Center for Studying Health System Change

he Orange County health system has experienced considerable consolidation within the hospital, physician and health plan sectors during the past two years, and this horizontal consolidation is expected to continue, especially among hospitals. Health plan-provider integration efforts, in the form of ownership arrangements, have been largely abandoned in favor of contractual relationships to coordinate the health care delivery and insurance functions. Despite the impediments posed by California’s Corporate Practice of Medicine and Knox-Keene laws, hospital-physician integration is being pursued in various forms. Respondents expressed varying opinions about how vertical relationships between providers and plans and between physicians and hospitals will continue to evolve.

Locally based and nationally headquartered hospital systems have been consolidating their ownership of Orange County facilities. Currently, only six of 34 hospitals are not affiliated with larger hospital systems and at least two of these are evaluating consolidation options. Physicians in general and primary care physicians in particular have also consolidated, typically to increase their bargaining power in negotiating managed care contracts. Mid-size and large IPAs and medical groups are now powerful players in this market. The health plan market has also become more concentrated, as plans merge to amass market share and economies of scale. Two of the three largest HMOs operating in Orange County have completed mergers within the last two years.

Health plans such as Cigna and FHP have sold off their staff-model groups and hospitals and moved to network-model contracting because they have found it cheaper to contract with physician groups and hospitals than to own and manage providers themselves. There is one successful integrated provider and insurer organization -- the Kaiser Foundation Health Plan and its affiliated Kaiser Permanente Medical Group and Kaiser Foundation Hospitals. But even Kaiser, in its statewide strategy, is reducing its reliance on its own hospitals and reportedly has considered contracting with non-Permanente Medical Group physicians. There are few examples of provider ownership of health plans in this market. One hospital system, Columbia/HCA, recently purchased a local PPO.

Respondents expressed skepticism that exclusive relationships between providers and plans would be viable in this market. Neither hospitals nor physician organizations in Orange County believe that they can afford to rely solely on any one health plan for their revenue and patient volume. Providers depend on the revenues from multiple plan contracts to earn profits within a competitive, capitated market. It is common, for example, for a mid-size to large physician group or IPA to contract with more than a dozen health plans, even though most of its revenues may come from just a few of those plans. Respondents noted that the market’s continual consolidation makes it particularly important to maintain relationships with all major plans. Even provider groups that have obtained limited Knox-Keene licenses report reluctance to compete with their health plan partners.

There are signs, however, that tighter relationships are forming between providers and plans. Longer-term contractual relationships have formed between several health plans and providers. PacifiCare, for example, has established 5- to- 10-year contracts with selected medical groups and hospitals in Orange County, including a recently announced 10-year contract with Memorial Health Services. Some plans have established preferential terms with the providers with which most of their business is concentrated. Other arrangements typically trade off some level of provider price discount for guaranteed business over time. These activities reflect the relative leverage of the parties involved rather than attempts to achieve financial or clinical integration.

Health plans have been able to win price concessions from providers competing to maintain their share of patient volume amidst excess hospital and physician capacity. This, in turn, is driving hospitals and physicians to find ways both separately and jointly to improve their relative bargaining positions.

There are indications of tighter vertical relationships between hospitals and physicians, although some respondents cast doubt on the long-term viability of exclusive vertical relationships. For example, long-term relationships have formed between some hospital and physician entities, including St. Joseph’s and its St. Jude Heritage Health Foundation and Tenet and MedPartners. On the other hand, many providers and plans dismiss the likelihood of exclusivity between physicians and hospitals. Physicians and hospitals want to achieve the size and geographic breadth necessary to be viewed as indispensable and to ensure that they are included in plan networks at favorable terms. They express discomfort, however, with structuring arrangements that rely on a single partner and the potential bargaining power such reliance would give that exclusive partner.

Finally, the pursuit of limited Knox-Keene licenses by several physician groups may alter the relationships among physicians, hospitals and health plans. Limited Knox-Keene licenses are essentially limited state HMO licenses that allow physician groups or hospitals to assume global risk for health care services from health plans. MedPartners, for example, holds a limited Knox-Keene license that enables it to receive global capitation for physician and hospital services and provide care by using its own hospital and contracting with other local hospitals. An advantage of Knox-Keene licensure is that the holder of global risk may be able to establish contractual terms with other providers (e.g., hospitals) that are more favorable than those available through joint contracting. Management service organizations (MSOs) and other contracting structures are required to hold separate physician and hospital contracts by the state law’s prohibition on assumption of risk by non-licensed entities, even though these organizations often are formed to facilitate joint hospital-physician contracting. Some of these organizations behave virtually identically to other entities that assume global risk in terms of how they structure their contracts and negotiate with health plans. Several providers, including some physicians and a hospital system, reportedly are pursuing limited Knox-Keene licensure to assume global risk under one health plan contract.

