American Journal of Law & Medicine

Regulation of "downstream" and direct risk contracting by health care providers: the quest for consumer protection and a level playing field.


As the delivery of health care continues to be driven by the search for an

effective means of reducing costs and delivering quality care to the greatest

number of people, the industry's most beloved buzzword, perhaps ironically, has

a root suggestive of a focus on the individual: capitation.(1) Capitation is

widely regarded as a method of realigning economic incentives to produce fair

prices, real value, reasonable profits and predictable growth in Costs.(2)

Beyond being a mere payment mechanism, though, capitation represents a

philosophical shift to an accountability approach for health care delivery,

whereby focus is increasingly directed on prepayment of capitated amounts to

risk-bearing delivery Systems.(3) Theoretically, the premise makes a great deal

of sense: to achieve optimal levels of care delivered and costs expended,

incentivize persons or entities with the capacity to affect such levels so that

economic reward follows effective management of resources.

Placing, for the moment, faith in the innovative capacities of the

marketplace to seek out new and improved ways of delivering health care, the

evolution of the capitated arrangement indicates that what makes sense in

theory may also make sense in practice. As capitation becomes the dominant form

of payment within the United States health care arena and emerges as an

effective tool for cost savings and efficient delivery of care, providers and

insurers alike are now appreciating the overwhelming dollar amounts that will

be represented by the capitated flows.(4) It is now clear that controlling

capitation means controlling an increasingly large amount of money. Naturally,

what follows is that competing interests -- most notably, health maintenance

organizations (HMOs), insurance companies, and providers -- now vie for command

of capitation.

This Article examines regulatory attempts to monitor provider-driven efforts

to gain control of capitated premiums. Regulators seeking to tether

entrepreneurial physician groups must maneuver through a maze of contractual

arrangements, by which varying portions of the capitated dollar and inhering

risk are transferred, in search of providers undertaking what amounts to

"insurance risk." Provider-sponsored organizations (PSOs) are assuming risks

previously limited to insurance companies and HMOs,(5) and now state insurance

regulators are scrambling to determine to what extent these organizations may

be regulated under state authority. The ongoing debate that now rages, as

regulators struggle with PSOs and search for a consistent rationale for

regulating these risk-bearing entities, calls for inquiries into the very

nature of capitation and its place in relation to traditional insurance and the

purview of state oversight.

This Article's analysis of the controversy surrounding the regulation of PSOS

proceeds in several parts. Part I sketches some of the various arrangements

developing in the health care marketplace, with particular emphasis on the

"downstream" and direct contracting in which PSOs have become involved. Part II

provides insight into the nature of insurance regulation, including how it may

restrict the risk-bearing activities of PSOs. Part II also introduces the

complicated and contentious provisions of the Employee Retirement and Income

Security Act of 1974 (ERISA),(6) along with relevant case law dealing with the

preemptive effect of specific ERISA provisions(7) on the regulatory efforts of

state insurance commissioners. Part III outlines some of the approaches taken

by different states searching for a coherent regulatory scheme that can account

for the dynamic nature of PSO risk contracting. Part IV assesses sundry

arguments regarding the regulation of risk-bearing PSOs, devoting special

attention to a recent draft white paper of the National Association of

Insurance Commissioners (NAIC)(8) and the representative stance of that

organization. Part IV also evaluates provider and employer responses to the

NAIC and other views, in an effort to distill the essentials for effective

regulatory development. This Article concludes that, absent further federal

legislation, state insurance regulators would be best advised to limit their

efforts to regulate PSO arrangements so not to impede cost-cutting and

innovative market advances made by provider organizations. Nevertheless,

congressional intervention in this complex and increasingly crucial area of

health law is needed to permit PSOs to proceed with new and improved mechanisms

for both delivery and insurance of health care.


Understanding the controversy surrounding the regulation of risk-bearing PSOs

depends on recognizing the types of provider organizations involved and the

nature of the risks they are assuming in the health care marketplace. Because

the market is changing so rapidly, and because the entities involved and the

payment arrangements utilized can vary so greatly, it is essential initially to

flesh out who is involved and what objectives they have.

