Healthcare’s Blurring Lines: Part 1

— Ashwin Varma, Venture Partner @ Rice University

For the last couple of years, the healthcare industry — specifically focused on providers and insurers — has engaged in a truly remarkable number of mergers and acquisitions. For example, in the last month of 2017 alone we witnessed mergers between the Ascension Health Providence and St. Joseph hospital systems, Advocate and Aurora Health Care, the continuing acquisition spree from UnitedHealth’s Optum group, as well as the much discussed $69 billion acquisition of Aetna by CVS. More globally, Kaufman Hall & Associates ranked 2017 as the most acquisitive year on record since they started compiling data on hospital and health system deals in 2000.

Many of these mergers have been horizontal in nature: hospital chains are getting bigger by combining their assets in different states and insurers respond by trying (and generally failing) to combine in response to that very same provider consolidation But a new trend, not seen for a while, has also crept into the M&A landscape: vertical mergers. For example, physician groups, even relatively large ones, have continued to join local hospital-centered systems. Additionally, United Health Group’s acquisition spree of independent physician groups (IPAs), ambulatory surgical centers and urgent care centers, which has been ongoing since at least the 2011 reorganization of the Optum subsidiary, also continued with its $4.9 billion acquisition of DaVita Group’s outpatient care assets. CVS and Aetna on the other hand joined to create one of the first (if not the first) combination of insurer, PBM, pharmacy chain & distribution, as well as a network of retail clinics. While vertical integration isn’t a new phenomenon — in healthcare or elsewhere — it’s clear that the healthcare value chain is changing. But questions remain as to how the different existing players are changing and why they are choosing to do so. Here I hope to explore the strategic context surrounding vertical integration to identify who wins, who loses, and why.

Trends toward Vertical Integration

Textbook treatments of the U.S. healthcare value chain generally divide into 5 functions, each occupied by a set of organizations:

  • End-payers, in the form of governments (Medicare, Medicaid, etc.), individuals (made more important by the ACA exchanges), employers (both in the form of self-insured employers as well as those in the large-group market). These institutions ultimately foot the bill for healthcare services in one form or another.
  • Fiscal Intermediaries in the form of insurers, who offer a number of different types of products (HMOs, PPOs, wide-network plans), as well as Pharmacey Benefit Managers (PBMs). These organizations generally help blunt the high-cost of medical service for end-payers.
  • Providers in the form of hospitals (inpatient), speciality surgical centers, outpatient care (physician clinics), pharmacy chains and newer types of delivery assets like urgent care centers, stand-alone ERs, etc. Each organization here takes on a different use case for the provision of healthare services and products to consumers.
  • Purchasers, like drug, medical device, and durable medical equipment (DME) wholesalers and group purchasing organizations (GPOs) that serve to bridge the gap between the products used in medical service and the service providers themselves.
  • Producers, such as biopharmaceutical companies and medical device makers. They actually make the products used in varying types of medical care.

While the CVS-Aetna merger and the continued expansion of United’s python-esque grip on U.S. healthcare take center stage as the notable vertical expansions in 2017, the lines between different the nodes in the healthcare value chain stated above have been blurring for a long time now, catalyzed most often by regulatory change.

The first thing we have to understand about this blurring is the mechanism by which its occuring.There are a couple of ways this trend towards value chain extension have been realized.

Hospital Systems forward integrating by acquiring physician practices and other outpatient care assets.

This trend might not be so much of a surprise in 2017. But wind the clock back to say, 1990, and there truly was a distinct organizational barrier drawn between small and mid-sized physician groups and more intensive inpatient care settings (usually owners of multiple hospitals organized into a ‘health system’, in which physicians were contracted or employed in a select number of specialties such as emergency medicine, radiology, anesthesiology, surgery, and pathology). However, as many once inpatient, and financially lucrative procedures began to migrate to outpatient settings like freestanding surgical and imaging centers, formerly inpatient-led organizations started to buy up smaller specialty physician groups to create ‘networks’ that could theoretically provide most — if not all — healthcare services. Building upon these acquisitions, recent years have seen the extension of these principals of verticalization to their logical conclusion: acquisitions of PCP-practices, institutions that have been thus far laid claim to the patient entry-point to the healthcare system. This forward integration has obvious financial advantages for health systems.

