Credit FAQ:

How Is Health Care Reform Affecting U.S. Health Insurers' Market Opportunities And Risks?
Primary Credit Analyst: Joseph N Marinucci, New York (1) 212-438-2012; joseph.marinucci@standardandpoors.com Secondary Contacts: Neal I Freedman, New York (1) 212-438-1274; neal.freedman@standardandpoors.com David P Peknay, New York (1) 212-438-7852; david.peknay@standardandpoors.com

Table Of Contents
Frequently Asked Questions Related Criteria And Research

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Credit FAQ:

How Is Health Care Reform Affecting U.S. Health Insurers' Market Opportunities And Risks?
Standard & Poor's Ratings Services recently hosted its annual health care conference (Health Care 2013: On the Cusp of a New Market) at the McGraw-Hill Building in New York City. The agenda included a session devoted to benefit expansion opportunities and risks. Joseph Marinucci, director with Standard & Poor's Insurance Ratings, provided initial commentary about how Reform and ongoing private/public sector engagement are significantly influencing marketplace opportunities and risks for U.S. health insurers and their sector counterparts. He then moderated the panel discussion that included perspectives from two senior Standard & Poor's analysts: David Peknay, director with Corporate Healthcare and Neal Freedman, director with Insurance Ratings.

Frequently Asked Questions

In what way might Reform and the 2014/2015 period in general set the stage for a change in care delivery?
With the potential growth in demand for services due to the expected growth in the number of insured individuals, and with reimbursement changes that include the evolution of value-based payment methodologies, we believe hospitals must learn to adapt to survive. Hospitals must adjust to an environment of efficiency and quality to remain viable. More standard clinical protocols are likely. Providers that retain the historical fee-for-service mentality will be in jeopardy.

How might the business model for providers evolve in response to changes in payer mix brought on by reform and ongoing changes in utilization patterns?
We believe the business model will evolve such that providers will work closer with each other. Coordination will become more commonplace. This will become necessary as providers take on more insurance risk. Networks and joint contracting will become more the norm. We have already seen the evolution of healthcare transform the relationship between hospitals and physicians as direct physician employment by hospitals and clinics grows more rapidly, effectively displacing the more-traditional independent practice model. Hospitals may reduce the scope of their services, shedding those that are not profitable. This may trigger growth among certain specialty providers.

What is the potential for virtual and vertical alignment?

We believe partnerships will expand quickly. Virtual alignment will prevail. Hospitals will align with other providers along the continuum of care far more extensively. Insurers aligning with providers will become more commonplace. We expect virtual alignment to remain the relationship model of choice as providers get more comfortable working with each other and with insurance companies. We believe the number of larger-scale organizational mergers and acquisitions will remain small for now. But uncertainty about reform and the reshaping of the healthcare industry will cause industry participants to retain the ability to adapt to unforeseen developments.

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Credit FAQ: How Is Health Care Reform Affecting U.S. Health Insurers' Market Opportunities And Risks?

What do you consider to be the largest challenges facing providers and insurance companies as they work closer together to manage risk?
On the supply side, the largest challenge for providers is their adjustment away from a fee-for-service environment. The historical keys to success are less meaningful. In addition, providers' relationships with insurers have been somewhat adversarial due to their diametrically opposed incentives: Hospitals tried to fill beds and negotiate the highest payment, while insurers tried to keep patients out of beds and negotiate the lowest provider payments. With risk sharing, the relationship becomes cooperative. This transformation will be most difficult for the providers because they have a learning curve in risk management, whereas insurers are already experienced at it.

With regard to expansion opportunities and risk mitigation, how do the strategies of the for-profit providers differ from those of the not-for profit providers?
They don't differ at all. Whether a hospital is not-for-profit or for-profit is simply a descriptor of its tax status. All hospitals, notwithstanding their tax status, are affected by the same industry factors. They provide the same product--hospital services. They get paid by the same payers and compete against each other. Their keys to success are the same.

How might changes in business mix tied to Reform influence health insurer capital needs or financial policy, and how do you factor this into your rating process?
We believe that capital needs will vary among insurers but may increase as insurers are required to invest in technology to comply with the provisions of the Affordable Care Act (ACA) and design new strategies in a new environment. Different strategies will have different capital needs. These needs coupled with insurers' financial policies will determine their degree of participation in the exchanges and other ACA-related strategies. They will then need to allocate the capital necessary to execute these strategies. This capital can either be internally generated from current earnings and cash flow, from statutory capital, or from some combination of the two. We will be closely monitoring each insurer's strategic response to the ACA, the cost of funding the strategy, and the financial policy governing the sources of those funds. During the next several years we expect to see a number of successes and failures of insurers' strategies, insurers modifying their initial strategies, and continued fine tuning of the ACA in Washington. Our challenge will be to determine which of these changes are more permanent and have a rating impact, and which will be resolved in the near to intermediate term and therefore have less of a rating impact.

