? Why do I want to sell someone something that is going to take 20 percent off my brokerage commission?

So, I think a couple of things might be needed in order for this to move forward. The first is that the large employer market needs to move more towards cost sharing, which hasn’t yet happened. Even though we have had a couple of years of increased cost sharing we are still a long way from the HSA plan design, which is why HRAs are much more popular. Secondly, we may need some broker commission reform.

Robert Laszewski: Let me give you a real life HSA experience. I tried to buy an HSA last month. CareFirst is our insurance provider, $1,000 single, $2,000 family deductible. I called up CareFirst. Their basic HSA plan would become a $3,500 deductible per person. The insurance premium was $10 more a month than the $1,000/$2,000. I called up MAMSI, which is United Health Care in Maryland. We are not in the HSA business but if you call this 800 number they might be able to help you. I am sure Dr. McGuire would be happy to know that they are not in the HSA business--

[Laughter]

Called the 800 number. It is disconnected.

[Laughter]

Aetna, $3,500 deductible--not $2,000 but $3,500 is the minimum and the premium would be $200 more per month. Why did I want an HSA? I wanted it for the tax benefits. I am sitting there thinking, you know, I could be putting $5,000 a year away in additional tax deferred money. So, that is the real life experience in HSAs. I think the market is a lot more immature than I sure thought it was before I started making those phone calls.

The trade association said that HSA enrollment went from, I think, 300,000 lives in November of last year to a million, I think it was, lives early this year through the January renewals. So, that was terrific growth, 300,000 to more than a million. But, remember, there are about 167 million people I think in the commercial insurance market. As of this spring we had just a little over a million in the HSA product 15 months after it was launched. We have less than one percent of the market in the HSA. We have HRAs over there as well.

So, you know, why aren’t we seeing more growth? Well, I think the products are complex. It is not as easy to access these products as we thought it might be. The cost breaks up front are not as great as we thought they would be, and we seem to be going through a period now where employers particularly are not as eager to shift costs as they were a couple of years ago. We are finding that more and more employers are coming in at or under their budgets because the trend is coming down. Most of the grown in the HSA market is on the individual side for obvious reasons. The people already have the deductibles. The individuals are fairly well compensated and are looking for more tax breaks.

Consumer-driven healthcare is a wonderful thing but don’t ever lose sight of the fact that consumer-driven healthcare focuses on first dollar benefits. Seventy-five percent of all costs are incurred by 15 percent of the people. It is the sick people who incur healthcare costs, who blow through the deductibles, get to the outer pocket maxes. Nothing changes for 75 percent of all healthcare costs. Under consumer-driven healthcare the incentives never change. Why people don’t understand that--you know, you get all these policy people that say consumer-driven healthcare is going to change the world. Not for sick people and the sick people are the ones who control costs. So, consumer driven is a wonderful thing. It increases the deductibles, gets some skin in the game, yadee, yadee, yadah. But when the day is done the incentives haven’t fundamentally changed. So, consumer-drive healthcare is neat and in about another year or two we are going to get this out of our system.

[Laughter]

Paul Ginsburg: Roberta is going to give us the last word on this.

Christine Arnold: I just wanted to make a couple of comments. One is that I would tend to think that, like any other market, this market will continue to be characterized by diversity of product. There are a lot of basic human needs--food, clothing, shelter, health insurance. We don’t all eat the same food. We don’t all wear the same clothes. We don’t all live in the same kind of houses. There are going to be preferences that go into this and I think there will be portions of the market that find consumer-driven health plans appealing, but I do think that there is going to be a segment of the market that is going to want an HMO and a segment of the market that is going to want a PPO. I don’t think that you will have tsunami and ten years out everybody is going to be in a consumer-driven health plan.

The second thing I would say is that I think that what we are talking about is changing the conversation of how people relate to the health plans. I would agree that, you know, if start looking a year or two years out that segment of the population that blows through deductibles, blows through the outer pocket max--no, they are not going to change how they interact with the system. But somebody who enrolls in a plan and starts using the data tools and starts thinking about healthcare as more of a consumer of healthcare when they are in their 20s and 30s, as they are used to interacting with the system in a certain way as they get older, as they do start to develop healthcare problems, they will continue to interact with the healthcare system in that way. They will use the Internet-based tools. They will look at the data. They will look at things differently.

Now, will that be true of somebody who is a high school dropout, working at Walmart? Probably not. I mean, realistically, that is not going to happen. But I think for an important segment of the market it will change how people look at healthcare over a broad period of time and I think by doing that it will also change how some of the providers look at what they do and how they interact with their patients. So, I think of it as a continuum, not a one-time event.

Paul Ginsburg: Before we move off this topic, just briefly, just a number, your predictions of, in 2010, the percent of the health insurance market that will be in HRAs or HSAs. Ted?

Ted Shannon: Forty to fifty percent.

Paul Ginsburg: Christine?

Christine Arnold: Eighteen percent.

Paul Ginsburg: Roberta?

Christine Arnold: Fifteen to twenty.

Paul Ginsburg: Bob?

Robert Laszewski: They will change the definition--

[Laughter]

--we will all be in it, just like we are all in managed care today.

Paul Ginsburg: Sure.

Ted Shannon: I would like to point out one thing. It is actually easier to buy consumer-directed health product, and it is interesting because I bought a product for my in-laws who own their own business and didn’t have health insurance for a variety of reasons that aren’t important right now. So, we helped them buy an insurance product; tried to go through a traditional broker. The broker was not, as Christine said, incented at all to help us find a product. I actually went through an online broker, found a product through Life Mart who is not publicly traded and has no public debt--I don’t think so; bought a product that cost my in-laws 20 percent less and they had the same type of savings and tax advantage that you mentioned before. So, in some parts of the country it is actually possible to buy but the broker reform comment that Christine made is actually quite accurate.

Paul Ginsburg: Yes. This was good. I want to ask you a few questions about insurance market structure. I have perceived on our site visits that bigness is becoming more important both at the local level and national level, and that one of the sources of growth of the large insurers has been taking share from the small insurers. Any comments on the outlook for increased concentration at the local market level?

Christine Arnold: I think it is an oligopoly market. We are already there. So, if you look at kind of where we are in terms of the membership concentration, you have about 40 percent of the insured business with publicly traded companies and on the full-insured, self-insured side, and then there are about 91 million people who are in the "Blues." Some of those are double counted because you have the host and you have the control and I don’t know how many independent lives they actually have but it is probably somewhere around 50-60 million kind of counted once. So, you are dealing with somewhere around 67 percent of the market with the publicly traded plus the "Blues."

So, I think we are already at a place where we have seen consolidation of the marketplace for a couple of reasons. The first is that as corporate American downsized the HR departments became smaller. As we surveyed employers we found that they didn’t want to have 20 or 30 different health plans. They transitioned to self-insuring and they picked one or two. So, that took the concentration of lives and purchasing power and brought it into a few managed care companies which destabilized the balance of purchasing power among those that weren’t among the chosen consolidatees among the largest employers because they are the ones that purchase in bulk.

Secondly, you saw that brokers had their favorite plans. They weren’t going to sell 20, 30 or 40 or 50 plans, first of all, because of the commission structures and, secondly, because they would get comfortable with a couple of plans that can serve the needs of their customers and those are the plans with which they developed relationships and they could help to facilitate any claims issues for their customers because they represented a good portion of that health plan’s business in that market place. So, they were better able to conserve their customers and get paid more because the commission structure is by concentrating their business. I like to fly American and Delta because that is where my miles are. It is kind of the same situation if you think about the brokers.

So, I think the marketplace has already consolidated share and the question is, is the value of administrative cost savings, potential technology and information because all this claims data is concentrated within fewer hands worth the offset of lower incentive to innovate because you already have 30 percent of the market and there is a huge barrier to entering? And, I am not sure what the answer is.

Ted Shannon: My own conversation with large employers suggests that the consolidation effort that Christine just mentioned isn’t done yet; that the larger employers went from having, say, 20-30 health plans that they are doing business with down to 10 to 15 and now they are going to go from 10 to 15 to 3 to 5. So, I think there is actually going to be continued consolidation on the carrier side at the highest end in the marketplace. At the lower end of the marketplace there are still something like 500 different health plans in this country, and most of them don’t have the capital resources to invest enough in their business to be able to go through the consumer education stuff that we talked about for consumer-based products. They don’t have the technology capabilities to participate in performance-based networks or to actually create products where they can change provider fees based off the performance of that provider in their book of business. So, these businesses are not going to be around to the extent that they are today in five or ten years. So, that 30-40 percent of the marketplace that is not already in one of the 10 largest health plans in the U.S. will eventually roll into those 10 or 15 largest health plans over time.

Again, the analogy I talked about before I think is still apt. This business as a whole looks a lot like the banking industry in the mid ’80s where you saw massive consolidation to create national platforms for both larger books of business to average SG&A scale and to average underwriting expenses.

Robert Laszewski: When I look at these mergers I think the most important thing to understand about the mergers is that they are not about improving economy as a scale and, therefore, pricing. If I take the old WellPoint in California and I take Anthem based in Indianapolis and I look at those two organizations, they were beyond optimal levels already. If you merge the two do you have better provider clout negotiation? Do you have a better expense ratio? No, you don’t. It really doesn’t change the paradigm at all.

There was a study out of California about a year ago that looked at the markets and found that most markets were dominated by three health plans, one Blue Cross and two privates. I forget who did it.

Paul Ginsburg: Jamie Robinson.

Robert Laszewski: Yes. So, the vast majority of markets a year ago were dominated by three players--there is your oligopoly. Since then we have had WellPoint and Anthem come together. We have had Pacific Care and United come together. This is being driven by the need to improve shareholder value by making a bigger company with bigger earnings. But it is not one that is doing anything to necessarily manage healthcare cost better, which drives me to a question that I have always wanted to ask panelists, and that is, where is the value proposition long term? Analysts have got buy ratings, hold ratings on the managed care industry because earnings have been so good and look to be good for the next year or two. But this industry is in a long walk off a short pier. Where is the long-term value proposition, and what is your view of that?

