Aches and Pains for HMOs : Critics Assail Trend to For-Profit Businesses

In the sometimes lucrative but increasingly volatile health maintenance organization business, California usually is the nation’s pacesetter.

This is especially true in the area of HMO conversions--the leveraged buy-outs in which the managers of the nonprofit plans take over the companies they run and enter the for-profit sector. Of the approximately 25 nonprofit HMOs which have made the switch since 1980, 17 were based in California.

But these conversions are not without controversy, as was demonstrated by the recent battle over Fountain Valley-based FHP Inc.

Questions about who wins and who loses when an HMO converts continue to bedevil state regulators, legislators and the HMOs themselves.

Conversion can strengthen a marginal HMO, but the switch may translate into higher health care costs for HMO members, according to a recent Harvard University study. The study showed that members of for-profit HMOs often pay 10% more than members of nonprofit organizations for the same care.

Donation to Charity

The big winner in the conversion process is supposed to be charity. In some states, including California, nonprofit HMOs which seek to remake themselves into money-making enterprises first must agree to donate an amount equal to their net worth to charity, either by a direct donation to an already existing organization or by setting up a charitable trust.

However, in many conversions charity comes up short because the HMO managers undervalue the concerns, according to consumer groups, legislators and the state attorney general’s office. Managers are essentially buying the plans for what the Consumers Union has charged are “bargain-basement prices.”

The result, said Jim Schultz, a policy analyst with the San Francisco office of Consumers Union, the publisher of the magazine Consumer Reports, is a conflict between the managers’ duties to the nonprofit corporation and their responsibility as buyers to pay the lowest possible price for a company.

“The managers are wearing two hats. First they are responsible as stewards of the nonprofit corporation, and they’re the buyers of the plan,” Schultz said in a recent interview. “You have a conflict because you don’t have a separate buyer and seller.”

FHP Controversy

The issue of a separate buyer and seller was central to the conflict that enveloped the controversial conversion last year of FHP Inc.

The 24-year-old FHP was a success in an industry now beginning to suffer from shakeout and consolidation.

Following lengthy negotiations between the state Department of Corporations and FHP’s management, a conversion price of $36 million was reached in September.

Although the $36-million price tag already made the FHP conversion the most expensive ever, Maxicare Health Plans Inc. stepped in and offered $50 million for the company.

Filed Lawsuit

When FHP rebuffed Hawthorne-based Maxicare’s offer, the giant HMO, which itself had gone for-profit in 1981, filed a lawsuit in Los Angeles Superior Court to block the conversion.

Despite the entry of the state attorney general’s office on the side of Maxicare, a judge in October ruled that no law requires either a separate buyer nor competitive bidding for a conversion.

Nevertheless, argue critics of the FHP deal, the $11.5-million difference between Maxicare’s $50-million bid and the $38.5 million at which the HMO finally converted was lost to charity.

In all, Schultz estimates, low valuations cost charity about $20 million between the FHP conversion and the February, 1984, conversion of Foundation Health Plan (no relation to FHP) of Sacramento, which converted to for-profit status at $10.6 million, despite a higher valuation of $19 million by the Bank of America.

‘Specious Argument’

“You can say that, but it’s a specious argument,” countered Richard Camilli, assistant corporations commissioner, who said the charitable contribution made by buyers of Foundation Health had grown in value to more than $50 million by mid-1985.

That, said Camilli, is $50 million more than charity would have gotten had Foundation never converted.

In FHP’s case, said Camilli, the charitable trust established through the conversion gets $38.6 million, plus interest.

Had the state tried to force FHP to sell out to Maxicare, he said, FHP’s directors merely would have canceled the plan’s conversion and charity would have gotten nothing.

Endowments to Universities

Moreover, argued Stuart Byer, FHP’s director of public affairs, the $3.3 million in endowments recently awarded by the FHP Foundation--established as a result of the FHP conversion--to UC Irvine, Cal State Long Beach and the University of Utah shows that charity benefited from the conversion.

Still, critics argue that determining fair-market value must include not only the net worth of converting HMO’s assets but also what a willing buyer is prepared to pay in an actual sale.

“We didn’t think the conversion was at fair-market value,” said Assistant Atty. Gen. James Schwartz. “The fact that Maxicare was willing to pay $50 million was proof of that.”

Although Los Angeles Superior Court Judge Eli Chernow overturned the joint bid by the attorney general and Maxicare to block the FHP conversion, Schwartz said his office plans to amend its suit against FHP in an attempt to force a higher price for the company.

Discord Over Price

“We think that what Maxicare was willing to pay should have been the floor,” Schwartz said. “No one should have paid less than that.”

FHP, understandably, disagrees.

“It was never meant to go to the highest bidder and the law never contemplated that,” Byer said. “It’s important that the management team that started the business continue because they are an integral part of the success of the business.”