How will health insurance products made available through the public exchanges vary from what is currently available? What risks come with early-stage developments in this segment of the market?
When looking at a typical benefit summary, the structure will not appear much different. We are likely to see a higher degree of cost sharing, especially at the "bronze" and "silver" levels (per the ACA, insurers are required to offer plans that fit within four levels of standardized coverage: bronze, silver, gold, and platinum) as well as the mandatory benefits required under the ACA. Hidden behind the benefit summary is the size and scope of the provider network. We expect insurers to use more-limited networks as a way to keep premium rates down. As with any underwriting situation the key is to match pricing with risk--in this case morbidity risk. Therefore, we believe the critical item for insurers will be their ability to estimate the morbidity of their risk pool accurately. Estimates of the exchange population morbidity risks vary widely from many sources. On one hand, the subsidies available to lower-income individuals will likely encourage healthier people to participate in the exchanges. On the other hand, the potential for unexpectedly high pricing, especially in states where individual market premiums were low because of insurers' ability

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Credit FAQ: How Is Health Care Reform Affecting U.S. Health Insurers' Market Opportunities And Risks?

to underwrite medically, may keep some healthy people out the exchanges, leaving high utilizers in the risk pool.

Do you expect the various structural provisions meant to mitigate anti-selection (open enrollment, modified community rating, subsidies, and the individual mandate) in the health insurance exchange marketplace to be sufficient?
It is fundamentally difficult to predict the effectiveness of these provisions, as demonstrated by the wide range of predications regarding the exchange-population morbidity. We have more questions than answers. Although the open enrollment window will narrow over time, unless one's illness is quick and severe, there will always be the potential for someone who is ill and uninsured to opt-in. Furthermore, will the three-to-one ratio used to adjust the baseline community rate (partly to account for factors such as age, location, tobacco use, etc.) be sufficient to prevent sticker shock at the lower end of the rate spectrum, thereby keeping the healthier risks in the risk pool? Lastly, will the subsidies provide sufficient incentive for the healthier risks to enter the insured pool?

What about the various financial provisions linked to the exchange-oriented products (risk adjustors, risk corridors, reinsurance)?
We believe that they will be effective if the dollar amounts are sufficiently small. By this we mean that if these amounts turn out to be large, the cost to the taxpayers or the amount of transfers between companies will likely cause some form of disruption as the negatively affected parties--be they the taxpayers or a given group of insurers--seek relief and perhaps engage Washington for resolution.

What are some growth and risk-mitigation strategies that you expect to see health insurers employ in an exchange environment?
We think we'll see insurers go "wide" or go "narrow." Some insurers will market and price based on the theory that if they add as many members as possible they will get the "good along with the bad" risks. On the other hand, we may see some insurers focus their marketing efforts, network designs, and delivery systems around specific market niches. We are already beginning to see examples of this strategy with several small start-up insurers planning to participate in the exchanges. Perhaps the most effective growth and risk-mitigation strategy we will see is insurer participation with and creation of managed care organizations to manage utilization and unit cost. In particular, this strategy will compensate these organizations for overall member health improvement as opposed to the currently common fee-for-service arrangement in which compensation is based on volume of services performed.

What factors could influence a given insurer's choice of strategy?

We believe the most important factor is the insurer's geographic scope. As with any federal program--and we have seen this in the past with Medicare and Medicaid--the provisions of the program will have widely varying effects on different geographies, making some areas very attractive, other areas unattractive, and everything in between. We expect (and have already seen) the large national players to choose markets where they believe they have the greatest opportunity. In the case of the limited-geography Blue Cross Blue Shield plans, we expect pricing and marketing strategies to vary widely based on how favorable or unfavorable management perceives its environment to be. This will likely influence whether a plan's management sees the exchanges as an opportunity or as a potential financial concern. Many Blue Cross Blue Shield Plans have bolstered their balance-sheet positions (a key rating strength for these mainly non-investor-owned companies) during the past few years by retaining improved earnings, partly supported by a lower-than-expected medical inflation trend. For some health insurers, management sees the capital as a "war chest" to be used to fund business expansion, and will price and market with the intent to expand/preserve

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Credit FAQ: How Is Health Care Reform Affecting U.S. Health Insurers' Market Opportunities And Risks?

membership and market share. Other managements see the capital as a "rainy day" fund to be preserved, and see the exchanges as a potential threat. These will therefore price very conservatively to minimize the impact of the exchanges.

Related Criteria And Research

The Outlook for U.S. For-Profit Health Care Companies Is Stable As They face Challenging Industry Changes in 2013 , May 23, 2013 U.S. Health Insurers Credit Quality Is Strong As the Sector Prepares For Reform , May 3, 2013

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