PROVIDERS

Physician Organization and Changes

Many respondents report that Orange County’s mid-size to large physician groups and IPAs have developed sophisticated mechanisms for managing care under capitation. Physicians outside the group and IPA contracting arrangements are finding it difficult to remain independent as increasingly influential managed care plans funnel contracts through these large physician organizations, especially primary care groups. Some of the most prominent physician organizations -- MedPartners, the St. Jude Heritage Health Foundation and the Monarch IPA -- hold significant leverage with hospitals and health plans, according to respondents.¹²

In general, physicians are affiliating through a variety of contractual and ownership arrangements designed to give them leverage in health plan contracting. The strength of physician entities is calibrated in terms of how many physicians they include and how many capitated lives they serve. Together, MedPartners, St. Jude Heritage Health Foundation, Southern California Permanente Medical Group, St. Joseph’s Medical Corporation and Monarch reportedly have contracts for a significant share of the county’s capitated covered lives.

For example, one health plan respondent described MedPartners as the entity other competitors were "most likely to lose sleep over" because of its strength. MedPartners, a publicly traded national physician management corporation, holds contracts for more than one million capitated lives in Southern California and reportedly exerts great influence with health plans. MedPartners buys the assets and assumes the liabilities of physician groups and IPAs, and enters into long-term contracts with their physicians.¹³ MedPartners employs non-physician personnel, including nurses, to administer these physician practices.

MedPartners has arrangements with more than 600 physicians in Orange County. Its Southern California network includes more than 3,000 physicians.¹⁴ MedPartners is the second-largest physician organization in Southern California, after the Southern California Permanente Medical Group. MedPartners entered the Southern California market through its 1996 acquisition of Mulliken Medical Centers’ physician practices, a large physician group that owns a hospital in neighboring southern Los Angeles County. When MedPartners merged with CareMark, another national physician management company, the Orange County-based Friendly Hills Medical Group and the former Cigna staff-model group also came under MedPartners ownership.

Other large physician organizations include:

• the Monarch IPA, which was recently created through consolidation of three local hospital-affiliated IPAs representing about 300 physicians, and the bulk of whose physicians are in the southern part of the county;

• the St. Jude Heritage Health Foundation, which has more than 400 physicians in medical groups and IPAs affiliated with the St. Joseph’s Health System;

• the St. Joseph’s Medical Corporation, which has 250 physicians in a medical group and an IPA affiliated with the St. Joseph’s Health System; and

• the Southern California Permanente Medical Group, which has 250 physician employees in Orange County.

There are three physician organization structures for employing, supervising and compensating physicians: the IPA, the medical foundation and the medical group. Each structure uses different mechanisms for contracting with health plans. Although physicians who belong to IPAs generally maintain their independent practices and may belong to several -- sometimes competing -- IPAs, several IPAs offer preferential payment rates to physicians who contract solely with their organization. This practice blurs the distinction between the medical group and IPA forms. In general, IPAs carry much less overhead, and, as a result, they can negotiate very competitively with plans. On the other hand, IPAs generally do not offer as much practice support and are less able to coordinate care across their practices.

New physicians who do not want to invest in the start-up costs of establishing a practice are attracted to medical groups. Some respondents expect that as the proportion of HMO business grows, medical groups will start to look more attractive because they are better able to manage care. Unlike IPAs or medical groups, practice management companies rely more heavily on non-physician administrators -- so-called "MBA types" -- to administer physician services, including health plan contracting. These companies usually offer physicians an equity interest. Physicians participating in IPAs and medical groups may receive similar services from contracted MSOs, and they may choose to invest in those MSOs.

Hospital Organization and Changes

Consolidation prevails in the hospital sector. Almost every acute care facility is affiliated with a larger system. More than half of the county’s 34 facilities are owned by four hospital "systems" -- the St. Joseph’s system, the Tenet/OrNda system, the Memorial system and the UniHealth system -- and more than two-thirds of its 6,500 beds are owned by five systems. Many respondents expect only three or four systems to survive long-term. A number of the remaining independent hospitals, including the University of California Irvine Medical Center (UCIMC) and South Coast Medical Center, are actively considering affiliation. These hospitals, too, however, are considering the importance of size in negotiating with health plans and physician groups to ensure that they are not left out of contracting agreements.

