Group Chap 43: Analysis of Financial and Operational Performance Flashcards

1
Q

Maximization Framework

A
  1. Enterprises can be analyzed on how they maximize owner’s value
    a. Useful paradigm for understanding health plans even though they have no public shareholders
  2. Investors value based on stock price
  3. Management seek superior performance
    a. Stock price only indirectly affected by actions of management
  4. Investors employ valuation models that quantify performance
    a. Unlike stock prices models more directly reflect management
    b. GAAP informs of management’s progress in maximization objective
    c. Discounted future cash flow models estimate value of the corporation by the amount and timing of cash generated by the company and available to owners
  5. Cash available is often but not exclusively in the form of dividends
  6. Value depends on things that management can affect, such as dividends and their long-term growth rate
    a. Value also affected by discount rate in the valuation, reflecting riskiness of the enterprise
  7. Link between value and free cash flows broadly accepted in P/E ratios and PEG ratio
    a. PEG ratio is stock’s P/E divided by annual growth rate
  8. Gordon Constant Growth Model
    a. P = D / (K-G)
    - P = Price per share
    - D = Dividend per share one year from now
    - k = Required rate of return for equity investor
    - G = Growth rate in dividends (in perpetuity)

b. Dividing by D, then P / E approximately = P / D = 1 / (K-G)
- For a constant discount rate k, maximizing value means maximizing growth

  1. Financial Statements relate to objective of maximization
    a. Designed for external readers, mainly owners
    b. GAAP captures performance of the enterprise and translate into models that measure how well shareholder value is being maximized
    c. By contrast statutory designed to measure solvency, for an audience of creditors and regulators
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2
Q

Growth and Return on Equity

A
  1. ROE is a key growth metric
    a. Measures how fast net worth is growing
    b. ROE = Net Income / Sharehold Equity
    c. Suppose a company reinvests all earnings into enterprise and is able to earn same ROE each year
    d. Then earnings will grow by ROE as well
    e. ROE is growth rate if no dividends are paid and no external equity sources are added
  2. Plus ROE reflects limits of growth without external capital
    a. Amount of equity required by an enterprise is result of the requirements of its business model
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3
Q

Factors of Growth (aka DuPont Formula)

A
  1. The DuPont Formula breaks down ROE into metrics that summarize the components of the business model that contribute to its growth.
    a. These metrics suggest operational “toggle switches” for management to improve the performance of the company
  2. First part of DuPont formula is return on assets (aka return on investment)
    a. (Total Asset Turnover) x (Net Profit Margin) = (Return on Assets)
    b. (Revenues / Total Asset) x (Net Income / Revenues) = (Net Income / Total Assets)
  3. Second part of DuPont formula analyzes how financial leverage amplifies return on assets into return on equity
    a. (Return on Assets) x (Total Leverage Ratio) = (Return on Equity)
    b. (Net Income / Total Asset) x (Total Asset / Shareholder Equity) = (Net Income / Shareholder Equity) = ROE
    c. (Net Income / Revenue) x (Revenue / Asset) x (Assets / Equity) = ROE
  4. Total Asset Turnover
    a. How much investment (equity and debt) required to meet the requirements of customers of this business?
  5. Profit Margin
    a. For every dollar of sales, what percent does enterprise earn as a profit?
  6. Return on Assets
    a. What return on all assets can be earned by this enterprise?
  7. Total Leverage Ratio
    a. To what degree can creditors’ money be employed to magnify returns on assets?
    b. Strategies radically different from company to company even if ROE is the same
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4
Q

Ratio Analysis of Three Archetypcal Health Plans

A
  1. Business models can be radically different from company to company, even in the same industry, even if ROE is same
  2. 3 health plans may have the same ROE, but they achieve it in quite different ways
    a. The staff model plan has a higher profit margin than the FFS plan, which is necessary since it has a lower total asset turnover
    b. Greater financial leverage, measured by the total leverage ratio, is used by the staff model plan to achieve the benchmark ROE
    c. The Administrative Services Only (ASO) business has the highest profit margins on much lower total asset turnover
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5
Q

