Daniel K. Zismer, Ph.D.
Associate Professor & Director, Executive Studies Program, School of Public Health, University of Minnesota
Managing Principal, Essentia Health Consulting

The following article reflects the opinion of the author, and not necessarily that of The Governance Institute or its affiliates.

Adam Smith, arguably the father of formal economic theory, referenced the “invisible hand” in his prescient work published in 1789. Smith believed that individuals who compete for self-interest and private gain are “led by an invisible hand” to promote the public good.

Smith recognized that economies are products of human behaviors and all that means. His theory of the invisible hand at work suggests the predictability of market behaviors over time; markets are self-interested and rational. Smith believed that what is in the best interests of the individual can promote the public good. He wrote, “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”

If Smith’s theory applies to the U.S. not-for-profit, community-based system of healthcare delivery, then governing boards do have a context from which to evaluate the future and its likely effects on their missions and business models. Not-for-profit community healthcare organizations will need to focus even more on “their own interests” if they intend to maintain missions of benevolence to the public.

The future of healthcare markets is not a product of unpredictable, random activities and events.

To say that community hospitals and health systems must first focus on their own interests to ultimately serve their communities seems a statement of the obvious. However, as a fast moving industry accelerates change, hospital and health system boards will need to evaluate their community missions in a context of change—change expected to dramatically affect healthcare policy, regulation, economics, and the relationships between hospitals and physicians.

So while Adam Smith was advocating for the workings of free markets to cause benefit for the public good, this article neither encourages nor discourages free-market capitalism for community healthcare. It does provide a context within which community boards, together with management, should consider the design, funding, and execution of missions. The principal point is this: to under-appreciate the realities of a very dynamic healthcare market will certainly jeopardize a community-based hospital/health system’s ability to continue its mission.

The following is a framework of six “foundational” assumptions about healthcare markets and the future. Hospital and health system boards and management are encouraged to apply this framework to guide
discussions relating to the business and missions of community-based healthcare.

1. A Community-Focused Resource

Not-for-profit hospitals generally serve a wide range of medical and psycho-social needs for those in the community. The community often sees hospitals as a “general health services resource” to care for the community. Inside, however, hospitals are a portfolio of highly specialized clinical services; e.g., neurosurgery, cardiovascular care, hematology/oncology (cancer care), to name a few.

Each clinical service within the portfolio generates a distinct financial and micro-economic signature: varying input costs and labor cost inflation rates, distinct pricing and reimbursement strategies and, sometimes, unique treatment by payers and health service contractors.

Operating margins on a small handful of services are often applied to subsidize a much larger range of negative margin businesses including mission services. Each clinical service line is subject to unique capital consumption rates and very different futures relative to clinical care and technologic innovations (and related costs).

Health policy and related reimbursement changes affect each differently. If a substantial customer reduces reimbursement rates for a profitable service like cardiovascular care, its “cross-subsidization” potential is reduced and the effect ripples through the economics of the whole.

To rely on a few “products” to carry the weight of substantial community service commitments and missions could burden—even break—the general services model. Said otherwise, community hospitals that rely on substantial margins in a few clinical services to subsidize the whole are at risk. Governing boards together with management should evaluate risks in this regard.

2. “Partners” At Odds in Competing Business Models

Generally speaking, hospitals and affiliated physicians are in the same business—working together to care for patients for the good of the community. However, while the community hospital may be a not-for-profit, tax-exempt entity organized for the charitable good of the community, many physicians are private, independent entrepreneurs owning their own businesses, and working in a rational, self-interested manner to optimize their returns and to secure their futures. In these instances, the physicians are free to compete with the community hospital.

The clinical specialties that are profitable for the hospitals have been as or more profitable for the physicians, but this is changing. Specialty physicians have established competing enterprises; e.g., specialty hospitals, outpatient diagnostic businesses, outpatient surgery and procedure centers, and the like. And the results have been as follows: the margins from the services that once supported the community hospital’s generalized mission are diluted by diversion to competing interests. Capital is diluted at the macro level in the healthcare community and profitable revenues are diverted to new, specialized clinical ventures that often promise higher quality, enhanced customer service, and reduced prices due to efficiencies of specialization and relief from the burdens of subsidizing other negative margin community services.

On one level, one might say competition works! And, on that one level, it does work, and the consumer benefits. In practice, however, the economic vulnerabilities of this scenario have been less obvious, but no less destructive when they played out.

Specialty physicians often established the competing service lines including the application of all required capital dictated by the size and complexity of the business developed (e.g., specialty hospitals, surgery centers, imaging centers, etc.), and this usually moved markets from the hospitals affected. Given that the payers (e.g., health insurers) tended to contract for these specialized “niche” services at rates that initially approximated those paid to community hospitals, higher rates interacting with efficiencies and self-interested physicians often produced comparatively high profit margins until the payer markets (including Medicare) realized the potential to pressure price.

