A modern HMO - using economies of scale

This is the hard part. Gekko knows the health care crisis has persisted despite the strong efforts that have been made for decades to reduce health care spending. But he is confident. The key element that was missing from those prior efforts has now been supplied – the profit motive. Gekko – or rather, FTP – gets to keep whatever money it saves. What a wonderful way to concentrate the mind! He is sure he can find ways to cut costs.

Furthermore, the health care crisis itself will be very helpful to him, in that it provides him with some very useful cover. The need to trim the cost of health care gives him an acceptable reason to make cuts that might otherwise be unacceptable. And the mandate not to reduce the quality of care gives him an excuse to keep his premiums as high as he can. (If we cut our premiums too much, he can say, quality will suffer.) Confident that he has a lot of latitude, Gekko develops a strategy for minimizing his cost of doing business.

Right off the bat, Gekko can think of three general strategies for keeping the money he collects. He can grow FTP in order to take advantage of the economies of scale; he can act to avoid as much financial risk as possible; and he can act to gain control of the behavior of the physicians on FTP's physician panel.

Using economies of scale

Gekko resolves to grow FTP rapidly by acquiring major health care facilities (hospitals and nursing homes) in all its key cities of operation. Then, using the clout that goes along with being big, he will negotiate very favorable purchasing agreements with all his major vendors. He will be able to reduce pharmacy costs, for instance, by having the major pharmaceutical houses “bid” to have their drugs included on the limited FTP drug formulary (a list of drugs approved by FTP). And, he will be able to save on management costs by firing the layers and layers of old-fashioned administrators in FTP hospitals, and replacing them with streamlined management teams made up of his own people, using standard FTP operating policies and procedures. There are so many advantages to being big that Gekko resolves to expend a lot of energy in becoming as big as possible as quickly as possible.

Acquiring community assets

Along the road to becoming big, Gekko stumbles upon a gold mine. It is a gold mine not directly related to FTP’s scope of business, but it’s close enough.

The first time Gekko acquires a community hospital for FTP, he notices that within a week of the transaction the price of FTP’s stock rises by 5%. What he has just done, he realizes, is to cash in on a publicly-owned asset. So Gekko tries it again, and this time the stock rises by 7%. Gekko’s head spins. This scheme threatens to become such a windfall that Gekko momentarily worries that it might overwhelm the real business of FTP. The profits promise to be so astounding, however, that he decides not to worry about it.

Gekko is right. It’s a great scam, and completely legal to boot.

Non-profit hospitals exist in the first place because their communities decided they were needed for the public good. Accordingly, these hospitals were established under the nonprofit laws, which required them to be used solely for charitable purposes. Over the decades and in return for their service to the community, these hospitals have operated under the public largesse, in the form of their blanket tax-free status, their ability to raise tax-free bonds, and their ability to raise tax-free charitable contributions. Their boards of trustees, made up of prominent members of the community, were charged with guarding the accumulated public value represented by those institutions.

The widespread transfer of not-for-profit public assets (such as a community hospital) to for-profit corporations (such as an HMO) is a relatively recent phenomenon, fueled by the Gekkonian notion that for-profits are inherently more efficient. Such transfers only occur at the urging of the community hospital’s board of trustees, and must be overseen by either the state insurance commissioner or the state Attorney General. That state official, if he or she approves the conversion, is expected to put a formal dollar value on the hospital. The HMO then must reimburse the community for that amount, usually by establishing a charitable foundation.

It is a procedure that might be acceptable in theory. In practice, however, all too often the hospital’s board (the entity that recommends the transfer in the first place) might permit, or even encourage, a low valuation for their hospital. Also, state insurance commissioners seem congenitally unable to establish an accurate value for non-profit hospitals. In doing those valuations, for instance, they consider only the tangible property values. They ignore (and neither the hospital’s board nor the HMO insists on pointing out to them) the value of many of the assets owned by the hospital such as trademarks, reputation and name recognition, provider contracts and subscriber lists. The commissioners don’t insist on going through a competitive bidding process or conducting a formal market valuation. In fact, only the hospital’s value as a charity, and not as a business, is considered. And for some reason insurance commissioners often also seem quite happy to do the negotiations behind closed doors, and with no public disclosure.

Within six months Gekko establishes a routine for acquiring community hospitals, and it works like this. First, the hospital’s board of directors see fit (often induced by stock options or offers of directorships with FTP) to severely underrepresent the value of their institution to the insurance commissioner. The insurance commissioner then approves the transfer to FTP at a low valuation rate. Then, after the hospital becomes a hard asset of FTP, its true value is established by the open market as reflected in the price of FTP’s stock. Almost invariably, that value is orders of magnitude greater than the value set by the insurance commissioner. So, without doing a thing to improve the quality of care or to reduce the cost of care, FTP’s market value soars – and all at the expense of the public.

It’s a win-win. During Gekko’s first 12 months at the helm of FTP, not only does the company’s stock go through the roof, but also Gekko acquires key medical facilities in all his cities of operation (which he’s now expanded to 15). He is able to begin instituting all his efficiencies of scale. More importantly, he finds he is able to begin significantly influencing the health care markets in most of those cities, and consequently controlling the behavior of even the most recalcitrant of physicians (who find they now have to deal with FTP whether they want to or not).

Next: Avoiding risk

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