Total Asset Turnover

A
  1. Total Revenue divided by total assets
  2. Changes
    a. Take a long time to implement, or
    b. Require a major acquisition or divestiture
  3. Assets required by health plans include office space, information systems, intangible assets and health care delivery assets
  4. Size and nature of assets vary by model design
    a. Staff model plans have substantial fixed assets and high fixed assets per member
  5. Staff model plans not only require more capital but also can employ debt to finance it
  6. Some plans “rent” information systems or provider capacity so the liabilities and assets are kept off balance sheet, reflected in higher operating expenses
  7. Health plans possess cash and other liquid investments to honor claims by external providers
    a. Liquid assets preferred by state insurance departments to protect plan from failure
    b. Liquid assets vary with organizational structure
    c. Staff models provide care internally, so require less liquid assets for IBNR than FFS
    d. Non-profit Blue Cross Blue Shield possess higher levels of investment assets and mixes of equities to meet BCBS licensure requirements and lack of access to public equity markets
  8. ASO services have neither large fixed assets nor liquid assets for claims IBNR. Revenues per member are low. Total asset turnover tends to be very low
  9. All health plans have
    a. Accounts receivable
    b. Prepaid expense common, including plan’s own insurance
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6
Q

Profit Margins

A
  1. Most common metric by analysts
  2. Most meaningful in periods of stable level of assets and leverage
  3. The Margins Themselves
    a. Profit expressed as percent of total revenues
    - Profit levels are implied by the business model and its impact on investments measured by the total asset turnover
    -the lower the turnover, the higher the margins

b. Include premiums and ASO fee income, but exclude investment income
-Refer to as “Underwriting income” or “Operating income”

c. Operating margin is operating profits divided by revenues

d. Net margin is net income divided by revenues
- Operating profits = Revenues – Health benefits – Admin expenses
- Net income = Operating income – Net interest expense – Income taxes
- “net interest expense” = interest expense – investment income

e. Non-GAAP accounting would include increase in Reserve as expense

4.. Related Expense Ratios
a. These are calculated as the expense item (health benefit expense or administrative expense, respectively) divided by the revenue
b. In a simple insured business:
- Operating Profit Margin = 1 - Health Benefit Ratio - Admin. Expense Ratio

  1. The Same-Size Income Statement
    a. A financial analysis exercise
    - All income statement items are expressed as percentages of revenue
    - Profit margins can be divided into component parts, expressed independently of the size of the enterprise
    - Permits comparisons among health plans and year-over-year comparisons of the same enterprise
    - Differences from peers, and changes in a plan’s results can be immediately understood in terms of their impact on profit margins

b. Administrative Expense Ratio
- Administrative expenses divided by revenues
- Many health plans report administrative expenses in few lines on the income statement
* one line (Operating expense)
* two lines (Operating expense, Depreciation and amortization), or
* three lines, (Sales and marketing, Operating expense, Depreciation and amortization)

  • Administrative activities, expressed as functions
  • Sales and Marketing
    o Rating and underwriting
    o Product Development/market Research
    o Sales and Marketing (except Advertising and Promotion)
    o Commissions (external)
    o Advertising and Promotion
  • Medical and provider management
    o Provider network Management and Services
    o Medical Mgmt./Quality Assurance/Wellness
  • Account and membership administration
    o Enrollment
    o Customer Services
    o Claim and Encounter Capture and Adjudication
    o Total Information System Expenditures (as expensed)
  • Corporate Services
    o Finance and accounting
    o Actuarial
    o Corporate services (HR, Facilities, Legal, Regulatory)
    o Corporate executive / governance
  • Association Dues and License/Filing Fees
  • If an entity has insured products and ASO products, the unadjusted revenue denominator includes fees for which no health care is associated
  • To eliminate distortion, entity needs to allocate admin costs between insured and ASO products. 2 approaches:
  • First, may assume the ASO product operates at breakeven (ratio = 100%)
  • Second, may assume that both ASO and insured products have similar cost structures.