As the market (payers) “re-set” prices, real risk-adjusted returns are reduced, as are the incentives to remain in a competing business; especially given the need to recapitalize future operations. At a point in time (now or very soon) when the physician owners look for a buyer for their “pressured” business, the community hospital is often in no position to see it go to another competitor. Consequently, the physician-owned business is often purchased by the community hospital. The purchase applies new capital in a very inefficient manner; i.e., the hospital pays a premium for business it once held at a much lower cost of capital.

Does this mean there is no value to the community when hospitals and physicians compete? No, it’s just that community hospitals can be caught in the inefficiencies of a turbulent and competitive market—specialists pursue competing strategies until financial performance suffers and the enterprise is sold to the community hospital.

3. The Effects of Regulatory Constraints and Free Market Dynamics

No one would argue against the statement that U.S. healthcare is a highly regulated industry, especially for not-for-profit, tax-exempt organizations. Ostensibly, hospitals and physicians operate in free markets governed by dynamics associated with supply and demand, rational distribution of scarce resources, freedom of choice for buyer and seller, and price competition.

The reality is prevailing federal regulations, state and federal tax code procedures, financing regulations and, in specific states, corporate practice of medicine laws and certificate of need regulations significantly affect the potential for business arrangements between private physicians and the not-for-profit community hospitals, especially. Constraints on more typical free market business partnership opportunities manifest in a number of ways including; restrictions on co-ownership of ventures in which the parties benefit financially from directing patient referrals, an ability for physicians to be paid at market-sufficient rates for time dedicated to the benefit of the community hospitals, and sharing high-cost facilities and technologies.

At some level of legal, regulatory, and tax code constraints, any benefit of free market dynamics are neutralized or at least rendered insufficient to provide required benefits to the buyers and sellers.

In the face of daunting regulatory constraints, the essential service sellers in the economic equation (hospitals and physicians) may be left with two choices: all-out competition or a complete integration of all business interests.(1) The question is, will consolidation, driven in part by regulation and market pressures, lead to more or less efficient business models and better or worse conditions for the consumers?

4. Capital Markets’ Risk Tolerance for Community-Based Healthcare

In 2007 and 2008, not-for-profit community hospitals began to assume more tax-exempt debt. (2, 3) Applications of this debt appear to be focused on facilities replacement, information technologies, and clinical technologies.

A scan of the landscape shows not-for-profit hospitals are using new debt for higher-risk strategic investments—strategies including market share expansions. “Markets,” in this case can be identified in two categories; geographic and service line (“product” strategies).

New debt applied to market share strategies carries risks that community hospitals/health systems do not always manage well. At least two of these risk areas are: a) investments in more “general purpose” asset classes; e.g., renovation of inpatient services to provide patients upgraded and updated facilities (here significant investments in facilities are made with little or no incremental revenue return value); and/or b) new debt is applied to specific and specialized strategies to acquire incremental market share in specific service lines that have, historically, proved profitable (say, for example, cardiac services). The economic risks associated with these strategies lie, in part, with the comments made above; i.e., the risks associated with a reliance on a few profitable service lines funding broad-based missions.

Many new community-based health systems rely on independent physicians to meet complex expansion strategies for clinical specialty services, financed by new debt. This model rarely allows for sufficient coordination of effort and resources required for execution.(4) Governmental payers, specifically Medicare, are modifying payment policies to target specialties, which raises specialty services investment risk. (5) Also, commercial payers are exerting downward pressures on price and volume in all clinical service areas, especially the specialties. There is more risk in the expansion of new debt-finance specialty strategies when specialty physicians are independent “free agents” in markets.

Of course, credit markets have tightened and the cost of debt has risen significantly and is less accessible for most hospitals and health systems.

5. Risks Associated with Healthcare “Globalization”

The phrase, “all healthcare is local,” is often used as a defense to free-market threats in community health services delivery. Generally, globalization creates more specialization. In the case of not-for-profit community healthcare “globalization,” threats can be local, regional, national, and international. Local threats stem from the potential for “specialization”—typically competition from independent physicians and other community hospital competitors. Regional and national competition is typically from large centers of excellence with reputations for specialized care; e.g., Mayo Clinic, Cleveland Clinic, children’s hospitals, and the like. International competition is emerging from providers abroad (6) who will compete on the basis of quality and cost, and while marginal price differences may not move markets from the U.S. to Bangalore, India, heart surgeries at a 90 percent discount from U.S. prices, with quality held constant, might.

Globalization of healthcare may be seen as a distant and, perhaps, theoretical threat to community hospital/health system boards; it is a threat nonetheless—a logical outcome of free markets and rational market behaviors. The question is whether free markets will be allowed to work in healthcare or whether protectionism will raise its head here as with other industries and, if it does, whether it will be imposed at all levels: local, regional, national, and international. Attempts at protectionism nationally have been proffered as legislation (for example, preventing physicians from owning and operating clinical services thought to be the sole market province of hospitals).(7) Significant lobbies on all sides of the issue are active and the legislative/regulatory debate continues.