Paul Ginsburg: Actually, because we are running out of time, maybe someone will ask it as a question but I don’t want to spend--

Robert Laszewski: Okay, I don’t get to ask questions!

Paul Ginsburg: But I wanted to ask you, Bob, if you look at the growing concentration at the local market level and its implication for either buying power with providers or pricing power with employers, how concerned are you about this and how do you think policy might respond to it?

Robert Laszewski: What we have is a bigger and bigger indemnity model. It is not a model that is really using its clout to do anything to rock the boat. You saw the settlement yesterday or the day before with WellPoint and the class action suit. You have an industry that is basically backing off from the things that I think are going to be necessary to managed care for that long-term value proposition. The managed care industry is not going to take on the provider organizations. They are settling those suits and they don’t want to revisit it. And, gee, golly, why would you want to? If costs go up nine percent you price nine in; you take your piece off--you continue to increase the volume you are doing. You take your basic cut off the top of it. It drives earnings. The analysts are happy as a clam. It is a scenario that makes a lot of sense over a period of a few years. Long-term it is a scenario that is driving costs up at four times the wage rate. Where is the long-term value proposition? That is what scares the hell out of me in terms of where we are going.

Paul Ginsburg: Okay. I would like to just take a few more minutes to move into some Medicare advantage and Medicare prescription drug questions. It would be a good time for people in the audience who have questions, if they want to write them down, to do that and pass them over to the middle aisle so they can be picked up. Again, like consumer-driven healthcare, I have, it looks like, eight or nine questions on Medicare advantage just really to ask the analysts on the panel what is the most compelling thing they have to say about the outlook for Medicare advantage. How important is it going to be and do you expect to see product innovation or not?

Ted Shannon: Well, Medicare advantage scares the crap out of me. To start on the drug side, it is great that we have this product now available that, you know, seniors can now buy their medical needs through an insured product that probably should have been incorporated in the first place but, at the same time, the risks to underwriting this are not well known and not well understood despite all the data that people have put out.

And, finding a lot of these people is going to be tough. It is going to be a lot harder than people think. I mean, it is great that you are going to automatically enroll six or seven million people that are already in the Medicaid book--

Paul Ginsburg: You are talking about prescription drugs?

Ted Shannon: I am talking about prescription drugs.

Paul Ginsburg: Let’s do that first then and then we will go to Medicare advantages of managed care.

Ted Shannon: Okay. It all ends up being one and the same.

Paul Ginsburg: The question on the prescription drug plans is just people and scenarios for how that market will evolve so everything you have said is relevant to that.

Ted Shannon: I mean, the numbers that you hear about people thinking that there are going to be 30 million people participating in this product over the next year--I think that is an incredibly aggressive number. I think you are just going to have a hard time finding a lot of the people that are going to be willing to do this, and counting employers who take a tax break for doing nothing, that is kind of hard justification for saying that is a new member in the marketplace.

Christine Arnold: As far as the stand-alone drug business, the PDP, I am real excited about the Medicare opportunity because it is hard for me to imagine how the health plans and hospitals that are publicly traded can forego participating in treating seniors who produce the majority of spend in the U.S. So, I see an opportunity for the private sector.

I was an analyst during the Balanced Budget Act so I remember the havoc that that happened to produce to the earnings and to the stock prices of companies dependent on Medicare. So, let’s start with the PDP, the stand-along drug card. I am expecting about 19 million people to be in the drug card in 2006. That includes 5.6 million who are already in Medicare HMOs. So, we are looking for about 12 million incremental people to be in and we are dealing with 7-8 million of those being auto-assigned or facilitated.

So, I am not looking for huge penetration of those seniors who do not currently have a drug card because 67 percent of seniors who don’t have a drug card spend less than $1,000 a year on drugs and, therefore, the incentive to pay the $35 premium-plus out of their pocket to get this drug coverage and still have the donut hole, which is complicated, probably isn’t there. The good news here is I think there is a long-term secular growth opportunity for participants in the stand-alone drug card program because I don’t expect more than 35-40 percent of seniors to be in either one.

The challenge, of course, is the budget. We have just given folks a new entitlement. We are going to see an increase in drug utilization because some of those people who didn’t have a drug card and didn’t spend much didn’t spend because they didn’t have any money and they didn’t have a drug card and now we are going to solve that. So, we don’t know what the drug spend ultimately will be of those people who are going to pay the $35 to get a drug card, but I do know it is going to be bigger than $35 a month because the penalty for not signing up is only one percent of that $35 so you could wait ten years and only pay 40 bucks in incremental costs. So, I don’t think the penalty is going to be much of an incentive to get people in so over time I expect this to be less profitable because I think that seniors are efficient and I think they will do the math. I think that incorporating the penalty plus the premium, it is only going to make sense to sign up your 2, 3, 4 and 5 if your drug spends over what you spend out of pocket.

So, I think that the membership will become less profitable over time. If you look at the structure of the help you get from the federal government in terms of the risk quarters and the margins up and down, that diminishes over time. So, I think we have a near-term opportunity and I am not sure what the long term looks like. I think the key for the Medicare HMOs, such as Medicare advantage, is to link it with the PDP.

The problem with the Balanced Budget Act was that a maximum 18 percent of seniors were in Medicare HMOs. You could irritate 19 percent of seniors and still get reelected and they could all go back into fee-for-service because that was the backup plan. So, here is the issue, with the PDP, if 40 percent of seniors are going to be in year one, you can’t eliminate it and get reelected. I think it has a built-in layer of protection in the penetration rates that we expect to see immediately.

In addition, if we eliminate the PDP what is the fall back? Fee-for-service? No, fee-for-service doesn’t have a drug card. So, I think those two things protect the PDP. The Medicare HMOs need to link onto the PDP and they need to increase their penetration of the market. It needs to be better than 25 or 30 percent by 2008.

Ted Shannon: That is all fine and good until the people in this room write the law that says that the government will mandate drug prices.

Christine Arnold: These guys wouldn’t do that!

[Laughter]

Christine Arnold: I think there is another issue, and that is the matter of formularies. We have already seen for six categories that CMS says basically you have to include everything in the formularies. That really diminishes the purchasing clout of the plans because it is not the aggregate amount of dollars that they spend, it is how they are able to shift the spending within the category based on those dollars. So, if the market share stays the same because everybody is in the game, there is no real incentive to bargain very much.

I think there also could end up being issues in terms of some of the co-pay co-insurance structures that are used and whether seniors go back to their representatives and say, you know, hey, I thought I was getting a good benefit but this drug cost me X and this isn’t really a good benefit because I am paying for all of this stuff. There certainly will be push-back on the donut hole. So, I think that there are some built-in forces of instability in the system.

Robert Laszewski: I have never been optimistic about Part D for lots of reasons but I will tell you that I am really getting concerned about is the Republicans have to figure out whether they really want a market-based system or not. As I understand it, what this is about is bringing the private sector into the business of providing prescription drug benefits for seniors, and I am seeing all these regulations coming down from CMS that go in exactly the opposite direction. If you look at the way healthcare costs should be managed--and some of you attended a meeting that I chaired a couple of years ago when we brought in a number of the policy makers from Europe and looked at how they managed prescription drugs. You need to be able to limit that formulary. We need to have Part D plans that are primarily generic and, in fact, exclude most of the things and let them compete with the Cadillac Part D plan that doesn’t have those limitations, and let the prices reflect that.

We rag on the U.S. drug system a lot for a lot of very good reasons, but the one good thing that the U.S. prescription drug marketplace does is that we have developed the most robust generic drug industry in the world. You don’t have a generic drug industry to speak of in Canada or in the European Union. We have it here. We now have a little more than 50 percent of prescription drugs being purchases as generic as opposed to name brand. If it costs $100 a month retail for a drug in the U.S., it costs $70 in Canada, it costs $30 generic. You ought to be able to put a drug plan together that reflects that $30 price and let the seniors choose between the one that has everything in it and the one that is limited. I will tell you the one that is limited is going to save a lot of money and be affordable for people.

But where is CMS going? Where are the authors of Part D going with this? They are taking all the things we have in the tool bag to manage costs and they are prohibiting people from using them. That is a short-term trip to price regulation because if you put all this stuff in there prices are going to skyrocket; pressure is going to be on to regulate prices, so on and so forth--all the things Republicans have said they didn’t want. So, either make this a market-based system or quit kidding yourselves.

Paul Ginsburg: Let’s go to audience questions. Please come up to the microphone. Could you please answer Bob Laszewski’s question about the long-term value proposition?

Christine Arnold: I have a cautious view on the managed care sector so I had thought that this year the price cost spread would be inverted because of the dramatic deceleration of premium yield, coupled with the deceleration of benefit changes. So, I was early to come around to your point of view, and definitively wrong thus far. So, I see the issues that you are talking about but I see opportunities with Medicare, and my investment thesis this year was all about over-weighting the Medicare players and under-weighting the commercial price cost spread. It turns out that cost trends are decelerating for reasons that are still a mystery to me since we haven’t seen benefit changes and hospitals insist that their pricing is the same as it was a year ago. So, I think a lot of this was just a lower baseline in 2004 medical trends. I think medical costs definitely hold the key so I am going to keep a lookout for when medical trends turn because I think that will produce a potential inflection point in the commercial price cost spread.

Now that I have said all that, I have to tell you that I work at Morgan Stanley and on our web site are disclosures. I don’t own any stocks in my sector and Morgan Stanley seeks to do, and does do business with managed care companies.

Christine Arnold: Ted?

Ted Shannon: From my perspective, I actually disagree with Christine. I think these are actually attractive businesses that are at the beginning of a product cycle that has a very long tail and will continue to provide good opportunities, both from a membership growth perspective and from an earnings growth perspective. To the extent that you believe that product cycles are going to benefit the consumer, which I think they do and which I think they typically have in the past in this industry, I think it ends up being a win-win situation both from my perspective as a rather large investor and as someone who is helping my company make insurance decisions for our own audience.

I will put up a similar disclaimer to Christine’s, with the one caveat being that we are buying and selling names in this space all the time.

Paul Ginsburg: Please identify yourself.