Although HMOs originated largely from a philosophy that placed providing low-cost, quality health care above profits, the recent push for lower health-care costs have made prepaid plans more attractive to employers and consumers. As a consequence, HMOs increasingly are becoming big businesses.

As of last June, there were nearly 400 HMOs in the United States, of which 136 were for-profit, according to Interstudy, a health policy research organization based in Excelsior, Minn.

Numbers Increase

Although figures for the end of 1985 are still being compiled, the total number of prepaid plans is expected to top 490, said Dari Holmes, an Interstudy researcher.

In California, there are approximately 40 HMOs, of which 17 are for-profit.

Advocates of HMO conversion say one key reason companies switch to for-profit status is that as nonprofits, they are limited both from practical and legal standpoints in their ability to raise capital for growth and expansion.

Moreover, many marginal plans convert because offering an equity position in the company often is the best way to attract qualified managers, said John Houck, a Los Angeles attorney who has participated in several conversions, including FHP’s.

Lenient Regulation

State regulators were lenient in many early conversions because the alternative would have been for the HMOs to fold, with their subscribers left without any services, he said.

“Most of the conversions in California were forced by financial disaster,” Houck said. “You hear about the Maxicares and the FHPs, but most were not really that good. In fact, many were a pain in the neck for the Department of Corporations.”

Despite the difficulties and controversy the conversion process engenders, making the switch is always a good move, Houck said.

“The process itself is expensive and distracts management away from its business. Once you get over that, I don’t see any disadvantage other than having to pay taxes,” Houck said.

Consolidation Seen

“The ability to raise capital was an important factor in the decision to go public,” said John Siefker, chief financial officer of PacifiCare Health Systems Inc., a Cypress-based HMO which converted in early 1984 and held its initial public offering a year later.

While the bulk of HMO conversions that have occurred since 1980 have been in California, the rapid consolidation of the health care industry that was unheard-of 10 years ago means that HMO conversions are beginning to spread to other states, as well.

“It’s pretty much the direction the industry is taking,” said Paul Ellwood, founder of Interstudy.

Competitive pressures, loss of federal funding and fears that even the nonprofits will be taxed by the federal government all are factors fueling the drive among HMOs to convert to for-profit status, Ellwood said.

Winnowing Out

The end result of the present consolidation, he believes, will be the emergence of a handful of large HMOs competing nationally for subscribers.

“The direction the HMO industry is taking is toward a limited number of large organizations,” Ellwood said. “In my opinion, the bulk of services will be provided by 10 organizations. One of them will be nonprofit, and that one will be Kaiser.”

(Joe Criscione, vice president of governmental relations, for Oakland-based Kaiser Permanente, which pioneered the prepaid health plan more than 40 years ago, said, “Kaiser itself isn’t considering converting to a for-profit.”)

The future of HMO conversions in California--and possibly those in the rest of the United States--may be affected by a piece of legislation currently winding its way through the state Assembly that would radically alter the rules under which HMOs are converted.

Bill Calls for ‘Super Trust’

Introduced by Rep. Alister McAlister (D-San Jose), who as chairman of the Assembly Finance and Insurance Committee last December scrutinized both the FHP conversion and a similar one in Sacramento, the proposed law would strip the Department of Corporations of the authority to decide what converting HMOs are worth.

Under the McAlister bill, converting nonprofit entities--including hospital service plans, such as Blue Cross of California--would be valued by a state-operated “super trust,” which also would receive the charitable donations.

And, in addition to the valuation methods currently being used--typically based on the company’s book value--the trust would be permitted to take future earnings potential into account when setting a value and would be able to solicit bids from outside buyers, according to Sal Bianco, an aide to McAlister.

Bianco, who is critical of the way the Department of Corporations has handled recent conversions--including FHP’s--agrees with the Consumers Union that during conversion, “you have a missing seller and no one is looking out for the value.”

Help to Nonprofits

But perhaps the most crucial and far-reaching feature of the proposed law would be a provision that would make part of the money held by the trust available to struggling nonprofit HMOs as an incentive not to convert.

“Instead of forcing itself to convert, an HMO can go to the trust and seek a loan at a low interest rate,” Bianco said.

That could help save California consumers plenty, according to the Harvard study.

Over the long run, suggests the study, prepared by Harvard’s John F. Kennedy School of Government, the shift away from the nonprofit sector may result in higher health care costs overall.

Higher Costs

The study suggests that higher costs at for-profit HMOs may result in costs that are 10% higher than at nonprofit HMOs.

Conversion advocates say the argument that members of for-profit HMOs pay more for the care they receive is not true because competition will hold down patient premiums.

Still, contended Schultz, of Consumers Union, “the dividends have got to come from somewhere,” either by increasing premiums or cutting back on services.

“Once somebody gets into a health plan, they tend to stay because they either develop a relationship with the physician or because they live near the facilities,” he said. “They are not going to just walk away if the prices go up.”