A. The Entities: Provider-Sponsored Organizations

Until only recently, traditional indemnity insurers dominated the health care

insurance market.(9) HMOs(10) now play a major role in both health care

delivery and insurance, and they are expected to continue to do so in the near

future.(11) Doctors and hospitals have now begun to recognize, however, that

the shift from fee-for-service (FFS) to capitation has placed them in a unique

position to reap some of the monetary rewards generated by industry wide

cost-cutting efforts.(12) The doctors and hospitals -- the "providers" -- are

fighting back by forming large organizations and networks to increase their

bargaining power relative to insurers and HMOs.(13) These provider-run

entities, generically termed PSOs, are the source of much controversy.(14)

Physician-hospital organizations (PHOs) are joint ventures between hospitals

and physicians established to create a single marketing and contracting

entity.(15) PHOs bring hospital and physician providers together in a separate,

vertically integrated enterprise for delivering health care in a managed care

environment.(16) Thus, a common characteristic, though not an essential element

of PHOS, is the acceptance of capitation risk.(17) PHOs are usually created to

develop cooperative relationships between the parties while allowing for

flexibility, in terms of both organizational structure and capacity for a

variety of activities and growth.(18) Individual (or, independent) practice

associations (IPAs) are provider organizations that contract with payors on

behalf of a group of providers to provide health care services.(19) These types

of PSOs operate to bring together otherwise separate providers, usually

physicians, in an affiliated manner to provide health care.(20) Most often, the

IPA will take the form of a legal entity, such as a professional corporation or

professional association, which is separate from the medical practice

organizations of the individual providers.(21) IPAs allow physician practices

that are otherwise too small to be competitive in the marketplace, to integrate

moderately and access managed care contracts.(22) Although not usually

organized to engage in the practice of medicine, IPAs can be structured both to

practice medicine and to take capitation payments.(23)

Besides PHOs and IPAs, a variety of other entities are structured and

function in a manner that they too can properly be classified as PSOs. Group

practices, for instance, are physician groups that provide health care services

and share income and expenses.(24) Preferred provider organizations (PPOs),

which contract with a network of providers who deliver services to enrollees

and set charges based on a negotiated fee schedule, may operate as PSOs.(25)

Among some of the other entities that can be classified as PSOs, depending on

how they are structured, how they operate, on who is describing them, are:

physician organizations, integrated delivery systems, provider-sponsored

networks, HMOs,(26) organized delivery systems,(27) integrated delivery and

financing systems,(28) limited service provider networks,(29) alternative

health care delivery and financing systems,(30) integrated service networks and

community integrated service networks.(31)

Arcane nomenclature notwithstanding, the impact of PSOs is now difficult to

deny. In a September 1996 report, the 202 PSOs surveyed covered more than ten

million lives in forty states and generated total revenues greater than four

billion dollars.(32) The survey also found that most PSOs were relatively new

ventures.(33) As individual entities, however, the PSOs surveyed neither

generated great profits nor covered large numbers of enrollees.(34) Assuming

current market trends, these organizations should continue to develop, improve

operations and gain further acceptance in the marketplace.(35)

Although PSOs are not overwhelmingly profitable at this stage and, indeed,

some will continue to struggle or even fail,(36) PSOs Seem to keep

proliferating. This proliferation seems to support a growing body of evidence

showing that delivery networks perform most effectively when they are lead by

providers.(37) Other evidence indicates that salaried physicians are less

productive than self-employed physicians, thus implying that potential benefits

exist in creating PSOs.(38) Hence, for our purposes, identifying and

implementing an appropriate level of insurance regulation for PSOs might

suggest that regulatory obstacles such as licensing and reserve requirements

actually have a deleterious effect on provider-driven attempts to introduce

competitive products into the health care market.(39)

B. Risk-Transferring Arrangements

1. PSO Arrangements

PSOs operate in such a way that the customary distinction between "providers"

and "insurers" quickly disintegrates.(40) This phenomenon occurs largely because

capitation is creating the opportunity for providers to assume risk in managed

care contracts.(41) By assuming a degree of risk, PSOs begin to look much like

insurers. Capitation creates an environment in which, to the dismay of many

state insurance commissioners, it becomes difficult to distinguish between

appropriate performance incentives and the provision of insurance.(42)

Given the highly competitive and fluctuating markets for health care delivery

and insurance, PSOs enter into contractual arrangements that represent varying

methods of payment.(43) Comprehending the payment methods, replete with

risk-sharing mechanisms, is essential to classifying the nature of the risks

that contracts transfer.(44) Prior to contemplating the appropriate level for

PSO regulation, though, one must first gain a sense of the different

arrangements shaping the market environment.