MS. FRIEDEN: Joyce Frieden. Mr. Laszewski, you said that consumer-driven healthcare plans probably won’t affect the 75 percent of costs that are incurred by the really sick people. I wonder if you thought it could be ameliorated at all with adding any kind of prevention benefits, paying for a part of those.

Robert Laszewski: Yes, I am a big fan of the first dollar benefits for the wellness, and so forth. I think it makes all the sense in the world. I do believe consumer-driven healthcare will help cost trends. It has been shown to be significantly valuable on moving us from brand name to generic drugs; emergency room visits; sometimes primary care visits--there is not a whole lot of data that it is hurting quality. Consumer-driven healthcare is great and it is going to have a positive impact on costs.

But here are the first dollar costs and here is the sick cost, and it is going to have that effect on the first dollar cost. So, everybody, buy a consumer-driven health plan. If I could find somebody to sell me one I would buy it.

[Laughter]

But it is not going to fundamentally change the problem that we are facing, which is the cost of sick care.

Paul Ginsburg: This is another area I couldn’t get to so the questions are great, to comment on Medicaid managed care. I think the questioner means that in light of the tight state budgets and Medicaid reform, what are the prospects as a business for Medicaid managed care? I guess both as a business for insurers and how much value is it going to bring to the states?

Christine Arnold: I think we are seeing some efforts, given the state budget crunches, to contain the eligibility standards, particularly in my State of Tennessee where we are going through some continued legal battles over TennCare. But you do have limits imposed upon the states as to what they can do from a reimbursement standpoint and a benefits standpoint. So, if you are looking at the price being somewhat set externally, then the only way to really control the aggregate spend is by looking at the volume, hence the focus on eligibility.

I do think that Medicaid managed care has some real benefits to offer. You are dealing with populations that are very much at risk, that don’t tend to have access, that have some very basic needs that can be accommodated very well within a managed care system. You are dealing with a population that tends to be women and children, so a very defined set of needs that they have. And, I think there has been evidence from various companies involved in this business that they can improve the process and outcome of care, and do so within what have been relatively tight budgets.

Paul Ginsburg: Any other comments?

Christine Arnold: I think there is a role for managed care, particularly disease management efforts within the Medicaid population. The challenge is the budget issues. So, I am looking to the Medicare Modernization Act and the privatization of the Medicare marketplace to give me a sense for whether or not we are going to see that defined as a success. If so, I think there will be more movement to privatize Medicaid on a federal level which will take a leadership position. But I am fearful that this does not represent as strong a voting bloc as the Medicare constituency and, in a world of only so many dollars to go around on a federal level, what concerns me the most is that the states may want to privatize this and may want to use managed care companies and are in fact, in states like Texas and Georgia, awarding contracts to the private sector. But if the dollars, from a federal perspective, are cut it could erode the private market opportunity beyond the enrollment opportunity that we are seeing on a state level. So, I am watching very carefully the federal budget and the perceived Washington success of privatization of Medicare in order to help me figure out whether there is going to be an appetite for supporting, through proper funding, privatization of Medicaid.

Ted Shannon: I think you need to look at Medicaid across the categories and for TANF and CHP the cost trends that managed care plans incur is around 3-5 percent. In a fee-for-service-based environment the cost trends in CHP and TANF are typically closer to 10 percent. So, what is the difference? It is giving pregnant women access to an OB/GYN so that she gets prenatal care. It is actually improving access to care for children and to the women principally in the TANF population. So, it actually works out to be a positive benefit both for the state and for the member and for the health plan as well. I think the data is fairly clear on all that. Across the SSI population I don’t know that you have good data to support that it saves money or that it is a significant benefit to the states or to the members or to the health plan because it is still a little too early.

Paul Ginsburg: So, the comment you made about the different cost trends in the TANF and CHP population between fee-for-service and managed care would imply that managed care is becoming better at what it is doing over time.

Ted Shannon: Look, a healthy baby costs $5,000, to have a baby in this country. For a healthy, no problem baby it is about 5 to 6 grand. If you have that kid hit the NICU it is 50 60 70 grand at least, depending on how early that kid comes out. So, if I can, as an insurance company, find people who need access to care, who can improve the prenatal care delivery, just that alone is a significant savings and a significant benefit both to the managed care who is taking on the insurance risk, to the state who has the budget issues, and to the member and ultimately to the child that is born.

Robert Laszewski: Paul, we lament managed care’s inability to bring healthcare costs under control, but I think it is easy to forget where would we be without managed care. Managed care has had some very significant impact, positive impacts--controversial impacts but certainly a lot of positive impacts on cost. Where would we be without it?

What the Medicaid market really is, it is this sort of virgin territory that hasn’t had the effect of managed care yet. So, when you open it up to some of these techniques it has a very positive and profound impact on costs. If we had Medicaid entirely managed care, we would see a diminishing return there but that is not where we are in that cycle.

Paul Ginsburg: I have a question here about the perspective of health plans towards pay for performance programs. This question kind of assumes that plans are against it. It says how strongly do you think that health plans insurers will try to sabotage efforts to restructure payment around performance? So, I want to just broaden that. You know, how to plans feel about it? Is this something they are eager to do? Is it something they will do for PR reasons? And, how significant will this be down the road?

Ted Shannon: I think some health plans that have invested aggressively in their own technology and actually believe that they are in the business of providing a better product to the marketplace--I am not saying that is a lot of them, they actually are aggressively going after this and they are trying to roll this out in multiple networks, and they are experimenting with different flavors and different ways to approach it. Is the entire market in favor of it? No, absolutely not. But are the people who have been the product leaders? Yes, absolutely.

Christine Arnold: I think there is much more resistance on the part of providers to performance-based networks than by the health plans. I would echo what Ted is saying. A number of the companies have various initiatives. They have been aggressively fought, particularly in places like California, by providers who have a great deal at stake and a great deal to lose because, by definition, somebody is going to get less than somebody else out of these structures and whether it is that somebody will get an increment or you are going to get a decrease, it does gore a bunch of oxen.

Christine Arnold: Health plans each want to do this individually but the care focus purchasing initiative is all about employers getting together to say if each health plan is designating different providers as good it undermines the effort with consumers to develop any confidence that the managed care companies either know who is good, or want to tell you, or doing anything based on anything but price. So, the goal is to move us away from each company trying to create a competitive advantage by having their own efficient network--here are the docs and hospitals that have the best price and who I think deliver the best quality for that price so efficiency includes my price with that provider--to a more macro perspective where here are the best outcomes for these particular disease states, and that requires a pooling of data. So, I think sabotage is a strong word. I would use the word resistance by the health plans because each of them is trying to use this initiative as a competitive advantage and the tug of war is that employers want this to be on a macro basis. They want the equivalent of a "Consumer Reports" for providers--one place you can go to figure out whether this is good or bad.

Robert Laszewski: I think your comments really underscore the issues involved because what the employers are saying is your health plans are going out there; you are doing this analysis and you are all coming up with different providers as being the most efficient ones. Well, what does that tell you? It tells you that somebody is either very right or a lot of people are very wrong. If you are doing the analysis and you are coming up with different people as the efficient providers, it probably says that the work you are doing isn’t terribly accurate. If you are out there with all the data looking at all the providers because, remember, everybody has got 20, 30 percent market share with all the providers. You ought to be coming up with the same answer. The fact that you are not coming up with the same answer probably says that we are not very good at figuring it out.

So, I don’t think there is as much resistance on the part of the health plans as most health plans don’t have the confidence that they could do it. A couple of health plants think that that is where their strategy has to be but even those who have invested a lot of money and think that is where their strategy has to be are selling it in the self-insured market where they are telling the employer to take the risk that they write. They are not giving discounts in the fully insured market. They are not saying here is 15, 20 percent off my fully insured rates because I figured it out and that is the telling point right there.

Paul Ginsburg: I would like to take our break now. Let’s get back in ten minutes. I would like to thank the panel. You did a great job.

[Recess]

Paul Ginsburg: I would like to begin with the second panel. I realize you can’t read these signs so, starting on my right, we have Bob Reischauer, Fred Martucci, Chris McFadden and Ted Shannon, who was at the first panel.

First, I would like to begin the discussion with a little more of a drill down on cost trends or underlying healthcare spending trends and really ask about what is notable in the trends for hospitals, physicians and prescription drugs. Then I am going to get into what about new technologies? Are there major items in the pipeline that are likely to affect costs? So, if anyone would like to begin?

Christopher McFadden: Sure. Thank you and good morning, everyone. I think when you think about the trend patterns over the last several years the one that stands out most notably, of course, is the pharmaceutical cost trend which has declined meaningfully over the last four to five years and, I am sure, is one of the more important contributory factors to the types of overall managed care pricing and cost trend that the earlier panel did such an outstanding job I thought of discussing.

Clearly, you know, what is so interesting about the pharmaceutical cost trend is that it really represents I think a microcosm of the types of tools that can be applied to patterns of utilization, whether it be cost shift, whether it be utilization management through, in the case of pharmaceuticals, formulary design to really have a pronounced impact on the overall cost trend and, of course, the overall market growth characteristics.

Beyond that, the only other point I would make is that we have seen hospital costs up-tick here modestly. That is, of course, a blending of inpatient and outpatient and, I suggest, represents a degree of stability or returning perhaps to a more normalized level with both unit and price contributing to the overall hospital trends that we are seeing.

Paul Ginsburg: Bob?

Robert Reischauer: I think if we look at input price trends, they look pretty good. We have had a period where the major input prices, particularly the employment cost index for the health sector has been significantly above that for the economy as a whole, and that gap has now narrowed rather significantly not withstanding the fact that the health sector is still scarfing up a disproportionate share of new employment in this country. So, this means that the numbers are about where the industry needs for expansion at the level that it is going right now. The real question will be whether various of the players develop enough market power to extract some rent and, therefore, push up these price indices over that for the economy as a whole. Particularly if you look at this in real terms where the inflation rate is sort of drifting up and the various input prices are staying about where they have been for the last couple of years.

Paul Ginsburg: What about utilization? Utilization, I guess, has been a relatively low trend for a few years. Do you expect this to continue or is there a basis for seeing it re-accelerating?

