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January 31st, 2012 Newsletter

Independent Research & Management

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providers to maximize the volume of services they provide.

An alternative business model is for each patient to be provided a lifetime healthcare budget, over and above which the patient is responsible for the costs. If a patient stays healthy his entire life, his lifetime budget would not be drawn down. What would happen to these funds depends on the type of approach one takes; in theory this should accrue to the patient for use whatever way they choose.

The choice of business model has a huge impact on the overall economic sustainability of the payers of health care, ~ patients and insurers.

In 2008 the US spent 16.2% of its resources [as measured by overall cost of health care as % GDP]. Yet quality in US is consistently ranked lower than Holland, Great Britain and Germany which have “socialized” healthcare systems. In a 2008 survey of quality of Healthcare service provided, the US ranked 37th.

US healthcare is primarily of “fee for service” [FFS] business model. Healthcare providers are paid on the basis of the amount of services they provide. Doctors as entrepreneurs, make money on treatments that they can provide; the more service or drugs they can prescribe, the more money they make. Clearly in a FFS world it is in the interest of Medical service

US HEALTHCARE COSTS:Why US Healthcare is most expensive in world and yet ranks 37th in developed

world in terms of effectiveness

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Since 1960 the cost of healthcare in the United States as % GDP has tripled. The Congressional Budget Office has estimated that in 2025 is expected to quadruple to 24% of GDP, if the business model that has been adopted by the healthcare providers does not change. If unchecked in 2080, Healthcare will consume > 40% of GDP.

It is inherently dangerous for one sector of the economy to account for >40% of national resources, as we saw when the financial system crashed in 2008. By 2008 the US financial system accounted for > 40% of all S&P 500 profits.

The cost of healthcare in the United States is borne principally by employers, who pay premiums to insurers and by individuals who either un-insured or have own insurance.

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This paper examines ways in which patients and insurers can contain healthcare costs.

STRUCTURE OF HEALTHCARE IN US:

The US system as we have discussed is a fee for service system, [FFS]. This business model is a payment model in which services are unbundled each service is paid for separately. In an entrepreneurial healthcare system, it incentivizes physicians to provide more treatments (including unnecessary ones) because payment is dependent on the quantity of care, rather than quality of care. Similarly, when patients are shielded from paying (cost-sharing) by health insurance coverage, they are incentivized to welcome any medical service that might do some good. A variety of reform efforts have been attempted, recommended, or initiated to reduce its influence (such as moving towards bundled payments and capitation, or per capita services).

The table on the left demonstrates the effects of the FFS. The US system essentially costs 3 times for the same healthcare than it would cost a patient in New Zealand, considered one of the top countries in the world for quality of life and living standards.

A simple check up in the US costs double what it costs in Canada or the Netherlands. Canada has the highest quality of life index in the world, and is a developed country.

A hospital visit in America costs three times what a hospital visit costs in France. Many Hospitals in America have extensive art collections on the walls, plush facilities and extra-ordinary overhead expenses, all of which are being paid for by the patient and the insurer.

WHY THE COSTS ADD UP UNDER FFS:

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FFS payments are issued retrospectively, after the services are provided. One of the main features of FFS, is that no cost savings are negotiated for an entire procedure up front. FFS causes an inflationary pressure on costs, as no bundled services can be priced, raising health care costs. FFS also creates a potential financial conflict of interest with patients, as it incentivizes overutilization—treatments with either an inappropriately excessive volume or cost, nor does it incentivize physicians to withhold services. When bills are paid under FFS by a third party, patients (along with doctors) have no real incentive to consider the cost of treatment. When patients “are insulated from the cost of a desirable product or service, they use more", such as endless medical tests, diagnostics and procedures. There is a large body of evidence that suggests primary care physicians paid under a FFS model, tend to treat and refer patients to more procedures than those paid under

capitation or a salary. FFS incentivizes primary care physicians to invest in radiology clinics and perform physician self-referral in order to generate income. This vertically integrated business model creates very large barriers to entry and local heathcare provider monopolies are very common in regions all over the USA. FFS has been a barrier to coordinated care, or integrated care—exemplified by the Mayo Clinic—because it rewards individual clinicians for performing separate treatments. FFS also does not pay providers to pay attention to the most costly patients, ones that could benefit from interventions such as phone calls that can make some hospital stays and 911 calls unnecessary. FFS became the main healthcare business model after WWII when there was need for a business model that could deal with high inflation; thus was born the inflation monster ~ FFS. The familiarity of FFS to doctors and patients in the US is the main reason FFS is seen by many patients as the only or main payment method, [e.g. Medicare is FFS]. Doctors as entrepreneurs want to be reward for output not

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effectiveness, so FFS does just that. The Soviet Union’s economic system also rewarded output not effectiveness in meeting consumer demand. The “heaviest” TV sets in the world were produced in the Soviet Union, because output = weight. So in the US we have the “heaviest” healthcare system, a result of FFS.

