Provider-Sponsored Health Plans: Valuation Considerations
EARLY EDITION: BRIAN GORE, CFA, AND DAN PLATTEN, CPA, ABV
PROVIDERS CONTEMPLATING THE ACQUISITION OF HEALTH PLANS SHOULD NOT PROCEED WITHOUT A FULL UNDERSTANDING OF THE ALL OF THE NUANCES INVOLVED WITH HEALTH PLAN VALUATIONS.
The healthcare industry is undergoing its biggest transformation since the 1990s. With the implementation of the Affordable Care Act (ACA) several years removed and continued movement from fee-for-service models to fee-for-value models, healthcare providers increasingly have been exploring the strategy of sponsoring their own health plans.
Many articles have outlined the strategic considerations for providers that are contemplating the viability of such a strategy. But once a provider has decided to pursue the development or aquisition of a provider-sponsored health plan (PSHP), it must turn its attention to tactical considerations related to valuation of the health plan, which must be addressed both before due diligence efforts commence and after the deal closes.
Before the agreement is finalized (whether the provider is launching a new health plan or acquiring one), the provider should perform a careful financial analysis of the potential value of all PSHP opportunities, given that health plans are subject to a unique set of value drivers. Only through such an analysis can the provider a make an informed decision based on a clear understanding of the PSHP’s true potential value.
After the deal, the provider must account for the acquisition in compliance with prevailing U.S. Generally Accepted Accounting Principles (U.S. GAAP). In particular, the provider must ensure the health plan’s assets and liabilities are fair valued and reported appropriately, based on a clear understanding of the unique nature of those assets and liabilities.
Brief Overview of the Movement Toward PSHPsThe 1990s saw a large number of providers move into the health insurance market. But for the most part, these initiatives failed, and most of the providers exited the market. The reasons for failure were mostly operational and related primarily to particular nuances of the health insurance business, which most providers had not experienced previously. For example, challenges included the need to maintain sufficient levels of capital, a lack of functional expertise unique to insurers (e.g., actuarial and underwriting proficiency), and the difficulty of competing with incumbent commercial insurers.a
A number of themes have emerged over the past several years signaling the reemergence of PSHPs, primarily as a result of the shift in focus from fee for service to value-based care—a trend that was solidified with the enactment of the ACA. Initial attempts by providers to holistically manage the care of their patients have included new delivery methods such as accountable care organizations (ACOs) and the use of narrow networks. Both forms of healthcare delivery involve providers partnering with health plans for the benefit of the consumer.
PSHPs are a natural extension of this trend. Owning a health plan gives providers the ability to control all elements of healthcare delivery in an integrated manner that cannot be matched by an ACO or a narrow network. And the secret is out: Today, 13 percent of all U.S. health systems offer health plans in one or more markets, covering approximately 18 million members, or roughly 8 percent of all insured lives across 39 states.b Moreover, acquisitions of health plans by providers have proliferated in the past 12 to 24 months, with the following being noteworthy examples:
Nuances of Provider ValuationsThe following factors constitute the primary nuances involved with valuation of provider organizations with respect to both pre-deal and post-deal analyses.
Pre-deal provider valuation. Transactions in the provider space are subject to regulations such as Stark Law, the anti-kickback statute, and tax-exempt laws, which require healthcare entities (with some exceptions) to pay no more than fair market value (FMV) for the assets or equity ownership received. The most significant requirement in these regulations is that the consideration or payment must not incorporate the value or volume of referrals.
For example, if a hospital purchases a physician practice for more than FMV in anticipation that the physician practice will generate referrals, the transaction would be in violation of these regulations because the above-FMV purchase price may be construed as an inducement for physician referrals. To avoid such a situation, the acquiring organizations must fully understand and analyze its cash flows in a valuation within the context of healthcare regulatory guidance. It is beyond the scope of this article to provide details regarding how to estimate FMV, other than to note that there are three primary valuation approaches that should be considered: income approach, market approach, and asset-based approach.c
Post-deal provider valuation. To comply with U.S. GAAP requirements under Accounting Standards Codification (ASC) Topic 805, Business Combinations, an acquirer must record the acquired assets and assumed liabilities at fair value, as defined in the FASB’s ASC Topic 820, Fair Value Measurement. Given the capital intensive nature of healthcare providers, the largest acquired assets typically are the plant, property, and equipment. However, there are unique intangible assets to consider in establishing the opening balance sheet, as presented in the exhibit above.