Ted Shannon: Well, as the consumers continue to have more of their own money at risk and they suddenly have to become much more aware of the cost that they are incurring you are going to see utilization across a macro level continue to fall. If you look at some of the experience in the consumer-directed products that we were talking about earlier, utilization falls pretty significantly across the board in just about every category except for specialty physicians. So, to the extent that my comments earlier about being at the beginning of a product cycle hold true, utilization should continue to kind of steadily abate over time.

Robert Reischauer: I think you have to look at the whole market though, not just the private component of it. Actually, I am a skeptic about how much of this consumer-driven healthcare there is out there and how big the impact is now, and I am an agnostic with respect to the future but what we have to do is not just look at the private component but also at Medicaid and Medicare. If you look at utilization in Medicare for some of these items, it is mind boggling. You know, physician visits in 2004 rose by 11 percent; imaging, 22 percent; minor procedures, 20 percent; you know, numbers of people, one percent, 1.5. So, we have had a huge expansion in volume of services provided in Medicare and I don’t think we know whether that is going to abate or not.

Ted Shannon: But, I mean, if you want to go to the ultimate macro level, hospital volumes are down year over year. Number of prescriptions per person in the United States are down year over year. Generic utilization of prescriptions is up year over year across all population categories. So, if you want to just go from the simplest macro level utilization continues to still fall. Falls isn’t the right term. It is growing at a decelerating rate. So, you are probably going to see utilization probably continue to edge down its growth rate steadily over time. That is my belief.

Christopher McFadden: I would just build on some of the secular comments by saying that our research suggests a certain dynamic that is reasonably timed to the job cycle on a two-year lag basis. So, if we look at aggregate hospital data which is, of course, still the single largest component of the Medicare spend what we can see is looking back over 50 years or seven business cycles about a two-year lag relationship between the trough in the job market as measured by the unemployment rate and when you begin to see some re-acceleration in admissions behavior again. That is a cyclical dynamic which is distinct and separate from the secular trend, and I think there are some very good points made here. If that relationship holds for the eighth time we should begin to see an upturn in admission behavior for the U.S. hospital market sometime in the second half of 2005. Whether that happens or not obviously will be something we will be watching very closely.

Paul Ginsburg: What about technology? It is really hard to summarize it. In fact, some of the figures that Bob was citing may really be due to new technologies that are being provided. Is there any way of gauging whether the pace of new technology, or at least the way in which it influences costs, is going to be accelerating or decelerating?

Ted Shannon: Costs in new technology will continue to accelerate. You spend $40,000 to give a cancer patient five more weeks of life. When the biotech companies get away with that, then the next hurdle becomes can I get 60 grand? Can I get 70 grand? The trend has been always, yes, sure, why not?

To the extent that the market will not push back either because of government regulations or because of market forces that prevent people from actually have effective purchasing power against the biotechnology industry for political or policy or for just bad public perception reasons--I mean, you can’t say no to someone who has cancer. Right? You can’t say no to someone who needs a stent. You can’t say no to someone who needs some new technology. That is the perception. So, because you can’t say no, you can’t control the price. So, the price and cost in new technology will continue to escalate until, you know, someone says enough is enough, and I just don’t see that happening any time soon.

Paul Ginsburg: Let me move on to the next topic. In our round of site visits over the last six months one of the most striking things which we saw in virtually every site was the degree to which hospitals are seeing physicians, their physicians, as their most threatening competitor and that adding ancillary services to practices so it is creating free-standing surgery centers, imaging centers, etc., is a phenomenon we have seen as fairly pervasive. I would like to ask panelists if they have perceived this and what they see as the upshot of these competitive developments.

Frederic Martucci: Yes, I would love to jump in here. My world is a little bit different. I deal in the not-for-profit tax exempt sector and just the topics that we have raised so far as far as utilization, the hospitals that we deal with--there are 5,000 hospitals in the U.S. Most of those are not-for-profit. Less than 1,000 of those are "able to access" the capital markets tax exempt debt. So, we have taken 5,000 and we have dropped them down to probably 600-800. In our portfolio of 300 rated credits, 340 credits, utilization trends inpatient-wise at worst are stable. Outpatient trends get really interesting because that is where we run into a real hodge-podge and this is where physician competition comes in.

We started to do a paper a year ago on specialty hospitals and what a threat they pose to our hospitals. About two weeks into our research we sort of dropped that and we figured out--well, we didn’t figure out anything; the numbers were incredibly dramatic with what was going on in ambulatory surgery centers, and I will throw in there imaging centers and those other things--document box, depending on where you are, what they are called. Some of the numbers are so dramatic it is sort of in-your-face and I am an analyst so analysts love numbers.

Okay, outpatient business, in 1981 80 percent of all surgeries were done inpatient, 80 percent of all surgeries in 1981. In 2002 the number of surgeries, the multiple was 2.5 times. Only 22 percent of those surgeries were now being done inpatient. Where did they go? Well, in 1981 90 percent of all outpatient surgeries were done by your hospitals. In 2002 53 percent were being done by hospitals. For our hospitals, we echo what they say. That is where we get our education. And the major issues for them--they always have a top 10, top 5, top 3 list and right up there at the top of the list now is physician competition.

What they are doing or not doing is kind of interesting. Some of our hospitals in our portfolio say they will be approached or they will find out that the orthopedists are going to start a clinic or a hospital and they will kick they off the staff. Sometimes that works. What the majority are doing is trying to get a piece of the action. That has also been interesting. A lot of hospitals try to start out being friendly, meaning, yes, we don’t need to have a control in share. But some of our best credits now--and best means they are good; they are very good at what they do, they know how to run a business--the best comment we ever heard, we asked what they were doing with the physician joint ventures and if they required 51 percent and the response, after a very pregnant pause, was "we discovered that control is not a dirty word." That is enough; I talk too much.

Paul Ginsburg: No, no, that is great!

Christopher McFadden: I guess I would just build on that by making the observation that a lot of what is referred to here might by the symptom. The problem, of course, is economics, and what distinguishes all this discussion is the opportunity for physicians to participate in another revenue stream and that other revenue stream is around owning the facility and participating in providing the facility side of the surgical experience. So long as the economics are there and the legislation permits it, it will continue to be a particularly significant problem.

I would emphasize though it tends to be more of an urban problem than a rural problem. That is a very generalized statement and there are lots of markers between urban and rural extremes. But, generally speaking, one needs a density of population and a market dynamic which is more characteristic of an urban or suburban market than a rural market. When one thinks about the distribution of hospitals in this country one has to kind of overlay this problem or this dynamic with where the facilities are actually located.

Ted Shannon: Yes. The only thing I disagree with what Chris said is the term "problem." I mean, if you are a hospital this is a problem. If you are an insurance company this is great. If you are the government this is positive. If you are the consumer you will most often than not have better quality care in an ambulatory surgical center than you will in the hospital.

So, yes, our hospitals can continue to be challenged by this, absolutely. Like I said before, doctors are very efficient small business managers and they are going to do everything they can to maximize their revenue stream. If that means owning a surgery center, they are going to own a surgery center. If that means owning a specialty hospital, if that ever comes back again, they are going to own specialty hospitals. And, if that means that the hospital systems are going to have to sell part of the hospital to the doctors--and we are hearing more and more from both for-profit and recently non-profit hospital systems telling us syndicating a hospital on a market-by-market basis might happen. It is going to happen. So, to the extent that doctors are continuing to be motivated to make more money, I mean, this is going to be an issue that the industry is going to have to learn to deal with.

Robert Reischauer: I think what Ted said is very important but over the long term we have to ask whether payers of both insurers and Medicare/Medicaid government are going to see that these efficiencies lead to lower costs, and change the reimbursement for procedures done in an ASC, for example, versus an outpatient department accordingly. So, maybe the percentage margin might be the same but you won’t get quite the opportunity that is incenting some of this at present. As you said, there are a lot of other things going on--consumer satisfaction, the notion of control and the facility reflecting the doctors’ priorities. So, one would expect this to continue anyway but maybe not at the pact it has been going in recent years. I mean, ambulatory surgical centers I think have been growing, the number of facilities at 8, 9 percent a year which is, you know, pretty dramatic.

Paul Ginsburg: Let’s talk about some of the mechanisms the hospitals are using to compete with physicians. Fred, you mentioned a few as far as forming a joint venture. So, I wonder if you can talk more about what your perception of these joint ventures is. Is it really instead of having the physicians take all the action, they are just sharing it? Or, is there more to it than that?

Frederic Martucci: Just to back up for a little bit, if you needed healthcare you went to your doctor, the doctor’s office or you went to the hospital and there really wasn’t a whole lot in between. Well, now there is a whole lot in between. There is no question that specialty hospitals, because they are specialists, do what they do very well. They do it more efficiently, etc., etc. But the delivery system still is surrounded or monopolized or concentrated in a hospital so it opens up a huge question of, well, is that the right way to deliver care.

Maybe I am naive but I think in my lifetime if you know someone who goes to a hospital, our definition of a hospital--whoever that is, is really sick; they have to be in a bed in a hospital. The technology is incredible and the drugs are incredible. If you just go back to where surgeries are done, everything is outpatient. You do in, in the morning and you leave in the afternoon. So, if you are going to be in a hospital it raises all sorts of questions that we can’t get into here as to what is the best way to do it, the most efficient way to do it, etc., etc.

So, what are hospitals trying to do with their physicians? Well, they are trying to make sure they are real happy. Physicians I think are crummy business men. They didn’t go to business school. They are scientists. They want to deliver good medicine. A comment was made earlier that Medicare was a good payer. Right now, all things being equal, Medicare is pretty good for hospitals but it is crappy for physicians so they are trying to get more money. They are losing money. They made more money two years ago doing the same amount of business. So, they are looking for more money so a lot of hospitals are trying to take advantage of that fact. I hope at some point physicians and hospitals--everything is on the same even keel and they will figure out that they need each other to survive. So, what the hospitals are doing is, "you don’t want to be a businessman; I will set up the clinic. It makes sense. Let’s do this and here’s your cut," however they figure out what the cut is. So, I think hospitals are getting smarter about it and physicians--again, I think they are lousy businessmen.

I was very glad a few years ago when these big physician groups all blew up and when hospitals were all trying to buy physician practices. Jesus, what a disaster that was! They were stupid so I am glad it didn’t work. It shouldn’t have worked.