In general, the hospital systems have not centralized many hospital functions yet, although respondents report interest in greater centralization of health plan contracting and other administrative functions as merger plans are implemented. Despite provider ownership consolidation, respondents suggest that significant hospital overcapacity remains. The market has not experienced a great deal of hospital downsizing or closure; average hospital occupancy is below 50 percent.¹⁵

The St. Joseph’s Health System was founded in the 1920s to serve the Catholic mission of the Sisters of St. Joseph of Orange. It is characterized by many respondents as the most prominent hospital system in the county due to its long history, reputation for quality and economic stability. The system owns three hospitals in Orange County -- St. Joseph’s, St. Jude and Mission -- with a total of more than 1,100 beds, and has an affiliation agreement with the 192-bed Children’s Hospital of Orange County. The system recently added Mission Hospital to achieve county-wide geographic coverage. In addition, the system owns seven hospitals in Los Angeles, other parts of California, Texas and New Mexico. The system’s three Orange County hospitals own the St. Jude Heritage Health Foundation with more than 400 physicians, and have a minority interest in the St. Joseph’s Medical Corporation with 250 physicians. These arrangements are intended to better align the financial incentives of hospitals and physicians providing care to St. Joseph’s patients.

The Tenet/OrNda system consists of four Tenet hospitals and seven OrNda hospitals in Orange County, which together account for about 1,900 of the market’s total 6,500 beds. Of these 11 hospitals, six "came into" either the Tenet or OrNda fold within the last two years.¹⁶ Tenet announced the purchase of OrNda in 1996, but the new entity has not yet implemented a singular strategy for the Orange County market. Currently, each of the 11 hospitals operates fairly independently and negotiates separately with health plans. Tenet manages the Nobel Physicians IPA. Nevertheless, Tenet and OrNda each own hospitals in neighboring Los Angeles and San Diego counties, as well as other parts of the state and the country. Tenet/OrNda’s bargaining leverage with health plans that want any of these 11 hospitals in their networks is potentially very strong.

The not-for-profit Memorial system formed two years ago and is based in Long Beach. Two of the system’s three hospitals are located within Orange County (one in North County and one in South County). These hospital executives, too, saw the need to increase geographic coverage and size in order to preserve inclusion in health plan contracts. UniHealth, a large Los Angeles-based system, owns two hospitals in the county. Orange County also includes three relatively small hospitals owned by Columbia/HCA, one hospital owned by Kaiser Foundation Hospitals and one hospital owned by MedPartners’ Friendly Hills Medical Group.

UCIMC is the local academic medical center. Its mission is driven by medical education and research, and it offers a broad range of tertiary services. Since its purchase of the county hospital in the 1970s, UCIMC has served as an almost de facto public hospital because of the large indigent care load it has shouldered. It operates the only Level 1 trauma center in the county. It is staffed predominately by the UCI Faculty Practice Group, and is considering affiliating with either Columbia/HCA or Tenet/OrNda. Several respondents believe that the "commercialization" of UCIMC would alter the institution’s role as a safety net provider and medical education center.

Hoag Memorial Hospital Presbyterian is a stand-alone tertiary hospital with a national reputation for clinical excellence and a "carved-out" geographic niche in Newport Beach. It has relied on the Greater Newport IPA for most of its physician services. Hoag is aligning with the St. Joseph’s Health System for joint health plan contracting. South Coast Medical Center, a small stand-alone hospital in South County, is in the process of merging with Adventist Health, a large system predominantly in Northern California.

Physician and Hospital Integration

In addition to horizontal consolidation, Orange County hospitals are pursuing strategies to align themselves more closely with physicians. The St. Joseph’s Health System, in particular, has carried out a physician-hospital integration strategy. The St. Jude Heritage Health Foundation’s purchase of the Bristol Park medical group’s assets and its MSO helped move the St. Joseph’s Health System toward a county-wide, integrated delivery system. The addition of Bristol Park Medical Group resulted in 120 new physicians in 13 Central and South Orange County sites. St. Joseph’s has added other groups and an IPA to the foundation, and is minority owner of the St. Joseph’s Medical Corporation, another physician entity with a large group, an IPA and its own MSO. Although physician-hospital alignment seems to be farthest advanced at this system, to date, physicians affiliated with the foundation do not have exclusive relationships with the St. Joseph’s hospitals.