Intangible Assets and Related Key Considerations in Provider Valuations
Unique Considerations of Health Plan ValuationsHealth plans present their own unique set of challenges from a valuation standpoint. Accordingly, once a provider has weighed the strategic considerations and opted to acquire a health plan or enter into a joint venture with one, the provider must begin to deal with the valuation issues that follow.
Like providers, health plans operate under a unique regulatory framework (made even more complex by state-by-state oversight), and both parties strive to ensure their customers receive high-quality and affordable care. But health plans and providers have inherently different operating models. Simply stated: While providers attempt to maximize the utilization of their assets, health plans attempt to minimize the amount by which their members utilize provider assets.
Because of these inherent differences, the valuation challenges differ between provider organizations and health plans, to the point that provider executives may feel they are venturing into uncharted territory in valuing a health plan. It therefore is incumbent on provider executives contemplating a health plan acquisition to familiarize themselves with the valuation issues unique to health plans that must be addressed before and after such an acquisition.
Pre-Deal Health Plan ValuationThe approaches to valuing health plans before the deal resemble approaches that providers use in valuing other providers. The traditional methods of valuation described previously still apply.
Discounted cash flow (DCF) analysis. Generally speaking, the DCF analysis of a health plan will attempt to estimate the future free cash flow (FCF) and then discount the FCF to present value using a risk-adjusted discount rate. But the fundamental drivers of FCF for a health plan are significantly different from those for a provider.
For one, provider forecasting focuses on projecting asset utilization. Providers make capital investments and then generate revenue from those investments by increasing the utilization of capital. Increasing revenue will generally translate into higher returns on capital due to operating leverage, and, in turn, value. Providers have a relatively high amount of operating leverage (i.e., high ratio of fixed costs), and their capital investments are made in tangible assets.
By contrast, the FCF for health plans starts with revenue that can come from multiple sources, under multiple different payment models. Operating expenses are mostly variable, with the amount of a health plan’s largest expense dependent on the degree of utilization by a plan’s members. With a more-variable expense structure comes relatively lower operating leverage, but health plans must make capital investments that satisfy health and insurance regulators, thus restricting what would otherwise be FCF. Further discussion of the key drivers of FCF for a health plan is provided below.
Revenue. Revenue earned by a PSHP can come from multiple sources. Commercial health plans will generally receive premium income from individuals or employer groups that have purchased health insurance coverage. Government-sponsored health plans (e.g., managed Medicaid or Medicare Advantage) may receive income from a combination of members, federal government agencies, or state government agencies. Health plans that can increase their enrollment will generally increase their revenue, but increasing enrollment requires offering competitive rates that are commensurate with the underwriting risk of enrollees. Adverse selection was one of the causes of the failure of PSHPs in the 1990s, as was competition by incumbent commercial plans. Obtaining enrollees is subject to fierce competition among health plans, and these market dynamics must be understood when making revenue projections.
Expenses. Health plan expenses may pose a particular challenge for providers to manage and understand when performing a health plan valuation. Health plans have less operating leverage (i.e., more variable costs) than providers, meaning incremental revenue does not automatically translate into incremental operating profits.
Medical benefits expenses represent the single largest category of expenses for a health plan. Medical benefits, or claims, are subject to factors both in and out of a health plan’s control. Negotiating rates with providers and proactively managing the utilization of health care to ensure insurance beneficiaries are receiving high-quality care are two examples of strategies commonly used to manage medical claims. However, the best-laid plans are not always successful, as evidenced by the withdrawal of prominent health insurance organizations from the ACA health insurance exchanges in 2016 and 2017.
