Will HMOs Pass Their Physical

It's easy to forget the humble beginnings of America's health maintenance organizations (HMOs). Conceived as an experiment in providing care to a small number of members for a set monthly fee, they are now among the most potent forces in US healthcare. One in five Americans belongs to an HMO. Compound annual growth has averaged 12 percent during the past decade. And the industry has spawned several profitable publicly traded companies. What accounts for this remarkable success? The simple story is that HMOs offered the right product at the right time. Employers were looking for ways to contain the escalating cost of insuring their employees. HMOs were offering comprehensive coverage for a fixed fee - often more than 30 percent below indemnity prices. They soon found they could use their growing patient flows to squeeze healthcare providers (chiefly hospitals and physicians) on costs, winning savings that they were able to pass on to customers or keep for themselves. Healthcare markets across the United States have followed a consistent pattern. At first, providers do little or nothing as HMOs begin gaining share. As penetration increases, they enter a price war to preserve share - and HMOs strengthen their position as a result. Providers finally figure out the new game just as HMOs are reaching the height of their share penetration. When they do, their impact on HMO performance can be considerable. Only a few markets have reached the stage in their evolution where providers are becoming a competitive force. HMOs in these markets are often genuinely surprised to find providers flexing new muscles. They tend to assume that the skills that helped them prosper during the early days of managed care growth will also ensure their success as markets mature. In fact, they risk losing substantial shareholder value over the next few years if they fail to rethink their approach to managing provider relationships. Many HMOs in less mature markets will soon face the same challenge. Changing market conditions mean that they must develop new strategies and capabilities if they are to play a central and profitable role in the healthcare delivery systems of the future. The emerging challenge HMOs have enjoyed a remarkable run of success. Earnings have grown at 45 percent a year, and market capitalizations for the top 25 publicly traded HMOs have risen by 33 percent a year since 1985. But troubling signs can already be seen. Between March and August 1995, while market averages were at record highs, the same top 25 publicly traded [TABULAR DATA FOR EXHIBIT 1 OMITTED] HMOs saw their market valuations fall by 25 percent. This decline may reflect a growing awareness on Wall Street that many HMOs are no longer in a position to demand lower rates from providers or to dictate changes in their operations. Instead, it is providers that, having strengthened their relationships with patients and increased their influence over care delivery, are beginning to find themselves in a position to control and retain patients. The reality in many markets today is that a provider can walk away from the HMO upon which it had previously depended and be sure that most of its patients will soon follow. This power shift is evident in local markets across the United States as they follow a consistent evolutionary path from a traditional, fee-for-service stage to timid, turbulent, and potentially restructured stages (Exhibit 1). The shift tends to begin in the turbulent stage of evolution - the one where HMOs are most at risk. The difficulties presented by this shift are already affecting some of the biggest US markets, such as Los Angeles. Many other major metropolitan markets, especially those on the East Coast, are likely to evolve to the turbulent stage within the next two to five years. The turbulent stage This evolutionary stage is characterized by intensifying competition as providers attempt to consolidate, to form horizontal and vertical alliances, and to reposition themselves with employees and consumers in order to counter the market power of fast-growing health plans and share in the opportunities created by restructuring markets. …