It is important to note that General Practitioners have less autonomy after switching from an FFS model to integrated care. Patients, who moved from an FFS model saw their choice of physicians restricted, as was done in the Netherlands in their attempt to move towards coordinated care.

In a business model where physicians cannot bill for a service, it serves as a disincentive to perform that service if other billable options exist. In an electronic referral, for example, a specialist evaluates medical data (such as laboratory tests or examination of images) to diagnose a patient instead of seeing the patient in person; this has been found to improve health care quality and lower costs. The economies of scale of this approach might finally be passed onto the payer of the service, patient or insurer. It should be noted that, "in the private fee-for-service context, the loss of specialist income is a powerful barrier to e-referral, a barrier that might be overcome if health plans compensated specialists for the time spent handling e-referrals".

In Canada, the proportion of services billed under FFS over the period of 1990 to 2010 shifted substantially. Less care was paid out for patients under the age of 55 while for those over 65, payment for diagnostic services was sharply increased.

ALTERNATIVE BUSINESS MODELS:

Capitation: Capitation is defined as a method for paying health care service providers a set amount for each enrolled person assigned to that physician or group of physicians, whether or not that person seeks care, over time, such as lifetime of the patient.

Providers are contracted through health maintenance organizations (HMO) known as an independent practice association (IPA). The providers contract with the HMO to take care of patients enrolled in the HMO.

The amount of remuneration is based on the average expected health care utilization of that patient (more remuneration for patients with significant medical history). Other factors considered include age, race, sex, type of employment, and geographical location, as these factors typically influence the cost of providing care.

MOVING OFF AN FFS SYSTEM:

Proponents of leaving an FFS system argue that this increased efficiency, improved overall quality standards, leading to a better understanding of the economic relationship between costs and quality, cost and volume of services provided. According to a 2002 Juran Institute study, there is no consistent, direct correlation between the cost of care and its quality. The "cost of poor quality" is in effect caused directly by FFS overuse, misuse, and/or waste amounts to 30 percent of all direct health care spending. The emerging practice of evidence-based medicine is being used to determine when lower-cost medicine may in fact be more effective.

Critics of managed care argue that "for-profit" managed care has been an unsuccessful health policy, as it has

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contributed to higher health care costs (25-33% higher overhead at some of the largest HMOs), increased the number of uninsured citizens, driven away health care providers, and applied downward pressure on quality (worse scores on 14 of 14 quality indicators reported to the National Committee for Quality Assurance).

The most common managed care financial arrangement, ~ capitation, places health care providers in the role of micro-health insurers, assuming the responsibility for managing the unknown future health care costs of their patients. Small insurers, like individual consumers, tend to have annual costs that fluctuate far more than larger insurers.

"Professional Caregiver Insurance Risk” describes the inefficiencies in health care finance resulting from the inefficient transfer of insurance risks to health care providers who are expected to cover such costs in return for their capitation payments. As a study by Thomas Cox Ph.D RN (2006) shows, providers may not be adequately compensated for their insurance risks, without forcing managed care organizations to become price uncompetitive vis-à-vis risk retaining insurers. Cox (2010) also shows that smaller insurers have lower probabilities of modest profits than large insurers, higher probabilities of high losses than large insurers, provide lower benefits to policyholders, and have far higher surplus requirements. All these effects work against the viability of health care provider insurance risk assumption.Moving away from FFS towards pay for performance introduces quality and efficiency incentives, instead of solely rewarding quantity.

The famous Mayo Clinic, has among others, offered a system that serves as a coordinated/integrated care alternative to the FFS model. The Pennsylvania Geisinger Health System has a system

where the physicians, residents and fellows are paid a salary with the potential for bonuses depending upon patient performance. Utah's Intermountain Healthcare, the Cleveland Clinic, and Kaiser Permanente also use a coordinated healthcare system in alternative to FFS. However while coordinated care can produce cost savings of ~ 50% when compared to FFS programs, long term savings may be compromised by Physicians wanting higher base compensation because of the loss “volume” business relative to FFS. [See interesting study by Peter Zweifel (March 2011). "Swiss experiment shows physicians, consumers want significant compensation to embrace coordinated care". Health Affairs (Project Hope) 30 (3): 510–518].