In addition, with the onset of the ACA, many types of healthcare coverage are now bound by minimum medical loss ratios (MLRs)—approximately equal to medical expenses divided by premium revenue—generally ranging from 80 percent to 85 percent depending on the nature of the coverage. During a given coverage period, premium income is relatively known, but medical expenses are uncertain, making the management of medical expenses just as important as managing enrollment, if not more so.
Apart from medical benefit expenses, health plans have other expenses that are not trivial. If a health plan uses third-party brokers or benefits consultants to assist with the generation of new business, such parties will generally charge up-front commission expenses. These expenses can cause an earnings drag, leading to operating losses for health plans that are ramping up or growing at high rates due to enrollment growth. For providers acquiring small health plans with the intent to grow rapidly, having adequate liquidity to fund early operating losses from these expenses is paramount.
Health plans also incur underwriting and actuarial expenses, expenses related to provider contracting and maintaining provider relationships, and other administrative-related expenses, all of which must be covered by the narrow margin remaining after paying medical expenses.
Statutory reserve. For providers, after expenses are paid, management has discretion to determine how to allocate remaining profits. For health plans, sufficient capital must be retained in liquid assets to meet prevailing statutory reserve (or capital) requirements, which generally are set on a state-by-state basis.
Some states require a constant percentage of premium income to be retained as capital, whereas others use risk-based capital models that are more commonly used by larger health insurers. Either way, a buyer of a PSHP must understand the specific requirements relevant to the markets in which it operates and ensure sufficient capital investment is factored into the forecast, because every dollar of capital that is required reduces available cash flow.
Pre-deal valuation wrap up. It is critical for provider executives to understand all of the above drivers when analyzing the prospective financial results of a health plan and when estimating the health plan’s value. Proper analysis of these factors will ensure acquiring providers are prudently investing their capital and setting themselves up for success in the PSHP market.
Post-Deal Health Plan ValuationOnce the decision has been made to acquire a health plan, and the transaction has closed, a new set of valuation issues arise related to accounting for the transaction under U.S. GAAP, just like the requirements that would exist in a provider-to-provider transaction. However, several assets and liabilities that are material to a health plan’s balance sheet are unique health plans and require an appropriate understanding to value appropriately.
Medical claims payable. Medical claims payable represents the largest liability on a health plan’s balance sheet, and accounts for reserves held for future medical claims payable. Such reserves are usually short-tailed, meaning the amount of time between when the claim is incurred and ultimately settled (paid) is relatively short.
Reserves may fall into different categories, such as claims that have been reported but not paid as of a measurement date, and claims that have been incurred but not reported (IBNR). IBNR claims are subject to a significant amount of actuarial expertise and analysis to estimate properly.
Other intangible assets. The types of intangible assets that are commonly analyzed for a health plan are shown in the exhibit on page 5.
Intangible Assets and Related Key Considerations in Health Plan Valuations
Making the Best of an Exceptional OpportunityThe decision to enter the PSHP market is not one to be taken lightly. From strategic inception, to due diligence, to execution, to integration, the challenges that provider executives can face will be trying and require careful judgment and expertise. Providers considering PSHP acquisitions should familiarize themselves with the nuances of health plan valuation to ensure an exciting opportunity starts on the right foot.
Brian Gore, CFA, is managing director, Duff & Phelps, LLC, Chicago.
Dan Platten, CPA, ABV, is director, Duff & Phelps, LLC, Milwaukee, and a member of HFMA’s Wisconsin Chapter.
Footnotesa. Goldsmith, J., Burns, L.R., Sen, A., Goldmith, T., Integrated Delivery Networks: In Search of Benefits and Market Effects, Report for the Academy’s Panel on Addressing Pricing Power in Health Care Markets; National Academy of Social Insurance, February 2015.
b. Khanna, G., Smith, E., Sutaria, S., “Provider-Led Health plans: The Next Frontier—or the 1990s All Over Again?” McKinsey on Healthcare, McKinsey & Company, January 2015.
c. For more information, see Pratt, S.P., and Niculita. A.V., Valuing a Business: The Analysis and Appraisal of Closely Held Companies, Chapter 3, New York: McGraw-Hill, 2008.
Publication Date: Saturday, October 01, 2016
Bruce Lorenz, Chair