Robert Reischauer: So, hospitals are bad businessmen and physicians are bad businessmen--

Frederic Martucci: We have some good businessmen. I am amazed at how they survive, to tell you the truth. We obviously rate a lot of hospitals in New York. I think you have to be a masochist to work in a hospital in New York. Some of them are very good at it; some of them are not too good. When I was in school I had an internship at this little community hospital in Arlington, Massachusetts, Symmes Hospital. Symmes Hospital is closed. They went bankrupt. When I worked at Coopers & Lybrand I did a ton of work for St. Vincent’s, down in Greenwich Village, a big Catholic institution. Over the years St. Vincent’s has changed and it has got bigger and I think it is seven hospitals and I don’t know how many nursing homes. They just filed for bankruptcy.

Christopher McFadden: I guess I would build on that by pointing out that, yes, sick people go to hospitals in traditional market but other people who go to hospitals are uninsured. And, one of the structural problems about all this fragmentation in delivery of care is that the uninsured aren’t finding their way to ambulatory surgery centers and they are not finding their way to physicians’ practices to have these procedures done. They are still going back to hospital where they know they will be delivered care. The way the reimbursement, obviously, is configured puts those community hospitals, which are still a pivotal part of delivering care in local markets, in further financial jeopardy or certainly puts a more disproportionate financial burden on those facilities. So, in the big scheme of the economics of this marketplace that becomes something that we need to address if Ted’s point is right, and I think he makes an extraordinarily effective point about why quality and cost can be advantaged in different care locations. We need to think about how the uninsured fit into that bulkinization or fragmentation of the care delivery model.

Paul Ginsburg: Good. I can think of three factors that are driving physician investment in facilities. One is changes in technology. You know, downsizing some equipment technologies makes it feasible to put in a physician practice. Costs of capital must be very low these days. Also, what one of the panelists mentioned, you know, the very low reimbursement for professional services, which is not just Medicare and Medicaid but private insurance too in most cases. How would you rate those three? Or, maybe another factor I didn’t list is which are the most important drivers of these trends?

Ted Shannon: One of the things to realize is that an ambulatory surgical center is one of the best return on investments you can ever make. The things cost almost no capital to start up and once the startup costs are overtaken after between three and six weeks of being open, they suddenly start printing money for the owners. I mean, it is a license to have an ATM!

And, the reason hospitals aren’t in it is because, face it, they have only recently moved, on the non-profit side, from nuns with checkbooks to actually having business people running some of these hospitals.

Frederic Martucci: Wow, we rate a lot of nuns! These nuns, they have more degrees than you can sniff at.

Ted Shannon: I am not knocking the nuns!

Frederic Martucci: Again, when we started to do this research paper on specialty hospitals, how much to start it was a big deal and cost of capital is cheap. But then you get back to what does the hospital do? A hospital is just like you have a grocery store and you go in and you buy certain products so you have hospitals providing lots of services where they don’t make money. I don’t know of a burn unit in the country, anywhere that I have ever seen, that makes money. You don’t make money in a burn unit. And, there are other services where you don’t make money. Some other services are very profitable. So, a lot of hospitals, when they are doing physician additions, do economic credentialing. They figure out that, no, I really don’t need an OB/GYN; what I really want is a neurosurgeon because, boy, I make money on neurosurgery and there is a demand and, great, I am going to go there.

Well, you have these surgery centers and these are high profit business. Has anyone ever gone to an imaging center? They are great! You can pull right up. You can park ten yards away from the front door. You walk in. They know who you are. You don’t have to follow a blue line on the floor to figure out where you are going, and you are done. And if you have direct insurance, your insurance pays. So, that is where I am going to go.

So, you run into incredible problems. So, cost of capital is absolutely key because it is peanuts to get started. Then they want more money. I think pretty well everyone wants more money but I don’t think the physicians want to be businessmen and hospitals are saying we can run it. You might not get as much as you would have if you ran it on your own or with your buddies but we will take care of all the pain in the neck stuff so you can practice medicine.

Paul Ginsburg: One thing that surprised me on the visits is that we saw the phenomenon of some hospitals employing specialists, not primary care physicians but specialists, as a way of competing with hospitals. So, in a sense, when you mentioned that physicians aren’t great business people, is this a direction that could be a substantial one, perhaps easier than forming these joint ventures? You just pay them what they are worth.

Frederic Martucci: Practically every hospital we rate has employed physicians at least in certain areas--pathology; usually the emergency department is a contract; sometimes radiology is. I think that can happen. Whether that is a good idea or not I don’t know. Again, I think for some physicians being salaried is pretty good. There has been a lot of literature that the new physicians who are coming now--I forget what the percentage is--with women, and please don’t interpret this the wrong way, but what they have found about women, women like to have a life. In other words, they are not going to work 120 hours a week, or whatever the number is. Some of them want to have a family and they want to have a job that they enjoy, and they picked medicine, but they want to work "normal" hours and, as an employed physician for a hospital you can do that. So, it is kind of neat.

Robert Reischauer: Paul, that isn’t a solution because if you take the people who have sort of higher profit margins in their activity who otherwise would go off and set up a facility of their own and gain that rent themselves, and if you say, no, you can stay in the hospital and we will give you that rent then the hospital has lost that margin that Chris says it needs to cover the other activities it is involved in or the uninsured.

Paul Ginsburg: That is right. That is a good point. This trend of physicians competing with hospitals, what effect do you think this will have on healthcare costs? Will this lead to more services delivered? Will this lead to lower prices paid by third-party payers?

Christopher McFadden: I think one observation would be, and clearly to the earlier point about the syndication potential of traditional hospitals to physicians, is that it is often the case or it is opined that you can get physicians to be more actively involved in how you think about deployment of technology costs like implantable technologies that, of course, in the surgical market have been big drivers of overall expenses for hospitals certainly relative to slower rates of growth, at least in the Medicare market, of some of the other underlying DRG categories. Because if you link, again, the physician into the economics of the facility, they may be more rational actors. So, one of the ways to theoretically help impact technology costs is to make physicians more engaged in the process and, therefore, perhaps put a more even-handed approach to how you think about cutting edge technology and balancing that against the clinical needs of the patient and the clinical needs and the economic needs of the organization.

Ted Shannon: In the short term this will help decelerate the growth in cost of healthcare. In the long term it doesn’t change the core problem that healthcare costs in this country are too damned high. We charge too much money. The input prices that were mentioned before, whether it is for new technology or just for continuing services, are material above anything else in the real world. So, does this impact the overall growth rate for the short term? Yes, absolutely. Does it make a bit of difference over the long term? Will it actually lower the cost of healthcare? No, not at all.

Robert Reischauer: There are two things going on here. One is the possibility that the proliferation of these services increases the utilization, the amount that is going on. And, we can argue, well, in some areas that might be good. You know, the number of colonoscopies will rise and we are under-colonoscopied. On the other hand, certain kinds of invasive cardiac procedures maybe we do too many of and that might be bad. So, you have, you know, the efficiency of the fact that it could be done cheaper going in one direction but, on the other hand, the volume going up. So, I am not at all sure that even in the short run it leads to moderation of total expenditures.

Ted Shannon: I mean, by definition, arbitrage works. Surgery that costs $10,000 in the hospital costs $2,000 to $3,000 in a surgery center. So, definitionally, even if you have 3X the utilization I am still--

Robert Reischauer: You are under the numbers you just provided. I can provide you some other numbers that don’t come out that way.

Ted Shannon: But, I mean, the average surgery in the hospitals are--what?--around $12,000. The average surgery in a surgery center is between $2,000 and $3,000.

Robert Reischauer: I mean, there are different kinds of things. I mean, the Medicare Payment Advisory Commission did a pretty good study--actually, an excellent study, being the vice chair--

[Laughter]

--of specialty hospitals and, you know, from the data we were able to mine, it appeared that the more complex cases go to hospitals and simpler cases are in the surgical centers or in the specialty hospitals and the costs are different. Somebody said--Fred, I think, said that the costs are less and they are more efficient, and that might be true in some of these settings. From what we could determine with respect to specialty hospitals, it wasn’t true. In fact, the costs were comparable in the statistical sense and without any significance. They were actually higher for the specialty hospitals risk adjusted.

Paul Ginsburg: I would like to do two topics together. One is the hospital competitive strategies. The panelists know the things I emphasized were the expanding high margin services, and also I think that is part of the hospital capacity expansion story. So, if panelists would comment on what hospitals are doing, are the services and facilities there emphasizing--are they doing that because they are more profitable or because that is where the demand is? Let me stop right there.

Frederic Martucci: Well, if you are dealing with the nuns, the nuns are balancing mission and margin. I think what is interesting, again, for what we see in our portfolio, expansion is not the word we would probably use; it is more like reconfiguration. A lot of the hospital projects we see now--there are still a lot of hospitals out there who don’t have private beds. So, private bed is a big thing. Even the smaller community hospitals that we rate, one of the things they want to do is get everything on private bed. There is a huge investment in outpatient areas because that is where the margin is. There is also a real scrutiny of other businesses. We only have a handful now of hospitals who have their own managed care plan. We only have a handful of hospitals now who are interested in owning and managing non-acute care services. There is an awesome, a huge investment in technology.

This is digressing just a little bit, I was interested in the comments of the prior panel about provider resistance to quality. Wow! I will tell you what, here is the way I look at quality and what we see, and I will put providers into three categories, the insurance companies, the hospital and the physician, the biggest insurance company in the world is Medicare I think and Medicare is into quality only a little bit but, to me, the camel’s nose is in the tent and as long as Medicare is interested in rewarding providers, hospitals, with quality I think other people are going to jump on the bandwagon.

When you move down to hospitals, every single one of our hospitals is on a quality kick that you can’t believe. The way they are trying to get at it is through data. The University of Pittsburgh Medical Center--I will tell you, the amount of money that they are investing in quality is staggering, and their concern is we want to be the best; we just hope we get paid for it.