ACCOUNTABLE CARE ORGANIZATIONS:

One of the goals of accountable care organizations (ACOs), part of the 2010 U.S. Patient Protection and Affordable Care Act (PPACA), has been to move from FFS to integrated care. ACOs, however, fit largely into a FFS framework, and do not abandon the model entirely, as has been pointed out by John K. Iglehart (April 2011) in "The ACO regulations – some answers, more questions". The New England journal of medicine . This approach suggests policymakers are attempting to avoid provoking public outcry, as happened with managed care in the 1990s by giving providers incentives to give less care. The PPACA aims to first move Medicare away from FFS, then other payers. A Swiss Peter Zeiwfel study showed physicians wanted significant pay raises to leave FFS for an integrated care model, while patients wanted lower premiums before they would choose one, results that hint at difficulties for PPACA aims.

In China—where FFS resulted in costly,

inefficient, and poor quality health care with a degeneration in medical ethics—reforms have been initiated to realign health care provider incentives, see Winnie Chi-Man Yip, William Hsiao, Qingyue Meng, Wen Chen & Xiaoming Sun (March 2010) and "Realignment of incentives for health-care providers in China". The Lancet . Experimentation with new payment models is ongoing with recommendations including a strengthening of medical ethics, alignment of provider's profit motives with patient needs, and, in cases where hospitals retain their profit motive, segregating physicians from the goal of profit.

In the 1990s the move in the US from FFS to pure capitation provoked a backlash from patients and health care providers. Pure capitation pays only a set fee per patient, regardless of sickness, giving physicians an incentive to avoid the most costly patients. In order to avoid the pitfalls of FFS and pure capitation, models of episode-of-care payment and comprehensive care payment have been proposed. In 2009, the U.S. state of Massachusetts (with the then highest

health care costs in the country) had a group of ten health care experts who worked under legislative mandate to come up with a plan to tackle costs (the Massachusetts Payment Reform Commission); they unanimously concluded the FFS model must be done away with. Their plan included a move away from FFS to a global payment system that had similarities to a capitated system. No U.S. state, up to 2009, had attempted to do away with FFS. The Medicare Payment Advisory Commission (MedPAC), in their mid-2011 report to Congress, called for a mechanism so that Medicare beneficiaries would have disincentives to undergo discretionary care, but not needed care.

WHY CONSOLIDATION IN INSURANCE INDUSTRY HAS NOT BROUGHT LOWER COSTS:

One of the mysteries of Healthcare Insurance is why consolidation resulting in larger insurers has not provided lower costs, as we should have expected had the

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Thomas Cox Ph.D RN “case” studies of 2000 2011. Two studies published by Health Affairs, the bible of health policy, document the shortcomings of health industry consolidation.

James Robinson, a professor of health economics, calculates that the top 3 health insurance companies control two-thirds or more of the business in all but 14 states, with numbers reaching as high 92 percent in Maryland and 98 percent in the District and Northern Virginia.

Robinson juxtaposes these numbers with the 2000 to 2003 financial results of the top five national firms. He shows a decline in the percent of each premium dollar that goes to cover medical costs, along with an even stronger trend toward higher premiums, profit and stock prices. While this doesn't prove causality, it certainly raises serious questions about the consumer benefits of consolidation.

Alison Evans Cuellar, an economist at Columbia University, and Paul Gertler, a business professor at the University of California at Berkeley, have also weighed in with their study of hospital mergers two years out. It shows that costs increased, not decreased, that there was no improvement in basic quality measures such as mortality and adverse safety events, and that prices increased 7.7 percent for managed care customers and 4.1 percent for fee-for-service plans.

How do we explain these data?

In the case of hospital mergers, Cuellar states that administrative efficiencies wind up being minimal, while efforts to realize operational efficiency often run into a stone wall of opposition from doctors uninterested in changing the way they practice. That was the undoing of the merger between Mount Sinai and New York University hospitals in New York, she said.

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Meanwhile, the effort to gain negotiating leverage through mergers often proves to be an arms race with no winners. Insurance mergers beget hospital mergers, and vice versa, neutralizing any negotiating advantage.

One result of all this consolidation is the reduced chance of a new entrant coming along to shake things up with a new technology or business model. In a world where giants deal only with giants, that's not likely.

An emerging source of competition has come from regional companies deciding to grow the old-fashioned way, moving into geographically adjacent markets to win new customers. But now that national insurers have gobbled up most of the regional players, there aren't many left. [UnitedHealth's purchase of MAMSI and Oxford in the Virginia/Maryland areas].