  1. As previously mentioned, it prevented the leakage of high-margin services to outpatient settings outside of the health system.
  2. Control of the PCP allows for control of referrals, ensuring that patients don’t leak outside of the walls of the healthcare system.
  3. The vertial consolidation allowed the hospital systems to gain market power that benefited them directly in negotiations with insurers. An insurer — even one with a narrow network product — has little in the way of leverage to extract price concessions if there is not a substitute provider to which the insurer can turn to. While horizontal integration did impact leverage as well, forward integration is also important in explaining market power beacuse it prevents the insurer from engaging in many individual negotiations with different (usually smaller) sites-of-care. Therefore, instead of being able to manage many smaller negotiations with provider groups for each type of care, the insurer is left with a ‘take it or leave it’ proposition for the entire vertical spectrum of care for its members, an undesirable position to be in with respect to negotiating leverage.
  4. Facility fees, which are payments made my Medicare (and thus, likely to be replicated by private insurers) for services conducted in outpatient settings that could be performed in a freestanding physician clinic, are available to hospitals that employ larger number of physicians in the outpatient setting.
  5. The re-emergence of value-based care payment models, specifically those embedded in the 2015 Medicare Access and CHIP Reauthorization Act, provided yet another strategic (and marketing) motivation for vertical consolidation: care coordination and the regulatory burden of reporting. For smaller physician groups who have thus far held out against acquisition, the new Merit-based Incentive Payment System (MIPS) as well as the more advanced tracks of value-based payment, rely heavily on reported quality metrics which are onerous for small clinics to abide by. MedPAC clearly has been warned about these issues and is trying to compensate, but it’s unclear whether their efforts will be successful. For larger systems, ACOs in particular make a pretty explicit monetary trade-off between specialist and inpatient services and primary care, arguing that we should be spending more on the latter. Thus, it makes sense for them to invest in the full-spectrum of care activities to try to control members utilization and healthcare costs.

Joint-Ventured Narrow Network Insurance Products.

While the last section was all about health systems intergrating forward into parts of the care spectrum outside that of the traditional inpatient hospital, this section discusses trends that see providers integrating backwards into functioning as health plan sponsors in some form or another. Unlike the acqusition of outpatient care assets, this trend is probably newer to emerge. And because this trend is newer, the strategic logic surrounding these moves is not as fleshed out as it might be for the previous example.

The form of backwards integration with the most interesting strategic dynamics comes in the form of a redo of an old concept: the narrow insurance product. Specifically, I refer to narrow networks insurance products centered around a joint-venture between an insurer and a single provider system,encapsulated within (and in part motivated by) a value-based payment structure. We’ve seen these types of deals explode onto the marketplace recently: As early as 2011, both theSteward Health Systemand the Carillion Health System made deals with insurers to sell co-branded health insurance products featuring one system as the network of providers. In Wisconsin in 2013, theAurora health-system and Anthem created a narrow network product for the public exchange. United Health then responded with another narrow-network ACO deal with Aurora’s competitors. In 2014, Anthem launched the Vivity narrow network product to California consumers in order to compete with Kaiser Permanente, which already resembles a narrow-network insurance product with its fully integrated provider-insurer structure. And lastly, just this year, the insurance company Oscar Health launched a joint-venture with The Cleveland Clinic to sell co-branded insurance.

It’s easy of course to get lost in all the mind-numbing details and forget how truly revolutionary — and odd — it is to see these types of products changing the value chain. Firstly, these products explicitly restrict consumer choice of provider, a fact that would seem startling to anyone who was alive for the HMO-backlash in the late 1990s and witnessed the level of distate consumers expressed for the narrow networks of yesteryear. In fact, with respect to some of the single-system deals (which allow customers to only see physicians within one system’s network without prior authorization), these new products are even more restrictive than older HMOs. Secondly, these products are provider-led. Providers realized from their failures to launch health-plans of their own in the late 1990s that they need insurance companies for their risk-management and administrative capabilities; hence the structuring of these products as joint-ventures as opposed to being led by the providers themselves. But make no mistake, these networks are provider led, with the networks being tightly coupled to a single, or a set of interconnected providers. And these types of products centered around a system that can meet all of the consumers’ care needs would not have been possible without the trend of downstream/outpatient vertical integration described above. Thirdly, the impact of regulatory change cannot be understated. Most of these deals are structured based on value-based payment models (ACOs — it’s unclear whether they are quality and cost-adjusted FFS models or more advanced partially-capitated models). Thus the goal of the provider-network is to generally reduce care utilization by reducing the use of low-value care, intervening early in high-cost patients to avoid unnecessary hospitalizations, etc. — all the trappings of ACOs writ large.