c. Administrative Expenses, PMPM
- Analyzing expenses using member months, rather than revenues, as a denominator
* A member month is one member served during one month
* Costs are expressed per member per month or PMPM
- The PMPM approach is more actionable than the profit margin approach
- The traditional solution for analysts is to divide each of the expense items by the membership to which the expenses apply
* By isolating costs in this standardized form, the PMPM approach has the advantage of providing more actionable information
- Drawback to the PMPM approach is in communications with generalists, including board members or other external audiences who are more familiar with other ratios

d. Further Drill-Downs
- PMPM metrics of expenses can be further analyzed into actionable drivers
- The PMPM values, may be expressed as total costs per FTE X the health plan’s staffing ratio
* (Costs / FTE) x (FTEx / 10,000 Membs) = (Cost / Memb. Month)
- Total Costs per FTE
* (Non-Labor Costs / FTE) + (Staffing Costs / FTE) = (Costs / FTE)
- This analysis is most powerful when it is compared with other health plans, or other measurement periods for the same health plan
* If PMPM customer service costs are high, the source can be pinpointed to either high levels of staff, high compensation, or high non-labor costs
- Variances in the customer service costs per FTE can be analyzed as the product of cost per inquiry and inquiries per FTE per year
* (Inquiries / FTE) x (Cost / Inquiry) = (Cost / FTE)
- Inquiries per FTE per year can be further analyzed into members per FTE and inquiries per member
* (Inquiries / Member) x (members / FTE) = (Inquiries / FTE)

e. Health Benefit Ratio
- Often called medical loss ratio
- Calculated as a percent of premiums, not total revenues
- Health care costs can be analyzed in ways analogous to administrative costs
* (Day / Member) x (Cost / Day) = (Cost / Member)
* (Admission / Member) x (Average lenght of stay) = (Days / Member)
* Analyses of health costs may asist in determining whether variances are attributatble to unit cost or utilization rate differences

  • Companies vary which expenses they include with health benefits, affecting the ratios
  • Medical management costs considered either health benefit or admin expense
  • ACA allows the inclusion of certain medical management activities considered “activities that improve health care quality” and “health information technology to support those activities” in health benefits
  • Some health plans elect to report all medical management as health benefits
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7
Q

Quirks in Administration and Benefit Ratios due to Capitation

A
  1. Capitated health care expenses must be accounted for carefully
    a. Recognition of capitation as an expense implies plan has satisfied its requirements to members served by the capitated provider

b. However, provider’s insolvency could require plan to cover losses

c. Capitation of services affects segmentation of expenses into administrative and health benefits

d. Plan with capitated arrangement that includes medical management and claims processing will have higher benefit ratio and lower administrative ratio
- Due to administrative expenses included with the capitation and treated as benefit expenses

e. 3 approaches may improve comparability
- Remove capitated services from both admin expense and benefits
* Appropriate for specialty services such as mental and pharmaceutical
- Consolidate economics of the capitated entity
* Appropriate for global capitation in which all health benefits are capitated
- When a subset of members subject to global capitation, perform ratios only for members not subject to capitation

  1. Adjustments for Revenue Reporting Differences
    a. Reinsurance
    - Some include reinsurance recoveries as a revenue
    - More useful to consider reinsurance recoveries as offsets to health care costs

b. Commissions
- Sometimes excluded from premiums
- They should be considered admin expense, and revenues should include commissions

c. Investment Income
- “Float” from premium received in advance of claims payments
- Not possible to separate investment returns through float from returns of capital
market activity
- Helpful to group investment returns with capital costs as non-operating income

d. Administrative Services Only Products
- The only revenue is for administrative services such as claim processing, customer service inquiries
- Administrative expenses relative to revenues high
- One way of normalizing ratios is based on “premium equivalents”
* Estimating what premiums would have been if plan bore risk by adding health benefits to fee revenue
* Not appropriate in actual financial reports
* Note that level of administrative expenses different between ASO and fully insured products
- Helpful to look at reports for each product separately (e.g. ASO vs. insured products)
* Can be limited by unavailable data

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8
Q

Return on Assets (ROA)