As for the newly merged hospital "systems," some -- like Inova Health System's nicely profitable "nonprofit" operation in Northern Virginia -- are now so dominant they have become somewhat immune to competitive pricing pressures.

Others have discovered that they so overpaid for recent acquisitions, or have become so stymied by integration issues, that they have neither the time nor money to leverage the

benefits of size to install computerized record systems or introduce the kind of evidence-based medical practices that hold out the best promise for lowering costs and improving medical outcomes. In the few places where such innovations have taken hold, it turns out that management and culture are the key factors, not scale.

CONCLUSIONS:

There is undoubtedly a need on the part of insurance companies to be pro-active with both patients and healthcare providers so as to formulate a strategy for cost reduction in healthcare.

In the view of the authors of this paper, it is very likely that the very same experience curve effects that exist in any other industry exist for healthcare providers as well. [An example of the “effect” of an experience curve on overall costs is shown overleaf].

We submit that it is likely that healthcare providers have deliberately promoted the FFS business model because it maximized revenues, while allowing them

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to “privatize” almost all the gains from “experience effects” for the provider.

In order to reduce the rate of increase of healthcare costs for patients, it is essential to begin to move the industry off FFS and to a capitation business model. Employers are pushing this change of business model, as the healthcare insurance costs are the highest benefit cost facing employers.

Many employers like for example Pitney Bowes who have a young healthy hourly work force, are insisting that these employees do not opt out of healthcare coverage while at the same time promoting a form of capitation.

For more than a decade Pitney Bowes has provided subsidies that make coverage more affordable for lower-wage workers. It seems to work: 78 percent of U.S. employees opt for health coverage at Pitney Bowes. Starting this year, the company took a step that ties health coverage costs even more closely to pay. In its consumer-directed health plan, the company sets the deductible, out-of-pocket maximum and company contribution based on salary. Hourly workers, for example, have a $1,500 deductible and $3,000 out-of-pocket maximum, while employees at the director

level or higher have a $2,500 deductible and $5,000 out-of-pocket maximum.

How to drive a patient and provider to accept these types of new business models, and how to reconcile the conflicting priorities of patient needs, health-insurers and the profit motives of health care providers is the subject for another paper.

Gnostam LLC

Philip CorsanoPatrick Kelly

Bibliography:

Gosden T, Forland F, Kristiansen IS et al [2000] “Capitation, salary, fee-for service and mixed systems of payment: effects on the behavior of primary care physicians, Cochrane Database Syst. Rev;Thomas Bodenheimer [March 2008] “Coordinating care – a perilous journey through the healthcare system” The New England Journal of Medicine [358-10];Medicare Option in Biden Budget talks get a boost. NPR, Associated Press June 2011;Rachel Mendleson [Oct 25th 2010]. “The worst run industry in Canada – Healthcare. Canadian Business;Phil Galewitz: Jordan Rau and Bara Vaida [March 31st 2011]. Accountable Healthcare expected to save millions, Kaiser Health New, [McClatchy];Peter Zweifel, [March 2011] “Swiss Experiment shows that physicians, consumers want significant compensation to embrace coordinated healthcare, Health Affairs, [Project Hope] 510-518;

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Diagram of flows of a FFS Business Model

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Debt Explosion in US is not unique. See European experience in graph below, in part because of unfunded liabilities in the public healthcare sector.

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Differening share of Profit and Labour 1947 to 2011United States

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Gnostam LLCPO Box 960Inverness, CA 94937 USA

E-mail: pcorsano@gnostam.com

www.gnostam.com

Disclaimer:

The information and any statistical data contained herein have been obtained from sources which we believe to be reliable, but we do not represent that they are accurate or complete, and they should not be relied upon as such. All opinions expressed and data provided herein are subject to change without notice. Gnostam LLC and/or its shareholders, directors, officers and/or employees, may have long or short positions or deal as principal in the securities discussed herein, related securities or in options, futures or other derivative instruments based thereon. The securities mentioned in this report may not be suitable for all types of investors. ALL investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made by the Gnostam LLC. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment and we are expressly prohibited from guaranteeing accounts against losses arising from market conditions.

Past performance is no guarantee of future results, and current performance may be lower or higher than the performance data quoted.

Investment Disclaimer All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made. All products sold are subject to market risk and may result in the entire loss to the client's investment. (For example: excessive withdrawals may result in the depletion of your account). Please understand that any losses are attributed to market forces beyond the control or prediction of Gnostam LLC. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment and we are expressly prohibited

January 31st, 2012 Newsletter

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