Physicians--every hospital we have is on--well, it is kind of interesting how they did it. Adventist in Florida is a really good credit, and they went to their physicians and said we now have best practices for physicians. That is the way it was introduced to them, and the physicians’ reaction was, "what? You’re telling me how to do my business? I’ve been doing this for 30 years. Get out." So, they literally got kicked out of the room. They went back to them in less than six months and said, "what we have for you, guys, is best evidenced medicine." Now, physicians are scientists and they said, "ah, well, show me the data." We have lots of hospitals now who give physicians their individual--call it whatever you want, report cards. They will go to their orthopedists and say, "you had ten admissions, you had ten admissions, and they are all same DRGs, whatever, whatever. You gave these many x-rays, these many tests, this much this, and here is how the number dollars stack up. You cost us money; you made us money. By the way, your patient stayed two days longer and we saw him again three weeks later. You’re off the staff unless you change the way you practice." So, the quality stuff is a really big deal here. Now I forget what the original question was.

[Laughter]

What was the original question?

Paul Ginsburg: It was too long a question. But, actually, I would like to pursue the quality thing. That is very interesting. I have often perceived that quality is getting a lot more emphasis. How much of this is driven by professional pride in the work of the Institute of Medicine and how much of it is fear that this is going to be something we are going to have to compete over in the future?

Frederic Martucci: I think, yes, it is all of the above. It is funny, this is an article--it is recent, "Lung and Health Care," June 27. Blue Cross/Blue Shield, there are 51 plans in the country and 29 of them--that is a pretty big number--are already paid for performance for physician piece, which is kind of interesting. Right now only six of the plans--and I am quoting from the article, only six "Blues" plans publicly report physicians’ performance but eight others said they plan to do so by 2006, 2007.

Quality. Well, what is quality? I am telling you it is coming. Why shouldn’t it come? Not all hospitals are created equal. I did a speech not too long ago in Pennsylvania so I have all this Pennsylvania data in my head. I can’t remember the web site. There is a web site and what you can do is you put in I am going to have a liver transplant, or whatever you are going to have and I am going to say there are 60 DRGs that you can track. So, you put in what you are going to have done. You put in your zip code and you get back the list of 30 hospitals that do the procedure. The information--you know, it is kind of interesting, it will tell you how much it costs. They tell you how many they do and I forget what else. There are one or two other things.

Robert Reischauer: Risk adjusted mortality rate.

Frederic Martucci: Yes, that is right.

Robert Reischauer: But who would care about that?

Frederic Martucci: Right.

[Laughter]

So, if I am a patient and I have access to the Internet, I might do that. I do it when I buy a car so if they are going to mess around with my liver I had better figure out who does it well, and who does it a lot and who is good at it. So, all of the above.

Christopher McFadden: I think the other piece of it, of course, is there are financial incentives being engineered into at least how Medicare has approached the market. And, I think we would agree that the managed care marketplace will follow. If you look at the two pay for performance initiatives or quality initiatives that CMS has launched, hospital quality initiatives and the premiere hospital quality demonstration project has three billion dollars in potential incremental reimbursement to the industry over a multi-year period. That is a lot of money and I think the nose under the tent analogy is the right one.

The ten or so metrics that have been selected are obviously not particularly sort of differentiating but I think it starts to change a mind set, and it begins to make the required investments in culture and technology that opens up, you know, for a lot more change over time. Now I think we draw back to some of the consumer discussion we had in the previous session because if, in fact, you are going to structurally shift more and more of the economic responsibility in some form or fashion to the individual there are going to be smart consumers, and smart consumers want good information and it takes technology and investment and data to give people that information. So, I think you can begin to see something, albeit at a glacier pace. I think you can begin to see some changes here that, hopefully, will be sustained.

Robert Reischauer: A couple of advertisements, the Medicare Payment Advisory Commission has recommended, over the course of the last couple of years, that Medicare move in the direction of pay for performance for hospitals, home health, physicians and dialysis centers. The Institute of Medicine, as a result of the Medicare Modernization Act, has a committee that is studying this and one would expect it to come out favorably along these lines.

It was interesting to hear the first panel discuss all the reservations and problems, of which there are many, and the resistance which they saw with insurers and providers of various kinds. This panel seems to be coming from a different place and saying, you know, this is building a head of steam. Even those who would rather live their lives without such performance measures being gathered, taken and disseminated realize that something is different and they are going to have to live with this.

Ted Shannon: Yes, the IOM study fundamentally embarrassed the industry. I mean, the fact that more people die in hospitals than just about any other professional setting in the country--I mean, it is ridiculous. It is equivalent to--what?--a 747 crashing at Kennedy every day. You can’t have that. I think that is one of the things that fundamentally embarrassed the industry into action and some of the trends that you have seen in healthcare IT providers, with the acceleration in some of their business trends over the past several years, selling more software to hospitals, trying to help them get ready for some of the stuff that this panel just mentioned.

As we go on, I believe you will all see your doctors rated and whether that actually leads to an improvement in the quality of care, which I believe it will ultimately, and/or a reduction in the total cost of the care of an episode, which I also believe it will, remains to be proven, admittedly, but it is definitely a movement that has not even started yet to pick up full steam but it is definitely coming. And, not all hospitals want it. Not all providers want it. Not all doctors want it and not all insurers want it. It doesn’t matter.

Christopher McFadden: I would just tack on to Ted’s point by saying what doesn’t seem sustainable, at a high level admittedly, is what has obviously been a market uptake in the amount of rhetorical support coming from the administration and the federal government over the role of information technology, and we can think about all sorts of press conferences and events that have occurred at hospitals around the country without any substantive or additional funding to support that. I mean, it is an important initiative to pursue I think from policy perspective but at some point hospitals with meager access to capital and meager operating margins are unlikely to be expected to make those investments on their own if all they are getting is a strong rhetorical direction in terms of a senior level sort of policy initiative. I think that is one of the things that makes this a very fragile dynamic.

Robert Reischauer: Yes, that raises a question that I wanted to ask somebody here. On this panel and on the previous panel people have said Medicare is a good payer, and Medicare’s Payment Advisory Commission’s best estimate of the margin on Medicare work for 2005 inpatient/outpatient is minus 1.3. With respect to physician payments, I think our best estimate is that the reimbursement for Medicare is somewhere between 80-85 percent of what private insurers pay. If that is the definition of the market of a good payer, I guess there is room for Medicare to provide some of this.

Frederic Martucci: Sure. What we are always asking our hospitals is who do you make money on because who walks in the door and what they have in their wallet or don’t have in their wallet depends on their reimbursement. So, Medicaid--no one raised the flag for Medicaid. The best we ever hear about Medicaid anywhere in the country is it is adequate. It covers our direct costs but when we allocate costs we don’t even come close. For Medicare, I would say probably half of our portfolio at least breaks even or makes a little and the other half don’t make money on Medicare either but they get close. Where else does it come from? It is not cost shift; it is revenue shift and it comes from the other insurers, hopefully. We will have some hospitals where they don’t make money on 50 percent of their business, Medicare and Medicaid.

Ted Shannon: Most of the hospitals that we deal with I think would echo the same things. You know, Medicaid is an okay payer if I don’t allocate any overhead costs to it. If I do, well, I am losing my shirt but that is what I have to do. On Medicare I have heard numbers that significantly differ from the Medpack but they are all over the board too. I mean, the spread on that is tremendous. Some people make good money, good money being defined as, say, 5-8 percent margins. Some people lose 5-8 percent depending, again, on location, the mix of services that they provide to the community. On the commercial side they are making better than that. Right? They are making about 10 percent margins on that business but where they are making most of their money is on things like workers comp., on the auto carriers, on the non-traditional payers in the marketplace.

Christopher McFadden: I guess I would just tack onto that by saying what hospital CEO in their right mind would say I am making too much money on Medicare?

Robert Reischauer: You referred to it as a good payer.

Christopher McFadden: I think generally speaking a healthy payer perhaps is more accurate--

Robert Reischauer: Predictable payer.

Christopher McFadden: Predictable payer, a prompt payer.

Frederic Martucci: Prompt and predictable is good, and it is much better than BBA. You know, everything is relevant.

Ted Shannon: Right, and it is all dependent upon which loophole I am taking advantage of.

Paul Ginsburg: That is right. You know, among the better financed hospitals is investment in IT a significant item now? You know, if you look at a hospital capital budget IT is going to be noticeable?

Frederic Martucci: Yes. I can tell you that for our hospitals number one on their list is that they want access to capital, and they want a lot of that capital, up to 30 percent although I would say the norm for our portfolio is between 15-20, spent on IT. One of the things that is very difficult about IT is all these better credits are talking about ROI. What is my return if I invest in this? And, some of that is easy to do. Some of these multi-hospitals, you know, different states, whatever, they will say, okay, I am going to invest my money not in New York but--let me pick one--North Carolina is a good spot. So, I am going to make money in North Carolina and invest my money in whatever hospitals I have there. IT--it is very difficult to get an ROI on a lot of that stuff. It is sort of squishy; it is sort of wishy-washy but, regardless, full speed ahead is what we are seeing in our portfolio--big numbers.

Ted Shannon: The level of spending is stepping up. I would argue it is still below where it needs to be. I mean, some of the better run, better graded hospitals with access to capital, still a majority of them don’t have enough money to go to someone like an HBO or Eclipses and buy a three-five million dollar software package to help them track clinical performance within their hospital. So, it is actually, from what we have seen, a market that is moving quickly to those that have and those that have not, with a significant portion of hospitals within the country in the "we have not" category because they simply can’t afford to keep up with the investment spend.

The same thing, by the way, is happening on the managed care side too. When I mentioned earlier that there is only one managed care entity that has invested a material portion of its income and its cash flow over the past several years in IT, if you look beyond even that most of the plans don’t invest nearly enough to maintain the legacy claims systems that they are running, much less the systems that are going to be necessary to integrate with the hospitals on the clinical side and to actually share and report the data accordingly. So, one person now calls it starvation in the land of plenty and I think that spread is going to become more dramatic over time.

Paul Ginsburg: Another change of topic, we have mentioned often the hospitals with good access to capital and there are a lot which don’t. You know, given changing technology, potential of demand for IT, what is the outlook, you know, numerically for a lot of hospitals in the country? Are they just going to fade away over time? Are they going to be acquired by for-profit or non-profit systems? How is this going to play out?

