American Journal of Law & Medicine

Insurance regulation of providers that bear risk.(Health Care Capitated Payment Systems)


The emerging king of the new health care order is capitation. "Whoever controls the capitated revenue stream will be poised to dominate the emerging health care delivery system--and to reap an enormous windfall that could total hundreds of billions of dollars."(1) Accordingly, we are witnessing a tremendous struggle over the locus of capitation. Once firmly ensconced in the insurance and HMO industry, capitation is now spreading to organizations controlled by doctors and hospitals.

In a world littered with countless acronyms and organizational types--HMO, IDS, MCO, EPO, PHO, IPA, PSN, OWA(2)--we are most reluctant to introduce yet another. But we must. None of the existing terms describes an important aspect common to all of them that is the subject of this article--providers bearing financial risk for medical expenses. We call these Risk-Bearing Provider Groups (RBPGs). The most prominent example of an RBPG is a physician-hospital organization (PHO),(3) which consists of at least one hospital and one physician practice group that accepts partial or full capitation for at least some of its patients.(4) Accepting capitation risk is not essential to being a PHO, but is a common characteristic. PHOs seek to maintain the financial center of gravity in a provider organization as insurers and employers increasingly come to dominate health care delivery. PHOs can do this by contracting directly with employers on a fully or partially capitated basis, thereby by-passing insurance companies. They can also subcontract with insurance companies or HMOs--so-called "downstream" capitation. Accepting treatment obligations under financial risk helps providers maintain their professional and institutional autonomy and offers the prospect of capturing some of the financial rewards created by the market restructuring that is presently sweeping the country.(5)

When they first emerged in the late 1980s, PHOs and other RBPGs were largely free from insurance regulations and other types of restrictions that govern HMOs and traditional insurance companies. This is because regulators frequently classify organizations by how the organizations define themselves rather than by the actual functions they perform. States are now beginning to recognize that RBPGs pose a significant potential for financial insolvency that could leave subscribers without a source of medical care. This concern is the central focus of this Article. The Article explores whether RBPGs should be regulated by the financial solvency standards governing traditional insurers and HMOs, or by a unique set of standards. Part 11 outlines the competing interests in consumer protection and market restructuring, and articulates the conflicting positions of insurers and providers. Part 111 undertakes a detailed analysis of whether existing laws and regulations can adequately regulate RBPGs and protect consumers. In particular, this section examines whether RBPGs should be regulated as insurers or HMOs or whether they require a specially tailored regulatory scheme. Since specially tailored laws almost always win out in these kinds of contests, it is no surprise that this is the option we favor; and in Part IV, we outline what we think is a very promising approach to regulation of RBPGs being developed by the National Association of Insurance Commissioners (NAIC).



Although comprehensive health care reform died in Congress two years ago, reform is thriving in the private market place. Driven by employers' desire to control costs, health insurers are increasingly turning to managed care techniques, such as exclusive contracting and utilization review, that may help contain costs but threaten doctors and hospitals with loss of revenue and autonomy. According to Ed Hirshfeld, an associate general counsel with the AMA, "[t]he risk is that doctors will become labor,"(6) working for giant insurance companies rather than for patients. In response, hospitals and doctors are forming networks either that attempt to circumvent insurers, or that force insurers to negotiate with them en masse. The stand-alone hospital and the individual physician practice are slowly going the way of the dinosaur.(7)

At present, these provider networks are often paid on a fee-for-service (FFS) basis, but increasingly they are agreeing to treat or insisting on treating patients on a capitated basis. A capitated payment system establishes in advance a fee per member that does not vary according to how much care each member requires. In exchange for this set fee, the health care organization agrees to provide all of the care, or a defined portion of that care, needed by the member during the period covered by the fee. This gives the provider a profit-based incentive to economize. As more and more providers realize the benefits of capitation within the reality of the current market, more and more Americans will find themselves in insurance plans with provider capitation.(8)


The same financial risk that motivates providers to economize can also cause provider groups to go bankrupt. Financial risk can lead to financial ruin, which could result in subscribers being left without a source of treatment. The primary protection against this risk is for capitated systems to maintain sufficient capital reserves to prevent poor financial performance from causing insolvency.

