FOOL ON THE HILL
An Investment Opinion

Managed Care's Liability Scare

By Brian Graney (TMF Panic)
September 30, 1999

As if making money in the managed care business wasn't already difficult enough, the country's public HMO establishment now has something else to worry about. According to an article in today's Wall Street Journal, a group of high-profile trial lawyers with deep pockets have set their sights on the industry and are threatening to launch class-action assaults on some of the sector's biggest players. The goal is to reimburse plan members for instances of alleged malpractice and other HMO-related wrongs.

Predictably, the news caused several of the country's largest HMOs to fall out of their hospital beds with a thud today. Among the hardest hit, Aetna <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AET)") else Response.Write("(NYSE: AET)") end if %> lost $10 9/16 to $49 1/8, Cigna <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CI)") else Response.Write("(NYSE: CI)") end if %> dropped $9 1/4 to $77 3/4, WellPoint <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WLP)") else Response.Write("(NYSE: WLP)") end if %> fell $6 3/16 to $57, United HealthCare <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: UNH)") else Response.Write("(NYSE: UNH)") end if %> slumped $11 13/16 to $48 11/16, Oxford Health Plans <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: OXHP)") else Response.Write("(NYSE: OXHP)") end if %> slid $3 25/32 to $12 1/2, and Foundation Health <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FHS)") else Response.Write("(NYSE: FHS)") end if %> slipped $1 1/16 to $9 7/16.

As Alex Schay pointed out in an article on the industry's health last year, the major shifts in the HMO landscape in recent years have tended to follow a storyline straight out of Hollywood:

"If healthcare were a movie trilogy, the first installment would have been 'Runaway Cost Wars' with the follow-up flick, The Payers Strike Back just exiting theaters. The 'evil empire' with its managed care denizens mounted a strong offensive and has been roundly despised for practices that some feel lead to decreased quality of care. The final movie has just come out though, it's entitled Return of the Customer."

In keeping with the cinematic theme, today's Journal report may then serve as a sneak preview for what is shaping up to be the next full-length HMO feature presentation, The Phantom Liability Menace.

Up to this point, the HMOs' malpractice liability has been limited by the no liability clause of the Employee Retirement Income Security Act, or ERISA. However, there are initiatives afoot in Washington that could have potential ramifications on ERISA, to the detriment of managed care providers.

Namely, during its upcoming term the Supreme Court has agreed to review an ERISA-related case examining whether it is the duty of employee-sponsored healthcare providers to look out for their members' best interests first and their own profit margins second. Additionally, so-called "patient's bill of rights" legislation, which includes right to sue measures, is now before Congress.

These are not trivial matters for anyone involved -- for plan members, for politicians, or for the health insurers themselves. From all appearances, changes to ERISA are a very real possibility, since the underlying fact is that the statute was enacted in the first place to protect employers against liability, not the HMOs.

This may not even matter in the end, however, since trial lawyers could opt for a legal end-run around ERISA. That tactic was most recently employed in the $51.5 million liability judgment handed down against Anthem Blue Cross & Blue Shield last week. A similar $120.5 million liability judgment landed on Aetna's doorstep earlier this year.

In a recent Harris poll, a majority of Americans said they would prefer to have the legal recourse to sue managed care providers, even if it meant higher premiums as a result. Of course, if the liability door is flung wide open and the trial lawyers stick it to the HMO industry with class-action suits comparable in scale to those seen recently in the tobacco industry, higher healthcare pricing will certainly follow. In short, Americans may get the right to sue, but they will ultimately foot the bill for that legal entitlement.

At the same time, there is no guarantee that the threat of liability lawsuits will have any net result on the major challenge confronting healthcare in this country -- how to deliver the best care at the lowest cost. With medical costs rising faster than inflation and spending on government reimbursement through programs like Medicare being cut back, the HMOs are struggling to just keep their heads above water.

Contrary to what some observers in the healthcare reform battle may believe, HMOs are not amazingly profitable businesses. Operating profit margins for the six companies referred to earlier averaged 6.1% in the most recent quarter -- which was considered a "good" period when the HMOs were generally able to increase pricing.

Competing against large, national not-for-profit entities such as Kaiser Permanente and the Blue Cross/Blue Shield Association, which don't have to answer to return-seeking shareholders, does not help matters much. The huge losses that the non-profits can incur -- Kaiser reportedly lost $435 million in 1998 while "the Blues" collectively had a $1 billion underwriting loss -- make growing through premium increases impossible for even the most nimble of public HMOs. Subsequently, an increasing-margins growth strategy is a pipe dream and the companies are forced to compete with each other through enrollment gains and sound working capital management.

Investor skepticism concerning whether or not HMOs can create substantial long-term value is reflected in the sector's rather puny market capitalization. For instance, the aggregate market cap of those same six HMOs after their falls today is only about $37 billion, or roughly one quarter of drug giant Merck's <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MRK)") else Response.Write("(NYSE: MRK)") end if %> market cap of $151 billion. Investors have been voting with their feet in recent years as to where they believe the majority of the value creation will be found in the healthcare field of the future, and it's not in HMOs.

Under the system currently in place in the U.S., it will be a Herculean challenge for any HMO to earn excess returns for a sustainable period of time. Even though today's liability development may only amount to sabre-rattling by trial lawyers in the end, the class action threat nonetheless only makes the chances that a company in this sector will outperform the market indices over the long-term all the more slim.