For providers, this move towards narrow network products centered around a given provider system, while seemingly attractive, introduces a few new strategic challenges they must contend with:

  1. Providers have to own the consumer relationship in a way that they just haven’t had to before. Most of the JVs described above are co-branded in such a fashion to try to preserve the insurers consumer-facing orientation. But, even in a co-branded setting, employers and consumers will be facing a dramatically different choice with regards to their healthcare purchasing decisions. Instead of merely paying for a network and choosing a site of care for each episode of care, employers and employees will be picking upfront between different competing provider networks. Insurers have been seen as the villains for premium increases and other consumer discontents (kind of like blaming cable companies for price increases when in reality they derive from the pricing power of cable networks like ESPN). What happens when the plan an individual buys is directly associated with one provider service? Who is the bad-guy now?
  2. In this scenario, providers are taking on more risk than before and therefore have to develop the capabilities to operate in such an environment. While certain organizations with risk management capabilities like Kaiser, Mayo, and Geisinger, have experience managing costs, it’s definitely not easy to transition into that model. Large provider systems might have the underlying assets to set up these narrow network products in such a manner that nearly all care types are included in the network. But, there is a certain degree of cultural and organizational effort that must go into managing costs more effectively across the entire care spectrum. Provider success in this regard will depend on how tightly they can couple their network around algined providers. A set of disconnected care assets that do not form any coherent whole management program will likely be unable to succeed in this regard. It is also important to note that the pricing power that these large systems will likely be able to weild over insurers using these products could offset these concerns in the short run.
  3. Getting to scale in their narrow network products will be critical to the success of these products. When providers first tried to launch their own insurance products in the 1990s, many of them failed because the numbers of patients in their panels paled in comparison to the numbers needed support adequate distribution of risk through the population.
  4. The cost curve presents an existential risk to health systems. In high-risk populations with multiple co-morbidities and a corresponding high average cost of care( such as those found in Medicare Advantage (MA) populations) payment models based around principles of broad utilization reduction to achieve savings have seen examples of success. Consider CareMore, an existing insurer/provider combination with around $1.2 Billion in revenue and a demonstrated history of working in SNP markets and general MA plans, or the number of new payer enrants into the Medicare Advantage market. In commercial and individual exchange markets, it’s unclear whether increases in overall healthcare costs are due primarily to prices, as argued for hereand here, or due to broad overutilization, as argued for here. ACO models as described in this section (system-lead) are clearly built to achieve utilization reduction, not price reduction. In fact, the consolidation necessary to even consider a “single system” narrow network has created a substantial amount of market power that will in all liklihood cause prices to rise. If the cost curve does not bend over time, these large health systems will face calls for regulated prices and a move towards single-payer.

For payers on the other hand, the proliferation of these products is strategically troubelsome.

  1. The consolidation of providers into large systems that are capable of launching JV, co-branded insurance products will lead to tougher rate negotiations.
  2. There is a future — if the current trends play out to their logical extremes — in which providers directly compete with insurers in the commercial, Medicare Advantage, and individual marketplaces, offering narrow network plans that compete with insurer constructed networks. Given that insurers have taken the brunt of consumer ‘bad blood’ over the last three decades, and that consumers generally have a positive disposition towards care providers (even though they account for the lion’s share of their medical expenses), this competition could be deadly for insurer market share. Thus it is in insurers’ benefit to try to influence the market such that they remain in control of network construction amongst many different sites of care. More on this later!
  3. Operating as a partner offering risk management and adminsitrative services in the provider-lead narrow network product-market is not likely to be nearly as lucrative as commercial and Medicare-Advantage risk contracts. If more of the market shifts toward a provider-lead, narrow-network format, their overall margin structure will suffer. It’s not clear exactly how payers are supposed to achieve competitive advantage in the narrow-network market. Theoretically, the savings produced by utilization reduction due to value based contracts must be divided between the payer and the provider; influencing the share such that more of it tips to the payer is a difficult strategic question to which I don’t have much of an answer at the moment.

So the future, if trends continue on the given track (always a risk in assuming so), does not necessarily inspire confidence for payers. But given that the payers in question are not likely to just concede and be relegated to commodity status, the question remains: **how are they going to adjust? **

The answers — albeit two vastly different ones — arrive in the form of UHG’s acquisition spree and the new CVS/Aetna merger.

We’ll explore these two deals next in Part II.

— Ashwin