For many years capitated payment systems have caused few insolvency problems because the insurance companies and HMOs bearing the financial risk were regulated by insurance solvency laws. Regulators and industry standards require insurers and HMOs to maintain enough capital reserves to offset possible operating losses.(9) This assurance does not presently exist for many RBPGs. They are covered only erratically by the insurance solvency requirements that govern insurance companies and HMOs. Inconsistent regulation of RBPGs raises "concerns about the adequacy of consumer protection and the fairness of the competitive environment for all health plans."(10) "Many state regulators are uncertain how to deal with the hybrid creatures, and are waiting for direction from their legislatures."(11) Some states do not assert jurisdiction over PHOs at all, others only in certain circumstances, and many do so only in theory but not in practice. And, when they are regulated, there is general confusion over how to do so.

A survey conducted by the Group Health Association of America (GHAA)(12) polled regulators in all fifty states to determine whether RBPGs are, or in their opinion should be, regulated in their states.(13) The surveyors divided potential RBPG business arrangements into four categories according to the source and extent of risk. "No Risk" contracts are on a FFS basis; "Full Risk" exists when the provider group accepts capitated payments directly from the subscriber/employer; "Partial Risk" is when the provider group contracts with the employer to stay within a budget but is responsible for losses only ten percent greater than that budget; and "Downstream Risk" is when the provider group contracts on a capitated basis with an HMO or insurer rather than directly with the consumer/employer.(14) The results are summarized in the following chart:

               Regulation or     Unclear     No regulation 
               licensure                     or licensure 
               required                       required 
No Risk           2                 8            41 
Full Risk        41                 9             1 
Partial Risk     25                25             1 
Downstream        2                22            27 

Based on this response, one would think that RBPGs are widely regulated in the states. One must realize, though, that this chart reflects only the opinions of state regulators about whether RBPGs are subject to regulation under state laws and not whether they have in fact imposed regulation. The reality is that "[w]hile 41 states claim that they would require licensing in circumstances where PHOs are assuming full capitation, . . . in those states few risk-bearing PHOs, if any, appear to have been licensed."(16) "In most instances where state regulators said they require licensure, [the surveyors asked] can you list examples where you've required licensure of a PHO, [and they] were surprised with the lack of specifics."(17)

The absence of actual regulatory oversight creates the possibility that the costs of services will be greater than the amount of capitated fees charged, leaving RBPGs insolvent and the members of the network without care. Actual insolvencies of this nature have occurred several times in the past with other prepaid care arrangements. Bankruptcies have plagued Medicaid programs that suddenly shifted to managed care on a massive scale. This occurred in California in the 1970s and in Arizona in the 1980s,(18) and it is threatening to happen again in Tennessee in the 1990s.(19) Some of these bankruptcies were the result of fraud or corporate mismanagement, but others were due to provider groups honestly promising more than they could financially deliver.

These failures did not leave any patients stranded because they occurred in government-funded programs. But similar failures in the private sector did expose the dangers of no regulation. In the 1980s, a new form of group insurance arose known as Multiple Employer Welfare Associations (MEWAs). MEWAs aggregated individuals and small employers into larger groups to spread risk and obtain cheaper insurance. In many instances, the aggregating entity itself bore the insurance risk by creating a group policy on a self-insured basis. Under this arrangement, the insurance company is only a claims processor; for an administrative fee, it writes checks payable out of the association's bank account. State insurance regulators ignored this development to their peril; in a number of states, MEWAs went bankrupt as a result of mismanagement or fraud.(20) Because the middleman in these transactions was unregulated, the end consumer was left without any effective remedy for obtaining coverage or recouping lost premiums.

According to Jeffrey Kang of HCFA's Office of Managed Care, almost all of the two dozen managed care plans that have failed in the past fifteen years have been plans dominated by providers. In his view, these plans failed because "they did not have the experience to manage risk or adequate capitalization for startup, marketing, and other functions."(21) The same conditions that led to these failures--sudden changes in the market spawning new organizational forms run by people without experience or training in actuarial principles--characterize RBPGs to a remarkable degree.