As PSOs become larger and begin to compete with the more sophisticated

insurance companies and HMOs in the marketplace, PSOs will enter into contracts

and financing structures that are more complex than the basic FFS arrangements

that were once the norm.(45) These arrangements include payment mechanisms

ranging from capitation arraignments with licensed insurers or HMOs to full or

partial risk-sharing with employers.(46)

PSOs may contract with HMOs, Blue Cross and Blue Shield plans, traditional

indemnity insurance companies or employer groups to provide health care

services.(47) Within these contracts are a wide range of payment methods, which

vary according to both the form of managed care arrangement and the

provider.(48) For example, risk arrangements with primary care providers often

involve capitation, global fees, withholds, risk pools and bonuses.(49) By

contrast, arrangements with specialty physician and hospital providers

encompass a broader spectrum of payment mechanisms, each involving differing

degrees of risk transfer.(50)

2. Classifying Risk in Payment Arrangements

Breaking down the risk-transfer arrangements into downstream contracting and

direct contracting is essential for analyzing both sides of the regulatory


It is useful to break down the various payment methods into categories based

on the nature of the risk transfer involved. These categories help isolate the

regulatory issues raised by different contractual arrangements. In a notable

PHO survey, the Group Health Association of America (GHAA)(52) evaluated four

categories of business arrangements into which PHOs may enter.(53) "No risk"

contracts exist when PHOS contract directly with employers on a FFS basis for

all medical services.(54) In these instances, employers retain full insurance

risk for the cost of employee medical services.55 In "full risk" arrangements,

PHOS again contract directly with employers, but here the PHOs are paid on a

capitated basis for the provision of all medical

services employees should require.(56) "Partial risk" contracting exists when

PHOs contract directly with employers and agree to stay within a budget

allocated to pay for all medical services.(57) Depending on whether the PHO

stays within the budgeted amount, the providers either will be liable for any

excess expenses up to 10% above the allotted amount or will be able to split

with the employers savings generated.(58) Finally, "downstream risk" exists when

PHOs contract directly with licensed HMOs or insurers, rather than with

employers, and are paid on a capitated basis.(59)

3. Downstream and Direct Contracting

Downstream contracting includes arrangements between PSOs and licensed

insurers, such as HMOs or PPOs, whereby the PSOs act as subcontractors and

accept risk transferred from the insurance entities.(60) By assuming risk

downstream from the "upstream" licensed entities, PSOs hope, by retaining

portions of capitation streams, to remain competitive in the marketplace.(61)

PSOs' downstream risk contracting may give them enhanced market power

without contracting with employers and assuming risk directly from them. By

using upstream insurers as intermediaries, PSOs can avoid possible pitfalls in

becoming directly involved with employers, including lack of organizational

discipline, insufficient management expertise and incomplete infrastructure for

bearing risk.(62) Downstream arrangements may also aid PSOs that lack the

geographic reach to satisfy the health care needs of a direct contracting

purchaser.(63) From a strategic business perspective, PSOs can prefer

downstream contracting to direct contracting, which breeds conflicting

cooperation and competition survival tactics with larger area health plans.(64)

Perhaps the most substantial barriers keeping PSOs from acting as direct

contractors, as will be discussed, are the significant capital requirements and

regulatory hurdles.(65)

Direct contracting, which arises in three of the four categories in the GHAA

survey,(66) involves agreements between a PSO and individuals, self-insured

employers or other unlicensed groups.(67) These arrangements may involve no

risk, full risk or partial risk transfers.(68) Direct contracting arrangements

with self-insured employers that include full risk or partial risk transfers

are perhaps the most controversial of the risk-bearing PSO contracts.(69)

Direct contracting is crucial to entrepreneurial PSOs because it allows them

to bypass insurers and HMOS and to assume risk directly from employers. PSOs

have, since the early 1990s, been using various forms of risk-transferring

agreements to take on full or partial risk from licensed HMOS and indemnity

insurers.(70) Currently, however, PSOs are becoming involved in direct

contracts with self-insured employers who are exempt from obtaining a state

insurance license because they are regulated under ERISA; and PSOs in some

instances are developing their own insurance products, insurance companies or


Thus, PSOs in various forms are actively seeking to adapt to the capitated

payment system, doing so through a potpourri of risk-transferring mechanisms.

Using both downstream and direct risk contracting arrangements, allows provider

organizations the opportunity to compete with indemnity plans and HMOs and to

regain some of the control they have lost to these insurance entities. But this

PSO activity raises considerable controversy, because PSOs do not readily fall

within the ambit of traditional insurance regulations in many states and

because they are increasingly bearing more risk and assuming larger chunks of

capitated payment streams relative to the insurers and HMOs they now

resemble.(72) To what extent risk-bearing PSOs should be covered by state

insurance regulations, then, is a serious issue.