A
  1. Income divided by total assets
  2. Sometimes called return on investment (ROI)
  3. How profitable business is relative to capital regardless of whether capital is equity or debt
    a. Debt includes claims payable and obligations to employees
  4. Investments (or assets) include office space, furniture and information systems
    a. May also include goodwill and health facilities
  5. Staff model plan has higher fixed assets than FFS and ASO
  6. Environmental conditions of health plan affect assets required
    a. Statutory requirements increase capital needs above what owners may deem necessary
    - Protect from risks of insolvency
    - additional required capital tends to be liquid since less likely to be discounted by regulators

b. Statutory requirements also affect operating decisions, because to achieve the same ROA as without such requirements, profit margins must be higher.External sources of capital
- Publicly traded companies have greater access to equity
* Tend to operate with thinner capital
- Management may prefer to retain more capital
* Not optimal capital efficiency but saves management time from consulting with regulators

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9
Q

Total Leverage Ratio

A
  1. Total Leverage Ratio = Assets / Equity = (Liability + Equity) / Equity
  2. Leverage amplifies ROA
    a. Example: if appreciation on your home is 5% but 75% of its value is debt, then ROE is 20% (5% / (1-75% debt))
  3. Long-term debt unusual unless related to fixed assets
    a. Example: Long-term debt employed by plans with provider-related assets, such as hospitals
  4. Frequently, liabilities are current (due within a year) and relate to claims payable
  5. Administrative cost of processing claims also included as a liability
  6. Lower days of claims payable in the staff model plan than FFS plans
    a. Calculated as Claims payable / Annual claims * 365
  7. Prepaid premiums are common in plans that serve Medicare Advantage members
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10
Q

Key Qualifications to the Analysis

A

Adjustments in financials for unusual items called normalization
a. Extraordinary for accounting purposes
b. Disputed items resolved after financial closing so reported in a later period
c. Expenses discovered after financial statement closing
d. Significant IBNR adjustments
e. Legal Settlements
f. Start-up costs for new products

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11
Q

Other Financial Analyses and Applications

A

1. Year-over-Year
a. Looks at financial ratios over different 12 month periods

b. Better than successive quarter approach
- Marketing and medical management exhibit seasonal patterns

c. Helpful to segment the source of change in revenues and expenses
- Separating membership and premium rate growth rates
- Growth interpreted in light of changes in the nature of the product

d. One risk: historical results cause the bar to be set too high or too low

2. Comparisons with Similar Health Plans
a. Insurers being compared should have similar business models and products
- Similar geographic focus, capital cost conditions, and size also helpful

b. Data is available, through NAIC, SEC
- Disadvantage: Quality/reliability of data may not be good
- Disadvantage: Segmentation by product may not be available
- Disadvantage: Cost definitions may vary from insurer to insurer

c. Data available through commercial sources
- Advantage: More precise cost information and product segmentation
- Disadvantage: Identities of the insurers contributing to data set may not be known to the user

3. Financial Planning and Analysis
a. Involves establishing goals and measuring performance relative to those goals

b. Financial planning complements financial analysis
- Prospectively in budgets
- Retrospectively review of performance compared to objectives

c. In addition to membership, prices, and costs, estimate the effect on Risk Based Capital

d. Interim results measured against long-term projections

e. Performance compared with peers, through statutory statements, SEC, or commercial

f. Discount rate should reflect riskiness of business

g. Time horizons should reflect planning process
- Future years of highly specific projections should be limited by a skeptical view of the analyst’s ability to achieve reliability
- Three to five years common
- Helpful to add a terminal value reflecting the value of the cash flows past the reliable planning horizon
- The Gordon Constant Growth Model is often employed which has an infinite horizon employing highly simplified assumptions

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12
Q

External Manifestation of Shareholder Value

A
  1. Maximization of owners’ value is useful for analysis
  2. While stock prices sometimes reflect short-term phenomena, planning should be long term
    a. Analysts may not understand insurance plan operational realities
    b. May be impossible to communicate strategies to analysts
    c. Errant decisions seldom lead to hostile takeovers
    d. To focus on share price rather than health plan performance may harm, rather than enhance long term shareholder value
  3. External manifestations (through share price) of shareholder value best achieved through:
    a. Shrewd management of earnings and growth
    b. Maximum feasible transparency
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