1. Providers' Concerns

The unfortunate side-effect of insurance regulation is that it may severely limit or foreclose the entry of some new types of organizations into the market, thereby frustrating the primary goal of market reform--to contain health care costs. Market reform seeks to lower costs through increased competition. Theoretically, the more health care players in the market offering capitated payment plans, the lower the price of the plans should be.(22) Therefore, the entry of new types of delivery systems should be encouraged for cost-containment reasons, and, incidentally, to make health benefits more accessible to consumers.

Excessive regulation may stifle the portion of market reform being driven by providers and close off an innovative method of health care financing and delivery. For example, regulation that forces provider networks to avoid assuming risk, or forces such groups to organize as, or affiliate with, traditional insurers and HMOs, may discourage providers from forming their own networks. The goals of market reform are not only to achieve cost containment within existing institutions, but also to encourage the creation of new, more effective institutions for combining the treatment and financing functions. In the 1970s, this occurred through the formation of HMOs, but at present the market is also generating PHOs and IDSs.

These organizational types share many characteristics, but they are not cut from a single mold. HMOs are usually large, operate regionally or nationally, and run under a traditional corporate hierarchy. Many observers and purchasers think locally based organizations that are controlled by providers would be more trustworthy and desirable. Forcing these new organizations to become conventional insurers and HMOs could tilt the competitive playing field against doctors and hospitals and undermine one of the central advantages of market reform.

Requiring RBPGs to abide by insurance and capital reserve regulations may demand more capital than these groups can realistically obtain. Currently, RBPGs are relatively inexpensive to establish; some estimates suggest physicians could form a PHO "for as little as $50,000,"(23) But start-up costs for more tightly integrated and regulated health care organizations range from $7.9 million to $30 million,(24) a figure that many provider organizations cannot come close to matching. Unlike large corporate insurance companies and HMOs, hospital and doctor groups are not endowed with a great pool of liquid capital assets. Even the deeper pockets of most hospitals will not be deep enough to meet some of the proposed capital requirements. Most hospital assets are tied up in physical plant and equipment costs and so are not readily available to cover financial losses. Furthermore, although physicians have the reputation of being financially well off, this is true only in comparison with other workers. Compared with corporations, most physicians are not wealthy and do not, individually, have the capital resources to meet regulatory requirements. "The result is a Catch-22 for undercapitalized physicians trying to enter the market. 'It's circular: To build an integrated system, you need substantial capital. But those capital resources are only produced by [organizations] that are large and wealthy to begin with.'"(25)

Even when physicians have substantial assets, they are usually not required to invest them in emerging PHOs. To the contrary, capital often flows to, not from, the member physicians as hospitals bid for their affiliation. Physicians' main assets in a PHO venture are their individual, professional expertise and personal relationships with patients.

A legal regime that favors all but the largest, most integrated, and best financed organizations could produce an oligopoly of corporate-controlled institutions rather than atomistic competition among professional groups. Elimination of market participants is never good, but the creation of a regulatory environment that permits only survival of the largest has particularly negative consequences in the health care industry. The population needed to support a large health care organization may exist only in urban areas. Elimination of smaller organizations may inflict a special hardship on smaller towns and rural communities. A large health care organization might be able to serve smaller areas only on a FFS basis, but a smaller RBPG might, in the proper regulatory environment, operate quite well there on a capitated basis.

Even if subjecting RBPGs to HMO and insurance regulation does not force them out of existence, it may force provider groups to eschew any risk-bearing function. This may seem preferable to providers having a profit motive to deny treatment, but the reality of resource limits must somehow be brought to bear on those who make treatment decisions. If resource limits are not internalized within provider organizations, they will be imposed from external sources. Many people would rather their doctors decide in cooperation with them where to draw the line on individual items of treatment than for categorical limits to be set by insurers or other corporate bureaucrats.(26)

Moreover, making it difficult for provider groups to bear insurance risk sends legal and regulatory signals that are inconsistent, or perhaps flatly contradictory, with other laws.(27) In particular, the antitrust laws make it difficult for physician groups to form that do not assume insurance risk. The antitrust laws tend to treat as per se illegal price-fixing any financial discussions or agreements among providers that are not organizationally and economically integrated. …

Log in to your account to read this article – and millions more.