Earlier this year, the Tenet system announced its affiliation with MedPartners for a Southern California contracting network. Details of the agreement have not been disclosed, but the affiliation reportedly will improve both organizations’ ability to negotiate with managed care plans in Southern California. As physician practices have become attractive purchases, many physicians are responding to the lure of "cashing out" their practices. Hospitals pursuing physician-hospital integration have offered physicians new financial incentives. For example, some "equity" MSOs are jointly owned by physicians and a hospital, and provide money-making opportunities for their owners.

Meanwhile, providers continue to refine their methods for distributing capitation revenues between physicians and hospitals through the split of the capitated dollar and through physician-hospital risk pools. Respondents generally reported that the "money to be made" was in savings achieved by managing hospital utilization. These savings often are shared by physicians and hospitals via physician-hospital risk pools. Shared risk pools are used as mechanisms to align physician and hospital incentives so that they don’t compete for health plan premium dollars. At St. Joseph’s Health System, increased physician-hospital alignment is leading to system-level standards on how capitation revenue is split and on distribution of hospital risk pool payments between participating physicians and hospitals. Similarly, health plans that want or need to do business with MedPartners physicians are forced to accept MedPartners’ terms for physician compensation because of MedPartners’ increasing market strength. As MedPartners amasses more physicians and covered lives, health plans that contract with it and separately with hospitals will be less flexible in the portion of the capitated dollar they can pay contracting hospitals.

INSURERS AND HEALTH PLANS

Orange County has a long history of managed care, with locally based HMOs and others based in neighboring Los Angeles. National plans (e.g., Aetna, Cigna) have also served Orange County through either multisite accounts or their Southern California regional strategy. Overall, HMO penetration is estimated at 47.5 percent, compared with a national average of only 20 percent.¹⁷ More recent estimates accounting for the shift of virtually all Medi-Cal enrollees into managed care place this figure closer to 60 percent. In addition, a few of the country’s largest PPOs are headquartered in Orange County. Very little indemnity insurance exists in the county. The health plan sector is undergoing a combination of ownership and operational changes.

Plans are consolidating into a few large entities in terms of ownership. At the operational level, however, individual plans are altering the structure of their health plan products, as well as their provider payment approaches and mechanisms.

Local HMO enrollment is becoming concentrated among three plans. The largest health plan is the combined PacifiCare/ FHP entity, which formed in 1997 when PacifiCare’s acquisition of FHP was approved. Both PacifiCare and FHP are headquartered in Orange County. This organization is best known for its Medicare business, which reportedly includes more than two-thirds of the county’s Medicare risk enrollees and 90 percent of South County’s Medicare risk enrollees. It serves a large commercial base as well. PacifiCare/FHP offers HMO and PPO products and a POS HMO product. FHP owned a local hospital, which it sold to the Memorial system, and spun off its physician group.

The second-largest health plan, by enrollment size, is Kaiser Foundation Health Plan, which, as noted, operates a group-model HMO built around an exclusive relationship with the Southern California Permanente Medical Group and the Kaiser Foundation Hospitals (including one in Orange County), as well as referral relationships with a few contracted providers. Kaiser competes in the commercial, Medicare and Medi-Cal markets. Although it historically has concentrated on the large employer market, its recent growth has been with small and mid-size employer groups. In January 1997, Kaiser announced a decision to merge its Southern and Northern California branches into one statewide organization.

The third-largest HMO is Southern California-based Foundation Health Systems, which is the result of a merger at the national level by Health Systems International and Foundation Health Plan. HSI previously had acquired Southern California-based HealthNet, its California HMO subsidiary, in 1992. Respondents describe HealthNet as the largest network-model HMO in California. It also offers a PPO product, although enrollment is quite small. HealthNet competes in the commercial and Medicare markets.

A few other HMOs have local enrollment estimated at 50,000 or greater. These include Los Angeles-based Blue Cross of California’s California Care product¹⁸ and plans offered by Cigna, Prudential and Aetna. Some of the largest PPOs in the country are headquartered in Orange County -- including Beach Street and Capp Care -- but Orange County represents a very small proportion of their overall business. San Francisco-based Blue Shield also has a sizable PPO presence in Orange County. HMOs with POS products sometimes contract with these PPOs for network development, payment and other functions.

Each of the top three HMOs is undergoing some type of consolidation, driven by regional, statewide and national marketing strategies. All three plans report that their recent mergers will enable them to compete efficiently across California and in other markets. As of September 1996, these three plans enrolled nine million of California’s 13 million HMO enrollees.¹⁹ Respondents estimate that within Orange County, these top three HMOs cover more than 600,000 lives, which is more than one-third of the county’s combined commercial and Medicare populations. Health plan size (and associated number of covered lives) is important in establishing bargaining leverage with providers, and in establishing administrative efficiencies necessary to offer competitive premiums to purchasers.