Frederic Martucci: I have been at Fitch for 16 years. Prior to that way a rating agency would talk because they would finish and I would say what did you say? One of the things I always used to say was, "oh, boy, the ’haves’ and the ’haves not.’"--but I will tell you what, if you just get rid of all emotion and just look at the numbers the spread between the "haves," meaning they have money; they have margins; they have an A rating; they have an A-plus rating; they are an AA-minus--the split between that group which is a select group, and all the others is getting worse. That is the word.

It is funny, at the beginning of this year we had a lot of review meetings where all these credits come to New York and they tell you what is going on and what they are doing. In one particular week we had one huge Catholic system after another come in. When we were done, you know, we went, boy, we had a real recurring theme and the theme was all the Catholics told us that you are going to see us in the market. And we said, oh, so what are you doing? They said, oh, we are talking mergers, acquisitions, affiliations, whatever. So, I think they are going to be very picky but I think they are going to be active and I think there is no question that a lot of them will go from strictly other Catholic institutions to other not-for-profits to other for-profits, wherever it sort of makes sense and where they can get their mission not get beat up too bad if they get in cahoots with a for-profit. So, I think there will be a weaning out of some of the "have nots" because I don’t know how they are going to do it.

Ted Shannon: What, 10-15 percent of hospitals have an investment grade rating? That is being generous?

Frederic Martucci: That is too generous. If you say there are 5,000 and, again, I only deal with the tax exempts so 4,000 or something are tax exempt. My guess is that right now maybe 600, 750 of them have a rating, meaning they are into the capital market, and I don’t know how many are As--

Ted Shannon: I was thinking Bs and above.

Frederic Martucci: Bs?

Ted Shannon: Yes.

Frederic Martucci: You have to remember, I am in the "muni" world so B is like dirt--

[Laughter]

--that’s not my fault; it is just the way it works.

Ted Shannon: I am in the corporate world so Bs I still make money on.

Frederic Martucci: You know, it is one of the things we try and tell our not-for-profits, they all think they are investment grade and we will start naming some big corporations and we will say you know what all these corporations have in common--some of them will be healthcare and some of them will be healthcare, and some of them will be air lines, and some of them will be car manufacturers--we say none of them are investment grade and you are a 100-bed hospital, a revenue base of $25 million and you are looking for an A rating. My point is it is not very many.

Robert Reischauer: At the other end of the food chain, there are about 4,000 hospitals, a little under 4,000 hospitals and Congress expanded the availability of the critical access hospital designation, and it is projected that there will be about 1,000 of them by the end of this year and under that Medicare will pay them costs. A lot of them probably have abysmal credit ratings and little access to capital. They do have this prop underneath them and that is going to change the fundamental picture of how many small, non big city hospitals are dropping out of the world every year.

Frederic Martucci: You know, it is funny you mention that because we have had three different investment banking firms come to us and, you know, here is the stroke of a pen and all of a sudden these little, tiny hospitals are going to get Medicare payment, and I think it is cost plus; I think they throw in something else too.

First of all, not all of their business is Medicare. Let’s say 50 percent is. Well, they still can’t access the market but what some of these banking firms are trying to do is pool them. So, they will go to these hospitals and say you need money, don’t you? Yes. Well, we can get you a tax exempt rate. What you are going to have to give up is sort of control of the form of the deal. In other words, the covenants will be this; you can’t negotiate because you are better than somebody else in the pool.

So, we got approached 14 months ago and we were supposed to be bombarded with applications to review, you know, XYZ hospital, and so far we have looked at a grand total of seven hospitals. Now, I hope it happens because it would be great if you could let these tiny hospitals--now I don’t know what they do for money. I think what they do for money now is they have somebody on the board who belongs to a local bank and they go get a loan at prime-plus--so, if they could access tax exempt money, that would be great but it hasn’t happened yet.

Paul Ginsburg: I am sorry, I think we need to move on. It would be a good time to pass your questions in. Let me just spend the last bit of the panel’s general discussion time on pharmaceuticals. I would like their perspective on the outlook for new drugs; what is expected; how they are going to be priced. I will stop there.

Christopher McFadden: Maybe I will kick things off by just putting the U.S. market in some historical perspective. You know, if we went back and looked at the rate of growth of the U.S. market, which is obviously a function of new products, volume and the price, the rate of price inflation of that market, you could have asked an analyst what is the rate of market growth in the U.S. and the answer would have been 10, 12, 15 percent, maybe in a weak year 8 or 9 percent. Here to date we are at 4.6 percent. So, we have seen a structural decline in the rate of growth in the U.S. pharmaceutical market and I would argue that there are a couple of things that have contributed to that.

While the total number of new products may be at the same level of molecules or compounds, the age of the block buster, those products that treat very, very large new, previously under-served or unserved therapeutic categories may well be fading. It doesn’t mean we won’t have wonderful innovation but the bias on innovation may be increasingly towards smaller diseases and smaller patient populations than larger, and that obviously has an impact on rate of growth.

The other thing that is arguably structural and, therefore, permanent is that we have seen a meaningful change in how the individual interacts with the cost of pharmaceutical care which has changed the free-rider effect, if you will, in the pharmaceutical market. Gone are the days of the $5 co-pay at your retail pharmacy. We are into co-insurance and others that really make people think.

Finally, under a number of different regulatory authorities we are clearly turning the corner as to how we promote pharmaceutical direct-to-consumer advertising, stop cards, blimps. A lot of that which really went after broad swaths of the consumer market are probably changing and that too is going to impact stimulation. So, I think for all of those things we are looking at a lower probably structural-related growth and a change in the complexion of what those products look like and how they are, therefore, delivered to the marketplace.

Ted Shannon: I mean, I think Chris hit on just about all the key points. What I would add on is that the PhARMA industry is--what is the right way to put it? The profitability of the average pharmaceutical company in the United States is roughly three standard deviations higher than the average profitability of any other company in the S&P 500. These are companies that, despite all their challenges and the slowing growth, still make a lot of money, and it is one of the last areas within healthcare marketplace where this and med. tech. are the only areas where you still see margins that high.

My own personal belief is that those margins are going to be compressed over time. So, part of it is through the sales initiatives that Chris talked about. Part of it is because the structural change in the industry as the block busters and everybody made tons of money on in the ’90s now are rolling over and becoming generically available products. The increased market share and pricing power that the managed care plans and PBMs are putting onto the prescription drug manufacturers is increasing. Ultimately, the biggest payer in the country is going to put out some sort of product that the private sector will then utilize to get better discounts.

I mean, let’s face it, when was the last time the federal government put out anything in Medicare that didn’t ultimately have some sort of structural pricing controls on it? You know, think about DRGs, HCPCS, just about every other--actually, every other reimbursement mechanism in the gov has fixed price controls of some sort. The drugs are the only things that don’t. I mean, it would be fairly logical to assume that eventually that is going to happen and the industry right now I don’t think is well prepared for that.

Paul Ginsburg: There was an article in "The New York Times" the day before yesterday about how some new biologics for oncology were phenomenal prices and that in some cases they had only marginal benefits for the patients. Do you think this is going to spur price controls, and how might that actually happen?

Ted Shannon: I am not a biotech. analyst. I simply cover health insurance companies and hospitals and people who actually deliver care and don’t actually make products. But, I mean, it is going to be an interesting debate and it is one that is going to be "public policy." How do you tell someone that I am not going to pay for this drug that is going to make you live longer? Say that to any of your constituents and see if you are here after the next election cycle. Have an insurance company say that in the local market and see what happens in the headlines in the local paper. You know, XYZ health plan won’t pay for drug for sick baby. That is going to feel real good for that health plan!

What we actually need to have is a structural change not in the way products are priced but in the way we talk about access and the appropriate cost of healthcare. I mean, healthcare costs overall in this country are too high. I mean, the numbers are just there. So, the question really isn’t is this biotech. drug that extends life for four weeks, is that worth 40 grand? What we have to have is a broader discussion on how much should we actually spend to extend life, to think about end of life cycles. After all, in the last six months of a person’s life they are going to spend roughly 40 percent of their lifetime medical expenses. If you think about putting it in that perspective, that drug is only part of the question.

Christopher McFadden: I would just tack onto Ted’s point by making the observation which hasn’t come up in the course of these two panels, which is somewhat surprising when everyone talks about healthcare and, therefore it goes to costs and, therefore, demographics, and someone uses the baby boom concept and, of course, all of the discussions we are talking about today are somewhat run rate discussions. Anyone who has looked at the forecast by any number of organizations knows that all these discussions get ten times more complicated when you look out 15 years from now just given the demographics. But the other cultural dynamic, not the mathematical dynamic, is to think about how this baby boomer generation has changed market after market as it has moved through its life cycle, moved through different phases of life and how they have thought about what has traditionally constituted a market, region, economic set of policies and now take that population that are very activist and are very engaged in a very Internet savvy population and start applying that to these complicated healthcare questions, like the one that Ted just proposed, and these issues get that much more dynamic and probably, therefore, are well outside the scope of these discussions. But it is something certainly to contemplate.

Paul Ginsburg: Thank you. I would like to turn to the questions now if anyone would like to come up and I have a few here. One was directed to Ted Shannon. Why is the growth in physician-owned imaging centers, surgery centers and hospitals good for insurers and the government?

Ted Shannon: I mean, across all those things? I wouldn’t say all those things are necessarily good but I would say at the macro level, looking at ambulatory surgical centers, if I can provide the same service in a lower cost setting with lower reimbursement and better outcomes, that is fundamentally a good thing. I just gave someone who is sick a better outcome at a lower cost. I don’t see what is bad about that.

On the imaging side, you could raise a lot of questions about some of the imaging practices that are going on out there right now. But on the ambulatory surgical side I think that you could make a pretty compelling case fairly easily.

Paul Ginsburg: I have one for Fred. What is the future of teaching hospitals and medical research?

Frederic Martucci: Yes, that is a big deal. There is no question that every academic medical center is more expensive, and they are more expensive because they educate people and they train people and they have more FTEs per beg, or however you want to count it. The Medicare system has rewarded them with GME graduate--you know, they give them a bump in their pay and, hopefully, in their reimbursement, and they are a case mixed index which is higher so they got more reimbursement there.