6. Independent Physicians in Community Hospital/Health System Governance

An issue that also is relevant for not-for-profit community hospital/health system boards is the independent physician as community hospital fiduciary. Although this has figured significantly as a governance topic of “high importance” over the last several years, the components of the discussion bear repeating. As healthcare markets become increasingly pressured, one would expect the “individual” to behave in a self-interested manner. Independent physicians can and do serve community hospital boards faithfully. They are also in a position to compete with the hospital. Problems arise when the physicians as community hospital fiduciaries are also community hospital competitors. The self-interested physician board member has access to all information useful to a competitor and will typically carry significant influence as a physician board member.

Should all independent physicians be dismissed from community hospital boards now? No. Boards should take time and care to manage the potential for conflict of interest, including access to proprietary business information.

What does the long-term future hold for the independent physicians as community hospital board members? As market forces play out, community hospitals and independent physicians will consolidate their business through “integrated” models of delivery.(8) Those that have already achieved high levels of integration have modified governance models and methods—where physician board members are also employed by the hospital/health system.

The positive potential for integrated models lies in the alignment of incentives with physicians (including as board members). This eliminates the threat of physician board members as competitors and the ability of the integrated governing board to chart more efficient courses of business and community mission strategies.

Summary

If healthcare is an industry operating under free market conditions subject to all laws of free market economics, then we should expect Adam Smith’s “invisible hand” to guide industry changes over the next several years. Fiduciaries of not-for-profit community hospitals/health systems should consider their current clinical service and business models in this context, and should also consider:

• Clinical service line portfolios with a few specialized services subsidizing broad and expensive community health service missions; missions may be “levered” to precarious economics.
• Less forgiving credit markets, increased scrutiny of business models and plans, and enhanced credit rating rigor. As community hospitals/health systems take on more debt to fund strategic ventures, the margin for execution error is reduced.
• Physicians as competitors or fully integrated partners. There is likely to be less middle ground as market forces spur on consolidation.
• A need to manage more closely community service missions in a context of prevailing and future market economics. Payers are not likely to provide margins on a few services to cross-subsidize community missions.
• A more consolidated payer system with an ability to leverage stronger market positions for reduced price and enhanced service.(9) The payer market has consolidated to fewer, stronger payers with strong balance sheets.
• Integrated models of community health service delivery with an ability to compete on new levels; e.g., longitudinal disease management and more visible expectations of clinical specialty programming with greater geographic reach.
• Instantaneous availability of clinical and business information mined from common integrated electronic data platforms—a “digital” competitive edge.
• Less market tolerance for the capital, operating, and service line portfolio inefficiencies that are necessary by-products of business models in pressured markets.

If Joseph Schumpeter’s theory of “creative destruction”  as a necessary process of industry and market innovation and improvement holds for the collective U.S. community hospital/health system, boards should, necessarily, be leading their community hospitals down this path.

The need to curb the macro U.S. healthcare cost inflation rate curve is real. The tools available to “flatten” the curve will challenge the very foundation of the traditions of community-based healthcare delivery models, and community-based hospital/health system boards cannot claim ignorance or community benevolence as defenses to the need for change.

The trick will be management of the trip. To ignore the “invisible hand” and its application to community healthcare is to deny that community healthcare has exposure to market forces. So, to apply Adam Smith’s theory of the “invisible hand” to the U.S. healthcare economy—and the positioning of community-based hospitals/health systems in that construct—is to require confrontation of existing community healthcare models, management methods, ideologies, and histories.

The Governance Institute thanks Daniel K. Zismer, Ph.D. for contributing this article. He can be reached at zisme006@umn.edu.

Citations/References

1. Zismer, D. K., “The Physics of Market Consolidation and the Likely Effects on the Private Medical Group Practice,” Perspective, Essentia Health Consulting, July 2008.

2. Cain Brothers, “Farewell to a Time of Plenty: Health Plan Strategies for Growth in a More Challenging Market” (white paper, Strategies in Capital Finance series), February 2008.

3. Moody’s Special Report, March 2007.

4. Cain Brothers, “Redefining Relationships: Hospitals and Physicians Join Forces in Alternative Delivery Models to Improve Quality, Safety, and Patient Satisfaction” (white paper, Strategies in Capital Finance series), August 2007.

5. CMS Proposal to Reimburse ASCs at 62% of the HOPD Rate Starting Fiscal Year 2008 (proposal dated August 2006).

6. Milstein, A. & Smith, M., “Will the Surgical World Become Flat?” Health Affairs, Vol. 26, No. 1, January/February 2007.

7. Burns, L. R. & Mullen, R.W., “Hospital–Physician Collaboration: Landscape of Economic Integration and Impact on Clinical Integration,” The Milbank Quarterly, Vol. 86, No. 3 (2008), pp. 375–434.

8. Zismer, D. K., “Integration as an Answer to the Challenges of the Legacy of U.S. Not-For-Profit Community Health Systems” Perspective, Essentia Health Consulting, September 2006.

9. “Understanding Hospital–Physician Alignment,” Corporate Finance, Fitch Ratings, October 26, 2007.