Health plan networks are broad and overlapping, with the exception of the Kaiser Foundation Health Plan. The mid-size and large physician groups and IPAs and the major hospital systems (as well as Hoag and UCIMC) have been included in all the major plans’ panels. Plan respondents report that the largest physician groups continue to carry "brand-name" recognition, and thus generally are included on all health plan panels. The breadth of networks does not translate to liberal access to providers. Primary care physician gatekeepers tightly control the number of referrals to non-primary care providers and whom their patients see for non-primary care.

Plans are pursuing changes in plan and network design. Respondents report that consumers are dissatisfied with overly restrictive gatekeeping. Plans are offering POS products that allow enrollees to bypass their gatekeepers and self-refer to specialists by paying a fee. Plans are also working on shortening the time required to approve referral requests, and on improving their overall levels of customer service. Plans are collecting and analyzing utilization and other information at the physician level to make decisions about network development for their plans. Some plans are actively recruiting ethnic minority physicians with specific language skills.

For the most part, plans have competed on the basis of price. Broad, overlapping networks have made it difficult for purchasers to evaluate other criteria in making their plan selections. Respondents estimate that commercial premiums hover around $100 to $120 per member per month and that the spread between the most expensive and least expensive HMO products is relatively narrow.

Health plans operating in Orange County have adopted different strategies for negotiating with providers. Blue Cross of California issued a statewide, competitive bid for hospital services. Competitors and providers report that Blue Cross has placed "all its eggs" into the basket of cutting hospital payment rates to produce competitive premiums. Kaiser Permanente, which owns most of the hospitals it uses, has implemented systemwide internal cost reduction targets, and has focused much of its attention on consolidating and streamlining its cost structure (in clinical and administrative services). Kaiser is considering altering its physician salary structure to put more compensation at risk, and altering its strategy for hospital services to include greater purchasing of hospital services from non-Kaiser facilities. Network and IPA-model HMOs such as PacifiCare/FHP and Foundation Health Systems seem to rely on a combination of bargaining leverage with contracted providers and internal administrative restructuring (e.g., reengineering, streamlining administrative staffing) to produce competitively priced premiums.

Like the local providers, health plans are changing the manner in which they divide the premium dollar. Some plans are considering rewarding provider groups in which their business is concentrated through a combination of longer-term contracts (e.g., 5 or 10 years), more advantageous payment rates and new provider support services, such as members’ enrollment and benefits information. PacifiCare, for example, recently executed a 10-year contract with the Memorial Health System for hospital services. Some plans have adopted percent-of-premium contracts under which they share the up- and downsides of premium-level risk with their contracted providers. Some plans are also considering altering their incentive-based bonuses to more explicitly reward superior outcomes and quality, in addition to productivity.

HMOs have relied on capitation to reimburse primary care physicians, but they use different mechanisms for paying specialists and hospitals. Normally, an intermediary organization -- the physician group or IPA -- between the health plan and individual physicians receives capitated compensation. Physician capitation usually includes "full professional risk" (i.e., responsibility for primary care and specialty physician services), and intermediaries adopt different mechanisms for paying primary care providers and specialists (salary, bonus, fee-for-service or sub-capitation). While ancillary services such as pharmacy, vision and mental health historically have not been included under primary care physicians’ capitation, plans report that physicians are requesting control over these services. While specialists continue to be reimbursed predominantly through fee-for-service, they increasingly are being brought into capitated contracts, particularly with large physician groups and IPAs.

Hospital payment has been based mainly on per diems and DRGs, and may come from the plan or from the medical group/MSO contracting structure. MSOs manage the contracts with health plans and pass on payment to providers. Some hospitals and health plans reportedly are interested in capitating hospitals. Physician groups report reluctance to capitate hospitals because they contend that physicians, not hospitals, control hospital utilization; therefore the physicians should benefit from any savings in this area through their share of the physician-hospital risk pool. Hospitals, on the other hand, are uncomfortable with being "at the last step of the food chain," but believe it is in their best interest to share hospital utilization savings with physicians to preserve patient flow. Shared physician-hospital risk pools with hospital utilization targets are common; the relative sharing or payout between hospitals and physicians is often close to 50/50, but varies depending on the relative leverage of specific hospitals and physician organizations.