Healthcare: Understanding Risk Adjustment

by: Sydney Williams

Author’s note: Among the least understood aspects of health reform, risk adjustment affects payers and providers alike, whether through the formation of accountable care organizations or the development of health insurance exchanges. Organizations that effectively deploy risk adjustment tools gain a competitive advantage that translates into bottom-line performance. Although UnitedHealth (NYSE:UNH) and Verisk Analytics (NASDAQ:VRSK) offer the most direct way to invest in risk adjustment—both as proprietary vendors of the software tools—the Department of Health and Human Services' ("HHS") requirement that open source solutions be considered could challenge current margins.

On Wall Street, capital markets facilitate securities' pricing and allow for efficient capital allocation. Buyers and sellers bid and offer prices based on multiple data points, and, in many cases, gut feeling. Risk—the uncertainty of systemic and non-systemic factors—plays a key role.

Market participants apply different models (some sophisticated, some not) to ascertain the value of a security. Their collective input generates a market bid-ask spread, not always accurate but in most cases more accurate than any one entity could otherwise determine over an extended time period. (Of the 8,500 plus mutual funds, almost none beats the market consistently.)

Seems like a logical process, right? Well, we should be at least familiar with it since we engage in price discovery in just about every aspect of our lives. That is, every aspect except for health care.

In health care, the actual delivery of care (going to the doctor for a checkup, for example), a transparent price discovery process does not exist. Health plans contract with provider groups to pay fees for services that physicians perform. The price setter is in many cases the U.S. government, specifically Medicare, the single largest payer which covers health care's highest utilizers, folks aged 65 and older. (Picture Goldman Sachs times one hundred, and everyone else following its lead.)

Unlike the capital markets, a transparent marketplace does not exist. Commercial health plans don't compete across state lines, and within states, plans can exercise near-monopoly power.

Moreover, because of the first-dollar nature of health insurance, what plans charge beneficiaries in premiums includes considerable actuarial assumptions about the health of their population, and how this changes over time.

Business risk and the health care payment system
Health reform—whether the Patient Protection and Affordable Care Act, "PPACA", or competing proposals—targets fundamental change in the payment system.

By requiring plans to offer equal access and prohibiting differentiated pricing based on health status, PPACA, in effect, standardizes insurance products. At the same time, it establishes a new care delivery vehicle in accountable care organizations ("ACOs")—or risk-based care coordination platforms.

As a result, risk selection—the result of not having full information in the marketplace—is shifting from plans to providers as a business strategy.

But before providers can consider selecting risk they need to model and quantify it first. Not an easy task when patient populations vary substantially, depending on demographics and location.

The process of measuring risk factors for the purpose of risk-adjusted reimbursement is called simply risk adjustment: something that Wall Street does quite efficiently in a marketplace setting.

For UnitedHealth, Wellpoint (WLP), Aetna (NYSE:AET) and other health insurance groups and HCA (NYSE:HCA), Tenet Healthcare (NYSE:THC), and other hospital organizations, expect the risk adjustment process to alter the long-term corporate landscape, by changing how entities select and manage risk and apply global payment systems (reimbursement based on expected costs and episodes as of care as opposed to the traditional fee-for-service model).

In terms of business risk and return, the risk adjustment process in conjunction with government-imposed coverage requirements will accelerate consolidation among health plans and investment in non-insurance operations such as IT and data management—that is, in so far as the individual mandate holds, and insurance product differentiation disappears.

It will also facilitate new revenue opportunities for hospitals and physician group practices as they pursue ACO structures and global payment systems—though not without commensurate risk. One consequence will be providers paying particular attention to the patient populations they serve and the extent to which they can minimize their total cost.

The two largest vendors of risk adjustment tools are Optum, a division of UnitedHealth, and Verisk Health, a division of Verisk Analytics. But more than the vendors themselves, consultancies advising the implementation and use of the tools should gain the most. Unfortunately for investors, the impact will be biggest among small, privately-owned firms.