The jeopardy is this, and it gets back to ambulatory surgery centers and specialty hospitals, when you start to have different venues for care and the ones--I guarantee you, you won’t see a specialty hospital for burn units because you are not going to make money on a burn unit. So, when these academic medical centers and other large hospitals lose the profitable business they are in jeopardy, and I can give you lots of examples of where that is happening. That says there had better be more scrutiny of the overall delivery system, what is the best way to do it; where should it be. And, you get into these huge questions. But overall a lot of the teaching and academic medical centers that we rate, they have other sources of revenue and usually it is philanthropy--big fund raiser.

Ted Shannon: And the other thing to keep in mind with the teaching hospitals is who is paying for the research now. As the amount of money on a relative basis that the federal government pays for research dwindles and the amount of money the private sector is paying for research continues to increase, less of that money on the private sector side is going into the academic hospitals on a percentage of total dollar basis. It is going into private practice for doctors doing research in their own clinics and their own labs and in their own settings and a few other, you know, non-traditional areas. So, as that shift continues to go against the teaching hospitals it is going to be a challenge.

Robert Reischauer: The academic health centers, by and large, do quite well through Medicare, and this has been pointed out, in no small part because of the IME and DSH payments that they get. The estimates are that the IME payments overcompensate for the additional costs. When Congress begins to think about ways to reduce the deficit that is a target. So, you know, I wouldn’t bet on that in the future. Should we ever collect the necessary data and decide to distribute the DSH money for uncompensated care as opposed to the factors that go into the formula now, there would be considerable redistribution and it might be away from these hospitals and towards community hospitals. So, I think the current position is at risk.

Paul Ginsburg: Yes, sir?

Stephen Jenkins: Stephen Jenkins, from Sg2. There was some discussion earlier about the medical technology and device and PhARMA industries being price setters in the market, payers and providers being price takers and that is part of what has enabled them to have much higher margins. Do you see anything in the near future that is going to change that set of economic relationships?

Ted Shannon: Yes. As physicians and hospitals work together, as you see more partnership structure--as you have seen already on the implant side of orthopedics--that will expand across multiple categories of healthcare if it can be proved to be successful. I don’t know that it will be but, if it can be proved to be successful and it can give the provider finance purchasing power by eliminating the number of vendors that they are purchasing from, you will see some shift at that end.

At the other end of the spectrum you have seen some insurance companies trying to flex their own market muscle in going to the manufacturers and saying, look, I have XYZ number of members in this market. That gives me 15 percent share. I can stop paying for your product tomorrow because it is clinically equivalent to your competitors. What are you going to do to help the hospital buy it cheaper? That is not exactly a common phenomenon and it is still an experiment by some of the carriers right now but that is also out there.

Robert Reischauer: To the extent that we move into comparative effectiveness more, I think the balance will shift a bit the other way.

Christopher McFadden: In the pharmaceutical market, as was alluded to earlier, you have an environment today in which the federal government, putting Medicaid to the side, is a relatively minor player in buying pharmaceuticals on a U.S. basis. That is about to change in a very dramatic way at least in terms of who is ultimately funding and ultimately, if there are proposed changes to how MMA’s drugs should become even a more direct mechanism, that would certainly flip at least the pharmaceutical market from government as a price taker to a price setter. There I think you would see the commercial market reset their pricing relationships to that market into which they would start indexing off of whatever government pricing, to Ted’s earlier point. You know, any other market that I can think of, DRG, prospective long-term care or any other market, that is how that market has set up and ultimately that is the risk or the opportunity, depending upon what seat you sit in, in the pharmaceutical market.

Paul Ginsburg: Great! I think this is probably a good time to end the meeting. I appreciate your staying late because I think we had a number of interesting things to discuss.

I want to first thank again the Robin Wood Johnson Foundation for its support of this conference and being HSC’s primary or principal funder. Please fill out your evaluation forms, if you haven’t already, the purple ones. I want to thank a lot of people on the staff of the Center for Studying Health System Change that have worked with me and made this meeting a success on the substance, and public affairs and on the arrangements, and also I finally want to thank our second panel which I think did a marvelous job.

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

Participant Biographies

CHRISTINE ARNOLD - Executive Director, Morgan Stanley
Christine Arnold is an executive director at Morgan Stanley and covers the managed care industry. She joined the firm in 1999 as the senior managed care research analyst. Arnold was ranked No. 1 in the 2004 and 2003 Greenwich survey. In 2000 and 2001, she ranked No. 2 and No. 3 in the Institutional Investor All-America Research Team survey. Arnold has spent 11 years in investment research and has specialized exclusively in managed care for the past 7 years. Prior to joining Morgan Stanley, she worked in research at Goldman Sachs, Furman Selz, and Montgomery Securities, and in corporate finance at Burns Fry, a Canadian investment bank. Arnold earned a B.S./B.A. with a concentration in finance from Georgetown University.

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 principally 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 GOODMAN, M.B.A. - Principal, Health Care Analytics, LLC
Roberta W. Goodman is principal, Health Care Analytics LLC, a Nashville, Tenn., strategic consulting firm specializing in the health services industry. Previously, Goodman was first vice president with responsibility for covering the managed care sector at Merrill Lynch (1997-2003) and vice president with responsibility for covering the health services sector (managed care, hospitals, alternate site providers and long-term care) at Goldman Sachs (1990-1997). As a senior analyst, Goodman was recognized as an All-Star Analyst by Institutional Investor Magazine for 11 consecutive years and was the top-rated analyst in the managed care sector in 1999 and 2000. In addition to 15 years as an equity analyst, Goodman also spent several years as an investment banker specializing in the health care industry and as a strategic planner for a nonprofit hospital system. She received an M.B.A. in finance and health care administration from the University of Chicago and a bachelor’s degree in history and economics from Cornell University.

ROBERT LASZEWSKI - President, Health Policy and Strategy Associates, Inc.
Robert Laszewski is president of Health Policy and Strategy Associates, Inc. (HPSA), a policy and marketplace consulting firm. Before forming HPSA in 1992, Laszewski was executive vice president and chief operating officer, Group Markets, for the Liberty Mutual Insurance Group. For 10 years he also served as national adviser on health policy issues for Ernst & Young. He is North American chair of the Global Medical Forum and also chairs the forum’s work in China in partnership with the Chinese Health Ministry. He was a founding board member of the bipartisan Alliance for Health Reform, as well as a member of the Board of Overseers of the C. Everett Koop Foundation at Dartmouth and the Dartmouth Medical School. He has offered his perspective on health care reform in testimony before several committees of both the House and Senate of the U.S. Congress. Laszewski has participated extensively in the nation’s health care debate, especially on health insurance reform and the impact it will have on existing health insurance programs, the insurance industry, and the evolving role between payers and providers. He has written and spoken widely on the subject of health care reform and market change

FREDRIC J. MARTUCCI - Managing Director, Fitch Ratings
Frederic J. Martucci is a managing director in Fitch Ratings’ public finance department. He is responsible for managing health care, higher education groups, and revenue-supported groups. In addition, Martucci is a member of Fitch’s executive committee, which drives fiscal and operational oversight and business development efforts for public finance. Martucci came to Fitch in 1989 from Municipal Bond Investors Assurance Corp., where he was vice president and manager of the health care unit. He was responsible for directing credit and legal analysis of all financings for potential insurance. Previously, he was a vice president in the bond funds division of Merrill Lynch, where his responsibilities included analyzing health care securities as well as developing and revising criteria for inclusion in, or removal from, bond fund portfolios. Before that, he was a manager in the consulting group at Coopers and Lybrand. Majoring in health care management, Martucci earned a bachelor’s degree from Harvard University and an M.B.A. from Boston University. He is a member of the American Institute of Certified Public Accountants, the Healthcare Financial Management Association, the Municipal Forum of New York, and the National Association of College and University Business Officers.

CHRISTOPHER MCFADDEN- Senior Equity Analyst, Goldman Sachs
Christopher McFadden is a senior equity analyst at Goldman Sachs responsible for U.S. health care services research coverage. He serves as a member of the Global Investment Research (GIR) Sounding Board. McFadden joined Goldman Sachs in 1999 as a vice president in equity research. He became a managing director in 2004. Prior to joining the firm, McFadden worked as a senior research analyst at Wheat First Securities (today Wachovia Securities). Prior to that, he held marketing and management positions at Xerox Corp. He serves as a board member for the Greenwich Village Center of the Children’s Aid Society. McFadden earned a B.A. in political science from the University of Richmond and is a candidate for an M.A. in economics from Virginia Commonwealth University. He became a Chartered Financial Analyst (CFA) in 1999.

ROBERT REISCHAUER, Ph.D. - President, The Urban Institute
Robert Reischauer is the president of The Urban Institute, a nonprofit, nonpartisan policy research and education organization that examines the social, economic and governance problems facing the nation. He served as the director of the Congressional Budget Office (CBO) between 1989 and 1995 and was CBO’s assistant director for human resources and deputy director of CBO from 1977 to 1981. Reischauer has been a senior fellow in the Economic Studies Program of the Brookings Institution (1986-89 and 1995-2000) and the senior vice president of The Urban Institute (1981-86). He has written, commented and lectured extensively on a wide range of topics, including federal budget policy, health reform, social welfare issues, and the Medicare and Medicaid programs. Reischauer is a member of the Harvard Corp. and serves on several educational and nonprofit organizations’ boards. He is vice chair of the Medicare Payment Advisory Commission and chair of the National Academy of Social Insurance’s project, "Restructuring Medicare for the Long Term." Reischauer earned his doctorate in economics from Columbia University.

TED SHANNON - Equity Research Analyst, Janus Capital Management
Shannon joined Janus in May 2003 as an equity research analyst. His primary emphasis is in the health care services sector. Previously, Shannon worked for four years as a healthcare equity analyst for US Bancorp Piper Jaffray. Prior to that, he worked as a consultant to the health care sector specializing in competitive strategy. He is a graduate of Carleton College and holds a bachelor’s degree in logic and philosophy.