The responsibility and authority for regulating insurance lies primarily

with the states.(73) Thus, states must regulate entities that bear health

insurance risk, such as risk-bearing PSOs.(74) State regulators are charged

with three tasks: (1) identifying the numerous species of risk-bearing entities

operating in the health insurance market; (2) determining whether each species

involves "insurance risk" or the "business of insurance"; and (3) deciding

which entities to regulate.(75) These are not easy chores to complete, for, in

many cases, they force a re-thinking of some of the most fundamental rationales

for regulating health insurance and require action consistent with the overall

regulatory climate and objectives.(76) Furthermore, when PSOs contract with

certain self-insured entities, regulating provider organizations is further

complicated by ERISA's potential preemptive effect on state laws.

This section of the Article examines the principles underlying state efforts

aimed at regulating health insurance, including certain risk-bearing activities

now being undertaken by PSOs. A preliminary review of some foundational

philosophies supporting health insurance regulation provides a context for

assessing what states may reasonably regulate as insurance risk and the

business of insurance. This Article then parses ERISA statutory provisions and

case law to determine ERISA's preemptive effect before ultimately analyzing

justifications for states' regulating the more controversial downstream and

direct contracting PSO arrangements.


1. Insurance Regulation

Each state has the ability to regulate the "business of insurance," as

clarified by the McCarran-Ferguson Act.(77) State insurance regulations are

typically based on market regulation(78) -- ensuring fair and reasonable

insurance prices, products and trade practices, and solvency

regulation -- protecting policyholders against the risk that insurers will not

be able to meet their financial obligations.(79) Market regulations include,

most prominently, rates and policy from regulation and market practice

regulation.(80) Solvency regulations, the more problematic form of regulations

for the purposes of the issues raised, encompass minimum capital and surplus

requirements, financial reporting requirements and solvency monitoring.(81)

Capital standards may arguably be the linchpin of solvency regulation,(82) and

that these standards seem to end up in the middle of the debate over PSO

regulation is not surprising.

Two fundamental concerns are motivating factors for state health insurance

regulators: consumer protection and a level playing field.(83) Insurance

regulators view their role in regulating health insurance as both ensuring that

the public is protected against insurer insolvency, and encouraging competition

among health insurers to lower the overall cost of health insurance.(84)

Depending on the view one takes about the proper function of health insurance

regulation, the goals of consumer protection and maintaining the fairness of

the competitive environment may create conflicting concerns.(85) Nonetheless,

state laws typically operate to balance these competing concerns, to the extent

they can, by requiring insurers and managed care entities to cover certain

mandated benefits, to maintain solvency standards, to include required

contractual language in written policies and to fulfill access and reporting


Before establishing authority over certain entities or activities, state

insurance regulators must make a threshold determination as to which entities

assume insurance risk and thereby engage in the business of insurance. Only

after defining the scope of the industry shibboleths can one examine which PSO

activities may fall under a state's regulatory umbrella.

2. "Insurance Risk" and "Business of Insurance"

Distinguishing insurance risk from other types of risk is crucial to

understanding states' abilities to regulate activities as the business of

insurance.(87) Although the word risk is often used generically to denote

exposure to the chance of loss,(88) the term insurance risk takes on a more

specific meaning.

To diminish the costs associated with a given risk, parties can choose to

establish what may loosely be described as a contract of insurance.(89) For

example, one party, the "insured," may choose to transfer all or part of a

given risk to another party, the "insurer."(90) In this type of transaction,

the party that assumes the risk also agrees, in exchange for a premium payment,

to perform some function in the event that the risk occurs.(91) The insurer

quite often assumes the unknown, future levels of risk faced by a number of

insureds and "pools" the risks together in order to spread each risk across the

group.(92) The insurer establishes a proper price for risk assumption and

calculates loss experience actuarial probabilities, hoping the premium payments

received will be ample to cover the costs associated with the risks assumed and

provide a fair profit.(93) The risk that is transferred from the insured to the

insurer is referred to as insurance risk.(94)

Delineating what is insurance risk is a useful starting point when seeking to

designate a range of activities as the business of insurance. That insurance

risk exists, however, is not the only factor analyzed when defining the

business of insurance.

Because the McCarran-Ferguson Act makes clear Congress's intent that the

states are responsible for regulating the business of insurance, each state has

been left the task of defining what activities fall within the Act. …

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