Imperfect science
As with any type of modeling, risk adjustment is an imperfect science, especially as it pertains to a price discovery process that involves thousands of beneficiaries but only one payer and one provider.

In a recent white paper written for the Massachusetts Medical Society, Milliman, the actuarial consultancy, tackles the intricacies of risk adjustment and submits key principles that both the payer and provider need to heed when looking to form ACOs. [Read "Risk Adjustment: Important Considerations for Global Payments to Providers".]

Many people, the Milliman paper explains, view the ACO concept as a viable alternative to the existing fee-for-service payment system. Not waiting for the U.S. government, commercial entities have already conceived and deployed ACO-type models, which included both a risk-adjusted global payment and a performance-based payment.

The government model continues the fee-for-service system but introduces additional payments based on a set of benchmarks for health care costs, outcomes, and quality. HHS is expected to recognize risk adjustment tools that will determine how much it reimburses groups for exceeding these benchmarks.

Milliman lists the following five key risk adjustment design principles:

  1. The groupings of medical conditions in a risk adjustment model should be clinically meaningful and reasonably specific, in order to minimize opportunities for gaming or discretionary coding.
  2. Diagnoses within the same condition category should be reasonably homogeneous with respect to health care cost and utilization, in order to optimize predictive accuracy and robustness of the model.
  3. Condition categories should have adequate sample sizes, to permit accuracy and stability of model predictions.
  4. The risk adjustment model design should encourage specific coding and discourage vague coding. Vague codes and nonspecific diagnoses should be excluded from the risk adjustment model
  5. The risk adjustment model should not reward coding proliferation. Providers should not be penalized for recording additional diagnoses. In other words, coding more diagnoses should not reduce the risk scores.

"When used to set payment rates," the Milliman report continues, "a risk adjustment methodology needs to strike a balance between predictive accuracy and incentives issues." The problem is physicians are human just like the rest of us, and will arbitrage gaps in mandates and models to realize additional compensation. A risk adjustment model needs to take this into account and avoid awarding overuse and overtreatment.

The ACO environment requires additional principles to address the organization's core competency and patient assignments. Under an ACO structure, the care delivery entity (a hospital or physician group practice) bears responsibility for assigned patient outcomes regardless of who ultimately provides the care—for example, a patient seeking care outside his assigned ACO.

What's more, there isn't a single risk adjustment model. Selecting and engaging a risk adjuster involves a detailed understanding the model itself and how it compares with different vendors.

And there's the matter of coding, the record-keeping system physicians use to indicate diagnosis and treatment. How physicians enter codes affects risk scores, and the coding system itself (encompassing tens of thousands of codes) is changing to an even more extensive system—a sort-of Y2K for health care—with the introduction of ICD-10-CM.

Market competition
Imagine now that you're a physician and that your practice or affiliation is considering an ACO structure featuring a highly sophisticated risk adjustment process. For many, the obvious answer is 'why bother?' At least in the fee-for-service model you had a clearer understanding of what your reimbursement rates were. Your compensation now comes down to a pool of money that the ACO's officers will allocate based on a black-box model.

Some who see no benefits in either system are existing the insurance model altogether, or simply vacating the profession. Over recent years, Wall Street hasn't exactly demonstrated perfection, but at least the marketplace model is transparent. The answer to risk adjustment's complexity as it's implemented might just be market competition and consumer choice.

Investors need to understand the payer-provider landscape in terms of business risk: specifically, how plans, hospitals and physician group practices measure and utilize it.

Rather than an immediate catalyst, investors should consider the risk adjustment process and its impact on business risk and the implementation of new payment systems as a long-term driver of corporate strategy.

If the current reform trajectory holds, expect plans to consolidate aggressively and expand investment in non-core operations—UnitedHealth being the primary example. Expect providers, meanwhile, to redesign business processes as they target new revenue opportunities and assume new risk factors.

Even if PPACA breaks apart, competing reform ideas still target global payment systems. Depending on how this scenario plays out, plans may ease M&A activity. Providers, though, will likely continue exploring and investing in alternative business models.

In either case, the risk adjustment process will play a material role.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.